Standard Costs-Management by Exception:
Learning Objective of
the Article:
- Define and explain the terms "standard cost" and
"management by exception".
Definition and Explanation of Standard Cost and Management by Exception:
A standard cost is the predetermined
cost of manufacturing a single unit or a number of product units during a
specific period in the immediate future. It is the planned cost of a product
under current and / or anticipated operating conditions.
A standard is a "benchmark"
or "norm" for measuring performance. Standards are found everywhere your
doctor, for example, evaluates your weight using standards that have been set for
individuals of your age, height and gender. the food we eat in restaurants
must be prepared under specified standards of cleanliness. The buildings we
live in must conform to standards set in building codes.
Standards are
also widely used in
managerial accounting where they relate to
the quantity and cost of inputs used in manufacturing goods and producing
services. Engineers and accountants assist managers to set quantity and cost
standards for each major input such as
raw materials and
direct labor time.
Quantity standards specify how much of an input should be used to make a
product or provide a service. Cost or price standards specify how much
should be paid for each unit of input. Actual quantities and actual costs
are then compared with these standards. In case of significant deviations
managers investigate the discrepancies. The purpose is to find the problem
and eliminate it so that it does not recur. This process is called
management by exception.
In our daily lives, we operate in a
management by exception mode most of the time. Consider what happens when
you sit down in the driver's seat of your car. You put the key in the
ignition, your turn the key, and your car starts. Your exception (standard)
that the car will start is met; you do not have to open the car hood and
check the battery, the connecting cables, the fuel lines, and so on. If you
turn the key and the car does not start, then you have a discrepancy
(variance). Your exceptions are not met, and you need to investigate why.
Note that even if the car is started after a second try, it would be wise to
investigate anyway. The fact that exception was not met should be viewed as
an opportunity to uncover the cause of the problem rather than as simply an
annoyance. If the underlying cause is not discovered and corrected, the
problem may recur and become much worse.
This basic approach to identifying and
solving problems is exploited in the variance analysis cycle, The
cycle begins with the preparation of standard cost performance reports in
the accounting department. These reports highlight the variances, which are
the differences between actual results and what should have occurred
according to the standards. The variances raise questions. Why did this
variance occur? Why is this variance larger than it was last period?
The significant variances are investigated to discover their root causes.
Corrective actions are taken. And then next period's operations are carried
out. The cycle then begins again with the preparation of a new standard cost
performance for the latest period. The emphasis should be on flagging
problems for attention, finding their root causes, and then taking
corrective actions. The goal is to improve operations - not to find blame.
VARIANCE ANALYSIS CYCLE
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Identify Questions |
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Receive Explanations |
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Take Corrective Actions |
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Analyze Variances |
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Conduct Next Period's Operations |
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Prepare Standard Cost Performance Report |
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Who Uses Standard Costs?
Manufacturing, service, food, and not-for-profit
organizations all make use of standards to some extent. Auto service centers
like Firestone and Sears, for example, often set specific labor time
standards for the completion of certain work tasks, such as installing a
carburetor or doing a valve job, and then measure actual performance against
these standards. Fast-food outlets such as McDonald's have exacting
standards for the quantity of meat going a sandwich, as well as standards
for the cost of the meat. Hospitals have standards costs (for food, laundry,
and other items) for each occupied bed every day, as well as standard time
allowances for certain routine activities, such as laboratory tests. In
short, you are likely to run into standard costs in virtually any line of
business that you enter.
Manufacturing companies often have highly
developed standard costing systems in which standards relating to
direct
materials,
direct labor
and overhead are developed in detail for each
separate product. These standards are listed on a
standard cost card that
provides the manager with a great deal of information concerning the inputs
that are required to produce a unit and their costs.
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In Business
| Standard Costing at Parker Brass
The Brass Products Division at Parker
Hannifin Corporation, Known as Parker Brass, is a world-class
manufacturer of tube and brass fittings, valves, hose, and hose
fittings. Management at the company uses variances from its standard
costing system to target problem areas for improvement. If a production
variance exceeds 5% of sales, the responsible manager is required the
variance and to propose a plan of action to correct the detected
problem. In the past, variances were reported at the end of the month -
often several weeks after a particular job had been completed. Now, a
variance report is generated the day after a job is completed and
summary variance reports are prepared weekly. These more frequent
reports permit managers to take more timely action.
Source: David Johnsen and Pervez
Sopariwala, "Standards costing is alive and well at Parker Brass,"
Management Accounting Quarterly, Winter 2000, pp. 12-20. |
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