Analysis of Standard Costing System and Decision Making free essay sample

Content 1. Introduction4 2. Part ? Standard Costing System and Variance Analysis5 2. 1. Definition5 2. 2. Scenarios of Standard Costing System and Variance Analysis5 2. 2. 1 Scenario ? Manufacturing Companies—Auto-making Firms6 2. 2. 2 Scenario ? Service Industries—Banks7 2. 2. 3 Scenario ? Other Industries That Have not Repetitve Processes—AdvertisingFirms8 2. 3. Standard Costing System on Different SIzes9 2. 4. Variance Analysis9 2. 4. 1 Total Production Cost Variance9 2. 4. 2 Marterials Variances10 2. 4. 3 Fixed overhead Variance11 2. 5. Summary12 3. Part ? —Relevant and Irrelevant Costs and Incomes13 . 1. Definition13 3. 2. Scenario ? —Shutting Down or Keeping Open Part of the Business13 3. 2. 1 Relevant and Irrelevant Costs andIncomes in Scenario ? 16 3. 2. 2 Qualitative Factors in Scenario ? 16 3. 3. Scenario ? —Pricing Products or Services16 3. 3. 1 Pricing Customized Produccts/Services17 3. 3. 2 Pricing Non-customized Products/Service s17 3. 3. 3 Relevant and Irrelevant Costs andIncomes in Scenario ? 18 3. 3. 4 Qualitative Factors in Scenario ? 19 3. 4. Scenario ? —Product Mix and Limiting Factor Analysis19 3. 4. 1 Relevant and Irrelevant Costs andIncomes in Scenario ? 1 3. 4. 2 Qualitative Factors in Scenario ? 21 3. 5. Scenario ? —Make or Buy Decisions21 3. 5. 1 Relevant and Irrelevant Costs andIncomes in Scenario ? 24 3. 5. 2 Qualitative Factors in Scenario ? 24 4. Conclusion25 Reference26 Appendix28 I. The Learning-Curve Effect28 II. Variance Analysis for A Variable Costing System28 III. Formula for Variance Analysis29 8 1. Introduction With more and more competitive in global market, costs of companies’ products become more and more important. In this assignment, the definitions of standard costing and variance analysis are introduced. This assignment refers that whether or not standard costing system and variance analysis are appropriate to any type and size of organization, and analyzes four scenarios about decision-making. At last, some relevant and irrelevant income and costs and qualitative factors are identified in these four scenarios. 2. Part ? —Standard Costing System and Variance Analysis 2. 1. Definition Standard costing system and variance analysis usually are used in improving the control of costs. Standard costs are predetermined costs and target costs that be incurred under efficient operating conditions (Drury, 2009). Purposes of standard costing are: 3. giving a forecast of costs that can be used for decision-making purposes; 4. offering a challenging target which can motivate individuals to achieve; 5. helping for setting budgets and evaluating managerial performance; 6. acting as a control device by warning managers to situations that may be ‘out of control’; 7. simplifying the task of tracing costs to products for profit measurement and inventory valuation purposes (Drury, 2008). Variance analysis refers to find out differences between standard costs and actual costs and to analyse reasons of these differences (Atrill McLaney, 2007). Managers analyse variances of each element of costs in each responsible centre to find out measures that can control costs more efficient. 2. 2. Scenarios of Standard Costing System and Variance Analysis The data of standard costing comes from historic costs. Standard costing is most suitable to organizations whose activities consist of a series of repetitive operations and input required to produce each unit of output can be specified (Drury, 2009). Manufacturing companies and service companies have the repetitive operations, such as auto-making companies and banks. There are, however, some industries that are not suitable for the standard costing system, since their activities have not the repetitive nature. For example, hospital whose patients differ individually and advertising firms that customize advertisements and focus on creating new things do not use the standard costing system as the cost of this system is too large. The reason of why standard costing system just can be used in companies which have the repetitive operations is that the costs of standard costing system in companies which own the repetitive operations are less than in others that do not have the repetitive operations. . 2. 1. Scenario ? Manufacturing Companies—Auto-making Firms In manufacturing industries, the processes of companies are usually repeatable. This nature of manufacturing companies is due to large economies of scale. Especially the auto-making firms, they use the assembly line to standardize their products. This can help to decrease their costs. For e xample, Honda produced standardized wheels (De Wit Meyer, 2010). Because Honda used the assembly line a lot of years, Honda can accurately calculate costs of a wheel, such as quantity of materials(1. 1 kg), variable overhead (? 2. 