To be solved by DKetan. Using Chapter 7 of your text as a reference, define a standard cost and explain what constitutes the components of a standard cost. Describe the advantages and disadvantages of a standard cost system and explain under what circumstances a standard cost system is most effective. Your initial post should be 200-250 words.

chapter 7 Cost Control Through Standard Costs Marka/SuperStock Learning Objectives After studying Chapter 7, you will be able to: Explain the significance of profit analysis for an organization. Describe the major characteristics and conditions of a standard cost system. Compute materials price and usage variances, and identify potential causes of such variances. Compute labor rate and efficiency variances, and identify potential causes of such variances. Describe the interrelationships that exist among materials and labor variances. Explain the major considerations that are the basis of standard costs for overhead. Distinguish between a budget variance and a capacity variance for overhead. Explain why the capacity variance is related only to fixed overhead costs. Explain how standard costs can be used in a process cost system. sch80342_07_c07_279-326.indd 279 12/20/12 11:53 AM Chapter Outline CHAPTER 7 Chapter Outline 7.1 7.2 Profit Analysis The Use of Standards Definition of Standard Costs Advantages of Standards The Quality of Standards Revising the Standards 7.3 Standard Cost Sheet 7.4 7.5 7.6 7.7 7.8 7.9 7.10 7.11 sch80342_07_c07_279-326.indd 280 Standards for Materials Materials Price Variance Materials Usage Variance Interrelationships of Price and Usage Variances Standards for Labor Setting Rate Standards Setting Time Standards Accounting for the Rate and Efficiency Variances Causes of Labor Variances Responsibility for Labor Variances Interrelationships of Variances The Influence of Automation Standards for Overhead Development of Overhead Rates Flexible Overhead Budgets Framework for Two-Way Overhead Variance Analysis Capacity and Control Variances Summary of Standard Cost Variances Disposition of Variances Standard Costs in Different Settings Standard Costs in Service Organizations Standard Costs in a Process Cost System Standard Costs in JIT/CIM Environments Target Costing and Kaizen Cost Targets Ethical Considerations Three-Variance Method for Overhead Framework for Three-Way Overhead Variance Analysis Spending Variance Efficiency Variance Four-Way Analysis 12/20/12 11:53 AM CHAPTER 7 Section 7.1 Profit Analysis Where Do I Start With Standard Costs? Jean-Claude Recca, President of Rue de Lorraine, a chain of fast food restaurants in central France, just returned from a reunion of his INSEAD graduating class. During the day of activities in the Riviera, he talked with several of his classmates who have become extremely successful in various businesses. One of those classmates suggested to Jean-Claude that adoption of a standard cost system eliminated most of her firm's unacceptable scrap and spoilage, caused an examination of nonvalue-added activities, and substantially reduced several inefficient operations. Jean-Claude did not know whether his restaurant chain would really benefit from a standard cost system. He wondered: If he makes the change, which costs should be put on standards? How does he set up standards? When do variances mean something? Isn't a standard cost system expensive to use? Isn't it a pain in the derriere? Wouldn't a tight budget do the same thing? These questions were more than Jean-Claude could consider. He decided to bounce the idea of standard costs off his controller. Introduction I n measuring success in any undertaking, a comparison is usually made between actual performance and expected performance. Any difference is a variance. A manager is then left with the responsibility to explain the what, why, and how of the variance. In doing so, the manager must understand the influence of key variables on the actual results, focus on areas that deserve more detailed investigation, and determine changes that must be made in future planning and control. This chapter introduces the concept of profit analysis and then concentrates on variances associated with a standard cost system for direct materials, direct labor, and factory overhead. The next chapter extends these concepts to analyzing revenues and operating expenses. 7.1 Profit Analysis P rofit is an overall measure of how well an organization is doing. A profit variance then is the difference between the actual net income and the planned net income for the same period. The causes of such a variance are related to the various elements that make up net income: revenues, cost of goods sold, and operating expenses. The following table shows a disaggregation of the profit variance into more detailed elements. sch80342_07_c07_279-326.indd 281 12/20/12 11:53 AM CHAPTER 7 Section 7.2 The Use of Standards Actual Revenues Cost of goods sold Gross margin Operating expenses Net income Budget Variance $385,000 $365,000 $20,000 Favorable 282,500 227,250 55,250 Unfavorable $102,500 $137,750 $35,250 Unfavorable 81,250 90,000 8,750 $21,250 $47,750 $26,500 Favorable Unfavorable To have a variance, a baseline with which to compare actual results is necessary. Common baselines are results of a prior month or year, a budget, a flexible budget, or a standard. The analysis of a profit variance necessarily looks at each significant area in the income statement, and each area has a baseline that management feels is appropriate for the circumstances. The analysis then looks at causes of variation from the baseline. The cost of goods sold, comprised of the cost of materials, labor, and factory overhead, is generally the most significant cost in the income statement. Consequently, companies expend great effort to manage and control these costs. Managers can easily cite examples of how small savings on a unit basisor on a single operation or task performedadd many dollars to profit. Analysis of cost variances helps managers to find cost savings. Cost variances are often based on comparisons between actual and standard costs. Besides cost control, cost variances are also used to evaluate the performance of managers who are responsible for particular costs. For example, a plant manager might examine materials, labor, and overhead cost variances in the grinding department to evaluate the performance of the grinding department manager. 7.2 The Use of Standards S tandard costs are appropriate where an organization has standard products, services, or repetitive operations, and where management controls the factors comprising a standard cost. Definition of Standard Costs A standard cost for a product is the amount that management believes one unit of product should cost and consists of a price standard (a generic term indicating price for materials, rate for labor, and rate for factory overhead) and a quantity standard (a generic term indicating quantity for materials, time for labor, and activity or volume for factory overhead). Setting standards for price and quantity involves management judgments, industrial engineering studies, work measurement studies, vendor analyses, union bargaining, as well as a number of other techniques. Standards are generally stated on a per unit basis: per unit of quantity, per unit of time, per unit of activity, or per unit of product. Once set, these standards remain unchanged as long as no changes occur in operating methods, in factors that influence quantities, or in unit prices of materials, labor, and factory overhead. sch80342_07_c07_279-326.indd 282 12/20/12 11:53 AM Section 7.2 The Use of Standards CHAPTER 7 Advantages of Standards A standard cost system presents many advantages to an organization. Although the primary purpose has always been cost control, properly set standards have many other advantages. This section covers five major advantages of standard costs. Cost Control. Cost control is comparing actual performance with the standard performance, analyzing variances to identify controllable causes, and taking action to correct or adjust future planning and control. As discussed