Chapter 10 Standard costs for control: direct material and direct labour Copyright ª 2006 McGraw­Hill Australia Pty Ltd 10­1 Controlling costs • Businesses are in control when operations proceed to plan and objectives are achieved • Control systems provide regular information to assist in control, which is an essential part of effective resource management • Necessary requirements for control – A predetermined or standard performance level – A measure of actual performance; and – A comparison between standard performance and actual performance continued Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 10-2 Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 10-3 Controlling costs • Standard costing is a part of the budgetary control system 1. A predetermined or standard cost is developed – A standard cost is a budgeted cost of one unit of product – Includes cost of material, labour and overhead 1. The actual cost incurred in the product process is measured 2. The actual cost is compared to the standard cost to form a cost variance continued Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 10-4 Controlling costs • Standard cost variances are used to evaluate actual performance and control costs • Standard costs can be developed for direct material, direct labour and overheads • When cost variances are significant, the cause of the variance must be investigated – May result in operations being changed to bring cost back in line with standards – Management may reconsider whether the standard costs are appropriate benchmarks Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 10-5 Setting standards • A variety of methods may be used to set cost standards • Analysis of historical data – Can provide a good basis for predicting future costs – May need to be adjusted to reflect expected movements in price levels or technological changes in the product process – Must be used with care as changes can make those costs irrelevant, and can include inefficiencies of the past continued Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 10-6 Setting standards • Engineering methods – Rather than what it cost in the past, the focus is on what it should cost in the future – Need to determine how much material should be required and how much direct labour should be used in the production process – Time and motion studies may be conducted to ascertain how long it should take for workers to perform each step • In practice, both historical cost analysis and engineering methods may be used in combination continued Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 10-7 Setting standards • Participation in setting standards – Standards should not be set by accountants alone – People will usually be more committed to meeting standards and have greater confidence in their accuracy if they are allowed to participate in setting them – Any manager who plays an integral part in an operation or process should participate in setting standards for that area continued Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 10-8 Setting standards • Perfection standards reflect minimum attainable costs under nearly perfect operation conditions – Assumes peak efficiency, the lowest material and labour prices, the use of the best quality materials and no production disruptions due to power failures or machine breakdowns • Perfection standards – May motivate people to achieve the lowest cost possible, as the standard is theoretically attainable – May discourage employees from working hard as the standards are unlikely to be achieved – May encourage employees to sacrifice quality to achieve low costs continued Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 10-9 Setting standards • Practical standards are the minimum attainable costs under normal operating conditions, with allowances made for downtime and wastage – Includes occasional machine breakdowns and normal amounts of raw material wastage – May encourage more positive and productive attitudes among employees compared to perfection standards – Some companies include allowances for idle time, material wastage or normal spoilage, which may encourage inefficiency and waste – Other companies build continuous improvements into standards to make them more demanding continued Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 10-10 Setting standards • Benchmarking of costs may involve – Identifying companies that have the best cost performance – Assessing their level of costs, and – Identifying the cost performance gap that needs to be closed • Cost standards may be formulated to achieve external performance standards over the medium to long term Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 10-11 Direct material standards • Standard material quantity – The total amount of direct material required to produce one unit of product • Standard material price – The total delivered cost of the material, less quantity discounts – Based on ordering a certain quality of material in specific order quantities from a specified supplier Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 10-12 Direct labour standards • Standard direct labour – The number of labour hours normally needed to manufacture one unit of products • Standard labour rate – The total hourly cost of wages, including on-costs – On-costs are extra salary-related costs that all Australian companies have to pay; usually treated as part of the cost of labour