PM - Budgeting and control

Standard Costing

STANDARD COST:

A standard cost for a product or service is a predetermined unit cost set under specified working conditions.

A standard cost can have the following uses:

1) Budget preparation. Standard costs and standard sales prices are necessary for the preparation of
budgets;
2) Motivation. A standard cost can motivate those working within the cost centre to ensure that the standard
is achieved;
3) Control. By comparing a standard cost to an actual cost differences are highlighted and can be
investigated;
4) Performance measurement. Differences between the standard cost and the actual cost can form the basis
for assessing the performance of cost centre managers;
5) Inventory valuation. Standard costs can be used for the measurement of inventory to be included in the
organisation’s SFP and P&L.

There are four main types of standard:

1) Basic Standards. The assumption is that nothing has changed since the standard was first set.
- Used for trend analysis to illustrate how costs have changed over time;
- They become outdated so they cannot be used to highlight efficiency levels or as a basis of performance
assessment;
- They demotivate employees as an outdated standard can become either too easy or too difficult to achieve;
- Performance assessment would be difficult given a demotivated employee.
2) Current Standards. They are based on current working conditions and assume current efficiency and cost
levels will be maintained.
- Staff may become demotivated as they are not encouraged or expected to improve on what they are
currently doing;
 - Productivity levels could suffer and fair assessment of performance would be difficult to achieve.
3) Ideal Standards. They are based on perfect working conditions and assume an optimal level of efficiency
and cost.
- It may not be possible to achieve the standard, which can have a negative impact on employee motivation
and productivity;
- Fair performance appraisal would be difficult to achieve.
4) Attainable Standards. It assumes there will be some improvements in current efficiency and cost levels.
- Employees should feel that attainable standards are challenging yet realistic and achievable;
- Employees should be motivated to meet the standard.

FLEXED BUDGET:

A flexed budget is prepared at the end of the period by applying standard costs and standard revenues to the
actual number of units produced & sold in that period.

Flexed budget variance = Actual cost - Flexed cost

Flexed cost = Standard cost x Actual units produced

Note: The variances should be analysed into its component parts (e.g. material, labour, overhead). They should
form the basis of performance assessment and future cost control.

CONTROLLABILITY:

A positive or adverse variance does not necessarily mean that the budget holder has performed well or
performed badly. A budget holder should only be assessed based on what they can control.

A controllable cost is a cost which is influenced by the budget holder.

An uncontrollable cost is a cost that cannot be changed by the budget holder.

 PM - Budgeting and control
Expected Value

Expected value is a weighted average of all possible outcomes. It calculates the average return that will be
made if a decision is repeated over and again.

EV = Σxp

X - value of each possible outcome;

P - the probability of that outcome arising.

Calculation pro forma:

Estimated result (x), $ Probability (p), % xp

Outcome 1 X P XP
Outcome 2 X P XP
Outcome n X P XP
Expected value = Total

Advantages Disadvantages

- EV takes uncertainty into consideration as - It calculates the long term weighted

the probability of each possible outcome average value. Expected values
is considered and then used to calculate should not therefore be applied to one-
an expected value; off decisions;
- The expected value calculation is - The EV may not equal any of the
relatively straightforward; possible outcomes;
- The actual EV is a single number meaning - The probabilities applied to the EV
decision making is facilitated. calculation can be subjective;
- EV can be seen to ignore the risk as
the range of possible profit outcomes
is not considered.
 PM - Budgeting and control
High / low Analysis

High / low analysis - method of analysis of semi-variable or mixed costs into its fixed and variable elements
based on analysis of costs incurred on various levels of activity and used to forecast total cost for specific activity
level.

4 Step approach:

Using the difference between activity levels, determine variable cost per unit:

Cost at high activity level - Cost at low activity level

Variable cost per unit =
High activity level units - Low activity level units

Find fixed cost by substitution at either high or low activity level:

Fixed cost = Total cost - Variable cost

Use variable and fixed cost to forecast total cost for specific level of activity.
 Advantages: Disadvantages:

- Simple technique; - Assumes only activity level drives the production

- Splits total costs into fixed and costs;
variable; - Two pairs of past data is considered;
- Easy to understand and apply. - Other data is ignored;
- Historical costs may not predict future costs;
- Not always possible to split total costs into
variable and fixed.
 PM - Budgeting and control
Learning Curve

When the workforce starts making a new product, the rate of production can be fairly slow, but as they make
more of the items they will become faster and therefore the average time taken to make each unit will decrease
and the labour cost per unit will drop.

This decrease in time taken is called the learning curve effect and it can be demonstrated in a following
graphical form:
Average time per unit

Y5

Y4

Y3

Y2

Y1

X1 X2 X3 X4 X5
Cumulative volume of production

As the volume produced increases the time taken per unit or batch drops and then slowing as the effect of the
learning curve effect starts to diminish.

