ACCA F5 Performance Management - 2010 - Study text

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Paper F5

Performancemanagement

CHAPTER

Standard costing

Contents

1 Using and deriving standard costs

2 Allowing for waste and idle time

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Using and deriving standard costs

 Standard units of product or service

 Standard cost defined

 Standard costing

 The uses of standard costing

 Deriving a standard cost

 Types of standard

 Reviewing standards

1 Using and deriving standard costs

1.1 Standard units of product or service

A standard costing system may be used when an entity produces standard units of

product or service that are identical to all other similar units produced. Standard costing

is usually associated with standard products, but can be applied to standard services too.

A standard unit should have exactly the same input resources (direct materials,

direct labour time) as all other similar units, and these resources should cost exactly

the same. Standard units should therefore have the same cost.

1.2 Standard cost defined

A standard cost is a predetermined unit cost based on expected direct materials

quantities and expected direct labour time, and priced at a predetermined rate per

unit of direct materials and rate per direct labour hour and rate per hour of

overhead.

 Standard costs of products are usually restricted to production costs only, not

administration and selling and distribution overheads.

 Overheads are normally absorbed into standard production cost at an

absorption rate per direct labour hour.

Example

The standard cost of a Product XYZ might be:

£ £

Direct materials:

Material A: 2 litres at $4.50 per litre 9.00

Material B: 3 kilos at $4 per kilo 12.00

18.00

Direct labour

Chapter 9: Standard costing

Grade 1 labour: 0.5 hours at $20 per hour 10.00

Grade 2 labour: 0.75 hours at $16 per hour 12.00

22.00

Variable production overheads: 1.25 hours at $4 per hour 5.00

Fixed production overheads: 1.25 hours at $40 per hour 50.00

Standard (production) cost per unit 95.00

Who sets standard costs?

Standard costs are set by managers with the expertise to assess what the standard

prices and rates should be. Standard costs are normally reviewed regularly,

typically once a year as part of the annual budgeting process.

 Standard prices for direct materials should be set by managers with expertise in

the purchase costs of materials. This is likely to be a senior manager in the

purchasing department (buying department).

 Standard rates for direct labour should be set by managers with expertise in

labour rates. This is likely to be a senior manager in the human resources

department (personnel department).

 Standard usage rates for direct materials and standard efficiency rates for direct

labour should be set by managers with expertise in operational activities. This

may be a senior manager in the production or operations department, or a

manager in the technical department.

 Standard overhead rates should be identified by a senior management

accountant, from budgeted overhead costs and budgeted activity levels that

have been agreed in the annual budgeting process.

1.3 Standard costing

Standard costing is a system of costing in which:

 all units of product (or service) are recorded in the cost accounts at their

standard cost, and

 the value of inventory is based on standard production cost.

Differences between actual costs and standard costs are recorded as variances, and

variances are reported at regular intervals (typically each month) for the purpose of

budgetary control.

Standard costing may be used with either a system of absorption costing or a system

of marginal costing. The only difference is in the valuation of inventory and the

calculation of variances for fixed overheads.

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1.4 The uses of standard costing

Standard costing has four main uses.

 It is an alternative system of cost accounting. In a standard costing system, all

units produced are recorded at their standard cost of production.

 When standard costs are established for products, they can be used to prepare

the budget.

 It is a system of performance measurement. The differences between standard

costs (expected costs) and actual costs can be measured as variances. Variances

can be reported regularly to management, in order to identify areas of good

performance or poor performance.

 It is also a system of control reporting. When differences between actual results

and expected results (the budget and standard costs) are large, this could

indicate that operational performance is not as it should be, and that the causes

of the variance should be investigated. Management can therefore use variance

reports to identify whether control measures might be needed, to improve poor

performance or continue with good performances.

When there are large adverse variances, this might indicate that actual performance

is poor, and control action is needed to deal with the weaknesses.

When there are large favourable variances, and actual results are much better than

expected, management should investigate to find out why this has happened, and

whether any action is needed to ensure that the favourable results continue in the

future.

Variances and controllability

The principle of controllability should be applied in any performance

management system

When variances are used to measure the performance of an aspect of operations, or

the performance of a manager, they should be reported to the manager who is:

 responsible for the area of operations to which the variances relate, and

 able to do something to control them.

There is no value or practical purpose in reporting variances to a manager who is

unable to do anything to control performance by sorting out problems that the

variances reveal and preventing the variances from happening again.

It is also unreasonable to make a manager accountable for performance that is

outside his control, and for variances that he can do nothing about.

1.5 Deriving a standard cost

A standard variable cost of a product is established by building up the standard

materials, labour and production overhead costs for each standard unit.