later in this chapter and the next chapter, costs can change for at least four reasons: (1) changes in levels of prices or rates, (2) changes in efficiency, (3) changes in activity or volume, and (4) changes in the product mix. Variance analysis must identify these changes as well as the managers responsible for these differences so that adjustments can be made to the standards or that good performance can be rewarded. Standard cost accounting follows the principle of management by exception. Actual results that correspond closely to the standards require little attention. The exceptions, however, are scrutinized. Management by exception can be desirable because it highlights only those weak areas that require management's attention. However, a behavioral effect can occur when management by exception is applied to people. If a worker is ignored when operating according to the standard and is noticed only when something is wrong, the worker may become resentful and perform less satisfactorily. While it may be argued that the worker is being paid to operate at standard, the human factor cannot be ignored. Without recognition, the worker becomes discontented; this discontentment may spread throughout the organization with a loss of both morale and productivity. Cost Management. Cost management is related to cost control, but here the emphasis is on establishing the level of costs that becomes the benchmark for measuring performance. It can be as simple as decreasing the costs of operations through improved methods and procedures, using better selection of resources (human, materials, and facilities), or eliminating unnecessary (nonvalue-added) activities. As standards are set and periodically reviewed, operations can be analyzed to identify waste and inefficiency and to eliminate their sources. These reviews can also highlight better than expected performance; appreciation will motivate employees to continue looking for better ways to operate. A standard cost system creates an environment in which people become cost conscious, always looking for continuous improvements in the process. Decision Making. If standards are set at currently attainable levels (a concept discussed later in the \"Quality of Standards\" section), the standard costs are useful in making many types of decisions. For example, some common decisions involve regular, special order, or transfer pricing; cash planning; whether to sell or process further; and whether to make or buy. When an analysis is used as the basis for setting the standard costs, managers need not perform a new analysis for each decision. Recordkeeping Costs. A standard cost system saves recordkeeping costs, not during the initial startup, but in the long-run operation of the system. When using actual costs, each item of materials issued from a storeroom has its cost, which came from a specific purchase order. The cost transferred to work in process inventory is calculated using an inventory flow method: specific identification, FIFO, LIFO, moving average, or weighted sch80342_07_c07_279-326.indd 283 12/20/12 11:53 AM Section 7.2 The Use of Standards CHAPTER 7 average. For companies with thousands of different materials categories in stock, identifying costs to move to work in process inventory can be an enormous task. When standard costs are in place, each item in the same materials classification has the same standard cost. Therefore, costs transferred to work in process inventory are the standard cost per unit times the number of units issued. This same process applies to work in process inventory transfers to finished goods. All inventories have their standard costs, and balances are always stated at standard. Inventory Valuation. A standard cost system records the same costs for physically identical units of materials and products; an actual cost system can record different costs for physically identical units. Differences between the two costs tend to be waste, inefficiency, and nonvalue-added activities. Such items, if incurred at all, are period costs and excluded from inventory amounts. They should not be capitalized and deferred in inventory values. Therefore, standards provide a more rational cost in valuing inventories. Occasionally, differences between actual and standard costs show positive efficiencies. Performance has been better than expected. If this situation will continue, the standards are revised. Otherwise, the current standards still provide a rational basis for costing products. The Quality of Standards The term \"standard\" has no meaning unless we know upon what the standard is based. A standard may be very strict at one extreme or very loose at the other extreme. We broadly classify standards as strict or tight standards, attainable standards, and loose or lax standards. No easy solution exists as to how standards should be set. The objective, of course, is to obtain the best possible results at the lowest possible cost. Often human behavior becomes the dominant concern in setting standards. A very rigorous standard may motivate some employees to produce exceptional results. On the other hand, a standard that is too strict and cannot be reached may discourage employees and produce only modest results. In setting a level of standards, management must consider the employees, their abilities, their aspirations, and their degree of control over the results of operations. Strict standards are set at a maximum level of efficiency, representing conditions that can seldom, if ever, be attained. They ignore normal materials spoilage and idle labor time due to such factors as machine breakdowns. These standards appear to represent perfection, something few employees will achieve. Although a standard should challenge people, a standard that is virtually unattainable will not motivate most employees to do their best and may actually be counterproductive. An employee is more likely to put forth increased effort when feeling successful. In other words, a person's aspirations increase with success and decrease with failure. In addition, variances from strict standards have little significance for control purposes. There will never be a favorable variance, only zero or unfavorable variances. In fact, most variances will be large and unfavorable. The question is: \"What does such a variance measure?\" sch80342_07_c07_279-326.indd 284 12/20/12 11:53 AM Section 7.2 The Use of Standards CHAPTER 7 Loose standards tend to be based on past performance and represent an average of prior costs. They include all inefficiency and waste in past operations. Such standards are not likely to motivate employees to higher performance. The very nature of loose standards means less than efficient performance. As a result, variances from loose standards are almost always favorable and provide little useful information for cost control. Again, the question is: \"What does such a variance measure?\" Attainable standards can be achieved with reasonable effort. Perhaps the standards should be somewhat lower than what can be achieved by earnest effort. With success, the employees gain confidence and tend to be more productive. For a more experienced group of workers, an exacting standard may serve as a challenge that motivates an employee to higher levels of performance. With less experienced workers, standards may have to be set at a lower level at first. As learning takes place, the standards may be raised. Increases in standards should be made with caution and should be accepted by the employees as being fair. Managers should expect to see favorable and unfavorable variances with an attainable standard. Some employees will meet and exceed the standard with reasonable effort, while others will not meet the standard because of poor performance. Revising the Standards Standard costs should be reviewed periodically to see if revisions are necessary to maintain a selected level of quality. Although many factors may combine that determine the best time to review standard costs, they should be reviewed at least once a year. Otherwise, they may not be current. This does not mean waiting until the end of the year. Companies with thousands of items on standards will have a department dedicated to reviewing standards throughout the year. A key for reviewing standards is to identify changes taking place that outdate existing standards. Changes that typically call for a revision to one or more standard costs include: 1. 