282 Introduction to Accountancy and Finance

Process 3
(Manufacture of product C)

Costs Rate per gallon Cost

incurred
£ £
Liquid A - 500 gallons @ £1 .5 500
Liquid B - 500 gallons @ £2 1.0 1000
Direct labour .6 600
Works overhead .4 400
£2.5 £2500
-- --
Output in gallons 1000
- -
Process costing, illustrated above, provides information on the costs of a product
which passes through various processes, which is useful for:

1. valuation of stocks at intermediate and final stages for financial accounting

statements.
2. cost control, through investigation of the changes in costs per unit.
3. decision making, if the costs are analysed into fixed and variable elements.
For instance, should one discontinue process 1 if an outside supplier can
deliver liquid A at £0.8 per gallon?

Problems arise in process costing where:

1. The output quantity is lower than the input quantity due to unavoidable
losses through chemical reaction or evaporation, or to avoidable losses ,sus-
tained through operating the plant below a planned level of efficiency.
Unavoidable (normal) losses increase the cost of fmished production, but
avoidable (abnormal) losses are charged direct to the profit and loss account.
2. Where several products arise from one process there is no accurate method
of apportioning the process costs over each of the products. These are known
as joint costs and there is no theoretically correct method of allocating them.
In many ways their allocation is just as arbitrary as that of overhead expenses.

5.8 Standard Costing

(a) Introduction
If the executives of the various departments through which a product passes
ensure that all operations have been performed efficiently, and if the rates paid
for labour and material are reasonable, then the actual cost of that product
should be satisfactory. This simple concept is developed in the technique of
 Cost Accounting 283
standard costing. Standard costs are predetermined, based upon some agreed
level of efficient operation, and used to measure the effectiveness of executives
in controlling the actual costs as production proceeds. The emphasis is placed
upon the control of costs by executives and not upon product costs. Standard
costs can be calculated for any future time period, although conventionally they
are set for the ensuing fmancial year. The setting of standards, both for quantities
and rates, requires considerable technical expertise in the determination for each
product made, of the type, quality and quantity of each direct material required
and of the labour and machine operations to be performed, together with the
relevant agreed operating times. Times are expressed in terms of standard hours,
the standard hour being a measure of the quantity of output, or amount of
work which should be performed in one hour.
The assistance of specialists will also be sought on setting the 'average' pur-
chase price for each direct material and the 'average' rate to be paid to each
grade of worker.
The accountant's main contribution lies in determining standard overhead
rates from information contained in the short term plan for the ensuing financial
year. The standard cost of each product will be calculated and recorded on a
Standard Cost Card.
Table 5.21
Geordie Ltd
Standard Cost Cards
Product X
Set by Quantity - per unit
period - Year 1
Revisions
])ate ])ate ])ate
Cost Centre Quantity Rate Cost
£ £
Material A 6lb .5 3.0
Labour
Operation 1 M.S.1 1 hr .6 .6
Operation 2 M.S.2 3 hrs .5 1.5
Works overheads
Operation 1 M.S.l 1hr 1.5 1.5 (see Table 5.11)
Operation 2 M.S.2 3 hrs 1.0 3.0 (see Table 5.11)
Works cost 9.6
Administration, selling
and distribution
Overheads 10% of standard selling price 2.0
Total cost £11.6
284 Introduction to Accountancy and Finance
Product Z
Set by Quantity - per unit
Period- Year 1
Revisions
lJate lJate lJate
Cost Centre Quantity Rate Cost
£ £
Material B 10 lb .4 4.0
labour
Operation 1 M.S.l 3 hrs .6 1.8
Operation 2 M.S.2 1hr .5 .5
Works Overheads
Operation 1 M.S.l 3 hrs 1.5 4.5
Operation 2 M.S.2 1hr 1.0 1.0
Works cost 11.8

Administration, selling
and distribution
Overheads 10% of standard selling price 1.5
Total cost £13.3
--

Provision is made for the revision of the standard cost due to changes in rates
and/or manufacturing methods. Although standard costs based on attainable
efficiency may provide a basis for evaluating product profitability, the great
strength of standard costing is its role as a control mechanism. Its main advan-
tages include:

1. the reappraisal of manufacturing methods, prerequisite to the setting of

standards, can lead to better methods and cost reduction;
2. the variances of actual from standard costs can be ascertained and reported
at each stage of manufacture, enabling corrective action to be taken promptly;
3. saving in clerical costs where detailed stores ledger records and actual
product costs can be dispensed with.

