Accounting: The Language of Business - Vol. 1 (Part 135)

Life is expensive when you do not know accounting.

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Performance Evaluation Using Variances from Standard Costs (Part B)

by

Charles Lamson

Budgetary Performance Evaluation

As we discussed in part 131, the master budget assists a company in planning, directing, and controlling performance. In the next several posts, we will discuss using the master budget for control purposes. The control function, or budgetary performance evaluation, compares the actual performance against the budget.

We illustrate budget performance evaluation using Western Rider Inc., a manufacturer of blue jeans. Western Rider Inc. uses standard manufacturing costs in its budgets. The standards for direct materials [Direct material is the physical items built into a product. For example, the direct materials for a baker include flour, eggs, yeast, sugar, oil, and water. The direct materials concept is used in cost accounting, where this cost is separately classified in several types of financial analysis (accountingtools.com).]direct labor (labor involved in production rather than administration, maintenance, and other support services), and factory overhead (costs incurred during the manufacturing process, not including the costs of direct labor and direct materials) are separated into two components: (1) a price standard and (2) a quantity standard. Multiplying these two elements together is the standard cost per unit for a given manufacturing cost category, as shown for style XL jeans in Exhibit 1.

The standard price and quantity are separated because the means of controlling them are normally different. For example, the direct materials price per square yard is controlled by the Purchasing Department, and the direct materials quantity per pair is controlled by the Production Department.

The budgeted costs at planned volumes are included in the master budget at the beginning of the period. The standard amount budgeted for materials purchases, direct labor, and factory overhead are determined by multiplying the standard costs per unit by the planned level of production. At the end of the month, the standard costs per unit are multiplied by the actual production and compared to the actual costs. To illustrate, assume that Western Rider produced and sold 5,000 pairs of XL jeans. It incurred direct materials cost of $40,150, direct labor costs of $38,500, and factory overhead costs of $22,400. The budget performance report shown in Exhibit 2 summarizes the actual costs, the standard amounts for the actual level of production achieved, and the differences between the two amounts. These differences are called cost variances. A favorable cost variance occurs when the actual cost is less than the standard cost (at actual volumes). An unfavorable variance occurs when the actual cost exceeds the standard cost (at actual volumes).

EXHIBIT 2 Budget Performance Report

Based on the information in the budget performance report, management can investigate major differences and take corrective action. In Exhibit 2, for example, the direct materials cost variance is an unfavorable $2,650. There are two possible explanations for this variance: (1) the amount of blue denim used per pair of blue jeans was different than expected, and/or (2) the purchase price of blue denim was different than expected. In the next several posts, we will illustrate how to separate the price and quantity variances for direct materials, the rate and time variations for direct labor, and the controllable and volume variances for factory overhead.

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 919-921*

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Accounting: The Language of Business - Vol. 1 (Part 134)

Time and money are the basic needs of accounting.
Unknown

Performance Evaluation Using Variances from Standard Costs (Part A)

by

Charles Lamson

When you play a sport, you are evaluated with respect to how well you performed compared to a standard or to a competitor. In bowling, for example, your score is compared to a perfect score of 300 or to the score of your competitors. In school, you are compared to performance standards. These standards are often described in terms of letter grades, which provide a mixture of how well you achieved the class objectives. On your job, you are evaluated according to performance standards.

Just as your class performance is evaluated, managers are evaluated according to goals and plans. Performance is often measured as the difference between actual results and planned results. In the next several posts, we will discuss and illustrate the ways in which business performance is evaluated.

Standards

What are standards? Standards are performance goals. Service, merchandising, and manufacturing businesses may all use standards to evaluate and control operations. For example, long-haul drivers are expected to drive a standard distance per day. Salespersons are expected to meet sales standards.

Manufacturers normally use standard costs [A standard cost is an expected cost that a company usually establishes at the beginning of a fiscal year for prices paid and amounts used. The standard cost is anexpected amount paid for materials costs or labor rates (opentextbc.ca).] for each of the three manufacturing costs: direct materials [Direct material is the physical items built into a product. For example, the direct materials for a baker include flour, eggs, yeast, sugar, oil, and water. The direct materials concept is used in cost accounting, where this cost is separately classified in several types of financial analysis (accountingtools.com),] direct labor (labor involved in production rather than administration, maintenance, and other support services), and factory overhead [costs incurred during the manufacturing process, not including the costs of direct labor and direct materials (accountingtools.com).] Accounting systems that use standards for these costs are called standard cost systems. These systems enable management to determine how much a product should cost (standard cost), how much it does cost (actual cost), and the causes of any difference (cost variances). When actual costs are compared with standard costs, only the exceptions or variances are reported for cost control. This reporting by the principle of exceptions allows management to focus on correcting the variances. Thus, using standard costs assists management in controlling costs and in motivating employees to focus on costs.