Chapter 9: Standard costing

In a standard absorption costing system, the standard fixed overhead cost is a

standard cost per unit, based on budgeted data about fixed costs and the budgeted

production volume.

Example

A company manufactures two products, X and Y. In Year 1 it budgets to make 2,000

units of Product X and 1,000 units of Product Y. Budgeted resources per unit and

costs are as follows:

Product X Product Y

Direct materials per unit:

Material A 2 units of material

1.5 units of

material

Material B 1 unit of material 3 units of material

Direct labour hours per unit 0.75 hours 1 hour

Costs

Direct material A $4 per unit

Direct material B $3 per unit

Direct labour $20 per hour

Variable production overhead $4 per direct labour hour

Fixed production overheads per unit are calculated by applying a direct labour hour

absorption rate to the standard labour hours per unit, using the budgeted fixed

production overhead costs of $120,000 for the year.

Required

Calculate the standard full production cost per unit of:

(a) Product X, and

(b) Product Y

Answer

First calculate the budgeted overhead absorption rate.

Budgeted direct labour hours hours

Product X: (2,000 units × 0.75 hours)

1,500

Product Y (1,000 units × 1 hour)

1,000

2,500

Budgeted fixed production overheads $120,000

Fixed overhead absorption rate/hour $48

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Product X Product Y

Direct materials

Material A

(2 units × $4)

(1.5 units ×

$4)

Material B

(1 unit × $3)

(3 units × $3)

Direct labour

(0.75 hours × $20)

(1 hour × $20)

Variable production overhead

(0.75 hours × $4)

(1 hour × $4)

Standard variable prod’n cost

Fixed production overhead

(0.75 hours × $48)

(1 hour × $48)

Standard full production cost

Deriving the standard usage for materials

The standard usage for direct materials can be obtained by using:

 historical records for material usage in the past, or

 the design specification for the product.

Deriving the standard efficiency rate for labour

The standard efficiency rate for direct labour can be obtained by using:

 historical records for labour time spent on the product in the past, or

 making comparisons with similar work and the time required to do this work, or

 ‘time and motion study’ to estimate how long the work ought to take.

Deriving the standard price for materials

The standard price for direct materials can be estimated by using:

 historical records for material purchases in the past, and

 allowing for estimated changes in the future, such as price inflation and any

expected change in the trade discounts available.

Deriving the standard rate of pay for labour

Not all employees are paid the same rate of pay, and there may be differences to

allow for the experience of the employee and the number of years in the job. There

is also the problem that employees may receive an annual increase in pay each year

to allow for inflation, and the pay increase may occur during the middle of the

financial year.

 The standard rate of pay per direct labour hour will be an average rate of pay for

each category or grade of employees.

 The rate of pay may be based on current pay levels or on an expected average

pay level for the year, allowing for the expected inflationary pay rise during the

year.

Chapter 9: Standard costing

1.6 Types of standard

Standards are predetermined estimates of unit costs but how is the level of

efficiency inherent in the estimate determined? Should it assume perfect operating

conditions or should it incorporate an allowance for waste and idle time? The

standard set will be a performance target and if it seen as unattainable this may

have a detrimental impact on staff motivation. If the standard set is too easy to

attain there may be no incentive to find improvements.

There are four types of standard, and any of these may be used in a standard costing

system:

 Ideal standards. These assume perfect operating conditions. No allowance is

made for wastage, labour inefficiency or machine breakdowns. The ideal

standard cost is the cost that would be achievable if operating conditions and

operating performance were perfect. In practice, the ideal standard is not

achieved.

 Attainable standards. These assume efficient but not perfect operating

conditions. An allowance is made for waste and inefficiency. However the

attainable standard is set at a higher level of efficiency than the current

performance standard, and some improvements will therefore be necessary in

order to achieve the standard level of performance.

 Current standards. These are based on current working conditions and what the

entity is capable of achieving at the moment. Current standards do not provide

any incentive to make significant improvements in performance, and might be

considered unsatisfactory when current operating performance is considered

inefficient.

 Basic standards. These are standards which remain unchanged over a long

period of time. Variances are calculated by comparing actual results with the

basic standard, and if there is a gradual improvement in performance over time,

this will be apparent in an improving trend in reported variances.

When there is waste in production, or when idle time occurs regularly, current

standard costs may include an allowance for the expected wastage or expected idle

time. This is considered in more detail later.

Types of standard: behavioural aspects

One of the purposes of standard costing is to set performance standards that

motivate employees to improve performance. The type of standard used can have

an effect on motivation and incentives.

 Ideal standards are unlikely to be achieved. They may be very useful as long

term targets and may provide senior managers with an indication of the

potential for savings in a process but generally the ideal standard will not be

achieved. Consequently the reported variances will always be adverse.