0/h) of one wheel. Because standard costs of Honda are relatively unchangeable, Honda can use basic cost standards. Basic cost standards are one of cost standards and represent constant standards that are left unchanged in a relatively long period (Broadbent Laughlin, 2009). Although even Honda would change its productions in every two years, standard costs are not changed so much. Because Honda changed its wheel very detailed, such as wheel’s size or pattern, managers could calculate new standard costs accurately. In conclusion, manufacturing firms can use standard costing system. . 2. 2. Scenario ? Service Industries—Banks The activities of service industries own the repetitive nature. To decrease running costs, service companies make a s eries of processes that standardize activities of their employees. For example, banks prescribe processes of loan applications (at below table). In processes, the labour standard cost (? 1. 50) is the most. Companies trained employees and paid salaries to them. In Lloyds TSB online payment, the process is standardized. First, a customer fills in details of payment, such as the name of acceptor and acceptor’s address. Then, TSB calls the customer to confirm the payment. At last, TSB send a message to the customer to notice details of payment. At this process, the cost is very low—labour cost and sending messages cost. Standard Costs of A Loan Application (? ) Direct materials 0. 6 Direct labour (10 minutes) 1. 5 Variable overhead 1. 0 Total standard variable cost 3. 1 In service industries, managers should pay the most attention to labour costs. Any employee needs time to be familiar to processes and directly attend service’s activities. If a new activity is made, or new employees attend an existing activity, a learning-curve effect will occur (Appendix ? ). At the beginning, the time taken per unit of output is long. With experience increases, employees take less time to do the service. So the learning-curve effect must be taken into account when setting standards (Atrill McLaney, 2007), especially in service industries. For example, if let a new employee to take care of customers’ loan applications, the time will be longer (20 minutes) and the labour standard cost will increase (? 2. 00). . 2. 3. Scenario ? Other Industries That Have not Repetitive Processes—Advertising Firms Now more and more companies pay attention to customers’ individual needs. Customers’ needs are relatively difference. For example, in clothes design, the designer makes unique clothes for each customer. If this kind of companies uses standard costing system, managers have to recalculate standard costs every time. T his will let managers to take a lot of time to calculate standard costs. In advertising firms, they use different projects to produce different advertisement. Because advertisements have to follow customers’ requirements, each project’s costs are different (at below tables). And this kind of firms is not suitable for variance analysis, as the types of materials and labours are different. Costs of Advertisement ? (? ) Direct materials A 150 Direct labour (group 1) 200 Variable overhead 250 Total budget variable cost 600 Budget contribution margin 250 Budget selling price 850 Standard Costs of Advertisement ? (? Direct materials B 350 Direct labour (group 2) 150 Variable overhead 230 Total budget variable cost 730 Budget contribution margin 200 Budget selling price 930 2. 3. Standard Costing System on different sizes On the small size organizations, the standard costing system is not very suitable. Because resources of small size organizations are limited and they cannot produce so many products, the costs of this system on small size organization are large. About medium size organizations, the range of products in medium size organization is larger than in small size organization, but I advise this kind of organization can use budget costs, because the repetitive processes are not many in the range of medium size organizations’ productions. The costs of this system are also high. In large organizations, the types of productions are a lot and there are many repetitive processes. So this system is suitable in large organizations. 2. 4. Variance analysis From the table (Appendix ? , there are 3 parts in the variance analysis—selling and distribution cost variances, total production cost variance, and total sales margin variance. In this assignment, total production cost variance will be mainly discussed. If a firm can establish standard costs, it can use variance analysis to analyse the differences between standard costs and actual costs. If standard costs cannot be used, costs should be managed by comparing budgeted and actu al costs (Verbeeten, 2010). So manufacturing firms, service industries, or other companies that own repetitive processes, can use variance analysis. Companies that have not repetitive processes, like advertising firms, cannot use variance analysis. 