Operational Performance Measurement: Sales and Direct-Cost Variances

Chapter 14 Operational Performance Measurement Sales and Direct- price disagreements, and the contri exclusivelyion of Nonfinancial Performance Measures Case 14-1 Pet Groom and Clean phoner Readings 14-1 timeworn tolling Is Alive and Well at Parker Brass by D. Johnsen and P. Sopariwala, direction Accounting Quarterly (Winter 2000), pp. 12-20. The Brass Products Division of the Parker Hannifin Corporation is a world-class manufacturer of tube and brass fittings, valves, hose, and hose fittings. De venom the introduction of popular youthful embodying administrations, the Brass Product Division operates a tumesce-functioning meter equaling administration.Discussion Questions 1. What features in the firms sample be that make it a success? 2. In admission to divisions seen in the textbook Parker Brass created several rising divisions. Describe these classs. Why atomic moment 18 these divergence added at Parker Brass? 14-2 Redesigning Cost Systems Is measuring rod Costing antiquated? by Carole B. Cheatham and Leo B. Cheatham, Accounting Horizons (December 1996), pp. 23-31. The article shows some new shipway to analyze modular be data, going beyond the conventional emphasis on deed court sectionalizations that focus on price and efficiency.Variances for harvest-tide quality be developed and explained, as come up as gross gross sales mutations base on sales orders received and orders genuinely shipped. There is also a discussion of how to incorporate activity-based costing, and round-the-clock amount feeler, including benchmarking and target costing. The main premise of the article is that timeworn cost carcasss be the most common cost systems in use, and while there argon a number of limitations to these systems, a c beful and creative social movement keep transform them into much useful cost systems. Discussion Questions 1.What are the main criticisms of traditional standard cost systems? 2. What is meant by push done yield? Is it preferred to pull through intersectionion, and why? 3. What are the crush ways to make standard cost systems more dynamic? 4. Considering the suggestions make in this article, in contrast to the chapter presentation of standard costing, which reports make the most sense to you and why? 14-3 Can Variance Analysis Make Media Marketing Managers More Accountable? by Ted Mitchell and Mike Thomas, steering Accounting Quarterly (F whole 2005), pp. 51-61.This article discusses, deep pig the context of a marketing application, an alternative rule for decomposing a total standard cost variance. The authors posit that in much(prenominal) applications the joint variance (that in conventional practice is assumed to be small) can be significant in do and therefore invalidate conventional regularitys that include the joint price-cost variance as part of the price variance. However, the treatment proposed by the authors for the joint price- cadence variance differs from the three-variance solution make in some cost/managerial news report texts. Discussion Questions . Explain what is meant by the term joint variance as this term is employ in standard cost systems used for control excogitations. 2. Explain what the authors of this article mean when they describe their proposed approach for standard cost variance decomposition as a geometric solution. 3. Explain the term Minimum Potential Performance Budget model. How is this concept employed in the variance decomposition process recommended by the authors? 4. What are the primary advantages and primary disadvantages of the variance decomposition model recommended by the authors of this paper? 4-4 Helping Students See the Big Picture of Variance Analysis by Neal VanZante, Management Accounting Quarterly, Vol. 8, No. 3 (Spring 2007), pp. 39-47. This paper presents two exemplars that can be used to reinforce concepts and procedures students learn in text Chapters 14 through 16. The starting time example, Fernandez Comp whatever, can be used as a comprehensive review of all three chapters the second example, Roger Company, can be used in federation with Chapter 14 if supernumerary coverage of the joint price- measuring rod variance for direct temporals (DM) is desired.The Fernandez Company example requires students to first calculate the total flexible budget variance (in direct income) for a design and then breakdown this variance into its constituent parts (selling price variance, variant cost variances, etc. ). Discussion Questions 1. What is meant by the total operating-income variance for a given invoice period? What alternative names are there to describe this variance. 2. What would be a first-level breakdown of the total variance exposit above in (1)? 3. How can the total flexible-budget variance be broken down (i. . , what are the constituent parts of this total variance)? 4. Explain the total sales volume variance for a period. How can this total variance b e decomposed? 5. Explain the meaning of the joint price- cadence variance that is the basis for the discussion in the Roger Company case. 14-5 Are first principle and RCA Accounting Systems Compatible with Lean Management? by Larry Grasso, Management Accounting Quarterly, Vol. 7, No. 1 (Fall 2005), pp. 12-27. This paper provides a critical compend of several alternative cost systems to traditional cost accounting systems.It then evaluates these alternatives in terms of how they great power support, or non, companies that adopt a lean philosophy. An example of nonfinancial exercise indicators that support a lean philosophy is offered in Tables 1 and 2. This discussion in the article of the diachronic development of forethought accounting systems reinforces in the minds of students the evolving nature of cost system design as the environment changes, so should watchfulness accounting systems. (Note this reading could also be used in conjunction with Chapter 15 of the text. ) D iscussion Questions . Describe what is meant by the term lean manufacturing. 2. According to the author of this article, what are the primary uses (or roles) of management accounting data within organizations today? 3. According to the author of this article, what are the primary implications of adopting a lean philosophy in terms of the design of management accounting systems? 4. Explain the importance of the examples provided in Tables 1 and 2 of this article. 