2. 3. 4. 5. 6. 7. 8. Increases or decreases in the price levels of specific materials and supplies. Changes in personnel payment plans or wage schedules. Modifications of materials type or specifications. Acquisitions of new equipment or dispositions of old equipment. Modifications of operations or procedures. Additions or deletions of product lines. Expansions or contractions of facilities. Changes in management policies that affect the amount of costs and the way costs are accumulated and identified with activities, operations, and products. 9. Increased experience of employees. Management policies can have a significant impact on standard costs. Examples of the most common policy areas are the definition of capacity, the classification of fringe benefits, depreciation methods, and capitalization and expense policies. Capacity definitions influence the level of waste and inefficiency that management will tolerate and the amount of fixed costs applied to individual units of an operation, task, or product. A redefinition sch80342_07_c07_279-326.indd 285 12/20/12 11:53 AM CHAPTER 7 Section 7.3 Standard Cost Sheet of capacity can be due to changes in the number of shifts, in hours of operation with given shift schedules, or in demand for the product or service. Fringe benefits can appear in several ways, any of which can influence a product cost significantly. Management can classify any element of fringe benefit cost as a direct cost of the product, an indirect cost through a labor-related cost pool, an indirect cost through a factory overhead cost pool, or a period cost through a general and administrative cost pool. Management determines which depreciation methods are in use. One common policy is to change from a declining balance method for existing equipment to a straight-line method at about the mid-life point of the asset life. Occasionally, management will change the method applied to new equipment purchased. The criteria for capitalization and expense decisions determine which costs are capitalized as assets and charged to operations through depreciation and amortization and which costs are charged immediately upon incurrence. Any change in the criteria alters the treatment of those costs affected. Throughout the chapter, we assume that standards are entered into the formal accounting system. As such, product costing is determined through a standard cost system. Many companies do not follow this practice. Instead, they use standards to determine cost variances for control purposes. Revision of standards is much more critical if the standards are the basis for product costing. 7.3 Standard Cost Sheet O nce standards have been set for each cost component (direct materials, direct labor, and manufacturing overhead), the costs are summarized in a standard cost sheet. Here the cost of each category of direct materials used, the cost of each direct labor operation employed, and the cost of all overhead tasks, operations, processes, and support functions applied to a unit of final product are itemized. Standard cost sheets can be extremely lengthy or very simple depending on the product and manufacturing process. Suppose that Zaner Restaurants, Inc., owner of over 200 Steakout Restaurant franchises, uses a standard cost system in accounting for its daily dinner special, the \"Goliath Feast.\" The standards currently are as follows: Component Total cost of component Unit cost Materials 3 lbs. at $4.00 per pound $12.00 Direct labor 5 hour at $7.00 per hour 3.50 Variable overhead .5 hour at $6.00 per hour 3.00 Fixed overhead .5 hour at $9.00 per hour 4.50 Total cost per meal $23.00 This standard cost sheet gives the total unit cost of each meal produced. For each completed meal, three pounds of direct materials at a total cost of $12 is taken from materials inventory and charged to work in process. Also, $3.50 is charged for direct labor, and a total of $7.50 in overhead costs is applied. Nothing is noted here about the actual costs incurred because all production is carried only at standard cost. Thus, when completed meals are transferred from work in process to finished goods and later to cost of goods sch80342_07_c07_279-326.indd 286 12/20/12 11:53 AM Section 7.4 Standards for Materials CHAPTER 7 sold, the cost is $23 per meal. The standard cost sheet becomes the basis for all accounting entries related to the cost of the meal. To explain standards for materials, direct labor, and overhead, we need to know the volume of output and the materials quantities allowed for that volume in order to calculate certain variances. The standard cost sheet lists the allowed amounts. The volume of output will be expressed as units of product or equivalent units, depending on the circumstances in production. 7.4 Standards for Materials S tandards are established for the cost of obtaining materials and for the quantities to be used in production. Managers then compare actual costs against these standards to ascertain variances. Basically, two types of variances exist: price and usage. Different variances may be developed for specialized purposes, but they can always be classified as variations in the price of materials or in the quantities used, or as a combination of price and usage. If the actual cost is greater than the standard cost, the variance is an unfavorable variance; if actual cost is less than the standard cost, the variance is a favorable variance. It should be noted that favorable versus unfavorable do not necessarily imply good versus bad for the overall interests of the company. Materials Price Variance A materials price variance measures the difference between the prices at which materials are acquired and the prices established in the standards. What is in the standard, how a variance is calculated, and what are potential causes of variances are now explained. Setting the Price Standard. A standard price is set for each item of materials the company expects to use. The cost elements that make up the standard are a matter of management policy. Although the purchase price is the dominant element, other costs may also be included, such as the cost of insurance for materials in transit, the cost of transporting materials, various cash and trade discounts, and costs of receiving and inspecting materials at the receiving dock. Once management decides on the elements, the next step is assessing prices. The estimation techniques are not discussed here, but common approaches to determining amounts include: 1. 2. 3. 4. Statistical forecasting. Knowledge and experience in the particular type of business. Weighted average of prices in most recent purchases. Prices agreed upon in long-term contracts or purchase commitments. Accounting for a Price Variance. A materials price variance is isolated at the time of purchase. To be able to act upon an excessive variance as soon as possible, management should determine the materials price variance when the materials are purchased rather than waiting until the time the materials are used in production. sch80342_07_c07_279-326.indd 287 12/20/12 11:53 AM CHAPTER 7 Section 7.4 Standards for Materials The actual quantity of materials purchased is entered in the materials inventory at standard prices. The liability to the supplier is recorded at actual quantities and actual prices. Any difference between the two amounts is recorded as a price variance. To illustrate, assume that Zaner Restaurants bought 40,000 pounds of materials for $159,200, which is $3.98 per pound. To make the example easier to follow, we will use the following symbols: AQP 5 Actual quantity purchased AP 5 Actual price SP 5 Standard price MPV 5 Materials price variance The cost flow of actual and standard costs would appear in T-account form as follows: Accounts payable Materials inventory AP 3 AQP 5 SP 3 AQP 