Cost assignment
Cost assignment
No Student name ID
1. Daniel Shebiru................0192/14
2. Sime Jifar........................0081/14
3. Tadela Shimelis.............0093/14
4. Desta Dida....................0196/14
5. Sumaya A/selam.............0196/14
6. Sara Belachew..............0195/14
7. Meseret Dejene............00202/14
8. Aster Mekonin.................00199/14
9. Fatra Abdala......................0198/14
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CHAPTER FOUR
STANDARDS COSTING AND FLEXIBLE BUDGET
4.1. Introduction
Dear learners in the previous unit you have studied the benefit of budget as a planning tool. Hence, budgets are
planning tools that are usually prepared prior to the start of the period being budgeted. However, the comparison
of the budget to actual results provides valuable information about performance. Therefore, budgets are both
planning tools and performance evaluation tools. In this unit, therefore the discussion focuses on how budget are
used to evaluate feedback and variances aid managers in their control function.
In evaluating performance the budgeted performance are compared with actual operational results and the
resulting variance will be examined so as to identify the causes for variance on the bases of which performance
can be rewarded for favorable variance or corrective actions will be taken to avoid unfavorable variance on the
coming operational periods.
The unit highlights the importance of variance analysis and show how the budget initially prepared at planning
stage creates problem while comparing actual results with the budget. In this unit you are also introduced with
the advantage of flexible budget over the static budget, steps in the preparation of flexible budget and evaluating
performance using flexible budget.
Clerical Efficiency:- A company using standard costs usually discovers that less clerical time and effort are
required than in an actual cost system. In an actual cost system, the accountant must continuouslyrecalculate
changing actual unit costs. In a standard cost system, unit costs are held constant for some period. Costs can be
assigned to inventory and cost of goods sold accounts at predetermined amounts per unit regardless of actual
conditions.
Motivation:- Standards are a way to communicate management’s expectations to workers. When standards are
achievable and when workers are informed of rewards for standards attainment, those workers are likely to be
motivated to strive for accomplishment. The standards used must require a reasonable amount of effort on the
workers’ part.
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Planning:- Planning generally requires estimates about the future. Managers can use current standards to
estimate future quantities and costs. These estimates should help in the determination of purchasing needs for
material, staffing needs for labor, and capacity needs related to overhead that, in turn, will aid in planning for
company cash flows. In addition, budget preparation is simplified because a standard is, in fact, a budget for one
unit of product or service. Standards are also used to provide the cost basis needed to analyze relationships
among costs, sales volume, and profit levels of the organization.
Controlling:- The control process begins with the establishment of standards that provide a basis against which
actual costs can be measured and variances calculated. Variance analysis is the process of categorizing the
nature (favorable or unfavorable) of the differences between actual and standard costs and seeking explanations
for those differences. A well-designed variance analysis system captures variances as early as possible, subject to
cost-benefit assessments. The system should help managers determine who or what is responsible for each
variance and who is best able to explain it. An early measurement and reporting system allows managers to
monitor operations, take corrective action if necessary, evaluate performance, and motivate workers to achieve
standard production.
Decision Making:- Standard cost information facilitates decision making. For example, managers can compare a
standard cost with a quoted price to determine whether an item should be manufactured in-house or instead be
purchased. Use of actual cost information in such a decision could be inappropriate because the actual cost may
fluctuate from period to period. Also, in making a decision on a special price offering to purchasers, managers can
use standard product cost to determine the lower limit of the price to offer. In a similar manner, if a company is
bidding on contracts, it must have some idea of estimated product costs. Bidding too low and receiving the
contract could cause substantial operating income (and, possibly, cash flow) problems; bidding too high might be
uncompetitive and cause the contract to be awarded to another company.
Performance Evaluation:- When top management receives summary variance reports highlighting the operating
performance of subordinate managers, these reports are analyzed for both positive and negative information. Top
management needs to know when costs were and were not controlled and by which managers. Such information
allows top management to provide essential feedback to subordinates, investigate areas of concern, and make
performance evaluations about who needs additional supervision, who should be replaced, and who should be
promoted. For proper performance evaluations to be made, the responsibility for variances must be traced to
specific managers.
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Budgetary control system Standard costing system
Budgetary control is related to all types of items Standard costing is related to production and
of revenue and expenditure, whether they production costs. Hence, it is more rigorous and
belong to the product or not, i.e. to all types of intensive.
business activities. Hence, it is more extensive.