14-1 Pet Groom & Clean (PG) David Green is considering his operating statement for 2010, which is displayed in the table below.David is the manager of line number 88, where he began as one of the stave 6 courses ago, and through wicked oeuvre has risen to buy the farm manager of the shop classhouse. The operating report shows his budgeted performance for the year and the actual results, showing a net improvement of 9% over budget$405. While his results are positive, the small improvement over the budget does non qua lify David for the bonus program which awards a $3,000 bonus for store managers who improve their performance over that of the budget by 20% or more. David manages one store in a 110 store chain of pet grooming stores owned by Pet Groom & Clean Company (PG&C).As for different PG stores, his store is open Monday through Saturday each week the only service provided at the store is a service in which a pet, dog or cat, is prepare and cleaned, typically while the client waits. The budgeted price for the service at the beginning of 2010 was $25. Budgeted variable cost were $2 for bodilys and $9 grok cost per service, as well as other variable be of $1. 50 per service. Materials are purchased by topical anaesthetic store managers, and all staff are hired and supervised by the local store managers. early(a) budgeted and actual info for 2010 are shown in the table below. David is an ambitious and hard working manager, who has applied himself to the job and has looked for different way s to reap customers and to reduce be. For example, he noniced that most of the companys customers brought their pets in on Friday, Saturday, and Monday, and the number of customers was significantly lower on Tuesday through Thursday. In fact, David budgeted that 80% of total demand for 2010 would be in the Friday-Monday period, and only 20% would be in the Tuesday-Thursday period.So at the start of 2010 David began a promotion that reduced prices on Tuesday through Wednesday to $18 in an effort to d desolate in more business during these three old age. Also, noning the strong demand in the Friday-Monday period, David decided to increase the price during those days from $25 to $30. An experienced manager, David was able to manage drive costs so that staff were not idle, even on slow days David scheduled the number of staff to meet the expected demand on each day, and because of his experience (and because his store encouraged appointments), his forecast of demand was usually qui te accurate.Thus, labor cost is fairly case-hardened as a variable cost for Davids store. Labor costs consists of 3 staff who are budgeted to work 2,500 minute of arcs per year at a budgeted pay rate of $12 per hour, thus the total budgeted labor costs of $ 90,000 (= 3 x $12 x 2,500). Through his careful computer programming of staff, and his effective management style, Dave was able to save labor time so that each of the three employees worked only 2,250 hours in 2010.Other expenses include didactics expenses each staff employee is expected to take hold at least 6 hours of training at the PG&C headquarters during the year the local store is charged $250 per hour for this training. The local store manager determines the amount of training time for each staff. Other expense also includes advertising expense, which is controlled by the local managers PG&C recommends that advertising should be about 1% of total sales. Service development is the cost of studying new harvest-times for use in he stores and for the study of potential new ways to improve the services provided at PG&C stores. Service development is charged to each store based on the allocation rule of 10% of store sales. Accounting, insurance costs, taxes, and management overhead (which includes store rent and managers pay) are paid at the home office of PG&C and are allocated based upon a formulation which combines store size, store sales, and the age of the store. Employee benefits accrue to staff at the rate of 20% of total pay. These benefit payments are contributed to a 401(k)-type hideaway plan for each employee.The result of Davids promotional price for the Tuesday-Thursday period was successful, as total sales increased from 10,000 to 10,500 and the Tuesday-Thursday sales increased from 20% to 30% of total sales. Required From David Greens perspective, develop an analysis which explains your performance for the year ended December 31, 2010. pic 14-1 STANDARD COSTING IS ALIVE AND WELL A T PARKER BRASS by David Johnsen and Parvez Sopariwala Many people live condemned standard costing, showing it is irrelevant to the current just-in-time based, fast-paced business environment.Yet surveys consistently show that most industrial companies in the United States and abroad1 still use it. Apparently, these companies energise successfully adapted their standard costing systems to their particular business environments. In gain, many academics cede contributed ideas on how the standard costing system could be and has been made more responsive to the needs of companies operating in this new economy. 2 The Brass Products Division at Parker Hannifin Corporation (here afterward, Parker Brass), a world-class manufacturer of tube and brass fittings, valves, hose and hose fittings, is one of the tandard costing success stories. It operates a well-functioning standard costing system of which we will show you some highlights. WHATS SPECIAL ABOUT THE STANDARD COSTING SYSTEM AT PAR KER BRASS? Parker Brass uses its standard costing system and variance analyses as important business tools to target problem areas so it can develop solutions for continuous improvement. Here are some examples of these standard costing- equald tools (Disaggregated product line data. Parker Brass has been divided into Focus Business Units (FBUs) along product lines.Earnings statements are developed for each FBU, and variances are shown as a percentage of sales. If production variances exceed 5% of sales, the FBU managers are required to provide an explanation for the variances and to put together a plan of action to correct the detected problems. To help the process, a ingraft accountant has been assigned to each FBU. As a result of these steps, each building block is able to take a much more proactive approach to variance analysis. ( Timely product cost information.In the past, variances were reported only at month-end, but often a particular job already would have been off the s hop floor for three or more weeks. Hence, when management questioned the variances, it was too late to review the job. Now exception reports are generated the day after a job is closed (in other words, the day after the last part has been manufactured). Any jobs with variances greater than $1,000 are displayed on this report. These reports are distributed to the managers, planners or schedulers, and botany accountants, which permits people to ask questions while the job is still fresh in everyones mind. Timely