412 Chapter 10 Standard Costing and Analysis of Direct Costs

Setting Standards
Methods for Setting Standards
Cost standards generally are established by a company’s managerial accountants, who
Learning Objective 10-2
use two methods for setting them: analysis of historical data and task analysis.
Describe two ways to set
cost standards and distinguish Analysis of Historical Data One indicator of future costs is historical cost data. In a
between perfection and
mature production process, where the firm has a lot of production experience, historical
practical standards.
costs can provide a good basis for predicting future costs. The methods for analyzing cost
behavior that we studied in Chapter 6 are used in making cost predictions. The company
often will need to adjust these predictions to reflect movements in price levels or techno-
logical changes in the production process. For example, the amount of rubber required to
manufacture a particular type of tire will likely be the same this year as last year, unless
there has been a significant change in the process used to manufacture tires. However, the
price of rubber is likely to be different this year than last, and this fact must be reflected
in the new standard cost of a tire.
Despite the relevance of historical cost data in setting cost standards, managers must
guard against relying on them blindly. Understanding how standards were derived can
provide important insights into their reliability. For example, even a seemingly minor
change in the way a product is manufactured may make historical data almost totally
irrelevant. Moreover, new products also require new cost standards. For new products,
such as genetically engineered medicines, there are no historical cost data upon which to
base standards. In such cases, the manager should turn to another approach.

Task Analysis Another way to set cost standards is to analyze the process of manu-
facturing a product to determine what it should cost. The emphasis shifts from what the
product did cost in the past to what it should cost in the future. In using task analysis, the
manager or accountant typically works with engineers who are intimately familiar with
the production process. Together they conduct studies to determine exactly how much
direct material should be required and how machinery should be used in the production
process. Time and motion studies are conducted to determine how long each step per-
formed by direct laborers should take.

A Combined Approach Managerial accountants often apply both historical cost

analysis and task analysis in setting cost standards. It may be, for example, that the tech-
nology has changed for only one step in the production process. In such a case, the mana-
gerial accountant would work with engineers to set cost standards for the technologically
changed part of the production process. However, the accountant would likely rely on the
less time-consuming method of analyzing historical cost data to update the cost standards
for the remainder of the production process.

Participation in Setting Standards

Standards should not be determined by the managerial accountant alone. Besides need-
ing to assess the standard’s reliability, as discussed above, managers generally will be
more committed to meeting standards if they participate in setting them. For example,
production supervisors should have a role in setting production cost standards, and sales
managers should be involved in setting targets for sales prices and volume. In addition,
knowledgeable staff personnel should participate in the standard-setting process. For
example, task analysis should be carried out by a team consisting of production engi-
neers, production supervisors, and managerial accountants.
 Chapter 10 Standard Costing and Analysis of Direct Costs 413

Perfection versus Practical Standards: A Behavioral Issue

How difficult should it be to attain standard costs? Should standards be set so that actual
costs rarely exceed standard costs? Or should it be so hard to attain standards that actual
costs frequently exceed them? The answers to these questions depend on the purpose for
which standards will be used and how standards affect behavior.

Perfection Standards A perfection (or ideal) standard is one that can be attained
only under nearly perfect operating conditions. Such standards assume peak efficiency,
the lowest possible input prices, the best-quality materials obtainable, and no disrup-
tions in production due to such causes as machine breakdowns or power failures. Some
managers believe that perfection standards help achieve the lowest production cost by
motivating employees to achieve the lowest cost possible. They claim that since the stan-
dard is theoretically attainable, employees will have an incentive to come as close as
possible to achieving it.
Other managers and many behavioral scientists disagree. They feel that perfection
standards discourage employees, since they are so unlikely to be attained. Moreover,
setting unrealistically difficult standards may encourage employees to sacrifice product
quality to achieve lower costs. By skimping on raw-material quality or the attention given
to manual production tasks, employees may be able to lower the production cost. How-
ever, this lower cost may come at the expense of a higher rate of defective units. Thus, the
firm ultimately may incur higher costs than necessary as defective products are returned
by customers or scrapped upon inspection.

Practical Standards Standards that are as tight as practical, but still are expected to
be attained, are called practical (or attainable) standards. Such standards assume a “At Best Foods, standard
production process that is as efficient as practical under normal operating conditions. costs are set at attainable
Practical standards allow for such occurrences as occasional machine breakdowns and levels.” (10b)
normal amounts of raw-material waste. Attaining a practical standard keeps employees Best Foods
on their toes, without demanding miracles. Most behavioral theorists believe that practi- (a subsidiary of Unilever)
cal standards encourage more positive and productive employee attitudes than do perfec-
tion standards.