Standard is established on the basis of technical
Budget is based on past experience and in most estimates. It is the projection of accounts.
cases a projection of financial accounts.
Standard are very rigid and ‘ought to be’
Budgets are comparatively less rigid and ‘should estimates. They fix targets.
be’ estimates. They fix limits.
Standard costing system cannot operate well
Budgetary control can be operated without a without a budgetary control system. Also, it is
standard costing system. It can be adopted in not possible to operate the system in parts
part.
Variance analysis is a subject of special study of
The study of variances is not a subject of special standard costing.
study as in the case of standard costing
1 The weakness of the traditional costing system can be estimated by compiling standard costs more carefully.
2. Standard costs can be used as a yardstick against which actual costs can be compared. It is an effective tool for
planning production costs. Hence, cost control is greatly facilitated.
3. Variance analysis helps management to have regular as well as better checks over costs incurred. It makes the
application of the principle of management by exception more easy. That is, the management can concentrate its
attention on variances only, leaving the other aspects of cost control to be taken care of at the lower level.
4. It is a valuable guide to management in the formulation of production and price policies in advance with
certainty. It also assists management in the areas of profit – planning, product –pricing, and inventory pricing,
etc.
5. Standard costing makes the reporting of operating data more meaningful and also fast. This makes the
interpretation of management reports easy.
6. As the emphasis of the standard costing system is more on cost variations, it makes the entire organization cost
conscious. It makes the employees recognize the importance of efficient operations so that costs can be reduced
by joint efforts.
7. Labor, materials and machines can be effectively used, and economies can be affected in addition to increase
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productivity. Standards may also be used as the basis for introducing incentive schemes.
1. Setting of standards is a very difficult task. It requires a lot of scientific studies such as time –study, motion
study, etc., and therefore it is very costly. Small firms may find it very difficult to operate such a system.
2 Standards are very rigid estimates and once set, are not changed for a considerable time. This makes the
standards highly unrealistic in certain industries which face fluctuations in prices of products due to frequent
changes.
3 The utility of variance analysis depends much more on the standard set. While a loosely set standard may be
ridicule the standards which are set very high may create frustration in the minds of the workers. At the same
time setting of correct standards is also, it is difficult to apply this system when production takes more than one
accounting period.
Once management has established the desired output quality and determined the input resources needed to
achieve that quality at a reasonable cost, quantity and price standards can be developed. Experts from cost
accounting, industrial engineering, personnel, data processing, purchasing, and management are assembled to
develop standards. To ensure credibility of the standards and to motivate people to operate as close to the
standards as possible, involvement of managers and workers whose performance will be compared to the
standards is vital.
Material Standards
The first step in developing material standards is to identify and list the specific direct materials used to
manufacture the product. This list is often available on the product specification documents prepared by the
engineering department prior to initial production. In the absence of such documentation, material specifications
can be determined by observing the production area, querying of production personnel, inspecting material
requisitions, and reviewing the cost accounts related to the product. Three things must be known about the
material inputs: types of inputs, quantity of inputs used, and quality of inputs used.
Specifications for materials, including quality and quantity, are compiled on a bill of materials. Even companies
without formal standard cost systems develop bills of materials for products simply as guides for production
activity. When converting quantities on the bill of materials into costs, allowances are often made for normal
waste of components. After the standard quantities are developed, prices for each component must be
determined. Prices should reflect desired quality, quantity discounts allowed, and freight and receiving costs.
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Although not always able to control prices, purchasing agents can influence prices. These individuals are aware of
alternative suppliers and attempt to choose suppliers providing the most appropriate material in the most
reasonable time at the most reasonable cost. The purchasing agent also is most likely to have expertise about the
company’s purchasing habits. Incorporating this information in price standards should allow a more thorough
analysis by the purchasing agent at a later time as to the causes of any significant differences between actual and
standard prices.
Labor Standards
Development of labor standards requires the same basic procedures as those used for material. Each production
operation performed by either workers (such as bending, reaching, lifting, moving material, and packing) or
machinery (such as drilling, cooking, and attaching parts) should be identified. In specifying operations and
movements, activities such as cleanup, setup, and rework are considered. All unnecessary movements by workers
and of material should be disregarded when time standards are set.
