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Learning Objectives By the end of this module you should understand: 1. The relationship between budgeting and standard costing 2. How standard costs are set 3. The motivational aspects of standards 4. The role of flexible budgets 5.5. How to calculate the principal variances surrounding material, labor and overhead costsHow to calculate the principal variances surrounding material, labor and overhead costs 6. The possible reasons for variances and when to investigate them 7. How to calculate sales variances and the managerial significance of the numbers produced Omar ElKheshen – omar@arabacademy.com 2
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Agenda 13.1 Introduction 13.2 Setting Standards 13.3 A Word about Motivation 13.4 Flexible Budgets 13.5 The Anatomy of Variances: Materials and Labor 13.6 Responsibility for Variances 13.7 Variable and Fixed Overhead Analysis 1313..88 Investigation of VariancesInvestigation of Variances 13.9 Sales Variances Review Questions Case Studies Omar ElKheshen – omar@arabacademy.com 3
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As we’ve covered in module 12, budgeting is concerned with planning the activities of an organization for a specific time period –usually 12 months Budgeting A plan of action, usually expressed in numbers and amounts, which sets targets for individuals and for the business over a defined future timeframe Management must give thought to the future in order to plan to meet its threats and opportunities Module 12 Module 13 Considers the mechanism Sets out the procedures for available to management to constructing the budget monitor the actual performance against the plan Omar ElKheshen – omar@arabacademy.com 4
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We can see from the Go- Straight Trolley Co. case that the budget was ultimately expressed in total numbers, quarter by quarter Master Budget provides: A picture of Allows management to gain a forward picture of cash flow; and Cash Flows consequently allows them to negotiate with their bankers in a planned manner Answers to Investment Equip management to deal with professional investment analysts – Analysts who advise potential investors on the company’s prospects Once constructed the budget should be used to control the actual operations of the business for the accounting period under review Omar ElKheshen – omar@arabacademy.com 5
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There can be no better benchmark to judge actual performance than the budgeted plan for the period – provided that plan was carefully worked out Control Process Judging actual performance than the budgeted plan for the period We use: A budget is built up from many standard costs Standard CostsCosts Standard costs are budgeted costs for individual cost items Standard costs are compared with actual costs & explanations are sought for any differences between the two; where if performance is not up to the desired level remedial managerial action Omar ElKheshen – omar@arabacademy.com 6
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Agenda 13.1 Introduction 13.2 Setting Standards 13.3 A Word about Motivation 13.4 Flexible Budgets 13.5 The Anatomy of Variances: Materials and Labor 13.6 Responsibility for Variances 13.7 Variable and Fixed Overhead Analysis 1313..88 Investigation of VariancesInvestigation of Variances 13.9 Sales Variances Review Questions Case Studies Omar ElKheshen – omar@arabacademy.com 7
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Remember the cost profiles of the timber-shelved DVD cabinet and the supermarket trolley Each of these products was costed in some detail with the DVD cabinet being allocated a share of the manufacturing and non-manufacturing overhead Omar ElKheshen – omar@arabacademy.com 8
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Consider first the matter of setting standards for materials; the best indicator of material usage per unit of product will be the consumption records of the previous period This year: A trolley consumed 11 meters of material Next year: Standard for next year at 10 meters Standard for next year at 11 meters It would be pointless unless theIt would be pointless unless the It would be wasteful if this numberIt would be wasteful if this number company could demonstrate an included inefficiencies in selection ability to save one meter due to of correct lengths and the new processes or techniques consequent trimming of sizeable ends of metal which could not be used for any purpose other than sale for scrap Omar ElKheshen – omar@arabacademy.com 9
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A firm needs to know precisely how much material it will require Before Production And During the product’s life cycle in production Putting a Prototype into Production Detailed Engineering Study Considers: The complexity of design ofThe complexity of design of the productthe product The availability of theThe availability of the required quality of materialrequired quality of material The skill of labor required toThe skill of labor required to make the productmake the product The engineering precisionThe engineering precision of the productionof the production machinerymachinery The resultant figure will be the ideal or engineered standard Amounts of material which should be required if every aspect of production works to maximum efficiency Omar ElKheshen – omar@arabacademy.com 10
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But of course this seldom happens in reality where the engineered standards are rarely reached Reasons behind this: Machines break downMachines break down Machines requireMachines require Workers make mistakesWorkers make mistakes recalibrationrecalibration Workers operate at fasterWorkers operate at faster Workers operate at a slowerWorkers operate at a slower Quality of raw materialsQuality of raw materials speeds than plannedspeeds than planned rate than plannedrate than planned variesvaries Normal or Operating StandardsNormal or Operating Standards Amount of material which is expected to be achieved by a productive operation operating carefully and efficiently but which also reflect the normal perils which surround a process where so many things can go wrong Omar ElKheshen – omar@arabacademy.com 11