Use of Standards by Service Organizations

Many service industry firms, nonprofit organizations, and
governmental units make use of standards. For example,
FedEx allows its crews 18 minutes to unload the 9 to 12
containers of packages from a Boeing 727. A delay of
over a minute must be explained at a daily 5 a.m. meet-
ing. Burger King sets a standard for the amount of meat
in a hamburger. Airlines such as American or United
set standards for fuel and maintenance costs. Insurance
companies such as Allstate or State Farm set standards
for the amount of time to process an insurance appli-
cation. Even a county motor vehicle office may have a
standard for the number of days required to process and
return an application for vehicle registration. These and
similar organizations use standards in budgeting and cost
control in much the same way that manufacturers use Insurance companies use standards to manage how long it takes to
standards. underwrite a new policy or settle a claim.
414 Chapter 10 Standard Costing and Analysis of Direct Costs

Cost Variance Analysis

To illustrate the use of standards in managing costs, we will focus on a producer of
Learning Objective 10-3
fancy desserts located in the Washington, D.C., area. You might be surprised to learn
Compute and interpret the that the fancy desserts available in a lot of restaurants are not actually made there. A
direct-material price and pastry chef is a luxury that not all restaurants can afford. That is where DCdesserts.com
quantity variances and the comes in.
direct-labor rate and efficiency DCdesserts.com supplies fresh and frozen desserts to a variety of restaurants, cater-
variances. ers, and upscale food stores. The company’s order-taking system is entirely Web-based.
DCdesserts.com posts its menu of fresh fancy dessert products for each day on its web-
site four days in advance of the delivery date. Orders are accepted via the Internet three
days in advance of delivery. For example, the menu of desserts to be available for deliv-
ery on Friday afternoon is posted to DCdesserts.com’s website on Monday, and orders
are accepted up to midnight on Tuesday. The company places orders for ingredients on
Wednesday and accepts delivery on Thursday. DCdesserts.com’s ordering is also done
largely via the Internet. Production then takes place throughout the day on Friday, and the
desserts are delivered Friday afternoon. DCdesserts.com uses three independent delivery
services to deliver its dessert products: Capital Couriers, Potomac Door-to-Door, and
Washington Delivery Service.
DCdesserts.com also produces frozen dessert products for upscale grocery stores.
Unlike the fresh desserts, which vary daily, the frozen desserts are stock items that are var-
ied less frequently. Like the fresh desserts, however, the frozen dessert menu is posted to
DCdesserts.com’s website, and orders are accepted entirely via the Internet. The company
produces its fresh fancy desserts and frozen desserts in two different production facilities,
both located on the outskirts of central Washington, D.C.
The production process for the fresh fancy desserts involves a combination of semiau-
tomated equipment and manual labor. Even in this era of widespread automation, making
fancy desserts still involves considerable direct labor. In the words of DCdesserts.com’s
founder and owner, “making a Black Forest cake or a Linzer torte to be served in the
U.S. Senate dining room is not the same as making your basic pumpkin pie. There’s a
lot of touch labor by skilled people in doing these fancy desserts.” The basic steps in the
production process are much as you might expect. These steps include selecting ingredi-
ents, mixing, baking, cooling, and finishing. The finishing work, of course, involves the
most skilled direct labor. In making a six-layer chocolate raspberry cake, for example,
each individual cake layer must be sliced into two pieces, and then fillings and icings are
spread on each layer. The cake’s top is finished artistically, and any additional toppings
are carefully applied.
DCdesserts.com’s director of cost management has set standards for direct material
and direct labor as follows for a category of dessert products generically referred to as
multilayer fancy cakes.

Direct-Material Standards
The standard quantity and price of ingredients for one multilayer fancy cake, such as a
Black Forest cake, are shown in the following table:
Standard quantity:
Ingredients in finished product ................................................................................................ 4.75 pounds
Allowance for normal waste .................................................................................................... .25 pound
Total standard quantity required per multilayer fancy cake ........................................................ 5.00 pounds
Standard price:
Purchase price per pound of ingredients (net of purchase discounts) ........................................ $1.30
Transportation cost per pound ................................................................................................ .10
Total standard price per pound of ingredients .......................................................................... $1.40