corrective action. Because each job is costed (in other words, transferred out of Work-in-Process and into stainless Goods) 10 days after the job has closed, there is adequate time for necessary corrective action. For example, investigating a large somatic criterion variance might reveal that certain defective absolute parts were not include in the final tally of finished parts. Such timely information would allow management to decide whether to rework these parts or to i ncrease the size of the next job.This kind of corrective action was not possible when variances were provided at the end of each month. (An effective control system. Summary reports are run weekly, beginning the second week of each month, to show each variance in total dollars as well as each variance by product line and each batch within the product line. In addition, at the end of each month, the database is updated with all variance- link information. As a result, FBU managers can review variances by part number, by job, or by high dollar volume. (Employee training and empowerment.Meetings are held with the hourly employees to explain variances and earnings statements for their FBU, thereby creating a more positive atmosphere in which the FBU team can work. These meetings help employees understand that management decisions are based on the numbers discussed and that if erroneous data are put into the system, then erroneous decisions whitethorn be made. For example, a railroad ca r may not be running efficiently. An operator may clock off of the job so that his or her efficiency does not look bad. Because the railroad cars efficiency is not adversely impacted, no contour 1 PANEL A THE FACTS shopworn production in 1 hour (units) 50 Standard batch quantity (units) 2,000 Standard hours requisite for 2,000 units 40 Standard time infallible for 1 disciplineup (hours) 4 Standard labor rate per hour $10 Actual quantity formulated (units) 1,200 Actual setup hours for 1 setup 4 Actual productive labor hours to make 1,200 units 24 Actual labor cost for 28 hours at $10 per hour $280 PANEL B WORKINGS Setups deed Total Standard time per unit Standard setup time ( hours) 4 Standard production time (hours) 40 Standard batch size (units) 2,000 2,000 Hence, standard time per unit (hours) 0. 002 0. 020 0. 022 Standard time charged for 1,200 units Standard time per unit (hours) 0. 002 0. 020 0. 22 of units very produced 1,200 1,200 1,200 Standard time charged (hours) 2. 40 24. 00 26. 40 PANEL C SOLUTION If SRQV is determined, the journal entranceway would be Work in process (26. 40)($10) $264 SRQV (4. 00 2. 0)($10) $16 Accrued payroll $280 If SRQV is not determined, the journal introduction would be Work in process (26. 40)($10) $264 LEV 28. 00 (1 . 200)(0. 022)$10 $16 Accrued payroll $280 maintenance is done to that machine, and the inefficiency continues. In addition, because the operator is not charging his/her cost to a job, the cost is be included in corroboratory labor, and manufacturing costs increase.If the operator had reported the hours correctly, management would have questioned the problem, and the machine would have been fixed or replaced based on how severe the problems were. WHAT NEW VARIANCES HAS PARKER BRASS designed? In addition to the aforementioned innovations that Parker Brass has made to adapt its standard costing system to its particular business envi ronment, the company has created the following new variances (The standard-run quantity variance to explain situations where the size of a lot is less than the optimal batch quantity. (The material substitution variance to evaluate the feasibility of alternative raw materials. ( The method variance to assess situations where different machines can be used for the aforementioned(prenominal) job. THE STANDARD RUN QUANTITY VARIANCEThe standard run quantity variance (SRQV) represents the amount of setup cost that was not recovered because the batch size was smaller than the earlier determined optimal batch size. Because setup costs are included in the standard labor hours for a standard batch quantity is likely to create an unfavorable labor efficiency variance (LEV). Unless, FIGURE 2 PANEL A THE FACTS Standard price per pound of material Ml $10 Standard price per pound of material M2 $11 Standard material quantity (Ml & M2) to make one C units (lbs. 2 Actual quantity produced (u nits) 2,000 Actual pounds of M2 purchased and used 43 PANEL B WORKINGS Standard quantity to produce 2,000 units Standard material quantity to make 100 units (lbs. ) 2 Actual quantity produced (units) 2. 00 Hence, standard quantity to produce 2,000 units 40 PANEL C SOLUTION If MSV is determined, the journal entry would be Work in process (40. 00)($10) $400 MEV (43. 00 40. 00)($11) $33 MSV (40. 00)($11 $10) $40 MaterialM2 (43. 0)($11)1 $473 If MSV is not determined, the journal entry might be Work in process (40. 00)($11) $440 MEV (43. 00 40. 00)($11) $33 MaterialM2 (43. 00)($11) $473 owever, the impact of actual production inefficiencies is separated from setup-related inefficiencies, the LEV hypothesises the combined impact of these two causes of inefficiencies and is not really useful for taking the necessary corrective action. See Figure 1 for an illustration of this issue. board A shows that standard batch quantity is 2,000 units, the s tandard production during one hour is 50 units, and, hence, 40 standard hours are needed to produce 2,000 units. In addition, it takes four standard and actual hours to set up one batch. Panel B reveals that standard hours for setup and production labor are 0. 002 and 0. 020 per unit, respectively, for a total of 0. 022 per unit.In addition, because actual quantity produced is 1,200 units, the total standard hours indictable to these 1,200 units is 26. 40 (0. 002 + 0. 