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The materials’ price standard will be based on external economic factors Factors include: Expected purchase pattern Suppliers’ estimates of price movements Quantity discounts negotiated Quality of raw material required A business whose raw material inputs are subject to significant price fluctuations, e.g. commodities such as wheat, may reduce their budget periods to shorter terms Omar ElKheshen – omar@arabacademy.com 12
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Labor usage and price standards are set in similar manner to those for materials Detailed Engineering Study Normal Standards would consider: The time taken for refreshmentThe time taken for refreshment Should be able to measure the timeShould be able to measure the time breaksbreaks required by a skilled operative:required by a skilled operative: Casual conversations withCasual conversations with To manufacture the productTo manufacture the product supervisors and colleaguessupervisors and colleagues To assemble the productTo assemble the product fetching raw material andfetching raw material and To test the productTo test the product consumables and carrying finishedconsumables and carrying finishedconsumables and carrying finishedconsumables and carrying finished components to the nextcomponents to the next workspace or collection pointworkspace or collection point Engineered Labor Usage StandardsEngineered Labor Usage Standards Normal Labor Usage StandardsNormal Labor Usage Standards Such a study would describe the quality of operative and the nature of training to be undertaken before production commences Omar ElKheshen – omar@arabacademy.com 13
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While labor usage is usually measured in units of time, the standard price for direct labor input is measured in money value considering several factors We have to consider: Current ratesCurrent rates Any anticipated uplift during the budgetAny anticipated uplift during the budget Due to: Negotiated cost-of-living TimeTime--served incrementsserved increments Anticipated bonus payments Omar ElKheshen – omar@arabacademy.com 14
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Overhead standards tend to be determined by reference to one of the four standards already described The standards for both variable and fixed overhead depend on three components: The budgeted cost of each overheadThe budgeted cost of each overhead The allocation key to be used to allocate overhead to productThe allocation key to be used to allocate overhead to product The volume expected of each allocation key to be usedThe volume expected of each allocation key to be used Example Assume budgeted fixed overhead amounts to €100,000 for next year and the allocation key to be used is machine-hours for all fixed overhead. If 400,000 machine-hours is anticipated next year a budgeted fixed overhead rate of €0.25 per machine-hour will be used. A product that uses 10 machine-hours will have a standard fixed overhead rate of €2.50 for next year. A change in either (b) or (c) will have the effect of altering the standard overhead cost per unit even if (a) remains the same. Omar ElKheshen – omar@arabacademy.com 15
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Agenda 13.1 Introduction 13.2 Setting Standards 13.3 A Word about Motivation 13.4 Flexible Budgets 13.5 The Anatomy of Variances: Materials and Labor 13.6 Responsibility for Variances 13.7 Variable and Fixed Overhead Analysis 1313..88 Investigation of VariancesInvestigation of Variances 13.9 Sales Variances Review Questions Case Studies Omar ElKheshen – omar@arabacademy.com 16
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The greatest role of budgets is in motivating the workforce to perform at their highest level of achievement Budgets Should : Budgets Should NOT: Be carrots to encourage and reward Be used as sticks to beat recalcitrant superior performance workers into shape But: If the budget is slack, there is little If employees are presented with a incentive for an employee to sharpen budget which is well beyond their performance (it has to be stretchedperformance (it has to be stretched reach they will not attempt to comereach they will not attempt to come but not slack) anywhere near the level expected The use of normal standard, provided there The use of ideal, engineered standards is a has been built into it an element of ‘stretch’ short-sighted demotivational device which and rigor, will give the incentive to well- should be resisted intentioned employees to strive to reach the level expected, and to reward them for so doing The setting of budgets and standards is therefore a task which involves every level of the organization and ‘external observers’ besides employees who know most about the processes under review Omar ElKheshen – omar@arabacademy.com 17
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Agenda 13.1 Introduction 13.2 Setting Standards 13.3 A Word about Motivation 13.4 Flexible Budgets 13.5 The Anatomy of Variances: Materials and Labor 13.6 Responsibility for Variances 13.7 Variable and Fixed Overhead Analysis 1313..88 Investigation of VariancesInvestigation of Variances 13.9 Sales Variances Review Questions Case Studies Omar ElKheshen – omar@arabacademy.com 18
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Imagine a quarterly report on production cost performance along the following lines: The production facility has spent €1,260 less than budgeted but the production level was reduced fromreduced from 22,,000000 toto 1,800 It is futile to compare the actual costs of making 1,800 with the budgeted costs of making 2,000; this could be dangerously misleading But which column should be adjusted? Should we flex the budget column down to the 1,800 level or the actual column up to the 2,000 level? Omar ElKheshen – omar@arabacademy.com 19
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The answer is that we must flex the budgeted column of costs down to the level of output actually achieved A far more meaningful presentation would use a flexible budget presentation: Net effectNet effect ofof these overruns & underruns was €240, or 1.65% over budget This report now gives a better picture of the activities of production over the third quarter to 31 March 20x4; is much more informative than the earlier one Omar ElKheshen – omar@arabacademy.com 20
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