The actual costs of direct material, direct labour and overheads will be collected
by cost centres, compared with the standard cost of operations performed and
the variances analysed. During year 1 'Geordie Ltd' produced 900 units of
product X and 800 units of product Z, actual costs being:
 Cost Accounting 285
Machine Shop 1 Machine Shop 2
£ £
Material A 5500 lbs@ £.51 2805
B 8200 lbs @ £.41 3362
Labour 3300 hrs@ £.61 2013 3600 hrs @ £.5 1800
Works overheads
Fixed 4125 2448
Variable 1650 1512

(b) Analysis of Material Variances

Table 5.22 Variance analysis - materials

Material A
Product Quantity Weight in lb Price per lb
made Per unit Total £
Standard cost X 900 6 5400 £.5 2700
Actual cost X 900 5500 £.51 2805
{100) £(105)
-- --
Material usage variance
(Standard- Actual Quantity) x Standard Price 100 X £.5 (50)
Material price variance
Actual Quantity x (Standard - Actual Price) 5500 X £.01 (55)
Material variance (Adverse) £(105)

Material B
Product Quantity Weight in lb Price per lb
made Per unit Total £
Standard cost z 800 10 8000 £.4 3200
Actual cost z 800 8200 £.41 3362
(200) (162)
-- --
Material usage variance 200 X £.4 (80)
Material price variance 8200 X £.01 (82)
Material variance (Adverse) £(162)
--
286 Introduction to Accountancy and Finance
The standard quantities and prices are taken from the standard cost cards, and
the material variances are analysed by cause. The departmental executive cannot
influence the prices paid for materials and so is held accountable for excessive
usage at standard prices. The purchasing officer negotiates prices with suppliers
and is held accountable for purchasing above standard price. The size of the
material price variance depends upon the prices paid and the quantities purchased,
the latter being affected by the need to replace stocks due to excessive material
usage. The material price variance could be analysed as follows:

Table 5.23 Analysis of material price variance

Material B
£
Responsibility of purchasing officer:
Standard Quantity x (Standard- Actual Price) 8000 x £.01 (80)

Joint responsibility of purchasing officer and

departmental executive:
(Standard- Actual Quantity) x (Standard- Actual Price) 200 x £.01 (2)
Material price variance (Adverse) (82)

An adverse material price variance does not necessarily imply buying inefficiency
but may more accurately reflect the difficulties in forecasting movements in
prices, when setting standard prices for a future time period. Frequent revision
of standard prices will necessitate recalculating the standard cost cards and be
clerically costly. Materials may be purchased at a high price to obtain quick
deliveries because the material control section has allowed stocks to run down to
an inadequate level; the resulting price variance could be charged to that section
but may result in inter-departmental recriminations. Material price variances,
analysed by types of materials, will be reported regularly to management. This
will reinforce the reports already submitted by the purchasing officer on material
price movements, and may lead to a review of product profitability and a revision
of selling prices.
 Cost Accounting 287
(c) Analysis of Labour Variances

Table 5.24 Variance analysis - labour

Machine Shop 1

Hours
Product Qty made per unit Total Rate per hour £

X 900 1 900
z 800 3 2400
Standard cost 3300 £.6 1,980
Actual cost 3300 £.61 2,013
--
Labour variance (Adverse) £ (33)

Machine Shop 2

Hours
Product Qty made per unit Total Rate per hour £

X 900 3 2700
z 800 1 800
Standard cost 3500 £.5 1,750
Actual cost 3600 £.5 1,800
--
Labour variance £(50)
--

Labour rate variance

Actual hours x (Standard - Actual rate) 3300 £.01 (33)

Labour efficiency variance

(Standard- Actual hours) x Standard rate 100 X £.5 (50)

The labour rate variance may arise from changes in rates due to wage negotiations
or to employing skilled labour on semi-skilled operations. Regular reports, daily
or weekly, on the efficiency of sections or individual operators, comparing
288 Introduction to Accountancy and Finance
standard hours produced and actual times taken, will already have been submitted
to the departmental executives. The accountant's report on the labour efficiency
variance will therefore not be new but it will indicate the cost of labour ineffi-
ciency in terms of reduced profits.