Employees may becoming de-motivated when their performance level is always

worse than standard and they know that the standard is unachievable.

 Current standards may be useful for producing budgets as they are based on

current levels of efficiency and may therefore give a realistic guide to resources

required in the production process. However current standards are unlikely to

motivate employees to improve their performance, unless there are incentives

Paper F5: Performance management

for achieving favourable variances (for achieving results that are better than the

standard), such as annual cash bonuses.

 Basic standards will not motivate employees to improve their performance as

they are based on achievable conditions at some time in the past. They are also

not useful for budgeting because they will often be out of date. In practice, they

are the least common type of standard.

 Attainable standards are the most likely to motivate employees to improve

performance as they are based on challenging but attainable targets. It is for this

reason that standards are often based on attainable conditions. However, a

problem with attainable standards is deciding on the level of performance that

should be the target for achievement. For example, if an attainable standard

provides for some improvement in labour efficiency, should the standard

provide for a 1% improvement in efficiency, or a 5% improvement, or a 10%

improvement?

1.7 Reviewing standards

How often should standards be revised? There are several reasons why standards

should be revised regularly.

 Regular revision leads to standards which are meaningful targets that employees

may be motivated to achieve (for example, through incentive schemes).

 Variance analysis is more meaningful because reported variances should be

realistic.

 In practice, standards are normally reviewed annually. Standards by their nature

are long-term averages and therefore some variation is expected over time. The

budgeting process can therefore be used to review the standard costs in use.

Chapter 9: Standard costing

Allowing for waste and idle time

 Materials and waste

 Materials wastage in standard costing

 Idle time and standard costing

2 Allowing for waste and idle time

2.1 Materials and waste

Waste is an unavoidable feature of some production processes. The actual amount

of materials wasted may vary from one period to another, but there may be a

standard rate of wastage or a ‘normal’ rate of loss which is a measure of the average

rate of wastage or loss.

Process costing, normal loss and abnormal loss

In process costing systems, an allowance is made for ‘normal loss’, which is the

average expected rate of loss or wastage in the process. Normal loss is not given any

cost, and the costs of actual production are based on expected output after allowing

for the normal loss. If actual loss differs from normal loss, the difference is reported

as abnormal loss (which is given a cost) or abnormal gain (which is given a value).

You may be familiar with process costing from your earlier studies, but a simple

example will be used to explain how the concept of normal loss is used.

Example

A company manufactures a product in a process production system. There is some

wastage in production, and normal loss is 10% of the number of units input to the

process.

During December, 10,000 kilos were input to the process and total costs of

production were $81,000. Actual output from the process was 8,600 kilos.

What was the cost of finished output in the month and what was the cost of the

abnormal loss?

Answer

Input was 10,000 kilos. Normal loss (expected loss) is 10% of input; therefore the

expected output is 9,000 kilos.

Paper F5: Performance management

The cost per unit produced is calculated as:

Costs of production

Expected units of output

In this example, this is $81,000/9,000 kilos = $9 per kilo.

Abnormal loss is the amount by which actual loss (1,400 kilos) exceeds normal loss

(1,000 kilos). Abnormal loss is therefore 400 kilos, and abnormal loss is given a cost.

The cost per unit of abnormal loss is the same as the cost per unit of finished output.

Abnormal loss is written off as an expense to profit or loss.

In this example:

 The cost of finished output = 8,600 kilos × $9 per kilo = $77,400.

 Cost of abnormal loss = 400 kilos × $9 per kilo = $3,600 (written off as an expense

to profit or loss).

Abnormal gain

Abnormal gain occurs when actual loss is less than the normal loss. Abnormal loss

is given a value, in the same way that abnormal loss is given a cost. Whereas

abnormal loss is written off to profit or loss as an expense, abnormal gain is treated

as an adjustment that adds to profit in the period.

In the previous example, if actual output had been 9,200 kilos (rather than 8,600

kilos):

 There cost per unit of finished output would be the same as before, $9 per kilo.

 There would be abnormal gain = 9,200 – 9,000 kilos = 200 kilos.

 The cost of finished output = 9,200 kilos × $9 per kilo = $828500

 Value of abnormal gain = 200 kilos × $9 per kilo = $1,800 (taken to profit or loss,

as an adjustment that increases profit for the period).

2.2 Materials wastage in standard costing

An allowance for expected loss may also be included in a standard cost, in a similar

way. The standard cost can be based on the expected quantity of input materials

required to produce one unit of output.

Example

A company manufactures a product in a process production system. There is some

wastage in production, and normal loss is 10% of the number of units input to the

process.

The standard price per unit of direct material is $4.50 per unit.

ACCA F5 Performance Management - 2010 - Study text - Emile Woolf Publishing

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