To develop usable standards, quantitative information for each production operation must be obtained. Time and
motion studies may be performed by the company; alternatively, times developed from industrial engineering
studies for various movements can be used. A third way to set a time standard is to use the average time needed
to manufacture a product during the past year. Such information can be calculated from employees’ past time
sheets. A problem with this method is that historical data may include inefficiencies. To compensate,
management and supervisory personnel normally make subjective adjustments to the available data.
Labor rate standards should reflect the employee wages and the related employer costs for fringe benefits, FICA
(Social Security), and unemployment taxes. In the simplest situation, all departmental personnel would be paid
the same wage rate as, for example, when wages are job specific or tied to a labor contract. If employees
performing the same or similar tasks are paid different wage rates, a weighted average rate (total wage cost per
hour divided by the number of workers) must be computed and used as the standard. Differing rates could be
caused by employment length or skill level.
Overhead Standards
To provide the most appropriate costing information, overhead should be assigned to separate cost pools based on
the cost drivers, and allocations to products should be made using different activity drivers. After the bill of
materials, operations flow document, and predetermined overhead rates per activity measure have been
developed, a standard cost card is prepared. This document summarizes the standard quantities and costs needed
to complete one product or service unit.
Data from the standard cost card are then used to assign costs to inventory accounts. Both actual and standard
costs are recorded in a standard cost system, although it is the standard (rather than actual) costs of production
that are debited to Work in Process Inventory. Any difference between an actual and a standard cost is called a
variance.
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incurred in achieving the standard.
Appropriateness:- Although standards are developed from past and current information, they should reflect
relevant technical and environmental factors expected during the time in which the standards are to be applied.
Consideration should be given to factors such as material quality, normal material ordering quantities, expected
employee wage rates, degree of plant automation, facility layout, and mix of employee skills. Management should
not think that, once standards are set, they will remain useful forever. Current operating performance is not
comparable to out-of-date standards.Standards must evolve over the organization’s life to reflect its changing
methods and processes. Out-of-date standards produce variances that do not provide logical bases for planning,
controlling, decision making, or evaluating performance.
Attainability:- Standards provide a target level of performance and can be set at various levels of rigor. The level
of rigor affects motivation, and one reason for using standards is to motivate employees. Standards can be
classified as expected, practical, and ideal. Depending on the type of standard in effect, the acceptable ranges
used to apply the management by exception principle will differ. This difference is especially notable on the
unfavorable side.
Evaluating performance based upon the master budget which fixed and prepared at s ingle level of activity may
not provide accurate picture of performance. This because usually the planned and actual output or activities
levels may not be equal, as a result the comparison is performed at two different level of activity which hides the
variance attribute to the actual performance units as well as overall organization. For example, if a company
budgeted to produce and sell 12,000 units, but the actual performance showed only 10,000 units, the comparison of
revenue, cost and profit at the budget and actual level of output do revels only the variance resulted from the
difference in the level of output. Therefore unless the analysis is re done by adjusting the budgeted level of output
towards the actual units produced and sold, the variance is not helpful to the management as performance
evaluation tool.
Static Budget Variance [SBV] is the difference between an actual result and the corresponding budgeted
amount in a static budget.
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budget for performance evaluation. The flexible budget asks the question: “If I had known at the beginning of the
period what my output volume (units produced or units sold) would be, what would my budget have looked like?”
The motivation for the flexible budget is to compare apples to apples. If the factory actually produced 10,000 units,
then management should compare actual factory costs for 10,000 units to what the factory should have spent to
make 10,000 units, not to what the factory should have spent to make 9,000 units or 12,000 units or any other
production level.
Variances help to fix the responsibilities so that management can ascertain the person responsible for the poor
results. For example, an adverse material usage variance would indicate that excess material cost was due to
inefficient use of materials. This would enable management to fix the responsibility on the supervisor in charge of
a particular operation in which the inefficiency occurred. It may be discovered that the variance was caused by
(say) inefficient handling, purchase of poor quality materials or employment of trainees. The important point is
that the reason for the variance must be found, explained and wherever necessary, corrective measures taken.
To have a better understanding of causes for variance managers usually require variance calculated at different
level. Variance according to the degree of detailed feedback on performance can be classified as:
In this unit the focus is on level 0, 1, and 2 variances, and the reaming will be discussed in length on the next unit.