020)(1,200). Finally, Panel C shows the recommended journal entry whereby an SRQV is created. This SRQV represents the unrecovered setup costs because 1,200 units were manufactured instead of the standard batch quantity of 2,000 units. Thus, because the company expected to overlook $40 (4 hours)($10 per hour) on each setup, the setup cost relating to the 800 (2,000 1,200) units not produced, or $16 U, is considered an unfavorable SRQV or the cost of producing small lots. On the other hand, using traditional standard costing, this amount of $16 U would most likely have been categorized as an LEV.Yet there really is no LEV,3 and the variance of $16 U attributed to labor efficiency is merely the unabsorbed portion of the setup cost attributable to the 800 units that were not produced. The advantages of extracting the standard run quantity variance are many. First, the SRQV ordinarily would be included in the LEV and could provide a misleading impression of labors efficiency. Second, because just-in-time practices recommend smaller lots and minimal finished right(a)s inventory the SRQV is essentially the cost of adopting JIT Third, to the extent that setup cost and the cost of carrying inventory are competing undesirables, a determination of the cost of small lots could be used in the trade-off analysis against the cost of holding and carrying inventories.Finally, to the extent that this variance can be separated for each customer, it would reveal how much of a disadvantage was suffered by allo wing that customer to purchase in small lots. Such information could be used in future bids. If a customers schedule required a smaller lot, then that customers job cost could be enhanced appropriately. THE MATERIAL SUBSTITUTION VARIANCE The material substitution variance (MSV) assumes perfect or near perfect substitutability of raw materials and measuring sticks the loss or gain in material costs when a different raw material is substituted for the material designated in the job sheet. Substitutions may be made for many reasons. For example, the designated material may not be obtainable or may not be vailable in small-enough quantities, or the company may want to use up material it purchased for a product that it has since discontinued. The utility of MSV is discussed in Figure 2. Panel A shows that both materials, M1 and M2, can be used to manufacture a product, and it is assumed that two pounds is the standard input per unit for both materials. Material M1 is the material desi gnated in the job sheet, but material M2 can be substituted for M1. The standard cost of M2 ($11 per lb. ) is higher than that for M1 ($10 per lb. ), and M2 is used because M1 is currently not available and a valued customer needs a rush job. 4 Panel B reveals that the standard quantity needed to manufacture 2,000 units is 40 lbs.For the purposes of this illustration, we assume that material price variance (MPV) is detected when material is purchased (in other words, the material account is maintained at standard cost). Hence, Panel C reveals the recommended journal entry whereby MSV is created. The MSV represents the benefit obtained by subbing a more expensive material (M2) for the less expensive material (M1) and hence represents the loss through substitution. The MSV is $40 U because (1) 40 lbs. is the standard quantity of M1 and M2 needed to manufacture 2,000 units, and (2) M2 costs $1 more per lb. than M1. In addition, the material efficiency variance (MEV) is $33 U because 43 lbs. instead of the standard quantity of 40 lbs. ere used to manufacture 2,000 units. In contrast, the traditional standard costing system might dilute the substitution, and the job might be charged with the standard cost of using 40 lbs. of M2. In that scenario, the job would cost $40 more and could have an impact on customer realiseability analysis even though the customer did not request the substitution. Now Parker Brass is evaluating an extension that would be to unbend the simplifying assumption that both materials require the similar standard input. See Figure 3. It adopts the facts from Figure 2 except that 1. 9 lbs. of material M2 are required for 100 units instead of 2 lbs. for both materials in Figure 2.In this situation, we have two MSVs, one for the price impact called MSV-Price and the other for the efficiency impact, called MSV-Efficiency. Panel C shows the recommended journal entry whereby two MSV variances are created. First, MSV-Price is unfavorable because M 2, a more expensive material, is being substituted for M1. As a result, MSV-Price is $40 U as material M2 costs $1 more per lb. than material M1. On the other hand, as you might expect, the MSV-Efficiency is favorable because only 1. 9 lbs. of M2 are required to make 100 units as compared to 2 lbs. required for M1. Thus, MSV-Efficiency is $22 F because each batch of 100 units requires 38 lbs. of M2 against 40 lbs. of M1. The net result of the MSV variances is $18 U (38 lbs. )($11) (40 lbs. ($10), suggesting that, barring any other complications, the substitution of M2 for M1 is not likely to be profitable under existing circumstances. Finally, the MEV using material M2 is $55 U, reflecting the fact that 43 lbs. of material M2 actually were used whereas only 38 lbs. of material M2 should have been used. This variance could have been caused by the fact that M2 was a new material and required initial acquirement and other nonrecurring costs. In such a case, the standard quantity of 3 8 lbs. for 2,000 units may not need to be changed. On the other hand, the MEV variance may have been caused because of the inherent difficulty in working with material M2. In such a case, the standard of 38 lbs. for 2,000 units may need to be amended.In contrast, as was shown in Panel C of Figure 2, the journal entry that is likely to be made using traditional standard costing would completely ignore the impact of material substitution and would likely inflate the cost of this particular job. The advantages of extracting the MSV are as follows. First, determining MSV lets the company assign the MSV cost to a customer whose rush job may have required using a more expensive material like M2. On the other hand, the MSV could be create verbally off if the substitution were made to benefit the company. Also, creating an MSV and breaking it up into its price and efficiency components allows the company to evaluate whether the substitution of M2 for M1 is a profitable one.While all these calculations can also be performed off the accounting system, creating the MSV makes the process a part of the system so a history of such evaluations is available for future reference. order VARIANCE A method variance occurs when more than one machine can be used to manufacture a product. 5 For example, a plant may have newer machines that it normally would expect to use to manufacture a product, so its standards would be based on such new machines. Yet the same plant may also keep, as backups, older and less efficient machines that also could manufacture the same product but would require more inputs in the form of machine and/or labor hours. For this example, we assume that labor hours and machine hours have a 11 relationship. 6 As FIGURE 3 PANEL A THE FACTS Standard price per pound of material M1 $10 Standard price per pound of material M2 $11 Standard material quantity of M1 to make 100 units (lbs. ) 2 Standard material quantity of M2 to make 100 units (lbs. ) 1. Actual quantity produced (units) 2,000 Actual pounds of M2 used 43 PANEL B WORKINGS Material M1 Material M2 Standard quantity to produce 2,000 units Standard material quantity for 100 units (lbs. ) 2 1. Actual quantity produced (units) 2,000 2,000 Hence, standard quantity to produce 2. 