5 $3.98 3 40,000 5 $4.00 3 40,000 5 $159,200 $160,000 Materials price variance (AP 2 SP) 3 AQP 5 ($3.98 2 $4.00) 3 40,000 5 $800 Favorable To calculate the variance without thinking in terms of accounts, the information from the T-accounts can be summarized into convenient formulas. AP x AQP 5 $3.98 3 40,000 5 $159,200 SP x AQP 5 $4.00 3 40,000 5 $160,000 MPV 5 (AP 2 SP) x AQP 5 2$0.02 3 40,000 5 $800 Favorable Note that the actual quantity is used in all three calculations above. Only the prices differ. A materials price variance can be either favorable or unfavorable when actual costs are compared with standard costs. In this illustration, the materials price variance is favorable because the materials were purchased at a cost below the standard. Causes of the Price Variance. A variance occurs for any number of reasons. If the variance is significant, we must identify causes. If performance is deemed good, the responsible people should be praised, and, where appropriate, rewarded. If the investigation sch80342_07_c07_279-326.indd 288 12/20/12 11:53 AM Section 7.4 Standards for Materials CHAPTER 7 finds out-of-control situations, corrections can be made so variations are eliminated in the future. In some cases, outdated standards are being used and need to be adjusted. Although many causes for variances pertain to any given situation, a list of the common sources is as follows: 1. 2. 3. 4. 5. 6. 7. 8. Fluctuations in market prices. Materials substitutions. Market shortages or excesses. Purchases from vendors other than those offering the terms used in the standard. Purchases of higher or lower quality materials. Purchases in nonstandard or uneconomical quantities. Changes in the mode of transportation. Changes in the production schedule that result in rush orders or additional materials. 9. Unexpected price increases or decreases. 10. Fortunate buys. 11. Failure to take cash discounts. Responsibility for the Price Variance. The purchasing department is usually charged with the responsibility for price variances. If the purchasing function is carried out properly, the standard price should be attainable. When lower prices are paid, a favorable materials price variance is recorded, indicating that the department's purchases were below the standard cost. Higher prices are reflected in an unfavorable materials price variance. In some circumstances price variances really should be charged to a production department instead of to the purchasing department. As examples, a rush order may be caused by last minute production changes, or production people may request a specific brand name for materials rather than allowing the purchasing department to buy by specifications. Periodic reports show how actual prices compare with standard prices for the various types of materials purchased. Reports on price variances may be made as frequently as daily, but will generally be weekly and monthly. They reveal which materials, if any, are responsible for a large part of any total price variation and can help the purchasing department in its search for more economical vendors. Materials Usage Variance Materials are put into production, but the actual quantity used may be more or less than specified by the standards. The variation in the quantity of materials is called a materials usage variance. Other names for this type of variance are materials quantity variance, materials use variance, and materials efficiency variance. Setting the Quantity Factor. The quantity factor in a materials standard is based on engineering specifications, blueprints and designs, bills of materials, and routings. Combined, these items specify the quality, size, thickness, weight, and any other factors necessary for a good unit of final product. Also included in the quantity factor are any desired allowances for normal acceptable waste, scrap, shrinkage, and spoilage that may occur during the manufacturing process. sch80342_07_c07_279-326.indd 289 12/20/12 11:53 AM CHAPTER 7 Section 7.4 Standards for Materials Accounting for a Usage Variance. As materials are used, the work in process account is increased by the standard quantity used multiplied by the standard price. The materials inventory account is decreased by the actual quantity used multiplied by the standard price. Returning to Zaner Restaurants, assume that 31,000 pounds of materials are withdrawn from Materials Inventory for making 10,000 meals. Because the standard cost sheet indicates only three pounds should be used for each meal, the standard quantity of materials that should have been used is 30,000 pounds (3 pounds x 10,000 meals). For our example, we will use the following symbols: SP 5 Standard price AQU 5 Actual quantity used SQ 5 Standard quantity allowed MUV 5 Materials usage variance The cost flow of actual and standard costs would appear in T-account form as follows: Materials inventory $160,000 Work in process inventory SP 3 AQU 5 SP 3 SQ 5 $4.00 3 31,000 5 $4.00 3 30,000 5 $124,000 $120,000 Materials usage variance SP 3 (AQU 2 SQ) 5 $4 3 1,000 5 $4,000 Unfavorable To calculate the variance without thinking in terms of accounts, the above information can be summarized into convenient formulas. SP x AQU 5 $4.00 3 31,000 5 $124,000 SP x SQ 5 $4.00 3 30,000 5 $120,000 MUV 5 SP x (AQU 2 SQ) 5 $4.00 3 1,000 5 $4,000 Unfavorable In the first two equations, the standard unit price is used, but the quantities differ. In one case, the actual quantities issued from the storeroom are used. In the other, the standard materials quantity allowed for each meal is used. Because only quantities can differ in the equations, any variation is a usage variance. The variance for Zaner Restaurants is unfavorable because the amount of materials used is greater than the amount called for by the standard. sch80342_07_c07_279-326.indd 290 12/20/12 11:53 AM CHAPTER 7 Section 7.4 Standards for Materials The following table illustrates the materials costs and variances: A B C D E F G AQP A-C5 AQP C-E5 AQU E-G5 SQ x AP Direct Materials Price Variance x SP Increase or Decrease in Inventory x SP Direct Materials Usage Variance x SP 40,000 3 $3.98 5$159,200 $159,200 - $160,000 5$800F 40,000 3 $4.00 5$160,000 $160,0002 $124,000 5$36,000 31,000 3 $4.00 5$124,000 $124,000 - 2 $120,000 5$4,000U 30,000 3 $4.00 5$120,000 Causes of the Usage Variance. What causes a materials usage variance? To answer this question, we look at the elements that make up the quantity standard and the specific situation. Examples of common causes include: 1. 2. 3. 4. 5. 6. 7. Changes in product specifications. Materials substitutions. Breakage during the handling of materials in movement and processing. Improper use of materials by workers. Machine settings operating at nonstandard levels. Waste. Pilferage. Responsibility for the Usage Variance. Ordinarily, materials usage variances are chargeable to production departments. They often arise as a result of wasteful practices in working with materials, or they arise because of products that must be scrapped through faulty production. Reports on the quantities of materials used are given to the responsible production department supervisor. A production supervisor, for example, may receive daily or weekly summaries showing how the quantities used in the department compare with the standards. At the operating level, managers can directly control the use of materials. Often, reports on variations from standard are for physical quantities only. Managers may not need immediate feedback from a cost report. Daily or weekly cost reports simply tell managers the financial magnitude of variations and serve as a reminder that corrections should be made before losses become too great. Summary reports of actual and standard materials consumption given in dollars, with variances and variance percentages, also go to the plant superintendent at least monthly. If the variances in any department are too large, the superintendent can take steps to reduce them. During the month, of course, the operating managers will watch materials usage; if they have been doing their jobs properly, the accumulated variances for the