MANAGEMENT AND COST ACCOUNTING SIXTH EDITION COLIN DRURY

MANAGEMENT AND COST ACCOUNTING SIXTH EDITION COLIN DRURY Management and Cost Accounting, 6 th edition, ISBN 1 -84480 -028 -8 © 2004 Colin Drury

Part Four: Information for planning, control and performance Chapter Nineteen: Standard costing and variance analysis 2 - further aspects Management and Cost Accounting, 6 th edition, ISBN 1 -84480 -028 -8 © 2000 Colin Drury © 2004 Colin Drury

19. 1 a Mix variance 1. A mix variance arises when the actual mix differs from the predetermined standard mix. Example Standard mix to produce 9 litres of output: 5 litres of X at £ 7 per litre = £ 35 3 litres of Y at £ 5 per litre = £ 15 2 litres of Z at £ 2 per litre = £ 4 £ 54 Standard loss =10% of input. Actual output = 92 700 litres Actual inputs: 53 000 litres of X at £ 7 28 000 litres of Y at £ 5. 30 19 000 litres of Z at £ 2. 20 100 000 = = = £ 371 000 148 400 41 800 561 200 Management and Cost Accounting, 6 th edition, ISBN 1 -84480 -028 -8 © 2000 Colin Drury © 2004 Colin Drury

19. 1 b 2. Mix variance = (AQ in standard mix – AQ) × SP AQ in standard mix ×SP X =100 000 × 5/10 × £ 7 Y =100 000 × 3/10 × £ 5 Z =100 000 × 2/10 × £ 2 £ 350 000 150 000 40 000 540 000 AQ ×SP 53 000 × £ 7 28 000 × £ 5 19 000 × £ 2 £ 371 000 140 000 38 000 549 000 Mix variance = £ 9 000 A Management and Cost Accounting, 6 th edition, ISBN 1 -84480 -028 -8 © 2000 Colin Drury © 2004 Colin Drury

19. 2 Yield variance 1. Yield variance is the difference between the standard output for a given level of inputs and the actual output: = (Actual yield –Standard yield from actual input) × SC per unit of output = (92 700 – 90 000 )× £ 54/9 =£ 16 200 F 2. Possible causes 3. Mix and yield variances are interrelated and should not be interpreted in isolation. Summary Total variance = SC (92 700 ×£ 6) – AC (£ 561 200) = £ 5 000 A Price variances + Mix variance + Yield variance £ 12 200 A £ 9 000 A £ 16 200 F £ 5 000 A Management and Cost Accounting, 6 th edition, ISBN 1 -84480 -028 -8 © 2000 Colin Drury © 2004 Colin Drury

19. 3 a Sales mix and quantity variances 1. Where a company sells several different products that have different profit margins, it is possible to divide the sales volume variance into a quantity and mix variance. Example Budgeted sales X = Y = Z = 8 000 units at £ 20 contribution 7 000 units at £ 12 contribution 5 000 units at £ 9 contribution 20 000 = = = £ 160 000 84 000 45 000 289 000 = = = £ 120 000 84 000 81 000 285 000 Actual sales X = Y = Z = 6 000 units at £ 20 contribution 7 000 units at £ 12 contribution 9 000 units at £ 9 contribution 22 000 Management and Cost Accounting, 6 th edition, ISBN 1 -84480 -028 -8 © 2000 Colin Drury © 2004 Colin Drury

19. 3 b Sales mix and quantity variances (contd. ) 2. Mix variance = (AQ – AQ in budgeted proportions) × Standard margin X Y Z AQ – AQ in budgeted proportions 6 000 – 8 800 (40%) 7 000 – 7 700 (35%) 9 000 – 5 500 (25%) 22 000 Standard margin × £ 20 = £ 56 000 A × £ 12 = £ 8 400 A × £ 9 = £ 31 500 F £ 32 900 A Management and Cost Accounting, 6 th edition, ISBN 1 -84480 -028 -8 © 2000 Colin Drury © 2004 Colin Drury

19. 4 Sales mix and quantity variances (contd. ) 3. Quantity variance X Y Z = (AQ in budgeted proportions – BQ) × SM = (8 800 – 8 000) × £ 20 = £ 16 000 F = (7 700 – 7 000) × £ 12 = £ 8 400 F = (5 500 – 5 000) × £ 9 = £ 4 500 F £ 28 900 F 4. If planned mix had been achieved the sales volume variance would have been £ 28 900 F. Management and Cost Accounting, 6 th edition, ISBN 1 -84480 -028 -8 © 2000 Colin Drury © 2004 Colin Drury

