Introduction to Variance Analysis and Standard Costs CMA Part 1 Determining the Level of Activity Costs are the result of activities that are undertaken to create products or render services. Therefore, it is activities, not costs, that managers manage. Thus, standards should be established for the cost drivers underlying the costs. When determining the level of activity or production for the calculation of standard costs, it is important to use the correct level of activity when developing the standards. If the standard level of activity is set too high, there will be no motivation among the workers. This is because they know that no matter how hard they work, they will still fail to meet the budgeted level of output. Ideal, perfect or theoretical level of output assumes that there are no breakdowns, no waste and no time lost to illness, and that the workers are already working at maximum effiCiency. An alternative to this theoretical level of output is the practical, or currently attainable, level of output. This is the level that will be achieved given the normal amount of time lost, normal amount of waste and a normal learning curve for employees. The goal is to use a level that is attainable, but difficult to attain. This will motivate the workers and still require them to work diligently. In practice, however, either the normal level of output or the master budget level of output is used to set the standards. Normal level is an average expected level of production within the time frame of several years (up to three) given the reasonable expectations of effective and efficient production and customer demand. Master budget capacity is the planned capacity for the next budget period. In addition to setting the correct level of output, the standard cost also needs to be reviewed from the perspective of the costs of the inputs into the process, because it will change over time. If the cost of materials goes up or down, the standard cost must also be adjusted. Sources of Standards Appropriate standards are often set by using several sources, including activity analysis, historical data, benchmarking, target costing and strategic decisions. Activity analysis involves identifying, delineating or outlining, and evaluating all the activities necessary to complete a job, a project or an operation. An activity analysis considers everything required to complete the task efficiently and involves personnel from several areas including engineers, management accountants and production workers. Product engineers specify product components. Industrial engineers analyze the steps or procedures necessary to complete the task. Management accountants work with the engineers to complete the analysis. Activity analysis is time consuming and expensive. However, if properly executed, activity analysis is the most precise way to determine standard costs. Use of historical data is a less costly way to develop standard costs. Historical data for a similar product can be a good source for determining the standard cost of an operation, if reliable information is available. Another advantage to using historical data is that it is based on the way the particular firm has operated in the past. This can also be a disadvantage, because a standard based on the past can perpetuate past inefficiencies. Although historical standards are more attainable than ideal standards, they are not consistent with a philosophy of continuous improvement. Benchmarking to develop standard costs is based on current practices of similar operations in other firms. Associations of manufacturers often collect industry information and have data available. The firm can use this data as guidelines for setting standard costs. By using benchmarking to set standard costs, a firm can have access to the best performance anywhere and this can help sustain its competitive edge. A disadvantage of using benchmark data is that it might not be completely applicable to the firms own situation. Use of target costing to set standard costs puts the focus on the market and on the price the product can be sold for. A target price is the price the firm can sell its product for, and the target cost is the cost that must be attained for the firm to realize its desired profit margin for the product. Once the target cost has been determined, detailed standards are then set to attain the desired cost.
Posted on: Thu, 13 Mar 2014 11:36:08 +0000
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