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Standard Costing: exploring manufacturing overhead cost concepts

发布时间:2017-04-26
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Standard Costing: Manufacturing Overhead Cost Concepts

Introduction

This paper examines standard costing, its use, and how it relates to manufacturing overhead while acknowledging its use for direct material and direct labour.

What is manufacturing overhead?

Manufacturing overhead is one of the three cost classifications of the manufacturing cost. It is sometimes referred to as factory overhead or production overhead and it includes the firm’s production costs that cannot be directly traced to the product. The production costs incurred other than the direct material and direct labour are classified as manufacturing cost Examples

  • Depreciation
  • Rent on Factory building
  • Electricity cost
  • Gas
  • Wages of Factory Manager, factory cleaners etc.

A standard cost system is a method of setting cost targets and evaluating performance. (CIMA, 2012).

A standard cost is an expectation of what costs should be. This expectation could be based on historical costs & projected costs.

Using Historical Analysis to set cost standards

In determining standard costs, a firm could make use of historical cost data. In a scenario where a firm has a lot of experience in manufacturing a product, it could use its past costs to predict its future costs.

Using Task Analysis to set cost standards

In determining standard costs, a firm could also perform a task analysis, which shifts emphasis from what it used to cost to produce, to what the cost of production should be in the future, considering current circumstances and conditions.

In performing task analysis the managerial accountant should works with engineers who could use time and motion studiesto determine standard costs.

The combination of both approaches is used in determining standard costs.

Perfect versus Attainable Standards

In setting standards, we must consider the behavioural effects on human behaviour.

An ideal standard is one that can be attained only when operating in near-perfect conditions. Ideal standards are set under the assumption that every aspect of the production process operates at peak efficiency.

An attainable standard gives room for inefficiency in the production process, such as machine breakdown, idle time, raw material wastage, etc.

An Attainable standard is more realistic than a perfect standard and it could motivate employees as opposed to a perfect standard which could discourage employees.

Standard Costing For Manufacturing Overhead

Using standard costing system for estimating manufacturing overhead is more complicated than using it for direct materials and direct labour. The major issue in accounting for manufacturing overhead costs per unit of output, is the difficulty in tracing indirect costs to specific products. In a firm that produces multiple products using the same factory, it will be difficult to determine exactly how much electricity product A is consuming

Overhead standards are typically estimated by relating total overhead costs to direct labour hours but due to highly automation in modern manufacturing we are witnessing a shift to the use of machine hours over direct labour hours.

Static Budgets vs Flexible Budgets

In using standard costing system for manufacturing overhead, it is important that we distinguish the difference between static and flexible budgets and why we should use flexible overhead budgets instead of static budgets.

A managerial accountant’s budgetary-control system has three elements.

  1. A predetermined or standard cost
  2. The actual cost incurred in the production process.
  3. Comparisons between the actual costs and the budgeted or standard cost.

A static budget is prepared for just one level of activity. I.e. the level of output planned at the beginning of the budget period while a flexible budget is based on the actual level of output in the budgeted period.

This use of the actual level of output in the flexible budget makes it a more accurate tool for cost comparisons unlike a static budget, which becomes ineffective as a tool for cost control once there is a change in circumstances.

If a coffee shop budgeted 5 machine hours for producing 10 cups of coffee at the cost of $50 but instead it used 8 machine hours, it produced 12 cups of coffee at the cost of $90.

If we make our comparisons on the static budget, we are going to get wrong results and make wrong managerial decisions, because we set our static budget for 5 machine hours and instead we used 8 machine hours, we exceeded our hours be 3 hours and we produced more, but did we produce up to the numbers of coffee we should be producing using 8 hours?

A flexible budget is needed, it will help us determine how much we should have produced, at what cost, using how many hours.

10 Cups

12 Cups

16 Cups

Budgeted machine hours

5

6

8

Total cost of production

50

72

128

10÷5=2hrs/unit

2hrs/unit x 8 = 16 cups of coffee

Our flexible budget allows us to make accurate cost comparisons, it shows us that we should have used 6 hours instead of 8 hours to produce 12 cups of coffee. This means we have an unfavourable efficiency variance of 2hrs.

The flexible budget also shows that we should have spent just $72 in producing 12 units rather than the $90 we spent. This means we have an unfavourable spending variance of $18.

Our example shows us why we need a flexible budget for manufacturing overhead and now we are going to examine what we mean variance and the four major variances we analyse under standard costing system for manufacturing overhead.

Variance analysis is the process of computing the difference between the standard cost and actual cost incurred and evaluating the causes of any difference. Under manufacturing overheads four major variances are computed and they are

  • Variable overhead spending variance
  • Variable overhead efficiency variance
  • Fixed overhead volume variance
  • Fixed overhead budget variance

VARIABLE OVERHEAD SPENDING VARIANCE

Variable overhead spending variance, which is also commonly referred to as variable overhead price or rate variance. This variance is computed by departments and cost centers to enable management to decide which cost item is out of line.