19. 5 a Recording standards costs in the accounts 1. Purchase of materials (Material A) Dr Stores ledger control account (AQ × SP) Dr Materials price variance Cr Creditors control 190 000 19 000 2. Issue of materials (Material A) Dr Work in progress (SQ ×SP) 180 000 Dr Material usage variance 10 000 Cr Stores ledger control account (AQ × SP) 209 000 190 000 Management and Cost Accounting, 6 th edition, ISBN 1 -84480 -028 -8 © 2000 Colin Drury © 2004 Colin Drury

19. 5 b 3. Recording of wages due Dr Wages control account (actual cost) Cr Wages accrued account 273 600 The wages control account is cleared as follows: Dr Work in Progress (SQ ×SP) Cr Wages control account Dr Wage rate variance Dr Labour efficiency variance Cr Wages control account 243 000 17 100 13 500 30 600 Management and Cost Accounting, 6 th edition, ISBN 1 -84480 -028 -8 © 2000 Colin Drury © 2004 Colin Drury

19. 6 a 4. Manufacturing overhead cost incurred Dr Factory variable overhead control account Dr Factory fixed overhead control account Cr Expense creditors 5. Absorption of fixed manufacturing overhead Dr Work in progress (SQ ×SP) Dr Volume variance Cr Factory fixed overhead control account Dr Factory fixed overhead control account Cr Fixed overhead expenditure variance 52 000 116 000 168 000 108 000 120 000 4 000 Management and Cost Accounting, 6 th edition, ISBN 1 -84480 -028 -8 © 2000 Colin Drury © 2004 Colin Drury

19. 6 b 6. Variable manufacturing overhead Dr Work in progress (SQ ×SP) Dr Variable overhead efficiency variance Cr Factory variable overhead control account Dr Factory variable overhead control account Cr Variable overhead expenditure variance account 7. Completion of production Dr Finished stock account Cr Work in progress 54 000 3 000 57 000 5 000 720 000 Note that the variances are transferred to the profit and loss account at the end of the period. Management and Cost Accounting, 6 th edition, ISBN 1 -84480 -028 -8 © 2000 Colin Drury © 2004 Colin Drury

19. 7 a Ex post variance analysis 1. A major criticism is that actual performance is compared with a standard based on the environment that was anticipated when the standard was set. 2. It is argued that an ex post variance analysis approach should be adopted that distinguishes between planning and operating variances. 3. A Original standard B Ex post standard given the benefit of hindsight C Actual outcome Planning variance = A – B Operating variance = B – C Management and Cost Accounting, 6 th edition, ISBN 1 -84480 -028 -8 © 2000 Colin Drury © 2004 Colin Drury

19. 7 b 4. Example SP = £ 5 per unit, market price at time of purchase = £ 5. 20 Actual purchases =10 000 units at £ 5. 18 Conventional variance analysis = 10 000 × £ 0. 18 = £ 1 800 A Ex post analysis: Purchase planning variance = (£ 5 –£ 5. 20) × 10 000 Purchase efficiency variance = (£ 5. 20 –£ 5. 18) × 10 000 = £ 2 000 A = £ 200 F £ 1 800 A Management and Cost Accounting, 6 th edition, ISBN 1 -84480 -028 -8 © 2000 Colin Drury © 2004 Colin Drury

19. 7 c 5. Sales variances Assume: Budgeted sales =10% market share (10% × 1 m units) Actual sales = 110 000 units Actual industry sales volume = 1. 2 m units Budgeted and actual contribution = £ 100 Ex post standard =120 000 units (10% × 1. 2 m) Conventional sales variance = £ 1 m favourable (10 000 × £ 100) Ex post analysis: Planning variance = 2 m favourable (20 000 × £ 100) Appraisal variance = £ 1 m adverse (10 000 × £ 100) Management and Cost Accounting, 6 th edition, ISBN 1 -84480 -028 -8 © 2000 Colin Drury © 2004 Colin Drury

19. 8 Investigation of variances 1. Variance investigation models can be classified into the following categories: • Simple rule of thumb models. • Statistical models that do not incorporate costs and benefits of investigation. • Statistical decision models that take into account the cost and benefits of investigation. 2. Reasons for variances • Measurement errors. • Out-of-date standards. • Out-of-control operations. • Random or uncontrollable factors. 3. Investigation will indicate that variance is due to: • Random uncontrollable factors when the operation is under control. • Assignable causes, but the cost of investigation exceeds benefits. • Assignable causes, but the benefits of investigation exceed the cost. Note : The aim is to investigate only those variances in the final category. Management and Cost Accounting, 6 th edition, ISBN 1 -84480 -028 -8 © 2000 Colin Drury © 2004 Colin Drury

