Chapter 17 Behavioural Aspects of Standard Costing

1.      Objectives

1.1       Calculate planning and operational variances for materials, labour, overhead and sales.
1.2       Calculate a revised budget.
1.3       Identify and explain those factors that could and could not be allowed to revise an original budget.
1.4       Describe the dysfunctional nature of some variances in the modern environment of JIT and TQM.
1.5       Discuss the behavioural problems resulting from using standard costs in rapidly changing environments.

2.      Planning and Operational Variances

2.1       Standards or plans are normally based on the environment that is anticipated when the targets are set. However, if the environment is different from that anticipated, actual performance should be compared with a standard which reflects these changed conditions, i.e. an ex post variance analysis approach.

2.2	Planning and operational variances
	(a)       A planning variance (or revision variance) compares an original standard with a revised standard that should or would have been used if planners had known in advance what was going to happen. (b)       An operational variance (or operating variance) compares an actual result with the revised standard.

2.3       Total planning and operational variances

2.3.1

Example 1

At the beginning of 2012, ABC set a standard marginal cost for its major product of $25 per unit. The standard cost is recalculated once each year. Actual production costs during August 2012 were $304,000, when 8,000 units were made. With the benefit of hindsight, the management of ABC realizes that a more realistic standard cost for current conditions would be $40 per unit. The planned standard cost of $25 is unrealistically low. Required: Calculate the planning and operational variances. Solution: With the benefit of hindsight, the realistic standard should have been $40. The variance caused by favourable or adverse operating performance should be calculated by comparing actual results against this realistic standard.     $   Revised standard cost of actual production (8,000 × $40) 320,000   Actual cost 304,000   Total operational variance 16,000 (F) The variance is favourable because the actual cost was lower than would have been expected using the revised basis.   $   Revised standard cost (8,000 units × $40) 320,000   Original standard cost (8,000 units × $25) 200,000   Total planning variance 120,000 (A) It is an adverse variance because the original standard was too optimistic, overestimating the expected profits by understating the standard cost. More simply, it is adverse because the revised cost is much higher than the original cost.   $   Operational variance 16,000 (F) Planning variance 120,000 (A) Total 104,000 (A) If traditional variance analysis had been used, the total cost variance would have been the same, but all the blame would appear to lie on actual results and operating inefficiencies (rather than some being due to faulty planning).   $   Standard cost of 8,000 units (× $25) 200,000   Actual cost of 8,000 units 304,000   Total cost variance 104,000 (A)

 

 

2.4       Operational price and usage variances

2.4.1

Example 2

Suppose a budget is prepared which includes a raw materials cost per unit of product of $2 (2 kg of copper at $1 per kg). Due to a rise in would prices for copper during the year, the average market price of copper rises to $1.50 per kg. During the year, 1,000 units were produced at a cost of $3,250 for 2,200 kg of copper. Required: Calculate the operational price and usage variances. Solution:   $   Revised standard price of actual materials ($1.50 × 2,200 kg) 3,300   Actual price of actual materials (2,200 kg) 3,250   Operational price variance 50 (F)   Kgs   Standard quantity at actual units (1,000 units × 2kg) 2,000   Actual usage 2,200   Operational usage variance in kgs 200 (A) × revised standard cost per kg × $1.50   Operational usage variance in $ 300 (A) The two variances of course reconcile to the total variance as previously calculated.   $   Operational price variance 50 (F) Operational usage variance 300 (A) Total operational variance 250 (A)

 

2.5       Planning price and usage variances

2.5.1

Example 3

The standard materials cost of a product is 5kgs × $7.50 per kg = $37.50. Actual production of 10,000 units used 54,400 kgs at a cost of $410,000. In retrospect it was realized that the standard materials cost should have been 5.3 kgs per unit at a cost of $8 per kg. Required: Calculate the materials planning variances in as much detail as possible. Solution: Total materials planning variance $   Original flexed budget cost (10,000 × $37.50) 375,000   Revised flexed budget cost (10,000 × 5.3 kg × $8) 424,000     49,000 (A) Planning price variance: Actual units × revised standard usage × (original standard price – revised standard price) = 10,000 units × 5.3 kgs × $(7.5 – 8.0) = $26,500 (A) Planning usage: (Original standard usage – revised standard usage) × actual units × original standard price = (5 kgs – 5.3 kgs) × 10,000 units × $7.50 = $22,500 (A)