000 units 40 38 PANEL C SOLUTION If MSV is determined, the journal entry would be Work in process (40. 00)($10) $400 MEV (43. 00 38. 00)($11) $ 55 MSV-Price (40. 0)($11 $10) $ 40 MSV-Efficiency (40. 00 38. 00)($11) $ 22 MaterialM2 (43. 00)($11) $473 If MSV is not determined, the journal entry might be Work in process (38. 0)($11) $418 MEV (43. 00 38. 00)($11) $55 MaterialM2 (43. 00)($11 ) $473 a result, the method variance becomes pertinent because the traditional LEV from operating the older machines could potentially include the following two impacts. First, an older machine may need additive labor hours to perform the same task, and the additional hours would be reflected in the LEV. Second, the LEV would include the workers efficiency or lack thereof on the older machine.We evaluate the utility of the method variance in Figure 4. Panel A shows that both machines, A and B, can be used to manufacture a product. Machine A is the more efficient machine and the one used for setting the standard time. Machine B is the backup. Panel B shows that the standard machine hours needed to produce 1,800 units are 30 on machine A and 36 on machine B, which can be compared to the 35 hours actually used to manufacture 1,800 units on machine B. Panel C of Figure 4 reveals the recommended journal entry whereby a method variance is created. This method variance represents the loss incurred by substituting the backup machine B for machine A.Because machine Bs standard of 36 labor hours is greater than machine As standard of 30 hours, there is an unfavorable method variance of $120. On the other hand, because machine B took 35 hours to manufacture 1,800 uni ts instead of its standard of 36 machine hours, there is a favorable LEV of $20. As you can see, while there was a loss incurred by using machine B instead of machine A, the actual usage of machine B was efficient. In contrast, assuming the traditional costing system recognizes that machine B was used, it is likely to charge the job $720 (36 hours) x ($20 per hour) instead of the $600 (30 hours) x ($20 per hour) that would have been charged if machine A had been used. Here are the advantages of extracting the method variance.First, the impact of the method variance ordinarily would be included in the LEV and would provide a misleading impression of labors productivity. Second, the method variance could be used to isolate the additional cost that was incurred during the year by operating machine M2. This could permit a trade-off amidst purchasing a new machine FIGURE 4 PANEL A THE FACTS Machine A standard time needed for one unit (minutes) 1. 0 Machine B standard time needed for one unit (minutes) 1. Labor rate per hour $20 Actual quantity produced (units) 1,800 Actual labor hours used to make 1,800 units using machine B 35 Actual labor cost $700 PANEL B WORKINGS Machine A Machine B Standard hours needed for 1. 800 units on Standard time needed for one unit (minutes) 1. 0 1. Actual quantity produced (units) 1,800 1,800 Hence, the standard hours needed 30 36 PANEL C SOLUTION If method variance is determined, the journal entry would be Work in process (30. 00)($20) $600 Method variance (36. 00 30. 00)($20) $120 LEV (36. 00 35. 0)($20) $ 20 Accrued Payroll $700 If method variance is not determined, the journal entry might be Work in process (36. 00)($20) $720 LEV (36. 00 35. 0)($20) $ 20 Accrued Payroll $700 and continuing to maintain the older machine, specially if tight delivery schedules are not the norm. Finally, the product cost would still be based on the standards for the more efficient new machine, and the j ob would not be charged a higher cost merely because a less efficient machine was used. That means a job that was completed on the older machine would not be penalized. 7 RELEVANT, NOT IRRELEVANT As you can see from the Parker Brass examples, standard costing has not become irrelevant in the new rapid-paced business environment.Parker Brass not only has managed to modify its standard costing system to achieve disaggregated and timely cost information for timely corrective action, but it has also designed additional variances to determine how setup time relating to small batches should be absorbed, whether an alternative raw material is economically feasible, and how a products cost might reflect the use of alternate production facilities. 1Studies reporting on the widespread use of standard costing in the U. S. , the U. K. , Ireland, Japan, and Sweden are summarized by Horngren, Foster, and Datar on page 225 of the 9th edition of their cost accounting text published by Prentice-Hall in 1997. 2C. Cheatham, Updating Standard Cost Systems, Journal of Accountancy, December 1990, pp. 57-60 C. Cheatham, Reporting the Effects of Excess Inventories, Journal of Accountancy, November 1989, pp. 131-140 C. Cheatham and L. R.Cheatham, Redesigning Cost Systems Is Standard Costing Obsolete, Accounting Horizons, December 1996, pp. 23-31 H. Harrell, Materials Variance Analysis and JIT A sensitive Approach, Management Accounting, May 1992, pp. 33-38. 3The standard production hours needed for 1,200 units were 24 (1,200) x (0. 020), whereas the actual labor hours used have been intentionally set at 24. In addition, the standard and actual labor hours for one setup have been intentionally set at four. 4An alternative scenario could have the cost per pound of M2 ($9 per lb. ) being lower than that for M1 ($10 per lb. ) because M2 is used to manufacture other products as well and the company obtains quantity discounts for large purchases of M2. To a limited extent, the rationale be hind the method variance is similar to that for the material substitution variance (MSV) discussed earlier. 6That is, the machine does not work independent of the worker. Hence, the labor hours spent on the machine are the same as the number of hours the machine was operated. 7A similar reasoning is applied in situations wherein the routing for the manufacture of a product is amended during the year, possibly because the customer wants an additional treat step. In such a case, the resulting process variance could be charged to the customer. 