2. 4. 1. Total Production Cost Variance In this part, there are four variances—material variances, labour variances, variable overhead variances, and fixed overhead variances. There is an example (at below tables) about variance analysis. The costs of materials, labour or variable overhead are determined by two factors—the price and the quantity. The differences between standards costs and actual costs will be happened, when the actual quantity (or price) is different from the standard quantity (or price). Standard costs on products (? ) Direct materials—10,000kg at 13 per kg 130,000 Direct labour—20,000 hours at ? 8 per hour 160,000 Variable overheads—20,000 hours at ? 3 per direct labour hour 60,000 Total variable standard costs 350,000 Fixed overheads 120,000 Total standard costs 470,000 Actual costs on products (? ) Direct materials—10,300kg at 12 per kg 123,600 Direct labour—28,000 hours at ? 9 per hour 252,000 Variable overheads—28,000 hours at ? per direct labour hour 84,000 Total variable costs 459,600 Fixed overheads 106,000 Total costs 565,600 2. 4. 2. Material Variances (Formula-Appendix ? ) About the material price variance, the standard price (SP) of material is ? 13, and the actual price (AP) is ? 12. There is a ? 1 saving per kg. In addition, because QP was 10,300 kg, the material price variance is favourable (? 10,300=? 1? 10,300 kg). This means BWM got a fewer price in actual price, because it found a good supplier that can off er materials in fewer prices. About the material usage variance, the SQ is 10,000 kg (10,000 units? 1 kg), but the materials that were used (AQ) is 10,300 kg. And the SP is ? 13. So the material usage variance is ? 3,900 and adverse. The reasons about adverseness are company changed its quality control requirements, and changed methods of production. Managers can reduce the usage of materials through improving product design or use promotion and advertising to improve its sales. About the total material variance, the standard material cost (SC) is ? 130,000 (10,000 units 13) and the actual cost (AC) is ? 123,600 (10,300 nits 12). So the total material variance is favourable (? 6,400=? 130,000-? 123,600). Or using the material price variance minutes the material usage variance (? 6,400=? 10,300-? 3,900). This result is due to the fewer price of materials. However, managers need to reduce the usage of input. Actually the labour variance and variable overhead variance have the same formula to calculate quantity vari ance and price variances, that is, and . Because the process of variance analysis in these three parts is same and words are limited, the labour variance and variable overhead variance do not explain. . 4. 3. Fixed Overhead Variance The formula of the fixed overhead variance is (BFO means the budgeted fixed overheads; AFO means the actual fixed overhead) (Atkinson et al, 2001). BMW’s BFO was ? 120,000 and AFO was ? 106,000. So the fixed overhead variance was ? 14,000 and was favourable. The reasons about the differences between BFO and AFO may have a lot, such as the appointment of additional supervisors, or salaries of supervisors were changed. Managers are likely to think this variance is uncontrollable in a short term. 2. 5. Summary Standard costing system and variance analysis may be used to any type and size of organizations, but not suitable for any type and size of organizations. Standard costing system is suitable for some companies which own different products under a series of common operations, such as manufacturing companies and service industries. However, some companies that own different operations do not be advised to use standard costing system, such as advertising firms. The cost of standard costing system is the most important reason. The variance analysis has the same situation. 3. Part ? —Relevant and Irrelevant Costs and Incomes 3. . Definition When managers make future decisions, they have to consider relevant costs; otherwise, the decisions will be subjective or even wrong. The relevant costs and revenues mean that in decision-making, costs will be influenced in the future decision (Antrill McLaney, 2007). In addition, the relevant costs include avoidable costs and opportunity costs. For example, if a firm purchase a new computer, ? 738 will be cost; if not, the expenditure of ? 738 will be avoided. ?738 is called avoidable costs. Opportunity is a tool to measure the cash benefit from the next most desirable alternative action (Proctor, 2009). Irrelevant cost is the cost that is not about decision-making (Davila et al, 2009). It includes 3 kinds of costs—sunk costs, committed costs, and non-cash costs. Sunk costs are past costs; committed costs are about legal costs that will be paid in the future (Proctor, 2009); non-cash costs are these costs that not cause any cash movement, such as depreciation. Qualitative factors are these factors that can’t be evaluated in monetary terms (Drury, 2009) and have to be taken into account in the decision-making. For example, employee morale and customer goodwill belong to qualitative factors. 