If you want to share this website
with your friends, classmates or family, click here
LINKS
Home
Bibliography
Contact
Interesting Articles
asr5@loscostos.info
If you want your article to be published, it should the following:
- Relationship of the article with Cost Accounting
- Article source
The articles will be published only if they meet the prerequisites of quality and information.
- Cost of materials (leather, zipper, buttons, etc.)
- Direct labor cost (the time required to cut the design, sew it, etcetera, at the rate of production of employees who work in the process), and
- Indirect manufacturing costs related to the product (depreciation of the skin cutter machine, electricity, rent of the factory, etc.).
Once the standard cost is established, this provides the basis for decision-making, to analyze and control costs, and to measure the inventory and the cost of goods sold (see valuation of inventories). The standard costs serve as a benchmark against which actual costs are compared. The differences between current costs and standard costs are called variances. The actual costs may differ from the standard costs due to differences in price, differences in quantity, errors, or other conditions. To determine the reasons for the variances a corrective action may be suggested or demonstrate that the products are currently costing more or less than the anticipated.
Direct
cost
Example: Assume that our leather jacket contains an average of 2 meters of skin at a cost of $16.00 per meter, a zipper at a cost of $5.00 per meter and two buttons at a cost of $0.50 each. Based on a time study recently made by the administration, a jacket requires an average of 5 hours of time spent by an employee to be produced. The production workers are paid on average $10 per hour of work, including benefits. The standard cost for the direct costs (the one for indirect costs will be seen later in this section) shall be as follows:
|
Quantity
X Price = Standard Cost
|
||
| Materials: | ||
| Skin |
|
|
| Zipper |
|
|
| Buttons |
|
|
| Materials Total Cost |
|
|
| Direct Labor Cost |
|
|
| TOTAL DIRECT COST |
|
|
Throughout
the year, our leather jacket company will buy leather, zippers and
buttons, and also recruit and pay to production employees.
But
what hill happened 1) if the company found skin at a lower
price
with a new supplier, which it is offering a discount, 2) a new machine
has been acquired by the company to minimize the amount of material
required by each jacket reducing the material scrap; 3) due to a very
special order, the company had to ask their workers to work overtime,
which must be paid on time and a half the normal rate, i.e. 150%; 4 )
the new machine to improved productivity, and now are used only 4.8
hours to produce a jacket. These
differences
will lead to variations between actual cost and standard costs budgeted
as follows:
|
Quantity
X Price
= Standard Cost
|
||
| Materials: | ||
| Skin |
|
|
| Zipper |
|
|
| Buttons |
|
|
| Materials Total Cost |
|
|
| Direct Labor Cost |
|
|
| TOTAL DIRECT COST |
|
|
Now
it's easy to see how jackets cost $5.00 more than what was budgeted.
To
understand a variance or variation, it must be analyzed and broken into
its component parts. The
analysis of
variance in material would be:
|
|
Quantity
X Price
= Standard Cost
|
|
| Skin: | ||
| Budget |
|
|
| Actual
|
|
|
| Material Variance |
|
|
| Price variance |
|
|
| Variance in quantity |
|
|
| Material Variance |
|
|
The
analysis of variance in direct labor would be the following:
|
|
Quantity
X Price
= Standard Cost
|
|
| DL:
|
||
| Budget |
|
|
| Actual |
|
|
| DL Variance |
|
|
| Price variance |
|
|
| Variance in quantity |
|
|
| DL Variance |
|
|
The
variance is added as follows:
| Standard Cost |
|
| Actual Cost |
|
| Total Variance |
|
| Material variance |
|
| DL Variance |
|
| Total Variance |
|
The
formulas to analyze variances can be expressed as follows:
Overhead
or
indirect costs
| Price Variance |
|
| Variance in quantity |
|
| Total Variance |
|
| Where: | |
| SP = Standard Price | |
| AP = Current Price | |
| SQ = Standard Quantity | |
| AQ = Actual Quantity | |
The direct costs vary in relation to the volume of units produced. Overhead or indirect costs or general expenses, however, are elements that vary directly with the volume (variable costs) and other elements that do not (fixed costs).
Overhead
Budgets. One
way to budget the overhead is ignoring the indirect effects of volume.
This
approach is called fixed costs budget.
Under
this approach, the administration determines the amount of overhead
that should be taken based on a desired or normal level of production.
The
total expenditure becomes
the overhead budget against which performance is measured, regardless
of the level of production currently achieved. An
example of this would be as follows:
|
|
|
| Rent |
|
| Machinery Depreciation |
|
| Supervision Salaries |
|
| Indirect Material |
|
| Electricity |
|
| TOTAL |
|
The
performance at the end of the year may be measured
against the total $3'600,000. However,
not taking
into account the true nature of costs, may lead to a manager to take
inaccurate conclusions about the performance. For
example, lets
assume that this budget is based on a "normal" level of production of
leather jackets (160,000 units). Also assume that the
costs of
electricity, accounting in part for cutting machines and sewing, vary
with the level of production. So,
if 200,000
jackets are produced during the year, the cost of electricity will
exceed $800,000, say that these were a total of $1'000,000.