14-2 Redesigning Cost Systems Is Standard Costing Obsolete? By Carole B. Cheatham and Leo B. Cheatham, Professors at northeast Louisana University.SYNOPSIS Since the early 1980s standard cost systems (SCSs) have been under attack as not providing the information needed for advanced manufacturers. In spite of its critics, SCSs are still the system of choice in some 86 percent of U. S. manufacturing firms. This paper discusses the criticisms of S CSs that (1) the variances are obsolete, (2) there is not provision for continuous improvement, and (3) use of the variances for accountability accounting result in inhering conflict quite an than cooperation. Updates for SCSs in the form of redesigned variances, suggestions for dynamic standards, and refocused responsibility and reporting systems are presented. The compatibility of SCSs and its main competitor as a cost system, activity-based costing (ABC), is examined.The authors discuss when it is appropriate to use ABC or SCS or some combination of the two. Since Eli Goldratts (1983) charge that cost accounting is the number one enemy of productivity in the early 1980s, traditional cost systems have been under attack. Although Goldratt subsequently softened his stand to say that cost rather than accounting was the culprit (Jayson 1987), others were quick to jump on the bandwagon to condemn the cost systems in use. New systems were proposed of which the most popular was activi ty-based costing (ABC). In spite of all the criticism, a 1988 survey shows 86 percent of U. S. manufacturers using standard cost systems (Cornick et al. 988). A survey by Schiff (1993) indicates that 36 percent of companies use activity-based costing, but only 25 percent of those use it to replace their traditional cost system. It would seem that only about 9 percent (25 percent of the 36 percent) of companies are using ABC as their main system while the vast majority use a standard cost system (SCS). This is not to say that traditional SCSs could not benefit from being updated. However, accountants in industry (as well as academia) seem unaware that a redesigned SCS can provide the information they need, and that modify their present system is an easier process than adopting a new system.The SCS is one vehicle of articulation among managerial, financial and operations accounting, and it is a control system while the candidates for its shift typically are only cost accumulation sy stems. In this article the major criticisms of SCSs are examined along with ways that the weaknesses can be remedied or ameliorated. The criticisms relate to the use of specific variances, the lack of provision for continuous improvement, and the fact that administration of the system results in internal competition rather than cooperation. The appropriate use of ABC systems in conjunction with SCSs is also discussed. UPDATING THE VARIANCES IN AN SCSConcerning the variables analyzed in an SCS, most criticisms center on the overemphasis on price and efficiency to the exclusion of quality. Other criticisms center on the use of the volume variance to measure utilization of capacity while ignoring overproduction and unnecessary buildups of inventory. In making such charges, critics lose it to realize variance analysis is not locked-in to a particular set of variables. Standards are only benchmarks of what performance should be. The particular variables used can be changed as the need a rises. The following discussion focuses on concerns of the new manufacturing environmentraw material ordering and inventory levels, quality, production levels, finished honorables inventory levels and completion of sales orders.Variances Pertaining to Raw Materials The set of variances in Figure 1 centers on the function of raw material ordering and inventory levels (Harrell 1992). The Raw Material Ordering Variance gives information about the effectiveness of suppliers. It contrasts the raw materials ordered with the raw materials delivered (purchased). Any variation may be considered unfavorable because the goal is to have orders delivered as placed. in like manner much delivered will result in unnecessary buildups of raw material stocks. Too little delivered is unfavorable because production delays may result. The Price Variance in Figure 1 is the traditional price variance computed on materials purchased.This variance has been criticized on the grounds that over-emphasis on pr ice leads purchasing managers to ignore quality. However, price is a legitimate concern that should not be overlooked. This system also uses a quality Variance (presented in a following section). If low quality materials are purchased in order to gain a low price, this will result in an unfavorable Quality Variance. Variances Pertaining to Material Inventories and Efficient Use The set of variances in Figure 2 focuses on raw material inventory levels and quantity or efficiency of material use. The Raw Materials Inventory Variance (Harrell 1992) shows either more material purchased than used (an inventory buildup) or more material used than purchased (an inventory change magnitude).With the JIT philosophy, purchasing more than used causes an unfavorable variance, while decreasing precedent buildups causes a favorable variance. The Efficiency Variance in Figure 2 is based on the end between the actual pounds of material used and the standard amount for total production. The tradit ional Efficiency or Quantity Variance is the difference between the actual pounds of material used and the standard amount for good production. The traditional variance is actually as combination of quality and efficiency factors. As can be seen in the next section, quality is better treated in a separate variance. Variances Pertaining to Production Levels and QualityThe next set of variances (Figure 3) turns from input analysis to output analysis and relates to production levels and quality. All cost factors are included in the standard cost per unit including labor and overhead. The Quality Variance is the standard cost of units produced that did not meet specifications (the difference between total units produced and good units produced). In traditional variance analysis, this variance is buried in the efficiency variances of the various inputs. Ignoring labor and overhead, suppose a company used two pounds of material per finished unit at a standard cost of $1. 00 per pound. Fur ther assume they used 4,900 pounds in the production of 2,500 total units, of which 100 were defective.Traditional variance analysis would show an unfavorable Efficiency Variance of $100 computed on the difference between the standard cost of the 4,800 pounds that should have been used to produce the 2,400 good units and the 4,900 pounds actually used. A better breakdown of the traditional variance shows a favorable Efficiency Variance of $100 and an unfavorable Quality Variance of $200. The Production section did use only 4,800 pounds to produce 2,500 units that should have taken 5,000 pounds. The fact that some of these units were defective should appear as a Quality Variance, as it does in this analysis. The Quality Variance is $200 unfavorable representing $2. 