3. 2. Scenario ? Shutting Down or Keeping Open Part of the Business Many organizations do periodical analysis to compare different profits between departments. If the profit of a department is negative, the firm needs consider a lot of factors to determine close it or not. There is an example about discontinuation decisions (at the below table). PGShampoo (? 000)Body wash (? 000)Soap (? 000)Total (? 000) Cost of goods sold80088010002680 Salesperson’s salaries160200240600 Sales office rent7090110270 Depreciation of sales office equipment20402090 Apportionment of warehouse rent25252575 Depreciation of warehouse equipment18162458 Departmental and headquarters costs380400320110 Total costs assigned to each location1473165117394863 Reported profit/(loss)427349(139)637 sales1900200016005500 PGKeep soap open (? 000)Discontinue soap (? 000)Difference in costs and revenues (? 000) Cost of goods sold268016801000 Salesperson’s salaries600360240 Sales office rent270150120 Depreciation of sales office equipment9090 Apportionment of warehouse rent7575 Depreciation of warehouse equipment5858 Departmental and headquarters costs11001100 Total costs assigned to each location487335131360 Reported profit/(loss)627387240 sales550039001600 PG Company analyses its profit by departments. There are 3 departments—soap, shampoo, and body wash. From the table, PG Company should not close the soap department. Because there is a contribution of ? 240,000 about reported profit, if PG close the soap department, it will lose ? 240,000 in its overall profits. 3. 2. 1. Relevant and Irrelevant Costs and Incomes in Scenario ? About the relevant cost and revenue, cost of goods sold, salespersons’ salaries, and sales office rent belong to relevant costs, and reported profit and sales are its relevant incomes. Irrelevant costs are these costs that do not affect the decision. Depreciation of sales office equipment, apportionment of ware house rent, depreciation of warehouse equipment, and departmental and headquarters costs are irrelevant costs, as their numbers do not change. 3. 2. 2. Qualitative Factors in Scenario ? In this scenario, employee morale, customer loyalty, and relationship with suppliers are qualitative factors. If PG make a closure decision, the redundancies arising will lead to the decline of employee morale. This may affect future output. Although reported profit of soap department was negative, its soap occupied 3. 4% market share (PG annual report, 2010). So if PG does not produce soap, it will lose a lot of customers. This will influence its long-term relationship with customers. At last, the close decision will break up the relationship with suppliers. This is not good for its future supply. Considering these qualitative factors, managers should not close soap department. 3. 3. Scenario ? —Pricing Products or Services In this scenario, there are two approach—cost-plus pricing and targeting costing, to determine the price of products. The cost-plus pricing means product costs are evaluated firstly and then a profit margin is jointed to decide the selling price (Horngren et al, 2005). The target costing is reverse of the cost-plus pricing. The start point is to determine the target selling price and then target costs are be gotten by deducting a desired profit margin. The purpose of this approach is to confirm the future actual costs will less than the target cost (Drury, 2008). In this assignment, the cost-plus pricing is mainly discussed. 3. 3. 1. Pricing Customized Products/Services Because market prices of customized products/services are often nonexistent, the cost-plus pricing is suitable for this situation. Companies can ensure costs first and then design future sales revenues to cover these costs. There is an example about pricing customized products (at below table). British CompanyMark-up percentage Cost-plus selling price (? ) Direct variable costs200160%520 Direct fixed costs100 Total direct costs30080%540 Indirect (overhead) costs80 Total cost38045%551 The British Company produces computers. In row 1, there is a mark-up (160%) is jointed to cover direct fixed costs. The situation is same in row 3. The 80% mark-up is added to cover indirect costs. At last, a 45% mark-up is added in total cost to provide a profit contribution. So the British Company makes ? 531 for customized computers. 3. 3. . Pricing Non-customized Products/Services For large volumes, managers have to make a pricing decision. In this pricing decision, the market research is very important. Through this research, managers can determine a range of selling prices and sales volumes by comparing with similar product types. There is an example about pricing non-customized products (at the below table). Chinese Company Potential selling price? 