ACCTG 202

BUILDING BUDGET STANDARDS

OVERVIEW
Cost standards form the basis of the organization's budget. Costs are based on two inputs:
quantity × price. Once the standard costs are formed for direct materials, direct labor, and
production overhead, they can be combined to establish the total standard cost for the
product or service. You'll learn in this lesson how standard costs are developed, and
important budgeting concepts that affect these cost standards and how they're used by
managers.
Upon completion of this lesson, candidates should be able to:
Demonstrate an understanding of the use of cost standards in budgeting (1.B.2.l).
Differentiate between ideal (theoretical) standards and currently attainable (practical)
standards (1.B.2.m).
Differentiate between authoritative standards and participative standards (1.B.2.n).
Identify the steps to be taken in developing standards for both direct material and direct
labor (1.B.2.o).
Demonstrate an understanding of the techniques that are used to develop standards
such as activity analysis and the use of historical data (1.B.2.p).
Discuss the importance of a policy that allows budget revisions that accommodate the
impact of significant changes in budget assumptions (1.B.2.q).
Define budgetary slack and discuss its impact on goal congruence (1.B.2.s).

I. COST STANDARDS
Companies use cost standards throughout the management process of planning,
controlling, and evaluating costs in the organization.
A standard cost sheet is, essentially, a “recipe card" that specifies standard prices
and standard quantities to build a single product or service, as demonstrated below

Note: The input quantity multiplied by the cost per input equals cost per unit. Also note in this example
that overhead costs are being allocated on the basis of direct labor (DL) hours.

These standards are used for both planning and evaluation purposes. A fundamental
issue to be addressed in the budgeting process is whether to use ideal (i.e.,
theoretical) cost standards or attainable (i.e., practical) cost standards.

1. Ideal standards represent the expected cost per input and input quantity
based on an assumption that prices paid for materials, labor, and
overhead are at the absolute lowest possible level, and assuming that the
use of materials, labor, and overhead is absolutely efficient without any
waste or error. When ideal standards are used in the organization, they are
generally created in a top-down budgeting approach.
2. Actual results are not likely to attain the ideal standards, and certainly
won't be better than ideal. However, these standards are consistent and
less likely than attainable standards to be biased in the standard-setting
process.
3. Attainable standards are based on more reasonable expectations about
average prices and usage. These standards are generally created in a
bottom-up budgeting approach.
4. Actual results may be higher or lower than the attainable standards. The
challenge in setting attainable standards is the higher likelihood of error or
bias that may be built into the numbers by managers.
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 Remember from the previous lesson that the budget process may be based on an
authoritative (top-down) or based on a participative (bottom-up) process. There is
an important balance between these two approaches that should be considered
when setting cost standards.
1. Authoritative cost standards are not likely to be biased by lower-level
managers who will subsequently be evaluated based on the standards.
2. On the other hand, participative cost standards will incorporate more of the
lower-level managers’ knowledge and experience, which should reduce
error in the forecast of cost standards.

REFER TO THIS LINK: Standard Costing

II. DEVELOPING STANDARDS

Computing the standard quantity of direct materials for one unit of finished output
involves identifying the amount of material content designed for the finished unit.
This content then needs to be adjusted for normal expectations (e.g., allowances)
regarding scrap or quality rejects, as exhibited below.

In addition to determining the standard quantity used, the standard price of the
direct material must also be computed. The price needs to include all expected (e.g.,
average) costs of receiving the raw material and preparing it for production, as
exhibited below.

Similarly, the standard quantity and standard price of direct labor costs are
determined by considering all costs of labor, and accommodating for normal
expectations of scrap and rejected output, as exhibited below.

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 Computing the standard costs for variable and fixed production overhead costs is
traditionally approached by simply dividing the budgeted quantity of overhead costs
by the budgeted quantity of the activity used to allocate overhead (e.g., direct labor
hours). However, this approach is often a gross simplification of complex overhead
costs. In a later lesson, we'll examine the challenges of building and using overhead
cost allocation rates.

III. CAPTURING DATA FOR STANDARDS

Where do the data come from that are used to build standard prices and standard
quantities? Often, the organization will begin by pulling historical data from its own
records to compute averages. This is a reasonable way to begin the analysis, but
managers need to forecast what may change in the future with respect to prices of
materials and labor, as well as quantities of materials and labor used in production.

Of the two cost inputs used for standards, prices and quantities, the most difficult
standard to accurately compute is quantities. The production process in most
organizations is complex, involving many activities that support and impact the
direct labor that forms the final product or service.
1. Due to this complexity, managers and cost accountants often engage in a
careful analysis of all activities involved in producing or supporting the final
product or service.
2. This activity analysis is the basis of activity-based costing (ABC), which will
be examined in a later lesson.

IV. BUDGETARY STACK AND GOAL CONGRUENCE

Most organizations choose to follow a participative, rather than authoritative,
approach to budgeting. This bottom-up approach that involves lower-level
managers has a number of advantages that we've examined in an earlier lesson.

However, the bottom-up (participative) approach to budgeting assumes that

everyone involved in establishing cost standards share the same goals and
objectives. This important concept is called goal congruence.

1. When the performance of managers is evaluated using the same cost

standards that go into the budget, these managers are personally at risk
from outside factors that can create unfavorable results that are outside of
their control. In this situation, the organization will not have a high level of
goal congruence.
2. When the performance evaluation and compensation of managers who
help to establish cost standards are at risk, then managers are tempted to
build slack into their estimates. Budgetary slack has been mentioned in an
earlier lesson, but this crucial concept is clearer in the context of setting
cost standards as we've discussed in this lesson.

Reducing budgetary slack in the budgeting process is handled by (1) limiting

performance evaluation to controllable costs, and by (2) periodically reviewing and
adjusting the budget when outside factors cause the original cost standards to
become less representative or irrelevant.

REFER TO THIS LINK: Standard Costing

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 SUMMARY
Standard costs can be developed and reported using an approach that approximates a
“recipe card.”
Standard costs are developed by determining expected quantity of inputs used, and
then multiplying that quantity by the expected price of each input.
In setting these standard quantities and standard prices, organizations choose to use
ideal (theoretical) standards or attainable (practical) standards.
Ideal standards are generally created in top-down budgeting and are less prone to error
and bias than attainable standards that are created in bottom-up budgeting.
Using the insight and information held by involved employees, attainable standards are
based on more reasonable assumptions.
However, attainable standards will often have some amount of budgetary slack built into
the quantity and price estimates by managers who are subsequently evaluated based
on their ability to achieve the budget.