00 per unit invested in 100 defective units.This analysis also yields a Production Variance based on the difference between the standard cost of good units produced and the scheduled amount of production. The goal in adva nced manufacturing environments is to produce exactly what is needed for sales orders (scheduled production). A variance from scheduled production either way is unfavorable because too much production results in unnecessary buildups of inventory while too little results in sales orders not filled. As is the case with the Raw Material Inventory variance, the critical factor is the cost of the keen invested in excess inventories. It is desirable to highlight this cost in responsibility reports by applying a cost of capital figure. o the excess (Cheatham 1989). For simplicitys sake, the above illustrations of input analysis furbish up to materials. Labor and volume-related variable overhead can be analyzed in a similar manner. Since there is no difference between labor purchased and labor used in production, the labor input variances would include the traditional Rate Variance and the updated Efficiency Variance. Other than showing a budget variance for the various elements of fixed overhead, there is no point in further analysis in terms of a Volume Variance. The updated Production Variance serves the same purpose in a far better fashion. VARIANCES PERTAINING TO SALES ANALYSISThere are various ways to analyze sales. One method is to use price, mix and volume variances. A further analysis is to break down the volume variance into market size and market share variances. The analysis in Figure 4 is presented because it articulates well with the output analysis for production. The sales variances indicate customer service as well as the cost of lost sales. The variances use budgeted contribution margin as a measure of opportunity cost. The Finished Goods Variance indicates the opportunity cost associated with orders completed but not shipped. A delay in shipment causes a loss because of subsequent delay in receiving payment.The Sales Order Variance represents the opportunity cost associated with sales orders that could not be filled during the time period for what ever reasonlack of capacity, scheduling problems, etc. The above discussion presents a variety of variances that are not used in a traditional standard cost system. The variances can be used for control purposes alone or can be integrated into the financial accounting records (Cheatham and Cheatham 1993). The system is not intended to be a generic solution for any companys needs. It is intended to demonstrate that, with a little creativity, it is possible to redesign SCSs to measure variables that are important to a particular company in todays manufacturing environment. UPDATING THE SCS FOR CONTINUOUS IMPROVEMENTIn a manufacturing environment in which continuous improvement is a goal of most companies, the charge has been made that SCSs do not encourage positive change. However, static standards based on railroad engineering studies or historical data are not an essential part of an SCS. Standards can be adjusted to be dynamic, or changing, by any of several methods. Using anterio r Periods Results as Standards One way to have dynamic standards is to use last periods results as standards. This idea has been advocated in the past as a way for small business to have the benefits of standards without the expense of engineering studies (Lawler and Livingstone 1986 Cheatham 1987).The objection can be made that last periods results may not make very good standards if last period was unrepresentative for whatever reason. If this is the case, last periods results can be modified. Another variation on using past performances as standards is the use of a base period. Comparisons can be made with the base period and all subsequent periods, if desired. Boer (1991, 40) describes a system of using a base year as a pseudo flexible budget from which unit costs are developed. He comments that the system encourages continuous improvement and never implies that a level of performance is adequate. Instead, it encourages managers to improve continuously. Still another variation on using prior periods results as standards is the use of best performance-to-date (BP).BP is a rigorous standard for self-improvement because it motivates workers as well as managers to exceed all past performance. Using Benchmarking Although past performance costs may be used in a variety of ways to formulate dynamic standards, any such system has an inward focus. Benchmarking looks outside the firm to the performance of industry leaders or competitors. Benchmarking typically is applied to performance measures rather than standard costs. However, using the performance of industry leaders as a standard provides motivation to become world-class in much the same fashion. The primary barrier to use of benchmarking standards is, of course, lack of information. Edward S.Finein (1990), former vice president and chief engineer of Xerox, lists the following sources of information when using benchmarking for performance measures (1) external reports and trade publications (2) professional a ssociations (3) market research and surveys (4) industry experts (5) consultants studies (6) company visits and (7) competitive labs. In the absence of hard information, an approach may be taken to estimate the performance of industry leaders. Trying to meet the supposed standards of industry leaders (or other competitors) can have results that are useful as long as the company is striving toward beneficial goals. Using Moving Costs Reductions Still another way to have dynamic standards is through use of predetermined cost reductions. Horngren et al. 1994) describe a system of what they call a continuous improvement standard cost or a base cost reduction standard cost. This system reduces the standard cost by a predetermined percentage each time period, such as a one percent reduction in standard cost per month computed by setting the new standard at 99 percent of the previous months standard. The question that their system raises is how to determine the amount of the cost reducti on. One possibility is the use of cost improvement curves. Cost improvement curves are a new variation of the old learning curve idea. Learning curves were based on reduction of direct labor costs due to learning by the workers.With a large percentage of product conversion being brought about by automated equipment rather than laborers, potential cost reductions relate to the experience factor for the organization as a whole which may be measured by cost