100? 90? 80? 70? 60 Estimated sales volume at the potential selling price (000s)110130170190200 Estimated total sales revenue (? 000)11,00011,70013,60013,30012,000 Estimated total cost (? 00)10,50011,10012,60012,80013,000 Estimated profit (loss) contribution (? 000)5006001,000500(1,000) Depending on a market research, managers of Chinese Company estimate a range of selling prices. In the profit (loss) contribution, profits are maximized at ? 80. So managers will choose ? 80 as the price of the new product, because it can obtain the maximized profit. 3. 3. 3. Relevant and Irrelevant Costs and Incomes in Scenario ? Direct variable costs, and profit contribution are relevant costs and incomes, and direct fixed costs and indirect costs are irrelevant costs in this scenario. Managers have to consider direct variable costs and profit contribution seriously, and they do not need to think about direct fixed costs and indirect costs, as they do not influence the decision-making. 3. 3. 4. Qualitative Factors in Scenario ? About qualitative factors, there are 2 factors, that is, the degree of market competition and management expertise. The degree of market competition is used to determine the mark-up. If market competition is intensive, mark-ups are likely to decline. And if market competition is not too intensive, mark-ups may increase. Management expertise relates to whether or not managers could analyse the market information accurately. They are able to determine the range of prices very exactly. Managers must own management’s general knowledge of the market. 3. 4. Scenario ? —Product Mix and Limiting Factor Analysis Limited productions may be due to the market demand or the shortage of resources. These resources include raw materials, labour, machinery, space, and so on. And these scarce resources are often known as key or limiting factors (Horngren et al, 2005). There is an example for product-mix decision (at below tables). Products Component XComponent YComponent Z Selling price per unit? 35? 30? 16 Variable cost per unit? 19? 17? 8 Contribution per unit of output? 16? 13? 8 Machine hours required per unit of output8 hours4 hours2 hours Estimated sales demand2000 unites2000 unites2000 unites Required machine hours for the quarter16,000 hours8,000 hours4,000 hours Component XComponent YComponent Z Contribution per unit? 16? 13? 8 Machine hours required8 hours4 hours2 hours Contribution per machine hours? 2? 3. 25? 4 Ranking 321 European Company produces 3 kinds of components and these components use the same machine. Because of the availability of machine capacity-European Company can provide 16,000 scare machine hours, output of these components is limited in the short term. At the first glance, component X should be produced firstly, since it owns the highest contribution per unit of output. However, this is incorrect. To produce component X, all of the 16,000 machine hours will be occupied. Because components Y and Z just use 4 hours and 2 hours respectively, European Company can firstly produce 2000 each units of each component and then still produce component X about 500 units. Because component Z spends the least hours, the company should produce component Z first, and then produce component Y. At the result, the company makes the decision—producing 2000 units of component Z, 2000 units of component Y, and 500 units of X. 3. 4. 1. Relevant and Irrelevant Costs and Incomes in Scenario ? About the relevant costs, the material costs and distribution costs belong to relevant costs, as depending on different decisions, these costs will be changed. In this scenario, the irrelevant costs include some fixed costs, such as warehouse rent, administrative expenditure and so on. . 4. 2. Qualitative Factors in Scenario ? Customer goodwill and long-term strategy are qualitative factors in this scenario. If European Company is unable to supply components Y and Z and just produce component X, customer goodwill may be lost, and this will lead to a fall in future sales. About its long-term strategy, managers must pay attention to company’s strategy. Through pr oducing different components to expend its market, European Company can obtain a long-term development and become the market leader finally. 3. 