Note: When producing budgets we need to consider these changes in the labour cost to ensure the budgets are
as accurate as possible given the information available to us.
This learning curve effect won’t work for all production scenarios. It works best when the following factors are in
place:

- A motivated workforce who are keen to work at a fast pace and are keen to learn;
- A low turnover of workers, so that each of the workers have time to learn the process and then speed up;
- Repetitive production process, so a learning effect can be massively saved;
- Labour-intensive production process, because if machines are being used for the majority of the process
they will work at the same pace with large or small volumes and at both the start of a new production
process and some time after the process has been in place;
- New production process to the business, because if the same production process has been used for
some time there will be little learning effect seen.

In order to calculate learning curve effect, we need to consider the percentage decrease in the cumulative
amount of time it takes each time the output doubles. For example:

1) We need Y hours in order to produce X units of products;

2) If the learning curve effect works we would expect that for the production of 2X units we will need less than
2Y hours. Let’s assume that production of 2X units takes 1.8Y hours.

3) Learning curve effect (learning rate) is 80% because the time to produce the second batch of products
drops by 20% as compared to the first one.

In order to estimate how the learning curve effect would work as production volumes increase we can use
following formulas:

logLR
y= axb b=
log2

where y - cumulative average time taken to make x units;

x - cumulative number of units made;
a - time taken to produce the first unit;
b - learning factor;
LR - learning rate as a decimal.

Steady state effect is reached once the learning curve effect has more or less disappeared. Usually it happens
when:

- Machines become efficient and restrict improvements;

- Machines reach the limit of safe running speeds;
- The labour force has reached maximum working speed.

Once the steady state has been reached the average time taken to produce a single unit or batch can then be
used for all future budgeting, costing and pricing purposes.
 PM - Budgeting and control
Material Mix and Yield Variances

There are different types of material variances that can be calculated:

a) Material price variance. This variance tells us whether we have spent more or less than planned on the
material we have bought and used within the production process;
b) Material usage variance. This variance tells us whether we have used more or less than planned.

The material usage variance can be split into a material mix and a material yield variance:

1) The material mix variance will give us more information on the financial impact of the cost of using
different proportions (or mixes) of materials. It is calculated using the following formula:

(Actual quantity x Actual mix - Actual quantity x Standard mix) x Standard cost

Note: We need to perform this calculation for each material in the mix and then total them together to find
the total material mix variance.

2) The yield variance measures the impact of the different materials on the output (or yield) from using those
materials. It is calculated using the following formula:

(Actual quantity x Standard mix - Standard quantity x Standard mix) x Standard cost
or
(Used per std mix - Should have used) x Std cost

Note: Cost and quality are key considerations and need to be balanced when determining the mix of
materials to use. The variances, therefore, provide management with useful information that will help them
determine the best mix for the production process and for the business.
 PM - Budgeting and control
Sales Mix and Quantity Variances

The sales volume variance can be split into the sales mix and quantity variances.

The sales mix variance looks at the proportions of each product actually sold compared to the proportions we
expected to sell when setting our budgets. It is calculated using the following formula:

(Actual quantity x Actual mix - Actual quantity x Standard mix)

x Standard contribution / profit

Note: Alternatively, we could state this calculation as what we did sell compared to what we thought sales of
each product would be using the standard mix, multiplied by the standard contribution or profit per unit.

The sales quantity variance looks at the difference in the contribution or profit generated by a change in the
sales volume of each product compared to budgeted sales of those products. It is calculated using the following
formula:

(Actual quantity x Standard mix - Standard quantity x Standard mix)

x Standard contribution / profit
 PM - Budgeting and control
Planning and Operational Variances

DEFINITION:

Planning and operational variances can be used to further break down the sales, material, or labour variances
to explore why our actual costs and revenues differ from those originally budgeted.

REVISED BUDGET:

A budget should be revised when there are factors outside of the business’s control that impact the original
budgeted figures. The factors resulting in us revising the budget include:

- Problems with the supplier;

- An unexpected increase in material prices;
- Workers going on strike;
- The government setting a new, unexpected minimum wage;
- A new competitor coming to market, meaning that we had to reduce our selling price.

PLANNING AND OPERATIONAL VARIANCES:

When revising the budget for direct costs, we flex the budgeted costs the budgeted costs for the actual volume
of units produced.

Planning variance is the difference between flexed figures and the original budgeted figures. It is calculated as
follows:
 (Budgeted standard cost - Revised standard cost) x
Material planning price variance = Actual usage

(Budgeted usage - Revised usage)

Material planning usage variance =
x Budgeted standard cost

Labour planning variance = Budgeted labour cost - Revised labour cost

(Budgeted sales volume - Expected sales volume)

Sales planning variance =
x Standard contribution

Operational variance is the difference between flexed budget and actual costs. It is deemed to be controlled by
management and calculated as follows:

(Revised standard cost - Actual standard cost) x

Material operational price variance =
Actual usage

(Revised usage - Actual usage)

Material operational usage variance =
x Budgeted standard cost

Labour operational variance = Revised labour cost - Actual labour cost

(Expected sales volume - Actual sales volume)

Sales operational variance =
x Standard contribution