19. 9 a Statistical investigation models not incorporating cost and benefits 1. Assume actual observations when under control indicate a mean usage of 10 kg per unit with a SD of 1 kg (normally distributed). 2. Actual usage is 12 000 kg for an output of 1 000 units. Therefore, average usage = 12 kg per unit. 3. Z = Actual usage (12 kg)– Expected usage (10 kg) = 2. 0 SD (1 kg) Management and Cost Accounting, 6 th edition, ISBN 1 -84480 -028 -8 © 2000 Colin Drury © 2004 Colin Drury

19. 9 b 4. Normal distribution table indicates that an observation 2 SDs from the mean has a probability of 2. 275%. 5. Thus the probability of actual average material usage per unit of output being 12 kg or more when the operation is under control is 2. 275%. It is very unlikely that material usage comes from ‘in control distribution ’. 6. Statistical control charts, which rely on the above principles, can be used to monitor resources usage and the probability that operations are out of control. (See figure on sheet 19. 10. ) Management and Cost Accounting, 6 th edition, ISBN 1 -84480 -028 -8 © 2000 Colin Drury © 2004 Colin Drury

19. 10 Statistical quality control charts Management and Cost Accounting, 6 th edition, ISBN 1 -84480 -028 -8 © 2000 Colin Drury © 2004 Colin Drury

19. 11 Variance investigation decision models 1. Bierman et al model assumes two mutually exclusive states exist: (i) System in control and variance due to random factors. (ii) System out of control and corrective action can be taken to remedy the situation. 2. If the process is out of control there is a benefit (B) associated with returning it to its in - control state (i. e. cost savings from avoiding variances in future periods). Assume B = £ 400. 3. Let C = cost of investigation (assume C = £ 100). Let P = probability that the process is out of control. 4. Expected benefit = PB 5. Investigate if PB > C, or P > C/B 6. P >100 /400 =0. 25 7. P (Process is in control) = 0. 02275 (see sheet 19. 9) 8. P (Process out of control) =1 – 0. 02275 = 0. 97725 9. Decision = Investigate the variance 10. Note the difficulty in estimating C and B. Management and Cost Accounting, 6 th edition, ISBN 1 -84480 -028 -8 © 2000 Colin Drury © 2004 Colin Drury

19. 12 a Criticisms of standard costing • The usefulness of standard costing has been questioned, and its demise predicted, because of the following: 1. The changing cost structure 2. Inconsistency with modern management approaches 3. Over-emphasis on the importance of direct labour 4. Delay in feedback reporting Management and Cost Accounting, 6 th edition, ISBN 1 -84480 -028 -8 © 2000 Colin Drury © 2004 Colin Drury

19. 12 b The future role of standard costing • Standard costs and variance analysis required for many other purposes besides cost control and performance evaluation: (e. g. tracking costs for inventory valuation and maintaining a database for decision-making) • Variance analysis adapted to report on items that are company specific. • Shift from treating the variances as the foundations for cost control and performance evaluation to being one among a broader set of measures. • Empirical evidence suggests that practitioners still regard variance analysis as being important for cost control. • Can still play a useful role within ABC systems particularly in relation to controlling unit-level and batch-level activities. Management and Cost Accounting, 6 th edition, ISBN 1 -84480 -028 -8 © 2000 Colin Drury © 2004 Colin Drury

19. 13 a The future role of standard costing (cont. ) • ABC and variance analysis: 1. Most appropriate for controlling the costs of unit-level activities. 2. Can also provide meaningful information for controlling those costs that are fixed in the short-term but variable in the longerterm provided suitable cost drivers can be established. Management and Cost Accounting, 6 th edition, ISBN 1 -84480 -028 -8 © 2000 Colin Drury © 2004 Colin Drury

19. 13 b Example Costs of set-up activity: Budget Activity level (1 600 set-ups) Practical capacity supplied (2 000 set-ups) Total fixed costs (£ 80 000) Total variable costs (£ 40 000) Cost driver rates: Variable (£ 25 per set-up) Fixed (£ 40 per set-up) Actual Total FC (£ 70 000) Total VC (£ 39 000) Variance analysis for fixed set-up expenses: Set-up expenses charged to products (1 500 × £ 40) Budgeted unused capacity variance (400 × £ 40) Capacity utilization variance (100 × £ 40) Expenditure variance Total actual expenses £ 60 000 16 000 A 4 000 A 10 000 F 70 000 Management and Cost Accounting, 6 th edition, ISBN 1 -84480 -028 -8 © 2000 Colin Drury © 2004 Colin Drury

19. 14 The future role of standard costing (contd. ) • ABC and variance analysis: Variance analysis for variable set-up expenses: £ Variable set-up expenses charged to products (1 500 ×£ 25) Variable overhead variance (Flexed budget — Actual cost) Total actual expenses 37 500 1 500 A 39 000 Management and Cost Accounting, 6 th edition, ISBN 1 -84480 -028 -8 © 2000 Colin Drury © 2004 Colin Drury