5. Scenario ? —Make or Buy Decisions Some companies do the make or buy decisions, because its production capacity is limited, or because products from outside are cheaper than from themselves. For example, the personal function could be subcontracted. Getting products or services from a subcontractor is called outsourcing (Horngren et al, 2005). There is an example for outsourcing (at below tables). Situation 1Total cost of continuing to make 10,000 components (? )Total cost of buying 10,000 components (? )Difference in extra costs/(saving) of buying (? ) Direct materials AB140,000(140,000) Direct labour100,000(100,000) Variable manufacturing overhead costs9,000(9,000) Fixed manufacturing overhead costs90,00070m000(20,000) Non-manufacturing overheads50,00050,000 Outside purchase cost incurred/(saved)350,000350,000 Total costs incurred/(saved)389,000470,00081,000 Situation 2Make component A and do not make component Z (? )Buy component A and make component Z (? )Difference in extra costs/(benefits) of buying component A (? ) Direct materials XY130,000130,000 Direct materials AB140,000(140,000) Direct labour100,000100,000 Variable manufacturing overhead costs9,0009,000 Fixed manufacturing overhead costs90,00090,000 Non-manufacturing overheads50,00050,000 Outside purchase cost incurred350,000350,000 Revenue from sales of component Z(380,000)(380,000) Total net costs389,000349,000(40,000) There are two situations—no alternative use of the released capacity (situation 1) and the released capacity can be used to make component Z (situation 2). The Asian Company can outsource component A to American Company. At the first glance, because the purchase price of outsourcing is just ? 35, this component should be outsourced. However, there are some irrelevant costs. They will be not changed whether or not Asian Company makes the outsourcing decision. In situation 1, because the total costs of outsourcing will be more about ? 60,000 than continuing make components, managers should not outsource component A. Although the company will cost ? 130,000 for direct materials XY in situation 2, it can obtain revenue from sales of component Z about ? 340,000. So at the result, if Asian Company can release capacity for making component Z, it can get a net benefit of ? 40,000. 3. 5. 1. Relevant and Irrelevant Costs and Incomes in Scenario ? In situation 1, the relevant costs are direct materials AB, direct labour, variable manufacturing overhead costs, and costs of outsourcing and the irrelevant costs are non-manufacturing overheads. However, in situation 2, direct labour, variable manufacturing overhead costs become irrelevant costs. In addition, fixed manufacturing overhead costs and non-manufacturing overheads are also irrelevant costs in situation 2. Direct materials XY and AB and costs of outsourcing are relevant costs, and revenue from sales of component Z belongs to relevant income. 3. 5. 2. Qualitative Factors in Scenario ? About qualitative factors, because a delay in meeting orders will lead to decline sales, the availability of future supplies has to be considered. Managers can find many suppliers to provide products. This can decrease the risk of the delay. Managers have to check products from outsourcing very carefully, because if the quality of products is not as good as before, customer goodwill will decrease and this will result a decline in future sales. If the company stops to produce component A and there are redundancies, employee morale will be declined. At last, managers cannot outsource companies’ core business, because core business is a company’s core competitiveness. 4. Conclusion Through analyzing situations that standard costing system is used by different organization, the first part obtains that standard costing system is suitable for some companies that own repetitive process and are large organization. Then variance analysis is analyzed. At the second part, four decision making scenarios are introduced, and relevant and irrelevant income and costs and qualitative factors of four scenarios are identified respectively. Reference ?Drury, C. , 2009. Management Accounting for Business†¢4th. Andover: South-Western Cengage Learning. ?Drury, C. , 2008. Management and Cost Accounting†¢7th. Andover: South-Western Cengage Learning. ?Atrill, P. , and McLaney, E. , 2007. Management Accounting for Decision Makers†¢5th. London: Prentice Hall. ?De Wit, B. , and Meyer, R. , 2010. Strategy: Process, Content, Context†¢4th. 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London: Prentice Hall. ?Horngern, T. , Foster, G. , Datar, M. and Bhimani, A. , 2005. Management and Cost Accounting †¢3th. London: Prentice Hall. Appendix I. The Learning-Curve Effect (Resource from: Atrill, P. , and McLaney, E. , 2007. Management Accounting for Decision Makers†¢5th. London: Prentice Hall. ) II. Variance Analysis for a Variable Costing System (Resource from: Drury, C. , 2009. Management Accounting for Business†¢4th. Andover: South-Western Cengage Learning. ) III. Formula for Variances Analysis Material Price Variance SP means the standard price; AP means the actual price; QP means the quantity of materials purchased. Material Usage Variance SQ means the standard quantity; AQ means the actual quantity. Total Material Variance SC means the standard material cost; AC means the actual cost. (Resource from: Drury, C. , 2008. Management and Cost Accounting†¢7th. Andover: South-Western Cengage Learning. )