Now let see the preparation of flexible budget as well as analysis of variance using the following:
Illustration 3.1: Kombolcha Garment Co. manufactures and sells a jacket. Sales are made to distributors who sell
to independent clothing storesKombolcha Garment’s only costs are manufacturing costs. All units manufactured
in April 2003 are sold in April 2003. There is no beginning or ending inventory. Kombolcha Garment has variable
cost categories. The budgeted data for April 2003 are:
DM costs………………………………… Br. 60
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DL costs…………………………………. 16
The number of units manufactured is the cost driver for all variable-manufacturing costs. The relevant range for
the cost driver is from 0 to 12,000 jackets. Budgeted manufacturing fixed costs are Br. 276,000 for production
between 0 & 12,000 jackets. Budgeted selling price is Br.120/jacket. The static budget for April 2003 is based on
selling 12,000 jackets.
Variable costs:
DM …………………….. 621,600
DL……………………… 198,000
Level zero variance analysis the least detail analysis which simply compares the operating income at static
budget income statement with the operating income at the actual income statement. The level zero variance for
Kombolcha Garment from the above given data is determined as,
The analysis revealed unfavorable variance as the actual operating income is lower than the budgeted operating
income by Birr 93,100. The result here couldn’t provide the management useful information as it couldn’t show
the contribution revenue and each cost element to operating income variance.
Level one variance can offer management a better insight about their organizational performance than level zero
analysis. At this level, operating income variance will be decomposed into revenue and cost component as a result
the management will identify the responsibility center that demands attention.
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Actual Results Static Budget Static Budget
(1) Variance(SBV) (2)
= (1) – (3) Result (3)
Items
Variable costs:
Operating Income
Br. 93,100U______________SBV
The static budget variance shows an unfavorable variance for revenue, fixed costs whereas favorable variance of
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total variable cost. These variances are due primarily to the fact that the static budget was built on an output level
of 12,000 units, while the company actually made and sold 10,000 units. The revenue variance might also be due to
an average unit sales price that differed from budget. The variable cost variances might also be due to input prices
that differed from budget (e.g., the price of fabric), or input quantities that differed from the per-unit budgeted
amounts (e.g., yards of fabric per jackets) that may be identified at the later stages of the variance analysis.
Level 2-variance analysis [Flexible Budget Variance (FBV) & Sales-Volume Variance (SVV)]
To identify the amount of variance attributed the difference in the level of output as well as to real performance of
the company, at this level the static budget variance will be decomposed into the flexible budget variance and
sales volume variance.
Flexible Budget Variance (FBV) is a better measure of operating performance because they compare actual
revenues to budgeted revenues and actual costs to budgeted costs for the same output level.
Sales-Volume Variance (SVV) is the difference between the flexible budget amounts and static budget amounts. It
represents the variance caused solely by the difference in the actual output volume and budgeted quantity of
output expected to be produced and sold in the static budget.
To determine the flexible budget variance and sales volume variance, first you need to develop a flexible budget.
The flexible budget, for the example given above is prepared at the end of the period after the actual output level
of 10,000 jackets is known. The flexible budget is that Kombolcha Garment would have prepared at the start of the
budget period had it correctly forecasted the actual level of 10,000 jackets.
The budgeted variable costs per unit are the same Br. 88/ jacket.
The budgeted fixed costs are the same Br. 276, 000, are used.
The only difference between the static budget and the flexible budget is that the static budget is prepared for the
planned output level of 12,000 jackets, whereas the flexible budget is based on the actual output of 10,000jackets.
10,000jackets.
Step 2. Calculate the flexible budget for revenues based on Budgeted Selling Price and
= Br. 1,200,000
Step 3. Calculate the Flexible Budget for Costs based on Budgeted Variable Costs per
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Unit, Actual Quantity of Output and Fixed Costs.
FB for FC 276,000
Step 4: Building the flexible budget based on the information from steps 1 and 2, and step 3 results a flexible
budget presented on column 3 of the following table.
After the flexible budget is developed it is possible to determine the flexible budget variance by comparing the
flexible budget and the actual operational results, and sales volume variance by comparing the flexible budget
results and the static budget as shown on the following table.
From this table, Kombolcha Garment sees that after adjusting for sales volume, revenue was higher than would
have been expected. The favorable Birr 50,000 variance must be due entirely to an average sales price that was
higher than planned which was Bir125 per jacket compared to the original budget of Birr120 per jacket.