 

2.6       Operational and planning variances for labour

2.6.1

Example 4

A new product requires three hours of labour per unit at a standard rate of $6 per hour. In a particular month the budget is to produce 500 units. Actual results were as follows. Hours worked 1,700 Production 540 units Wages cost $10,500 Within minutes of production starting it was realized that the job was extremely messy and the labour force could therefore claim an extra 25c per hour in ‘dirty money’. Required: Calculate the operational and planning variances in as much detail as possible. Solution: Total labour variance $   Flexed budget labour cost (540 units × 3 hrs × $6) 9,720   Actual labour cost 10,500     780 (A) Planning variance $   Revised standard cost (540 × 3 hrs × $6.25) 10,125   Original standard cost (540 × 3 hrs × $6) 9,720     405 (A) Operational rate variance $   Revised cost of actual units (1,700 hrs × $6.25) 10,625   Actual cost of actual units 10,500     125 (F) Operational efficiency variance Hours   540 units should have been (× 3 hrs) 1,620   Actual hours 1,700   Operational efficiency variance in hours 80   × revised standard rate per hour × $6.25   Operational efficiency variance in $ 500 (A)

 

2.7       Planning and operational sales variances

2.7.1

Example 5

CDE budgeted to sell 10,000 units of a new product during 2012. The budgeted sales price was $10 per unit, and the variable cost $3 per unit. Although actual sales in 2012 were 10,000 units and variable costs of sales were $30,000, sales revenue was only $5 per unit. With the benefit of hindsight, it is realized that the budgeted sales price of $10 was hopelessly optimistic, and a price of $4.50 per unit would have been much more realistic. Required: Calculate the operational and planning variances. Solution: The only variances are selling price variances. Planning (selling price) variance $   Revised budget (10,000 × $4.50) 45,000   Original budget (10,000 × $10.00) 100,000     55,000 (A) The original budget was too optimistic and so the planning variance is an adverse variance. Operational (selling price) variance $   Actual sales (10,000 × $5) 50,000   Revised sales (10,000 × $4.50) 45,000     5,000 (F) The total difference between budgeted and actual profit of $50,000 (A) is therefore analysed as follows.   $   Planning variance 55,000 (A) Operational variance 5,000 (F)   50,000 (A)

 

2.7.2

Example 6

PNG budgeted sales for 2012 were 5,000 units. The standard contribution is $9.60 per unit. A recession in 2012 meant that the market for PNG’s products declined by 5%. PNG’s market share also fell by 3%. Actual sales were 4,500 units. Required: Calculate the operational and planning variances for sales volume. Solution: Planning (sales volume) variance Units   Revised budget sale volume (5,000 × 95%) 4,750   Original budget 5,000     250 (A) @ contribution per unit of $9.60 $2,400 (A) Operational (sales volume) variance $   Revised budget sales volume 4,750   Actual sales volume 4,500     250 (A) @ Contribution per unit of $9.60 $2,400 (A) The fall in market size is uncontrollable by the management of PNG and therefore results in planning variance. The fall in market share is controllable and forms part of the operational variance.

2.8       The value of planning and operational variances

2.8.1    Advantages of a system of planning and operational variances
(a)        The analysis highlights those variances which are controllable and those which are non-controllable.
(b)      Managers’ acceptance of the use of variances for performance measurement, and their motivation, is likely to increase if they know they will not be held responsible for poor planning and faulty standard setting.
(c)        The planning and standard-setting processes should improve; standards should be more accurate, relevant and appropriate.
(d)       Operational variances will provide a fairer reflection of actual performance.
2.8.2    Limitations:
(a)        It is difficult to decide in hindsight what the realistic standard should have been.
(b)       It may become too easy to justify all the variances as being due to bad planning, so no operational variances will be highlighted.
(c)        Establishing realistic revised standards and analyzing the total variance into planning and operational variances can be a time consuming task, even if a spreadsheet package is devised.
(d)       Even though the intention is to provide more meaningful information, managers may be resistant to the very idea of variances and refuse to see the virtues of the approach. Careful presentation and explanation will be required until managers are used to the concepts.

3.      Calculating a Revised Budget

3.1       The syllabus requires you to be able to calculate a revised budget, which could involve revising standards for sales, materials and/or labour so that only operational variances are highlighted when actual results are compared to the revised budget.

3.2

Example 7

A company produces Widgets and Splodgets which are fairly standardised products. The following information relates to period 1. The standard selling price of Widgets is $50 each and Splodgets $100 each. In period 1, there was a special promotion on Splodgets with a 5% discount being offered. All units produced are sold and no inventory is held. To produce a Widget they use 5 kg of X and in period 1, their plans were based on a cost of X of $3 per kg. Due to market movements the actual price changed and if they had purchased efficiently the cost would have been $4.50 per kg. Production of Widgets was 2,000 units. A Splodget uses raw material Z but again the price of this can change rapidly. It was thought that Z would cost $30 per tonne but in fact they only paid $25 per tonne and if they had purchased correctly the cost would have been less as it was freely available at only $23 per tonne. It usually takes 1.5 tonnes of Z to produce 1 Splodget and 500 Splodgets are usually produced. Each Widget takes 3 hours to produce and each Splodget 2 hours. Labour is paid $5 per hour. At the start of period 1, management negotiated a job security package with the workforce in exchange for a promised 5% increase in efficiency – that is, that the workers would increase output per hour by 5%. Fixed overheads are usually $12,000 every period and variable overheads are $3 per labour hour. Required: Produce the original budget and a revised budget allowing for controllable factors in a suitable format. Solution: Original budget for period 1   $ Sales revenue [(2,000 × $50) + (500 × $100)] 150,000 Material costs X (2,000 × 5kg × $3) 30,000 Material costs Z (500 × $30 × 1.5) 22,500 Labour costs [(2,000 × 3 × $5) + (500 × 2 × $5)] 35,000 Variable overheads [(2,000 × 3 × $3) + (500 × 2 × $3)] 21,000 Fixed overheads 12,000 Profit 29,500 Revised budget for period 1   $ Sales revenue [(2,000 × $50) + (500 × $95)] 147,500 Material costs X (2,000 × 5kg × $4.5) 45,000 Material costs Z (500 × $23 × 1.5) 17,250 Labour costs [(2,000 × 3 × $5) + (500 × 2 × $5)] × 0.95 33,250 Variable overheads [(2,000 × 3 × $3) + (500 × 2 × $3)] × 0.95 19,950 Fixed overheads 12,000 Profit 20,050

 

3.3       A budget revision should be allowed if something has happened which is beyond the control of the organisation or individual manager and which makes the original budget unsuitable for use in performance management.
3.4       Any adjustment should be approved by senior management who should look at the issues involved objectively and independently. Operational issues are the issues that a budget is attempting to control so they should not be subject to revision. However, it can be very difficult to establish what is due to operational problems (controllable) and what is due to planning (uncontrollable).

 

4.      Standard Costing and Total Quality Management

4.1       Total quality management (TQM)

4.1.1	Total quality management
	TQM is the process of applying a zero defects philosophy to the management of all resources and relationships within an organization as a means of developing and sustaining a culture of continuous improvement which focuses on meeting customer’s expectations.

4.1.2    There are eight requirements of quality which could be seen as the characteristics of total quality management programmes.
(a)        Organisation wide there must be acceptance that the only thing that matters is the customer.
(b)       There should be recognition of the all-pervasive nature of the customer-supplier relationship, including internal customers; passing sub-standard material to another division is not satisfactory
(c)        Instead of relying on inspection to a predefined level of quality, the cause of the defect in the first place should be prevented.
(d)       Each employee or group of employees must be personally responsible for defect-free production or service in their domain.
(e)        There should be a move away from 'acceptable' quality levels. Any level of defects must be unacceptable.
(f)        All departments should try obsessively to get thing right first time; this applies to misdirected phone calls and typing errors as much as to production.
(g)       Quality certification programmes should be introduced.
(h)       The cost of poor quality should be emphasised; good quality generates savings.

4.2       Can standard costing and TQM co-exist?

4.2.1    Arguably, there is little point in running both a total quality management programme and a standard costing system simultaneously.
(a)        Predetermined standards are at odds with the philosophy of continual improvement inherent in a total quality management programme.
(b)        Continual improvements are likely to alter methods of working, prices, quantities of inputs and so on, whereas standard costing is most appropriate in a stable, standardised and repetitive environment.
(c)        Material standard costs often incorporate a planned level of scrap. This is at odds with the TQM aim of zero defects and there is no motivation to 'get it right first time'.
(d)        Attainable standards, which make some allowance for wastage and inefficiencies are commonly set. The use of such standards conflicts with the elimination of waste which is such a vital ingredient of a TQM programme.
(e)        Standard costing control systems make individual managers responsible for the variances relating to their part of the organisation's activities. A TQM programme, on the other hand, aims to make all personnel aware of, and responsible for, the importance of supplying the customer with a quality product.

4.3       The role in modern business of standards and variances

4.3.1    Surveys have confirmed the continued wide use of standard costing systems.
(a)        Planning. Even in a TQM environment, budgets will still need to be quantified. For example, the planned level of prevention and appraisal costs needs to be determined. Standards, such as returns of a particular product should not exceed 1% of deliveries during a budget period, can be set.
(b)       Control. Cost and mix changes from plan will still be relevant in many processing situations.
(c)        Decision making. Existing standards can be used as the starting point in the construction of a cost for a new product.
(d)       Performance measurement. If the product mix is relatively stable, performance measurement may be enhanced by the use of a system of planning and operational variances.
(e)        Product pricing. Target costs may be compared with current standards, and the resulting 'cost gap' investigated with a view to reducing it or eliminating it using techniques such as value engineering.
(f)        Improvement and change. Variance trends can be monitored over time.
(g)       Accounting valuations. Although the operation of a JIT system in conjunction with backflush accounting will reduce the need for standard costs and variance analysis, standards may be used to value residual inventory and the transfers to cost of sales account.

Examination Style Questions

Question 1 – Material planning and operational variances
Secure Net (SN) manufacture security cards that restrict access to government owned buildings around the world.

The standard cost for the plastic that goes into making a card is $4 per kg and each card uses 40g of plastic after an allowance for waste. In November 100,000 cards were produced and sold by SN and this was well above the budgeted sales of 60,000 cards.

The actual cost of the plastic was $5·25 per kg and the production manager (who is responsible for all buying and production issues) was asked to explain the increase. He said ‘World oil price increases pushed up plastic prices by 20% compared to our budget and I also decided to use a different supplier who promised better quality and increased reliability for a slightly higher price. I know we have overspent but not all the increase in plastic prices is my fault.’

The actual usage of plastic per card was 35g per card and again the production manager had an explanation. He said ‘The world-wide standard size for security cards increased by 5% due to a change in the card reader technology, however, our new supplier provided much better quality of plastic and this helped to cut down on the waste.’

SN operates a just in time (JIT) system and hence carries very little inventory.

Required:

(a)     Calculate the total material price and total material usage variances ignoring any possible planning error in the figures.                                                                                                         (4 marks)
(b)     Analyse the above total variances into component parts for planning and operational variances in as much detail as the information allows.                                                                           (8 marks)
(c)     Assess the performance of the production manager.                                             (8 marks)
(20 marks)
(ACCA F5 Performance Management December 2009 Q1)

Question 2 – Sales price and volume variances, material planning and operational variances, labour rate and efficiency variance
Carad Co is an electronics company which makes two types of televisions – plasma screen TVs and LCD TVs. It operates within a highly competitive market and is constantly under pressure to reduce prices. Carad Co operates a standard costing system and performs a detailed variance analysis of both products on a monthly basis. Extracts from the management information for the month of November are shown below:

		Note
Total number of units made and sold	1,400	1
Material price variance	$28,000 (A)	2
Total labour variance	$6,050 (A)	3

Notes
(1)     The budgeted total sales volume for TVs was 1,180 units, consisting of an equal mix of plasma screen TVs and LCD screen TVs. Actual sales volume was 750 plasma TVs and 650 LCD TVs. Standard sales prices are $350 per unit for the plasma TVs and $300 per unit for the LCD TVs. The actual sales prices achieved during November were $330 per unit for plasma TVs and $290 per unit for LCD TVs. The standard contributions for plasma TVs and LCD TVs are $190 and $180 per unit respectively.
(2)     The sole reason for this variance was an increase in the purchase price of one of its key components, X. Each plasma TV made and each LCD TV made requires one unit of component X, for which Carad Co’s standard cost is $60 per unit. Due to a shortage of components in the market place, the market price for November went up to $85 per unit for X. Carad Co actually paid $80 per unit for it.
(3)     Each plasma TV uses 2 standard hours of labour and each LCD TV uses 1·5 standard hours of labour. The standard cost for labour is $14 per hour and this also reflects the actual cost per labour hour for the company’s permanent staff in November. However, because of the increase in sales and production volumes in November, the company also had to use additional temporary labour at the higher cost of $18 per hour. The total capacity of Carad’s permanent workforce is 2,200 hours production per month, assuming full efficiency. In the month of November, the permanent workforce were wholly efficient, taking exactly 2 hours to complete each plasma TV and exactly 1·5 hours to produce each LCD TV. The total labour variance therefore relates solely to the temporary workers, who took twice as long as the permanent workers to complete their production.

 

Required:

(a)     Calculate the following for the month of November, showing all workings clearly:
(i)      The sales price variance and sales volume contribution variance;              (6 marks)
(ii)     The material price planning variance and material price operational variance;
(2 marks)
(iii)    The labour rate variance and the labour efficiency variance.                      (7 marks)
(b)     Explain the reasons why Carad Co would be interested in the material price planning variance and the material price operational variance.                                                                      (5 marks)
(20 marks)
(ACCA F5 Performance Management December 2010 Q1)

Question 3
Spike Co manufactures and sells good quality leather bound diaries. Each year it budgets for its profits, including detailed budgets for sales, materials and labour. If appropriate, the departmental managers are allowed to revise their budgets for planning errors.

In recent months, the managing director has become concerned about the frequency of budget revisions. At a recent board meeting he said ‘There seems little point budgeting any more. Every time we have a problem the budgets are revised to leave me looking at a favourable operational variance report and at the same time a lot less profit than promised.’

Required:

(a)     Describe the circumstances when a budget revision should be allowed and when it should be refused.                                                                                                                               (5 marks)

Two specific situations have recently arisen, for which budget revisions were sought:

Materials
A local material supplier was forced into liquidation. Spike Co’s buyer managed to find another supplier, 150 miles away at short notice. This second supplier charged more for the material and a supplementary delivery charge on top. The buyer agreed to both the price and the delivery charge without negotiation. ‘I had no choice’, the buyer said, ‘the production manager was pushing me very hard to find any solution possible!’ Two months later, another, more competitive, local supplier was found.

A budget revision is being sought for the two months where higher prices had to be paid.

Labour
During the early part of the year, problems had been experienced with the quality of work being produced by the support staff in the labour force. The departmental manager had complained in his board report that his team were ‘unreliable, inflexible and just not up to the job’.

It was therefore decided, after discussion of the board report, that something had to be done. The company changed its policy so as to recruit only top graduates from good quality universities. This has had the effect of pushing up the costs involved but increasing productivity in relation to that element of the labour force.

The support staff departmental manager has requested a budget revision to cover the extra costs involved following the change of policy.

Required:

(b)     Discuss each request for a budget revision, putting what you see as both sides of the argument and reach a conclusion as to whether a budget revision should be allowed.
(8 marks)

The market for leather bound diaries has been shrinking as the electronic versions become more widely available and easier to use. Spike Co has produced the following data relating to leather bound diary sales for the year to date:

Budget
Sales volume	180,000 units
Sales price	$17.00 per unit
Standard contribution	$7.00 per unit

The total market for diaries in this period was estimated in the budget to be 1·8m units. In fact, the actual total market shrank to 1·6m units for the period under review.

Actual results for the same period
Sales volume	176,000 units
Sales price	$16.40 per unit

 

Required:

(c)     Calculate the total sales price and total sales volume variance.                            (4 marks)
(d)     Analyse the total sales volume variance into components for market size and market share.           (4 marks)
(e)     Comment on the sales performance of the business.                                            (4 marks)
(25 marks)
(ACCA F5 Performance Management December 2007 Q3)