The variable overhead spending variance is a variance that can be caused by a composition of various factors, it might be caused by changes in prices of overhead items such as indirect material, indirect labour, other overhead such as supervision, maintenance, electricity, utilities etc. variance can occur due to efficient use or an inefficient use of these overhead items.

Variable overhead spending variance is the difference between the actual overhead incurred and the standard variable overhead set, or can be described as is essentially the difference between what the variable production overheads did cost and what they should have cost given the level of activity during a period.

Spending variance can occur if some activities which normally takes place in- house has been outsourced, if there has been changes in supplier’s prices, or if there has been a misclassification in the recording of variable overheads

Variable overhead spending variance can be derived by multiplying the actual hours worked by the difference between actual variable overhead costs and the standard variable overhead rate. In mathematical term in can be written as:

VOH Spending Variance = (SR − AR) × AH

Where,

SR is the standard variable overhead rate

AR is the actual variable overhead rate

AH is the actual Hours worked

(Assuming variable overhead application base is direct labour hours)

Standard variable overhead rate may be indicated in terms of the number of machine hours or labour hours. For business that use labour intensive manufacturing methods, standard variable overhead rate may be indicated in terms of the number of labour hours, in the case of businesses using Automated production systems for manufacturing machine hours would be a more appropriate bases. For businesses using both labour intensive and Automated production system, machine hour and direct labour hours can both be used as a basis for variable overhead Absorption ( this scenario is not common).

Alternatively, variable overhead spending variance can be expressed as

VOH Spending Variance = (SR × AH) − Actual Variable Overhead Cost

ANALYSIS

A favourable spending variance means that we have spent a lesser amount on variable overheads than was expected. This can be caused by the following reasons;

  • There has been a general decrease in price of indirect materials.
  • There has been more efficient cost controls (such as better use of electricity).
  • The business is enjoying an economics of scale due to purchasing indirect material in larger sizes

An unfavourable/adverse spending variance means that the business has spent more than it already set out to, i.e. Actual expenditure exceeds Standard. This adverse variance can be as a result of;

  • Inefficient cost controls ( such as inefficient usage of utilities)
  • Changes in labour contracts ( such as increase in minimum wages)
  • A decrease in the level of activity not fully offset by a decrease in overheads ( e.g. supervisors wages incurred even when a smaller unit of products are produced)
  • Planning error ( failing to take into account increases in electricity rates)

Some causes of this adverse variance are beyond the control of the management such as increase in minimum wages and increases in electricity rates.

Example

Kosem is a small restaurant specializing in the production of Doner kebab. Kosem currently manufactures 2 types of Doner Kebab:

Tavuk Kebab - a type of kebab that contains just chicken and other basic ingredients

Karisik Kebab - a type of kebab that contains both meat and chicken plus other ingredients

Following is a break-up of standard variable manufacturing overhead cost:

Tavuk Kebab

Karisik Kebab

Number of Hours

2 direct labour hours

1 machine hour

Overheads:

Indirect Labour

₺ 10

-

olive oil

₺5

₺1

Milk

₺1

-

Vegetables

₺1

₺0.5

Chicken flavour

-

₺0.5

Electricity

₺3

₺10

Total

₺20 (TL10 per direct labour hour)

₺12 (TL12 per machine hour)

Following information relates to the actual data from last month:

Variable Manufacturing Overheads

TL175,000

Direct Labour Hours

10,000

Machine Hours

5,000


Variable Overhead Spending Variance shall be calculated as follows:

Tavuk Kebab

Karisik Kebab

Total TL

Actual Variable Overhead Expense

175,000

Less:

Actual Hours

10,000

5,000

Standard Variable O.H. Rate

x ₺10

x ₺12

Standard Overhead Expense

100,000

60,000

(160,000)

Variable Overhead Expenditure Variance

15,000

Adverse

VARIABLE OVERHEAD EFFICIENCY VARIANCE

Variable overhead efficiency variance is the difference between the actual manufacturing hours worked and the standard manufacturing hours expected. Overhead efficiency variance is similar to direct labour efficiency variance. Variable overhead efficiency variance can be expressed as follows;

VOH Efficiency Variance = (SH − AH) × SR

Where,

SH are standard direct labour hours allowed

AH are the actual direct labour hours

SR is the standard variable overhead rate

A favourable efficiency exists if the standard hours allowed in larger compared to the actual hours worked. A positive variance does not translate to a company incurring less overhead, but instead it means that there has been an improvement in the allocation base that was used to apply overhead.

Causes of favourable efficiency variance can be as a result of the following;

  • Installing more efficient manufacturing machine; which translates to lower production time (reduction in machine break downs).
  • Utilizing higher skilled labour; thereby making production faster.
  • Using higher quality raw materials (this would result in reduction in product reruns).

