activity selection while ABC focuses on strategic selection of products, customers, and/or distribution channels.
Setting Standards
Standards come from three main sources: experience, theoreti- cal constructs, and practical references.
Experience gives the most realistic standard. Based on what was done in the past, it assumes those circumstances will trans- late well into the future. Unfortunately, this can lead to a rather cavalier budgeting exercise along the lines of “Take what we did last year, add or subtract 10%, and call it done.”
Theoretical constructs are less satisfactory. The ideal stan- dard usually cannot be met. It leads to unfavorable variances as it assumes minimum prices for all costs and optimal usage of all resources at 100% manufacturing capacity.
Practical standards, while often set as an intentional chal- lenge to line management, can usually be reached. These stan- dards should consider at least four things:
• Prices for materials are not always going to be the lowest.
• Labor is not 100% efficient.
• Normal spoilage will occur.
• Operations do not run at 100% capacity over time.
Most businesses presently use practical standards.
You should know that a new manufacturing environment is developing that stresses reaching ideal standards. This empha- sis comes because there’s too much slack and waste built into practical standards. Management efforts like Total Quality Management (TQM) look to cut this waste. Positive results have convinced some that businesses should now move toward ideal standards. Still, “stress” seems to be the operative word there and the jury is still out on how widely its use will spread.
The unit price standard sets the price at which direct materi- als should be purchased. Each material needs its own standard.
It should be contingent on the sales forecast. Suppliers need to have an estimate of the total quantity to determine the amount of any discount. Also, the company needs to give suppliers the quality and delivery standards before a standard price per unit can be set.
Direct labor price standards usually come straight from a union contract or other negotiations between management and personnel. Any known pay rate increases during the year must figure into the computation. Direct labor efficiency standards can come from union contract work rules or predetermined per- formance standards for the amount of hours that should go into the production of one finished unit. Any hiring contemplated should consider the learning curve effects: learning curve ineffi- ciency is most noticeable in complex processes that require dexterity, as opposed to processes that are fully automated.
Setting factory overhead standards usually involves input from many departments. Standard costing establishes a single cost per unit, which is applied despite fluctuations in activity.
Because of the amount of information, time, and interdepart- mental coordination involved, companies that use standard costing often establish a separate department for this task.
Once the standards are in place, management can budget for costs and production. After comparing the budgeted stan- dards with actual performance, management then adjusts oper- ations to track the budget more closely. Also, as noted earlier, management should review the standards periodically to keep them current.
Analyzing Variances
Variance analysis looks at the difference between actual and standard costs. It can measure performance, correct inefficien- cies, and deal with any accountability functions.
Variances can be favorable or unfavorable. Favorable vari- ance happens when the actual amount is less than the standard amount. Favorable variances are credits; they reduce produc- tion costs. Unfavorable variance occurs when the actual amount is greater than the standard amount. Unfavorable variances are debits; they increase production costs.
Variances come in three main flavors:
• price
• efficiency
• volume
Factors that can cause price variance include changes in market prices/rates, differences between standard and actual input quality (i.e., higher-quality inputs cost more per unit than lower- quality inputs), changes in delivery channels for materials input, changes in the mix of worker skill levels, outdated standard prices/rates, and random variation in prices/rates.
Efficiency variances can come from more or less efficient usage of materials, greater or lesser worker productivity, direct material quality, difficulty of working with materials, worker pro- ductivity and efficiency, less skilled workers, lower wage rates, lower worker productivity and efficiency, inappropriate stan- dards (e.g., ideal standards or outdated standards), and random variation in materials usage and/or worker productivity.
Output variances can accompany any of the causes of price and efficiency variances. In addition, output can be affected when one unit’s outputs become another unit’s inputs.
Standard Costing Critique
To many managers, standard costing seems out of step with the philosophy of cost management systems and activity-based management. They feel that standard costing puts too much focus on direct labor cost and efficiency, particularly as labor costs tend to become fixed rather than variable. In turn, auto- mated manufacturing processes tend to be more consistent in meeting production specifications.
Individual variances are lumped together in broad cate- gories. Specific product lines and production batches can be overlooked or managers find variances too late to be useful.
Flexible budget systems can also be slow. Shorter product life Favorable and
Unfavorable Don’t be misled by the terms “favorable” and unfavorable.” A favorable variance does not necessari- ly mean good, nor does an unfavor- able variance mean bad. Management should analyze all variances to deter- mine the cause.This analysis would include determining if the standard is correct. In reviewing standards, as always, compare costs and benefits.
cycles mean that standards are relevant only for a short time and the cost to update standards can grow out of proportion with the benefits. Standard costing’s tight focus on cost mini- mization ignores other significant concerns, like improving product quality or customer service.
Many traditional companies are experimenting with phasing out aspects of standard costing in favor of other cost accounting techniques. Many features can fit comfortably with techniques covered in this chapter and the next. In those companies, stan- dard costing will probably remain as the primary budget- planning tool.