month should be relatively small. sch80342_07_c07_279-326.indd 291 12/20/12 11:53 AM Section 7.5 Standards for Labor CHAPTER 7 Interrelationships of Price and Usage Variances We have treated the materials price and usage variances as though they are independent and unrelated. In many cases, the event that causes one variance also causes the other. For example, assume the purchasing department buys lower grade materials at a substantially reduced price. This generates a favorable price variance for purchasing. When those materials reach production, they result in a higher than normal waste. This gives the operating supervisors unfavorable usage variances. Keeping the two variances in isolation makes the purchasing agent look good, while the operating supervisors turn in poor performances. In reality, both variances are the responsibility of the purchasing department. If the variances net out favorable, the purchasing decision has benefited the company. On the other hand, a net unfavorable variance is a loss to the company. The operating people can also influence the price variance. If improperly adjusted machines, for instance, generate a higher than usual waste, more materials may be needed from the storeroom. When a production supervisor requisitions the materials and the storeroom manager realizes sufficient quantities are not available, a request is made to the purchasing department to order more. To keep the production schedule current, a rush order is issued. The higher prices paid for a rush order will result in an unfavorable price variance. The warning of these situations is simple: Investigation of variances must not be done in isolation. 7.5 Standards for Labor W e can set standards for direct labor and measure variances from the standards in much the same way as we did for materials. The price factor is called rate; the quantity factor is time. When referring to variations in time, we use the term efficiency. The labor rate variance measures the portion of the total labor cost variance caused by the difference between the actual wage rate paid and the standard wage rate. The labor efficiency variance measures the portion of the total labor cost variance caused by the difference between the actual hours worked and the standard hours required for production. When discussing standards for labor, we assume direct labor only. Indirect labor consists of the costs for people working in the production departments but not directly on products, and for the time of direct laborers classified as training time, break time, overtime premium, and idle time. These costs are often distributed from payroll to overhead and become part of overhead standards. Therefore, indirect labor is discussed later as part of overhead. Setting Rate Standards Standard cost systems rely on individual labor rates by skill-level classification for better control and accuracy. However, in some cases, standard rates can be set for entire cost centers or departments. Regardless of how it is structured, the underlying wage or salary rate used as the standard rate will be either established through contract negotiations or by the prevailing rates in the location where the work is performed. The details for selecting wage-level classifications cover training, education, experience, special physical abilities, and set of task skills. sch80342_07_c07_279-326.indd 292 12/20/12 11:53 AM CHAPTER 7 Section 7.5 Standards for Labor When setting the standard rates, management must decide whether to use a basic labor rate or a \"loaded\" labor rate as the standard. A \"loaded\" labor rate includes labor-related costs such as overtime premiums, shift premiums, bonuses and incentives, payroll taxes, and fringe benefits. Those factors not included in the labor rate standard will be included in overhead. Therefore, management will look at the advantages of treating these cost factors as direct costs or as indirect costs. For example, if the company is performing contracted work for the federal government, the company would typically recover more of its costs through the \"loaded\" standard labor rate. Setting Time Standards Time standards are more difficult to establish than materials quantity standards. People's productivity is the basis for setting time standards, and people tend to differ in behavior from one time to the next. Setting time standards involves answering two questions: (1) What operations are performed? and (2) How much time should be spent on each operation for the product or service? The answer to the first question is determined by reviewing operations and procedures, process charts, and routing lists. The answer to the second question will be determined from one or more of the following methods: 1. Operation and body movement analysis. (This involves dividing each operation into the elementary body movements such as reaching, pushing, turning over, etc. Published tables of standard times are available for each movement. These standard times are applied to the individual movements and added together for the total standard time per operation.) 2. Time and motion studies conducted by industrial engineers. 3. Averages of past performance, adjusted for anticipated changes. 4. Test runs through the production process for which standards are to be set. Accounting for the Rate and Efficiency Variances Unlike materials, labor cannot be purchased and stored until needed. We purchase and use labor at the same time. Therefore, accounting for both variances is combined. Zaner Restaurants shows a payroll for its direct workers of $38,584 and 5,200 hours. That gives an actual rate of $7.42 per hour. The standard cost sheet shows that each completed meal requires one-half hour of direct labor time. Since 10,000 meals were produced, 5,000 hours should have been worked (.5 hour x 10,000 meals). For our example, we will use the following symbols: AR 5 Actual rate SR 5 Standard rate AH 5 Actual hours SH 5 Standard hours allowed sch80342_07_c07_279-326.indd 293 12/20/12 11:53 AM CHAPTER 7 Section 7.5 Standards for Labor LRV 5 Labor rate variance LEV 5 Labor efficiency variance The cost flow of actual and standard costs would appear in T-account form as follows: Wages payable Work in process inventory AR 3 AH 5 SR 3 SH 5 $7.42 3 5,200 5 $7.00 3 5,000 5 $38,584 $35,000 Labor rate variance (AR 2 SR) 3 AH 5 Labor efficiency variance SR 3 (AH 2 SH) 5 ($7.42 2 $7.00) 3 5,200 5 $7.00 3 (5,200 2 5,000) 5 $2,184 Unfav. $1,400 Unfav. The labor rate variance is commonly calculated first. It results whenever the actual rate paid to a worker differs from the standard rate. Calculating a labor rate variance requires holding the actual hours constant while comparing the difference in rates, as follows: AR x AH 5 $7.42 3 5,200 5 $38,584 SR x AH 5 $7.00 3 5,200 5 $36,400 LRV 5 (AR 2 SR) x AH 5 $ 0.42 3 5,200 5 $ 2,184 Unfavorable The variance is unfavorable because the actual rate exceeds the standard rate. The labor efficiency variance (also called quantity, time, or usage variance) results when employees' total actual hours worked differ from the standard. We calculate the variance by holding the rate constant while comparing the difference in hours. The following summarizes this procedure: SR 3 AH 5 $7.00 3 5,200 5 $36,400 SR 3 SH 5 $7.00 3 5,000 5 $35,000 LEV 5 SR 3 (AH 2 SH) 5 $7.00 3 200 5 $1,400 Unfavorable The variance is unfavorable because the actual hours worked are more than the standard hours allowed for the 10,000 meals produced. sch80342_07_c07_279-326.indd 294 12/20/12 11:53 AM CHAPTER 7 Section 7.5 Standards for Labor Because the hours are purchased and used at the same time, an alternate approach to calculating the variances can be used: Actual cost Inputs at standard Standard cost AR 3 AH SR 3 AH SR x SH $7.42 3 5,200 hours 5 $38,584 $7.00 3 5,200 hours 5 $36,400 $7.00 3 5,000 hours 5 $35,000 Rate variance Efficiency variance $2,184 unfavorable $1,400 unfavorable Causes of Labor Variances Labor rates are usually set by contract, negotiations, management, or federal laws or regulations. So, why would a labor rate variance occur? Two basic reasons exist. First, labor rates often represent an average for a task, operation, or work center. If a departmental manager shifts workers' assignments because of sudden changes in personnel requirements or a shortage of personnel, the average rate can easily change depending on how the shift relates to higher paid or lower paid workers. A second reason is that standard labor rates may include cost elements beyond the basic labor rate. Any changes in overtime worked, shift differentials, payroll taxes, or fringe benefits will show up in a labor variance if these elements are part of the standard rate. Labor efficiency relates to how many units are completed per actual hour for each task, operation, or process. Many reasons exist for why productivity varies from the level assumed in the standard time. Some of the common causes of a labor efficiency variance include: 1. 