An unfavourable efficiency variance means that there has been a greater consumption of Actual hours than originally planned. Reasons for this adverse variance can be traced to the following;

  • Decrease in efficiency of Machines due to obsolesce, wear and tear and break downs.
  • Usage of cheap and substandard raw materials; causing several product reruns
  • Using lower shilled labour means more time would be spent in the production process.
  • Planning error i.e. overestimating the impact of learning curve on efficiency

Using the previous example, lets illustrate how to derive Variable Manufacturing overhead variance;

Production (units) - Tavuk Kebab 4,500

Production (units) – Karisik Kebab 5,200

Variable Overhead efficiency Variance shall be calculated as follows:

Tavuk

kebab

Karisik

kebab

Total TL

Standard Hours x Standard Rate / hour

Standard Hours (4500x2 / 5200x1)

9,000

5,200

Standard Variable Overhead Rate / hour

X ₺ 10

x₺ 12

90,000

62,400

152,400

Less:

Actual Hours x Standard Rate / hour

Actual Hours

10,000

5,000

Standard Variable Overhead Rate / hour

x 10

x 12

100,000

60,000

152,400

Variable Overhead Efficiency Variance

7,600

Adverse

FIXED OVERHEAD BUDGET VARIANCE

This is also known as fixed overhead spending variance, fixed overhead budget variance is the difference between the actual fixed overhead incurred and the expected fixed overheads.

The formula for this variance is;

Actual fixed overhead - Budgeted fixed overhead = Fixed overhead spending variance

Theoretically, the amount related to fixed-overhead remain relatively fixed as such it should not deviate from the actual figure. For there to be variation in fixed cost, there must have been a step fixed cost e.g. rental payment for new warehouse, or it can be due to seasonality in fixed overhead expenditure.

A favourable variance occurs when Actual fixed overhead is lesser than the budgeted amount, this can be due to the following reasons;

  • A planned expansion was no longer undertaken.
  • Adoption of cost rationalization techniques such as JIT techniques

An unfavourable variance means that the Actual fixed overhead exceeds the budgeted amount, this can be due to the following reasons;

  • An unplanned expansion which was not taken into consideration in the budget preparation process.
  • Inadequate administration of fixed overhead cost.

EXAMPLE

If a manufacturing company has the following cost

Actual Fixed manufacturing overheads $200,000

Budgeted fixed overheads $ (198,000)

$ 2,000 Adverse

FIXED OVERHEAD VOLUME VARIANCE

Fixed overhead volume variance measure the difference between the budgeted fixed overhead and the absorbed fixed overhead. It measures whether fixed overhead has been over absorbed or under absorbed. Volume variance calculates the cost of not producing up to the budgeted production capacity. Volume variance is displayed as:

Fixed overhead volume variance = Budgeted Fixed overhead – Absorbed Fixed overhead

Absorbed fixed overhead = Actual output * Fixed overhead Absorption rate (FOHR)

Budgeted fixed overhead ÷ Budgeted production = Fixed overhead rate

Volume variance can be further be divided into

  • Fixed overhead capacity variance
  • Fixed overhead efficiency variance

Fixed overhead capacity variance can be displayed as;

(Budgeted production hours - actual production hours) x FOAR

Fixed overhead Efficiency Variance can be shown as;

(Standard production hours - actual production hours) x FOAR

Illustration:

Given the information below;

Actual Production225,000 units

Budgeted Production260,000 units

Standard Fixed Overhead Absorption Rate$200 per unit

Calculate the fixed overhead volume variance.

Fixed Overhead Volume Variance

Absorbed Fixed Overheads(225,000 x $2,00)$45,000,000 m

Budgeted Fixed Overheads(260,000 x $2,00)($52,000,000 m)

Fixed Overhead Volume Variance7,000,000 negative

This shows that the total fixed overhead has not been absorbed.

Conclusion

Standard costing is a system with its merits and drawbacks, we are going to examine the advantages of using a standard costing system and its drawbacks.

MERITS OF STANDARD COSTING

  • Performance Evaluation: standard costing system can be used by management as a tool of performance evaluation, standard costing enables management to know the level of performance.
  • Cost management: through the use of Management by exception which helps to identify significant variances and tackle them. It saves management a lot of time and focuses their attention on more important issues.
  • Motivating employees: standard costing system can be used to provide incentives to workers and supervisors, since standard costing can be used to evaluate performance, then rewards can be tied to achieving certain standards.
  • Standard costing is also an effective tool for budgeting.

DRAWBACKS OF STANDARD COSTING

  • Standard costing does not concentrate on the quality of the product, it rather focuses on efficiency of labour and whether more money has been than should have.
  • Standard costing uses the traditional costing method which makes use of volume based cost allocation this making standard costing not suitable for service companies. ABC costing would be a better alternative but can be very cumbersome.
  • Standard costing would be ineffective in a fast paced system i.e. a production system that involves customized products and special orders as there would be no basis for benchmarking.
  • Standard costing is more of a reactive measure, it doesn’t help prevent problems.

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