Standard Costs-Management by Exception


Standard Costs-Management by Exception:

Learning Objective of the Article:

  1. 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

Identify Questions Receive Explanations Take Corrective Actions
Analyze Variances Conduct Next Period’s Operations

 ← ←

Prepare Standard Cost Performance Report

← ←

BEGIN

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 laborand 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.

In Business | Standard Costing at Parker BrassThe 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.

You may also be interested in other articles from “standard costing and variance analysis” chapter

  1. Standard Costs and Management By Exception
  2. Setting Standard Costs – Ideal Versus Practical Standards
  3. Direct Materials Price and Quantity Standards
  4. Direct Materials Price Variance
  5. Direct Materials Quantity Variance
  6. Direct Labor Rate and Efficiency Standards
  7. Direct Labor Rate/Price Variance
  8. Direct Labor Efficiency | Usage | Quantity Variance
  9. Manufacturing Overhead Standards
  10. Overall or net factory overhead variance.
  11. Controllable variance
  12. Volume variance
  13. Spending variance
  14. Idle capacity variance
  15. Efficiency variance
  16. Spending variance
  17. Variable efficiency variance
  18. Fixed efficiency variance
  19. Idle capacity variance
  20. Mix and Yield Variance – Definition and Explanation
  21. Materials Mix and Yield Variance
  22. Labor Yield Variance
  23. Factory Overhead Yield variance
  24. Variance Analysis and Management By Exception
  25. Managerial importance and usefulness of variance analysis
  26. Advantages and Disadvantages of Standard Costing System
  27. Standard Costing Discussion Questions and Answers
  28. Standard Costing and Variance Analysis Formulas
  29. Standard Costing and Variance Analysis Problems and Solution
  30. Standard Costing and Variance Analysis Case Study

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