2. 3. 4. 5. 6. 7. 8. 9. Use of lower skilled or higher skilled workers. Effects of a learning curve. Use of lower quality or higher quality materials. Changes in production methods. Changes in production scheduling. Installation of new equipment. Poorly maintained equipment or machine malfunction. Delays in routing work, materials, tools, or instructions. Insufficient training, incorrect instructions, or worker dissatisfaction. Responsibility for Labor Variances Labor rate and efficiency variances are charged to the department managers who have control over the use of workers. Labor rate variances are often the responsibility of personnel managers who manage hiring, union contracts, and perhaps labor scheduling. Although a labor rate variance is important to understand and control, managers tend to concentrate more on the labor efficiency variance because it has a greater impact on capacity utilization and the department's ability to meet production schedules. Labor efficiency is compared by department and by job with established standards. Daily or weekly sch80342_07_c07_279-326.indd 295 12/20/12 11:53 AM Section 7.5 Standards for Labor CHAPTER 7 reports to department managers and the plant superintendent help to locate and solve difficulties on a particular job or in a department. Differences between standard costs and actual costs incurred by a job or department may show that a job cannot be handled at the standard labor cost or that a department is not managed properly. Interrelationships of Variances As discussed with materials, variances should not be analyzed in isolation from one another. The event that causes one variance can easily be the cause for one or more other variances. Future cost planning and control can be improved when interrelationships among labor variances and between materials and labor variances are identified and understood. Labor Rate and Efficiency Variances. People perform the productive effort; thus, the rate of pay and the time required are related. Because so many relationships can exist between the two factors, only a few examples are cited to aid in identifying what to look for in a specific operation. Assume a number of employees are in various military reserve units that have been called to active duty. As a short-term solution, a manager has two options: (1) employ temporary workers or (2) shift other workers internally and add overtime. Using temporary workers may be cheaper or more expensive depending on the situation. They are not as experienced with the equipment, procedures, and processes. They may take more time than the standard allows. Therefore, hiring temporary workers can result in both rate and efficiency variances. The second option is to shift existing workers and use overtime. The move will put differently skilled workers on new jobs. The move can create either a favorable or an unfavorable rate variance depending on the mix of workers. Their experience levels may be higher or lower than the specific job requires and can result in an efficiency variance. Adding overtime could affect a rate variance, depending on how the company treats the overtime premium. Efficiency should not be an issue of overtime unless the workers become less productive through fatigue. In another case, suppose an employee is having difficulties working on a particular machine. The worker is taking more time than standard to complete good units. The manager, trying to keep production on schedule and not lose capacity to inefficiency, shifts a more skilled, higher paid worker to the job. The higher paid worker will yield an unfavorable rate variance but can reduce the unfavorable efficiency variance or create a favorable one. Materials and Labor Variances. Materials and labor variances can also be related to the same source. Assume, for instance, that a purchasing agent made a fortunate buy on a lower quality grade of materials. The \"good buy\" yields a favorable materials price variance for purchasing. However, when the materials are used in production, they crumble and create more waste than anticipated. More materials are needed, and an unfavorable materials usage variance arises. A department manager, desiring to minimize the lost time, moves higher skilled people to the operation where the higher waste occurs. This action leads to a labor rate variance and may influence the magnitude or the direction of a labor efficiency variance. sch80342_07_c07_279-326.indd 296 12/20/12 11:53 AM Section 7.6 Standards for Overhead CHAPTER 7 In another case, a worker starts the shift fatigued and stressed. Lack of concentration results in higher waste which takes more materials and time. This results in unfavorable materials usage and labor efficiency variances. Because more materials are needed, the manager requisitions additional materials from the storeroom. The storekeeper finds fewer materials available than are now required. Purchasing is asked to place a rush order so that production can proceed with minimum delay. The rush order increases the purchasing costs, causing an unfavorable materials price variance. The Influence of Automation Companies are constantly seeking to automate various aspects or even all aspects of their production. The purpose of this is to increase productivity and quality while keeping unit costs low. With automatic equipment, the need for high-skill levels of direct labor is substantially reduced. Direct labor in such an environment becomes such an insignificant element of cost that variances have little meaning. In some industries, automation may not go beyond a certain point, in which case direct labor will remain a smaller but significant cost element. However, with a great deal of automation, direct labor time becomes more dependent on the speed of a machine operation than on the speed of individual workers. Hence, labor efficiency is more related to machine efficiency than to employee efficiency. Therefore, a labor efficiency variance will carry little meaningful information. 7.6 Standards for Overhead T he factory overhead costs consist of all manufacturing costs that are not classified as direct materials and direct labor. Examples of factory overhead costs include indirect materials and supplies, indirect labor, maintenance and repairs, lubrication, power, factory property taxes and insurance, and depreciation. Service organizations will have similar overhead costs related to providing services. In a standard cost system, we use a standard overhead rate to apply these costs to products and services. We accumulate the actual overhead costs and compare them to the applied amounts to determine whether the standards were met. Variances from the standard help to direct management's attention to situations where costs should be controlled more closely, where managers should be praised and rewarded for good performance, or where the standards should be revised. Development of Overhead Rates Standard costs for overhead have price and quantity factors, just like direct materials and direct labor. Price is reflected in one or more overhead rates; quantity is the measure of activity. Price and quantity in this case are closely linked. In developing standard overhead rates, five major considerations must be evaluated. sch80342_07_c07_279-326.indd 