Materials costs were higher than would have been expected for a sales volume of 2,000 units. This unfavorable
variance is due to higher material prices, or to inefficient utilization of fabric (more waste than expected), or a
combination of these two factors. Labor and overhead were higher than expected, even after adjusting for the
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sales volume of 2,000 units. This unfavorable flexible budget variance implies that either wage rates were higher
than planned, or labor was not as efficient as planned, or both. Similarly, the components of variable overhead
were either more expensive than budgeted, or were used more intensively than budgeted. For example, electric
rates might have been higher than planned, or more electricity was used than planned per unit of output.
The fixed cost variances are identical in this table to the previous table. In other words, the flexible budget and
flexible budget variance provide no additional information about fixed costs beyond what can be learned from the
static budget variance.
If the actual price is larger than the standard price, this variance is unfavorable (U); if the standards are larger
than the actual; the variance is favorable (F)
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standard quantity allowed for the actual output. This difference is multiplied by the standard price per unit of
material. i.e. A material quantity (usage) variance is the difference between the actual quantity of materials used
and the standard quantity of materials that should have been used to produce the actual output, multiplied by the
standard price of materials per unit. It can be calculated as:
MQV = (SQ-AQ) x SP
If the actual quantity amounts are larger than the standard quantity amounts, this variance is unfavorable (U); if
the standards are larger than the actual; the variance is favorable (F)
Example In August 2001, East Publishing Company’s costs and quantities of paper consumed in manufacturing its
2002 Executive Planner and Calendar were as follow:
Required:
Total FBV
Solution:
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Actual unit purchase price (a) -------------------------------- Br 0.16 per page
= (Br 0.15 per page - Br 0.16 per page) 230,000 pages= Br. 2,300 (U)
MQV = (SQ-AQ) x SP
Just like we have done for material inputs, we will do the same meaningful analysis for labor inputs. Hence, the
variance investigation to flexible budget variance for labor resulted in: (i) labor rate variance that identifies the
effect of differences in the rates paid to workers, and (ii) labor efficiently or usage variance that identifies the
effect of differences in the quantities of labor used.
LRV= (SR-AR) x AH
AR is actual rate of labor per hour, AH is a total actual hour of labor worked
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AH is actual labor hours used for the unit produced
A flexible budgetis a planning document that presents expected overhead costs at different activity levels. In a
flexible budget, all costs are treated as either variable or fixed; thus, mixed costs must be separated into their
variable and fixed elements. The activity levels shown on a flexible budget usually cover the contemplated range
of activity for the upcoming period. If all activity levels are within the relevant range, costs at each successive level
should equal the previous level plus a uniform monetary increment for each variable cost factor. The increment is
equal to variable cost per unit of activity times the quantity of additional activity.
The use of separate variable and fixed overhead application rates and accountsallows separate price and usage
variances to be computed for each type of overhead.
Symbolically,
VOHV =SC-AC
It can be sub –divided intoVariable overhead expenditure variance, and Variable overhead efficiency variance.
VOH expenditure variance is the difference between the standard variable overheads for the actual hours worked,
and the actual variable overheads incurred. The formula for computing it is as follows:
VOH efficiency variance arises when the actual output produced differs from the standard output for actual
hours worked. It is a measure of extra overhead (for saving) incurred solely because of the efficiency shown during
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the actual hours worked. The formula to compute it is as follows:
VOH efficiency variance = (SHOV for actual hours worked)- (SHOV for actual output)
Example From the following information, calculate VOH cost variances assuming labor hours as cost driver for
variable manufacturing overhead.
Solution
VOH efficiency variance =SVOH for actualHrs- SVOH for actual output
Workings:
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SFOH = standard fixed overheads for actual output
Note that, if the AFOH is less than the SFOH, the variance is favorable (F), and vice versa. This variance can be
classified into two.
This is the difference between Actual fixed overhead costs and Budgeted fixed overhead
If the actual is greater than the budgeted, this variance is adverse (U), and vice versa
This is the difference between the budgeted fixed overheads and the standard fixed overheads absorbed on actual
production. The formula is as follows:
If the BFOH is greater than the SFOH on actual production, the variance is adverse (U) and vice versa.
Budgeted hours: 10,000 hours; Budgeted output: 5,000 units, Budgeted FOH: Br.3,000Actual hours: 12,000hours;
Actual output:4,800 units; Actual FOH: Br.3,600
Solution:
FOHV =AFOH –SFOH on actual output = Br.3600-(0.60* x4800) = Br. 3600-Br. 2880=.Br.720 (U)
FOHVV =BFOH –SFOH on actual output = Br.3000-(0.60x4800)= Br.3000 – 2880 =.Br.120 (U)
Workings: