Cost II CH4 (1) standard costing flexible budgeting and variance analysis

Cost accounting two chapter 4

1. Chapter- 4 Standard Costing, Flexible Budgeting and Variance Analysis 8:51 AM 1

2. 8 : 51 AM 2 Standard Costing Standard Cost is defined as “ the predetermined cost that is calculated at the management’s standards of efficient operations and the relevant necessary expenditure. The Standard Cost serves as a basis of cost control and as a measure of productive efficiency, when ultimately posed with an actual cost. Standard Costs are used to compare the actual costs with the standard cost with a view to determine the variances , if any, and analyze the causes of variances and take proper measure to control them.

3. 8 : 51 AM 3 Standard Costs and Estimated Costs: The distinction between Standard Costs and Estimated Costs should be clearly understood. While both Standard Costs and Estimated Costs are predetermined costs, their objectives are different. The main differences between the two types of costs are: Estimated Costs are intended to determine what the costs ‘will’ be . Standard Costs aim at what costs ‘should’ be. Estimated Costs are based on average of past actual figures adjusted for anticipated changes in future. Standard Costs are planned costs determined on a scientific basis. In Estimated Costing Systems, stress is not so much on cost control, but costs are used for other purposes such as fixation of prices to be quoted in advance. Standard Costs serve as effective tools for cost control.

4. 8 : 51 AM 4 Advantages of Standard Costing: 1. Es t ablis h es y ar d - stic k s agai n st which the efficiency of actual performances is measured. 2. The s tandard s pro v id e s moti v ati o n t o w ork with greater effort and vigilance for achieving the standard. This increase efficiency and productivity all round. 3. Cost are available with promptitude for various purposes like fixation of selling prices, pricing of interdepartmental transfers, ascertaining the value of costing stocks of work-in-progress and finished stock and determining idle capacity.

5. 8 : 51 AM 5 Standard Costing is an exercise in planning - it can be very easily fitted into and used for budgetary planning. Standard Costing system facilities delegation of authority and fixation of responsibility for each department or individual. When constantly reviewed, the standards provide means for achieving cost reduction. Standard costs assist in performance analysis by providing ready means for preparation of information. Production and pricing policies may be formulated in advance before production starts. This helps in prompt decision-making. Standard Costing optimizes the use of plant capacities, current assets and working capital

6. 8 : 51 AM 6 Limitations of standard costing 1. Es t ablis h me n t o f sta n dard costs is diffic u lt in practice. I n cour s e o f t i me, sometimes e v en in a s hort period the standards become rigid. Inaccurate, unreliable and out of date standards do more harm than benefit. S o met i m e s , s tandard s create ad v erse psychological effects. – If the standard is set at high level, its non achievement would result in frustration and build-up of resistance.

7. 8 : 51 AM 7 Setting of Standard Costs: W hile setting production costs standards, the following preliminaries should be considered: Study of the technical & operational aspects of the concern Review of the existing costing system and the cost records and forms in use. The type of standard to be used, i.e, The choice of a particular type of standard will depend upon two factors, viz. which type would be most effective for cost control in the organization, and whether the standards will be merged in the accounting system or kept outside the accounts as statistical data.

8. 8 : 51 AM 8 D. Proper classification of the accounts so that variances may be determined in the manner desired. E . Fixat i on of res p o n s i bi l it y for se t ting standards.

9. A budget is a plan for the future . Hence, budgets are planning tools, and they are usually prepared prior to the start of the period being budgeted . However, the comparison of the budget to actual results provides valuable information about performance . Therefore, budgets are both planning tools and performance evaluation tools

10. The Use of Variance A Variance is the difference between actual results and expected performance. The expected performance is also called Budgeted Performance , which is a point of reference for making comparisons Variance support managers in implementing their strategies Variances are also used in performance evaluation and to motivate managers .

11. Static Budgets and Static-Budget Variance The static budget, or master budget, is based on the level of output planned at the start of the budget period. The master budget is called a static budget because the budget for the period is developed around a single (static) planned output level. So in static budget every amount we are going to use is budgeted or forecasted there is no single actual information or amount we are going to use in developing static budgets. Discrepancies resulting from the fluctuating cost of raw materials or initial budgeting errors appear on a static budget as static budget variance .

12. The Static-budget variance is the difference between the actual result and the corresponding budgeted amount in the static budget. Static budget variance = actual Result– static budgeted amount

13. A favorable variance —denoted “F”, has the effect, when considered in isolation, of increasing operating income relative to the budgeted amount. For revenue items “F” means actual revenue exceed budgeted revenues. For Cost items, “F” means actual costs are less than budgeted costs. An Unfavorable Variance —denoted “U”, has the effect, when viewed in isolation, of decreasing operating income relative to the budgeted amount. Unfavorable variances are also called adverse variances . For cost items, “U” means actual costs are greater than Budgeted costs. For revenue item, “U” means the actual revenue is less than the budgeted revenue.

14. Flexible Budget A flexible budget calculates budgeted revenues and budgeted costs based on the actual output in the budget period. The flexible budget is prepared at the end of the period, after the actual output is known. The flexible budget is the hypothetical budget that would have prepared at the start of the budget period if it had correctly forecast the actual output of the company. The only difference between the static budget and the flexible budget is that the static budget is prepared for the planned output , where as the flexile budget is based on the actual output .

15. The Flexible Budget Variance will be favorable for revenue items when the actual result is greater than the flexible budget amount, and it will be unfavorable when the actual amount is less than the flexible budget amount. For the cost item the reverse is true . The Sales volume variance for the revenue item will be favorable when the flexible budget amount is greater than the static budget amount, but when the reverse is occurred it would be unfavorable. For the cost item the sales volume variance will be favorable only when the flexible budget amount is less than the static-budget amount , it will also be unfavorable when the reverse is true. The sales volume variance arise because of the solely difference between the actual quantity or volume and the quantity that is expected to be sold in the static budget.

16. Price Variances and Efficiency Variances A price variance is the difference between actual price and budgeted price multiplied by actual input quantity , such as direct materials purchased or used. A price variance is sometimes called an input-price variance or rate variance , especially when referring to a price variance for direct manufacturing labor.

17. An efficiency variance is the difference between actual input quantity used and budgeted input quantity allowed for actual output, multiplied by budgeted price of inputs. An efficiency variance is sometimes called a usage variance . The idea here is that the company is inefficient if it uses a lager quantity of input than the budgeted quantity for its actual level of output; the company is efficient if it uses a smaller quantity of inputs than was budgeted for that output level.

18. The above tables show the flexible-budget based variance analysis for Xyz Company, which subdivided the $93,100 unfavorable static-budget variance for operating income into two parts: a flexible-budget variance of $29,100 U and a sales volume variance of $64,000 U. The Sales volume variance is the difference between a flexible-budget amount and the corresponding static-budget amount. The flexible-budget variance is the difference between an actual result and the corresponding flexible budget amount.

19. In variance analysis there are three different levels, level 1 refers to the statics budget variance , level 2 refers to Flexible budget variance and s ales volume variance and level 3 reference to price variance and efficiency variance. , but before that we have to discuss about standards for material and labor.

20. Standards for material and labor A standard is a carefully determined price, cost or input quantity amount that is used as a benchmark for judging performance . Standards are usually expressed on a per-unit basis A standard input is a carefully determined quantity of input A standard price is a carefully determined price that a company expects to pay for a unit of input. A standard cost is a carefully determined cost of a unit of output

21. Measuring Mix and Yield Variances remember that the levels of variances detail introduced in previous section included the static budget variance (level 1) , the flexible-budget variance (level 2), and the sales volume variance (level 2). In this section we will discuss about how sales volume variance (SVV) introduced in previous section can be further analyzed when there are multiple customers and products

22. Sales Mix and Sales Quantity Variances Sales Mix Variance The sales mix variance is the difference between (1) budgeted contribution margin for the actual sales mix and (2) budgeted contribution margin for the budgeted sales mix . The formula for the computation of sales mix variance is:

23. Sales Quantity Variance The sales quantity variance is the difference between (1) budgeted contribution margin based on actual units sold of all products at the budgeted mix and (2) contribution margin in the static budget (which is based on budgeted units of all products to be sold at budgeted mix). The formula for the computation of sales quantity variance is:

24. Market Share and Market Size Variances Market Share Variance The market share variance is the difference in budgeted contribution margin for actual market size in units caused solely by actual market share being different from budgeted market share . The formula for computing the market share variance is

25. Market Size Variance The market size variance is the difference in budgeted contribution margin at the budgeted market share caused solely by actual market size in units being different from budgeted market size in units . The formula for computing the market size variance is

26. Example: The Payne Company manufactures two types of vinyl flooring. Budgeted and actual operating data for 2012 are as follows:

27. In late 2011, a marketing research firm estimated industry volume for commercial and residential vinyl flooring for 2012 at 800,000 rolls . Actual industry volume for 2012 was 700,000 rolls Required Compute the sales-mix variance and the sales-quantity variance by type of vinyl flooring and in total Compute the market-share variance and the market-size variance What insights do the variances calculated in requirements 1 and 2 provide about Payne Company’s performance in 2012

28. Note that the algebraic sum of the market-share variance and the market-size variance is equal to the sales-quantity variance : $5,950,000F + $4,250,000U = $1,700,000F Both the total sales-mix variance and the total sales-quantity variance are favorable . The favorable sales-mix variance occurred because the actual mix comprised more of the higher margin commercial vinyl flooring . The favorable total sales quantity variance occurred because the actual total quantity of rolls sold exceeded the budgeted amount . The company’s large favorable market share variance is due to a 12% actual market share compared with a 10% budgeted market share . The market size variance is unfavorable because the actual market size was 100,000 rolls less than the budgeted market size . Payne’s performance in 2012 appears to be very good. Although overall market size declined , the company sold more units than budgeted and gained market share.

29. Mix and Yield Variances for Substitutable Inputs Consider ABC Corporation, which makes tomato ketchup. To produce ketchup of a specified consistency, color, and taste, ABC mixes three types of tomatoes grown in different regions: Latin American tomatoes (Latoms), California tomatoes (Caltoms), and Florida tomatoes (Flotoms). ABC’s production standards require 1.60 tons of tomatoes to produce 1 ton of ketchup ; 50% of the tomatoes are budgeted to be Latoms, 30% Caltoms, and 20% Flotoms. The direct material inputs budgeted to produce 1 ton of ketchup are as follows

30. Budgeted average cost per ton of tomatoes is $123.20 ÷ 1.60 tons = $77 per ton Because ABC uses fresh tomatoes to make ketchup, no inventories of tomatoes are kept. Purchases are made as needed, so all price variances relate to tomatoes purchased and used. Actual results for June 2012 show that a total of 6,500 tons of tomatoes were used to produce 4,000 tons of ketchup:

31. Direct Materials Price and Efficiency Variances Exhibit 1 presents in columnar format the analysis of the flexible budget variance for direct materials . The materials price and efficiency variances are calculated separately for each input material and then added together. The variance analysis prompts ABC to investigate the unfavorable price and efficiency variances.

32. Direct Materials Mix and Direct Materials Yield Variances The total direct materials mix variance is the difference between (1) budgeted costs for actual mix of actual total quantity of direct materials used and (2) budgeted cost of budgeted mix of actual total quantity of direct materials used. Holding budgeted input mix constant, the direct materials yield variance is the difference between (1) budgeted cost of direct materials based on actual total quantity of direct materials used and (2) flexible budget cost of direct materials based on budgeted total quantity of direct materials allowed for actual output produced. Exhibit 2 presents the direct materials mix and yield variances for the ABC Corporation.