Comparing
this with a fixed budget, the manager can say that the supervisor of
the warehouse did his job poorly in terms of managing the costs of
electricity, when in fact, excessive spending is due solely to 40,000
extra jackets that occurred.
The
other approach for budgeting overhead is called flexible
budget.
A flexible budget specifies a cost permissible at each possible level
of production. Once
the period is
completed and the volume of production known, the standard budget is
determined by reference to flexible budget for the current level of
production. This
is a parallel
method to the way used to
determine the budget for direct materials and manpower. Example
of a simplified flexible budget:
|
|
|
|
|
(Normal) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||
|
|
|
|||||
|
Rent
|
|
|
|
|
|
|
|
Depreciation
|
|
|
|
|
|
|
|
Supervision
|
|
|
|
|
|
|
|
Indirect
Material
|
|
|
|
|
|
|
|
Electricity
|
|
|
|
|
|
|
|
|
|
|
|
|
|
A flexible budget
allows us to analyze in a more
intelligent way the variable overhead.
Overhead absorption.
Now that our
flexible budget is established, we need to establish how we are going
to allocate indirect costs to our products. The total cost of
a product should include all indirect costs that were generated to
bring the product to its complete form. So
apart from the direct labor and materials, the standard cost of a
product includes indirect costs as well. But, manpower and
materials are easy to measure and allocate their products. It
is much more difficult to
determine how much rent, indirect material, or depreciation was
consumed by a particular product.
The accountants
solve this problem by using an overhead allowance method. This is called overhead
absorption. First
indirect costs are collected in sets of
costs. A group can include all
the rent, other all the costs associated with the inspection, other the
costs of supervision, etc. Now
the sets of costs are allocated to products using a driver of
cost. For simplicity, in
the rest of this note we will assume that all indirect costs are added
in a single set of cost for assignment.
In companies that
produce a single product, the overall costs can be allocated based on
units, using the units produced in the period as a driver of cost. The total budgeted
indirect cost ($ 3.6 million using the example above) will be divided
between the volume of production planned (assuming 200,000 jackets).
Then for each
jacket produced, $18.00 ($ 3.6 million between 200,000) shall apply as
indirect costs. The standard cost per jacket under this
method would
be then:
|
|
|
| Materials |
|
| Manpower (Direct labor) |
|
| Overhead (Indirect cost) |
|
| Total Standard Cost |
|
In
multi-product firms, it is necessary to use a different method or cost
driver than the number of units produced, so a more fair distribution
of indirect cost between products can be made. For
example, if our company makes leather gloves in addition to jackets and
gloves can be manufactured in a quarter of the time it takes to produce
a jacket, it would be unfair to charge each pair of gloves the same
indirect cost that is charged to each jacket. Some
other method of utilization of capacity must be used, as the labor
hours, the amount paid by workforce in currency (either dollars, pesos,
quarters, etc.) or machine hours. The
choice for a business in particular should be based on which variable
is the one that best measures the level of utilization of capacity for
that business. For
example, the overall costs of machinery depreciation can be allocated
based on the number of machine hours per product as a cost
driver. The
entire
cost of supervision can be distributed using the direct labor hours as
a cost driver.
Since our production process of jackets is just more intense in direct labor, we will use the monetary cost of labor as a method of allocation (in this example we will use as currency the U.S. dollars). Using the direct labor dollars, the standard cost of overhead for a jacket would be $0.45 for each dollar of direct labor ($3.6 million of budgeted indirect cost divided by the total $8.0 million of budgeted manpower). Then, for a jacket $22.50 would be applied by indirect cost ($50.00 dollars per jacket multiplied by the $0.45 rate of indirect cost per DL dollar). The total standard cost for a leather jacket would be as follows:
Since our production process of jackets is just more intense in direct labor, we will use the monetary cost of labor as a method of allocation (in this example we will use as currency the U.S. dollars). Using the direct labor dollars, the standard cost of overhead for a jacket would be $0.45 for each dollar of direct labor ($3.6 million of budgeted indirect cost divided by the total $8.0 million of budgeted manpower). Then, for a jacket $22.50 would be applied by indirect cost ($50.00 dollars per jacket multiplied by the $0.45 rate of indirect cost per DL dollar). The total standard cost for a leather jacket would be as follows:
|
|
|
| Materials |
|
| Manpower (Direct labor) |
|
| Overhead (Indirect Cost) |
|
| Total Standard Cost |
|
This
would be the amount to be accumulated as
inventory by each jacket produced. However,
differences between the planned and actual volume will make a volume
variance to emerge. The
volume variance can be explain as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
If
the plan was to produce 160,000 jackets and currently there were only
140,000, and if we assume that the $3.6 million in indirect costs are
fixed and that at the end of the year we only have $3.15 million of
absorption by finished product; if the actual costs were $3.6 million,
that compared with the absorption have led to a volume variance of
$450,000.