improvement curves. Pattison and Teplitz (1989) calculate the new rate of learning for an organization that replaces labor with automated equipment as Ratenew = Rateold + (1 Rateold) * L * R where Rateold is the rate of learning for the old system, L is the proportion of learning attributed but to direct labor stated as a percentage, and R is the proportion of direct labor being replaced. The formula actually reduces the learning rate applicable to labor only, the assumption being that workers can learn but not machinery.An update d version of the formula is needed which encompasses factors such as managers, supervisors and engineers experience. The Japanese stress the formula 2V=2/3C, or if volume is doubled, the cost should be two-thirds of what it was originally. This formula equates to a 67 percent learning curve which represents a high degree of learning. However, their positioning is that learning does not just happenit should be made to happen. Using Target Costs Another idea borrowed from the Japanese is the use of target costs based on the market. Target costs are used in Japan primarily for new products that are still in the design stage. The idea is to set a cost that is low enough to permit a selling price that is viable on the market.The price is the starting point for calculate costs, and the various costs are backed out from the price. Typically, the target cost is very low. Hiromoto (1988) describes the use of target costs at the Daihatsu Motor Company. First, a product development order is issued. Then an allowable cost per car is calculated by taking the difference between the target selling price and the profit margin. Then each department calculates an accumulated cost based on the standard cost achievable with current technology. Finally, a target cost is set somewhere between the allowable and accumulated cost. All this takes place before the product is designed.The design stage typically takes three years. When the product is finally in production, the target cost is gradually tightened on a monthly basis. Later the actual cost of the previous period is used to drive costs down further. Market-based target costs have a strong appeal on a basis for standard costs because they focus on the customer rather than on internal engineering capabilities. However, using target costs is easiest with new products because as much as 90 percent of product costs are set in the design stage (Berliner and Brimson 1988). The way a product is designed determines the way it has to be manufactured and sets the stage for further cost reductions.Standard costs do not have to be static. Dynamic standards can be formulated using a variety of methods including past performance, industry leaders performance, or target costs based on predetermined reductions or the market. Market-based target costs have the most intuitive appeal because the focus is on the future and on the customer. However, they may work better for new products rather than for established products. UPDATING MANAGEMENT RESPONSIBILITY AND REPORTING Besides revamping the SCS to better reflect todays concerns in terms of variables to be measured and continuous improvement, there needs to be improved reporting of variances.Old reporting systems tended to foster internal competition and arguments about whose department was to blame for unfavorable variances. There needs to be an attitude of cooperation among workers, managers and departments. Revised lines of responsibility used with new plant layouts ar e improving some of the competitive attitudes that once prevailed in manufacturing organizations. Plants that used to feature push through production with large masses of raw materials and semi-finished product moving from one process to another are changing to work cells or similar arrangements. The work cell arrangement features equipment that can process a product from start to finish. Workers in the work cell typically can operate all or several types of machinery.This leaner pull through approach allows a sales order to be rapidly processed within the work cell which decreases cycle time and holds work in process and finished goods inventories to a minimum. The work cell arrangement allows a team of workers to be responsible for the entire product and reduces the likelihood that defects will be passed along to the next department. along with the work cell arrangement many companies are decentralizing functions such as engineering and making these personnel responsible for a par ticular work area or product line. With the decentralization, there is more focused responsibility. Decentralization and a team approach to production eliminate many conflicts that once existed.In addition to the new attitudes about responsibility, there needs to be improved reporting. The variances outlined in this paper can be reported in two types of management reports. The report illustrated in Fig. 5 shows the trade-offs between price, efficiency and quality. This type of report can be done on a plant level or department level as well as a work cell level. The price variance for work cells or departments should be computed on material used rather than purchased because this gives a better picture of the trade-offs involved. Upper-level management reports should probably show both types of price variances if there are significant differences between purchases and use.The report illustrated in Fig. 6 shows the effects of variances related to inventories. Raw material excesses at cost, related to both current and past purchases, are listed along with the related cost of capital. In this case it is assumed the excess was held the entire month and the cost of capital was one percent. Work-in-Process excesses are measured in terms of the Production Variance. This variance measures the difference between scheduled and actual production. Presumably if there were excesses from the previous month, there was an adjustment made in the scheduled production. Cost of capital figures show the effect of holding these excess inventories.In the case of Finished Goods, the crucial factor is the opportunity cost of sales orders not filled measured by the lost contribution margins. Therefore, if orders are completed but not shipped or there is an inability to fill a sales order because of lack of capacity, this is indicated by the Finished Goods Variance or the Sales Order Variance. The illustration assumes a favorable Finished Goods Variance because more sales orders were fil led than units produced, indicating a decrease in previous finished goods stock. Although a reporting system such as that illustrated in Figures 5 and 6 may not eliminate all conflicts, it is certainly