297 12/20/12 11:53 AM Section 7.6 Standards for Overhead CHAPTER 7 First, which cost elements are included in overhead? We need to identify the individual costs which compose overhead. When certain variances occur, these items will be examined for specific changes. The second consideration is the measure of activity for relating overhead costs to products. A measure of activity for this purpose represents the factor that best expresses how costs change as volume increases or decreases. As noted in earlier chapters, we refer to the measure of activity as an allocation base or cost driver. Although many factors can influence costs, we select a dominant cost driver. The common ones are direct labor hours or costs, machine hours, and units of products. In Chapter 5, we examined activity-based costing and identified other cost drivers that cause costs to be incurred. Our use of the measure of activity is the same as a primary-stage cost driver in those discussions. For standard costs, the appropriate measure must be selected if variances are to provide any meaningful information. Third, and closely related to the measure of activity, is the concept of capacity and the anticipated volume level for the current period. We discussed several capacity concepts in Chapter 3. The capacity or volume concept selected and the determination of the current period level significantly influence overhead rates because of the presence of fixed costs. A fourth consideration is cost behavior. The behavior of each cost within overhead is important because management plans and controls variable costs differently than it plans and controls fixed costs. Consequently, distinguishing variable from fixed overhead costs aids in analyzing variances for cause and responsibility. Standard cost systems often use dual overhead rates for variable overhead costs and for fixed overhead costs. In separating the variable and fixed cost rates, different cost drivers may be used for each cost behavior. The fifth consideration is the level at which overhead rates should be set: by task, by machine or labor operation, by activity center, by department, by facility, or overall. For a single product operation, overall rates for variable and fixed costs are sufficient. The greater the product and operation diversity, the more likely it is that rates are set for smaller groupings of costs. For our illustration with Zaner Restaurants, we assume an overall rate merely to illustrate the concepts. The same considerations will apply should a company compute rates by task, activity center, and so forth. Flexible Overhead Budgets As we have noted in previous chapters, a flexible overhead budget is based on a formula that expresses the budgeted overhead at any point within the relevant range. The formula recognizes that some costs are variable and some are fixed. The following schedule shows the flexible overhead budget formula for Zaner Restaurants. We assume here that the measure of activity is direct labor hours. sch80342_07_c07_279-326.indd 298 12/20/12 11:53 AM CHAPTER 7 Section 7.6 Standards for Overhead Cost item Fixed cost Variable cost per direct labor hour Indirect materials $ 1.90 Hourly indirect labor 1.27 Supervision $ 21,000 Repair and maintenance 3,600 1.11 Utilities and occupancy 10,580 1.00 Depreciation 13,800 520 0.72 $ 49,500 $ 6.00 Miscellaneous costs Totals The flexible budget cost function is: $49,500 1 ($6.00 3 number of hours). Since we know that the hours are related to meals prepared in terms of two per hour, we can restate the formula as: $49,500 1 ($3.00 3 meals prepared). Typically, we would have multiple products using different amounts of direct labor, which would require the use of the basic formula. As a sidelight, the overhead rates are also available from these numbers, if we assume a volume of 5,500 direct labor hours or 11,000 meals prepared. For variable costs, the rate is $6.00 per hour or $3.00 per unit (.5 hour 3 $6.00). The fixed costs are $9.00 per hour ($49,500 5,500 hours) or $4.50 per unit (.5 hour 3 $9.00). The significance of the flexible overhead budget becomes apparent in the next section where we identify variances for overhead costs. Framework for Two-Way Overhead Variance Analysis Because different factors give rise to underapplied or overapplied overhead, we need a framework to identify the areas of potential causes of variations. In our framework, we compare actual overhead costs with a flexible budget and with the applied overhead to arrive at two possible variances: budget variance and capacity variance. To begin, we need to know the actual overhead costs and the applied overhead costs. We have already seen for Zaner Restaurants that the company produced 10,000 meals during the month. Actual overhead costs for the month are $31,500 variable and $50,000 fixed. The overhead accounts would then show the following information: Actual costs: Variable Fixed $31,500 50,000 $ 81,500 Applied costs: Variable ($3.00 3 10,000 meals) Fixed ($4.50 3 10,000 meals) Underapplied sch80342_07_c07_279-326.indd 299 $30,000 45,000 75,000 $6,500 12/20/12 11:53 AM CHAPTER 7 Section 7.6 Standards for Overhead This information would appear in a T-account as follows: Manufacturing overhead Actual overhead 5 $81,500 Applied overhead 5 $75,000 Underapplied overhead 5 $6,500 Remember, the cost per unit for variable and fixed overhead is calculated in advance and appears on the standard cost sheet for individual products. Therefore, the rates used in the example are applied directly to actual units or equivalent units of product. The next step is to compare the actual costs and applied costs with the flexible budget for 10,000 meals produced. Figure 7.1 summarizes this information. Note that the two-way overhead variance analysis actually produces three variances: variable and fixed overhead budget variances, plus the fixed overhead capacity variance. Figure 7.1: Overhead variances for Zaner Restaurants Actual Flexible Standard Costs of Overhead Budget for Meals Produced Overhead Costs 10,000 Meals (Applied Costs) Variable.... Fixed........ Total......... $ 31,500 50,000 $ 81,500 $ 30,000* 49,500 $ 79,500 $ 30,000 45,000 $ 75,000 Budget Variance Variable............. Fixed................. Total.................. Capacity Variance $ 1,500 Unfavorable 500 Unfavorable $ 2,000 Unfavorable $0 4,500 Unfavorable $ 4,500 Unfavorable $ 6,500 Unfavorable and Underapplied *$6 x .5 hour x 10.000 meals Budget Variance. A budget variance is the difference between actual overhead costs and the flexible budget for actual units produced. It is also called a controllable variance. This variance is deemed controllable by the appropriate operating departments. In the foregoing example, the variance is unfavorable; more dollars were spent than were budgeted for 10,000 meals. A more detailed examination of the variance is necessary to identify areas where managers need to take action. One approach for providing greater detail is to show the budget variance by individual cost item with the use of the flexible overhead cost function, as shown in the following table: sch80342_07_c07_279-326.indd 300 12/20/12 11:53 AM CHAPTER 7 Section 7.6 Standards for Overhead Cost item Actual overhead Flexible budget for 10,000 units Budget variance Indirect materials $ 10,250 $ 9,500 $ 750 U 6,250 6,350 100 F 21,400 21,000 400 U Hourly indirect labor Supervision Repair and maintenance 9,050 9,150 100 F Utilities and occupancy 15,930 15,580 350 U Depreciation 13,800 13,800 0 4,820 4,120 700 U $ 81,500 $ 79,500 $ 2,000 U Miscellaneous costs Totals A number of causes may exist for either a favorable or an unfavorable budget variance. The common causes will fall into one of four categories: 1. Price changes in individual cost components of overhead costs. 2. Quantity changes in individual items within overhead cost components, probably in the variable overhead area. 3. Estimation errors in segregating variable and fixed costs. 