(d) Analysis of Works Overhead Variances

The basic comparison is between the overheads charged to product costs at the
standard rates on the standard hours produced, and the actual overheads incurred.
The total overhead variance may then be analysed into:

(i) Overhead Efficiency Variance

This measures the change in variable overhead costs per unit of product through
working at other than standard efficiency. If a unit of product X takes two
hours for operation 1 in Machine Shop 1, instead of the one hour planned, then
the extra cost due to slow working will include the additional (variable) overhead
costs, e.g. machine power incurred through running the machine for the extra
hour taken. Semi-variable overheads may also be affected by slow working. It
may cost more to supervise a section of 15 men who are only producing the
work output of 10 efficient men.

(ii) Spending Variance

This provides a comparison of each expense incurred with a target based on the
actual level of activity achieved expressed in actual (clock) hours of direct labour.
The overheads budget based on the planned level of activity will be adjusted for
variable and semi-variable expenses, to provide expense allowances appropriate
to the actual level of activity achieved. Even after allowing for extra variable
costs due to slow working, actual overhead costs may still be excessive for the
actual activity achieved. Poor methods of operating machinery can result in high
costs for machinery repairs and tool usage, and profits can drain away in count-
less other areas of inefficiency.

(iii) Volume Variance

This gives a measure of the gain or loss through over/under utilisation of the
production facilities which give rise to fixed overheads. Using the budget and
standard overhead rates derived shown in Table 5.11, the following illustration
shows the mechanics of overhead variance analysis.
 Table 5.25 Overhead variance analysis

Machine Shop 2

Standard hours budgeted 400 (A) Activity ratio (B/ A) 87.5%

Standard hours produced 3500 (B) Capacity ratio (C/ A) 90.0%
Clock hours taken 3600 (C) Efficiency ratio (B/C) 97.2%

Flexible budget
on Actual Overhead Variances
Std hrs on clock over-
Original produced std hrs hours heads
Overheads budget x std rate produced taken incu"ed Total Volume Efficiency Spending
£ £ £ £ £ £ £ £ £
Fixed 2400 2100 2400 2400 2448 (348) (300) (48)
Variable 1600 1400 1400 1440 1512 (112) (40) (72)
-- -- -- -- -- -- -- -- --
£4000 £3500 £3800 £3840 £3960 £(460) £(300) £(40) £(120)
-- -- -- -- -- -- -- -- --
(A) (B) (C) (D) (E) (B-E) (B-C) (C-D) (D-E)
290 Introduction to Accountancy and Finance
In practice, the condensed statement above would be amplified to show each
individual overhead cost and the spending variance applicable to it. The volume
and efficiency variances are more simply expressed as:

Volume variance= standard hours (budgeted- produced) x standard fixed

overhead rate
500 x £.6 = £300 adverse
Efficiency variance= (standard hours produced- clock hours taken)
x standard variable overhead rate
100 x £.4 = £40 adverse

The ratios, expressed in non-fmancial terms, can give an advance warning of the
probable financial effects of operating at other than the planned levels of activity
and efficiency. A volume loss on fixed overheads not charged to products will
arise from a low activity. This may be due to working less hours (capacity ratio)
or to a low rate of working (efficiency ratio). The supervisor will be held
accountable for the efficiency and spending variances but not the volume
variance. The latter may be due to a shortage of materials or suitable labour,
strikes, machinery breakdowns, production bottlenecks in other departments; or
to a shortage of sales orders which may arise out of inferior product design or
broken delivery promises. The volume variance should be investigated to deter-
mine the real problems which require individual or collective remedial action,
and not solely for the purpose of trying to allocate blame.

(e) The Application of Variance Analysis

Reports to individual executives may cover all the costs incurred in a department
or only the costs controllable by its supervisor, controllable costs being those
that are directly influenced by a manager within a given time period. The analysis
of material variance assumes that the departmental supervisor can influence
(control) material usage and that the purchasing officer can influence (control)
the prices paid to suppliers. Although labour efficiency is held to be controllable
by the departmental supervisor, this will not necessarily be true if he does not
engage and fire the work-force. Labour efficiency will then depend upon the
quality of workers recruited by the personnel department and their subsequent
training and motivating by the supervisor. In the short term very few costs may
be controllable, but given a long-time period, most costs can be changed (con-
trolled) by some executive. Rent payable under a lease expiring in 1980 will
only be controllable when the lease expires and is re-negotiated.
The following simple statement highlights the exceptions to the planned costs
which are controllable by the supervisor. It has been assumed that fixed over-
heads for rent, rates, depreciation and the apportionment of service department
 Cost Accounting 291
fixed costs are not controllable by the machine shop supervisor and are therefore
excluded from the statement.

Table 5.26

Machine Shop 2

Statement of planned and actual costs- year ended 31.12. Year 1

At standard rate Variance

Standard Clock
hours hours
Labour produced taken Total Efficiency Spending
£ £ £ £ £ £
Costs 1,750 1,800 (50) (50)

Flexible budget Actual

Overheads
on on
standard clock
hours hours
Works overheads produced taken
Fixed 900 900 923 (23) (23)
Variable 1,400 1,440 1,512 (112) (40) (72)

£2,300 £2,340 £2,435

-- -- --
Total controllable variances £(185) £(90) £(95)
-- -- --
Notes: (1) See Table 5.3.

Variance analysis may be much more elaborate than that illustrated but must
never be allowed to degenerate into an expensive and complicated arithmetical
exercise producing figures which are not used for remedial action. The real
reasons for an adverse variance may be difficult to pinpoint and quantify in
financial terms. An adverse labour efficiency variance may be due to working on
sub-standard materials bought 'cheaply' by the purchasing officer, poor employee
selection or more intangible factors such as the effect upon workers' morale of
the fortunes of the local football club. Variance analysis should not be used as a
stick with which to berate executives but as an aid in identifying problems which
require corrective action. The aim of standard costing is to motivate the entire
work-force to attain the targets set, so that there will be no adverse variances to
report. The degree of motivation depends upon acceptance of the standards set
as a realistic measure of performance. In this context standard costs may be
based on different levels of attainment.
292 Introduction to Accountancy and Finance
(i) Ideal Standard Costs

These are the lowest possible costs based upon ideal conditions, i.e. using the
most modern factory and equipment, most efficient labour force, including top
quality management, and purchasing at the keenest possible prices. Adoption of
these standards wm give unrealistic costs, result in adverse variances and probably
discourage the work-force and management, who are working in the actual
conditions prevailing which may well be far from ideal.

(ii) Expected Standard Costs Based on Past Performance

Adoption of this level of attainment wfll provide little incentive to improve on

last year's performance.

(iii) Attainable Standard Costs Based on Efficient Operation under Expected

Conditions

This level is the most satisfactory, as it is realistic and achievable with effort.
Any adverse variances reported will point the way to possible economies and
provide a spur to hit the targets.

5.9 Control Through Budgets

Control is necessary to guide operations to achieve defined objectives. It is

rather naive to talk of a corporation having objectives, as a corporation is not a
natural but a legal person. Corporate objectives must be those that will give at
least adequate satisfaction to the human parties on whom the corporation
depends. The principal parties and their interests are:

1. Management. Salary, promotion prospects, job satisfaction and security

of employment.
2. Work-force. Wages, working conditions, job satisfaction and security of
employment.
3. Shareholders and other lenders of finance. Adequate return on the finance
'invested', having regard to the risks involved, coupled preferably with little
risk ofloss of the money 'invested'.

Management has the task of trying to reconcile these various interests, several
of which may be conflicting, and to utilise the company's resources to produce