4. Any overhead costs that are incurred or saved because of inefficient or efficient use of the underlying activity measure (machine hours or labor hours, for example). The estimation errors come in two varieties: (1) the inaccuracies in predicting what will occur in the future and (2) the reliability of approximations made in separating overhead costs into variable and fixed categories. The inefficient or efficient use of activity relates to the fact that in an activity (labor worked, for example) overhead costs are incurred to support that activity. If the activity is inefficient, overhead costs support inefficiency. On the other hand, if less activity occurs, lower total overhead costs are incurred to support it. Therefore, efficient resource use also saves overhead costs. Capacity Variance. The capacity variance (also called a volume variance) is the difference between the flexible budget for the actual units produced and the amounts applied to work in process inventory. In Figure 7.1, because the variable overhead costs are the same in each column, the capacity variance is the difference between the budgeted fixed overhead and the applied fixed overhead. Therefore, the capacity variance is the amount of budgeted fixed overhead not applied (unfavorable) or the amount applied in excess of the budgeted fixed costs (favorable). A capacity variance, then, occurs when actual production differs from the capacity level used to calculate the standard fixed overhead rate. Continuing with the example, we know that fixed overhead for the month was budgeted at $49,500, and we presume that 5,500 direct labor hours or 11,000 meals constitute a normal level of operation. We first compute the hourly overhead rate: sch80342_07_c07_279-326.indd 301 12/20/12 11:53 AM CHAPTER 7 Section 7.6 Standards for Overhead $49,500 (Budgeted fixed overhead) 5 $9.00 per hour 5,500 (Hours of direct labor) We then convert the hourly rate to a rate per meal with the following computation: 0.5 hour per unit 3 $9.00 5 $4.50 per meal We see that the standard overhead rate for costing meals is computed at the normal volume, so in this case it is $4.50 per meal. During the month, Zaner Restaurants produced 10,000 meals. Fixed overhead is costed to the meals by multiplying the standard rate of $4.50 per meal by the 10,000 meals. $4.50 3 10,000 meals 5 $45,000 applied Fixed overhead budget $ 49,500 Fixed overhead applied 45,000 Capacity variance (unfavorable) $ 4,500 Figure 7.2 illustrates a graphical approach to the capacity variance concept. The diagonal line on the graph represents the amount of fixed overhead applied for various meal volumes. It rises at the rate of $4.50 per meal and reaches the $49,500 budgeted fixed overhead level at the normal volume of 11,000 meals. However, the company only produced 10,000 meals. With the rate of $4.50 per meal, only $45,000 of the budgeted fixed overhead was applied. The difference between the budgeted fixed overhead and the fixed overhead applied is the capacity variance, as designated on the vertical scale. Overhead Fixed Costs Figure 7.2: Analysis of capacity variance Fixed overhead applied Capacity variance Fixed overhead budget 11,000 units x $4.50 rate = $49,500 budgeted { $49,500 10,000 units x $4.50 rate = $45,000 applied $45,000 $22,500 5,000 11,000 Actual Normal output sch80342_07_c07_279-326.indd 302 10,000 volume 12/20/12 11:53 AM CHAPTER 7 Section 7.7 Capacity and Control Earlier we presented the budget variance for individual categories of overhead costs. We could extend the idea to the capacity variance, but we do not gain additional information from further detail. The capacity variance is an overall issue and has little to do with individual costs. 7.7 Capacity and Control I n general, we consider the capacity variance as an item that production departments do not control. The plant produces what marketing identifies as the sales requirements. Therefore, the production departments cannot be held responsible if the sales demand exceeds or falls below production at a normal level of plant operation. Other factors, however, may contribute to producing below capacity. Some of these factors are controllable (or somewhat controllable) by production departments. Excessive machine downtime (due to poor maintenance, for example) or inefficient production scheduling could be problems traceable to production managers. Lack of rapidity in completing tasks due to unskilled workers is a factor that is expected to some degree, but an excess of this condition may also be traceable to one or more production managers. For Zaner Restaurants, normal volume was defined at 5,500 direct labor hours or 11,000 meals. Normal volume, as defined in Chapter 3, represents the average level of actual operation over several years. Practical capacity, on the other hand, is the level at which all facilities are used to full extent. Some allowance is made under this definition for expected delays because of changes in machine setups, necessary maintenance time, and other interruptions. Hence, practical capacity is less than theoretical maximum capacity which could be obtained only under ideal conditions. A comparison of the actual output with the output for practical capacity broadly measures the failure of the facility to operate at the level for which it was designed. Assume, for example, that Zaner Restaurants can reasonably be expected to produce 15,000 meals a month. Yet only 10,000 meals were produced. The idle capacity is defined as the difference between the practical capacity and the actual production for a given month. The idle capacity for Zaner Restaurants is determined as follows: Practical capacity 15,000 Actual production 10,000 Total idle capacity 5,000 meals meals The idle capacity can be analyzed further to determine why facility capacity was not used as intended. Assume that the sales budget shows that 12,000 meals were expected to be sold during the month but that orders for only 11,500 meals were received. The differences between practical capacity, sales budget, orders received, and actual production are illustrated as follows: sch80342_07_c07_279-326.indd 303 12/20/12 11:53 AM CHAPTER 7 Section 7.8 Variances Practical capacity 15,000 Sales budget 12,000 3,000 (1) 500 (2) Orders received 11,500 1,500 (3) Actual production 10,000 1. Practical capacity minus sales budget. The difference between the practical capacity and the sales budget for the month requires further investigation. Perhaps the company was overly optimistic and provided too much capacity. Or the Marketing Department may not be obtaining potential available customers. Additional analysis may reveal the nature of the problem and provide a foundation for improvements. 2. Sales budget minus orders received. The difference between the sales budget for the month and the orders received is a measurement of the inability of the Marketing Department to meet the budget quota. Perhaps the quota was too high, or the Marketing Department was not sufficiently aggressive. 3. Orders received minus actual production. The difference between the orders received and actual production reflects a mixture of idle time and inefficiency. Suppose that Zaner Restaurants used 5,200 hours to produce 10,000 meals and 5,000 hours were allowed. The 200 hours of inefficiency, in this case, consumed time that could have been used for production of an additional 400 meals (200 hours .5 hour per unit). The difference between the orders received and the expected production for the time used (11,500 2 10,400 5 1,100 meals) is a measurement of idle time. 7.8 Variances W hen cost variances occur, managers need to know what caused them. Knowing the amount of variance does not disclose the cause(s); rather, investigation is required. However, managers must decide whether the benefits of investigation and corrective action exceed the related costs. Obviously, a $10 unfavorable materials usage variance from a standard cost of $50,000 would not be worth investigating. But where should the line be drawn? Ideally, if the costs and benefits of investigating and correcting can be estimated, these costs and benefits should be compared in deciding whether to investigate. In practice, however, this is extremely difficult. Instead, many companies