Standard cost systems are commonly used with job order and process systems. Automated manufacturing operations may also integrate standard cost data with the computerized system that directs operations. Such systems detect and report variances automatically and make adjustments to operations in progress.

Setting Standards

Setting standards is both an art and a science. The standard-setting process normally requires the joint efforts of accountants, engineers, and other management personnel. The accountant plays an essential role by expressing in dollars and cents the results of judgments and studies. Engineers contribute to the standard-setting process by identifying the materials, labor, and machinery requirements needed to produce the product. For example, engineers determine the direct materials requirements by studying the materials specifications for products and estimating normal spoilage in production. Time and motion studies may be used to determine the length of time required for each manufacturing operation. Engineering studies may also be used to determine standards for factory overhead, such as the amount of power needed to operate machinery.

Setting standards often begins with analyzing past operations. However, standards are not just an extension of past costs, and caution must be used in relying on past cost data. For example, inefficiencies may be contained within past costs. In addition, changes in technology, machinery, or production methods may make past cost irrelevant for future operations.

Types of Standards

Standards imply an acceptable level of production efficiency. One of the major objectives in settings standards is to motivate workers to achieve efficient operations. 

Like the budgets we discussed in earlier posts, tight, unrealistic standards may have a negative impact on performance. This is because workers may become frustrated with an inability to meet the standards and may give up trying to do their best. Such standards can be achieved only under perfect operating conditions, such as no idle time, no machine breakdowns, and no materials spoilage. These standards are called ideal standards or theoretical standards. Although ideal standards are not widely used, a few firms use ideal standards to motivate changes and improvement. Such an approach is termed "Kaizen costing." Kaizen is a Japanese term meaning "continuous improvement."

Standards that are too loose might not motivate employees to perform at their best. This is because the standard level of performance can be reached too easily. As a result, operating performance may be lower than what could be achieved.

Most companies use currently attainable standards (sometimes called normal standards). These standards can be obtained with reasonable effort. Such standards allow for normal production difficulties and mistakes, such as materials spoilage and machine breakdowns. When reasonable standards are used, employees become more focused on cost and are more likely to put forth their best efforts.

An example from the game of golf illustrates the distinction between ideal and normal standards. In golf, "par" is an ideal standard for most players. Each player's USGA (United States Golf Association) handicap is the player's normal standard. The motivation of average players is to beat their handicaps because they may view beating par as unrealistic.

Reviewing and Revising Standards

Standard costs should be continuously reviewed and should be revised when they no longer reflect operating conditions. Inaccurate standards may distort management decision making and may weaken management's ability to plan and control operations.

Standards should not be revised, however, just because they differ from actual costs. They should be revised only when they no longer reflect the operating conditions that they were intended to measure. For example, the direct labor standard would not be revised simply because workers are unable to meet properly determined standards. On the other hand, standards should be revised when prices, product design, labor rates, or manufacturing methods change. For example, when aluminum beverage cans were redesigned to taper slightly at the top of the can, manufacturers reduced the standard amount of aluminum per can because less aluminum was required for the top piece of the tapered can.

Support and Criticism of Standards

Standards are used to value inventory and to plan and control costs. Companies are also using standards to assess performance at lower levels of the organization, for shorter accounting periods, and for an increasing number of costs.

Using standards for performance evaluation has been criticized by some. For example, critics assert that standards limit improvement of operations by discouraging improvement beyond the standard. Regardless of this criticism, standards are widely used. Most managers strongly support standard cost systems and regard standards as critical for running large businesses efficiently. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 917-919*

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Accounting: The Language of Business - Vol. 1 (Part 133)

Study your accounting. As an entrepreneur, you should not make an excuse not to learn this vital subject. It is, after all, the language of business.
Abdul Malik Omar

 Budgeting (Part F)

by

Charles Lamson

Balance Sheet Budgets

Balance sheet budgets are used by managers to plan financing, investing, and cash objectives for the firm. The balance sheet budgets illustrated for Elite Accessories Inc. in the following sections are the cash budget and the capital expenditures budget.

Cash Budget

The cash budget is one of the most important elements of the budgeted balance sheet. The cash budget presents the expected receipts (inflows) and payments (outflows) of cash for a period of time.

Information from the various operating budgets, such as the sales budget, the direct materials purchases budget, and the selling and administrative expenses budget, affect the cash budget. In addition, the capital expenditures budget, dividend policies, and plans for equity or long-term debt financing also affect the cash budget.

We illustrate the monthly cash budget for January, February, and March 2023, for Elite Accessories Inc. We begin by developing the estimated cash receipt and estimated cash payments portion of the cash budget.

Estimated Cash Receipts

Estimated cash receipts are planned additions to cash from sales and other sources, such as issuing securities or collecting interest. A supporting schedule can be used in determining the collections from sales. To illustrate this schedule, assume the following information for Elite Accessories Inc.:

Accounts receivable, January 1, 2006 …………….      $370,000

Elite Accessories Inc. expects to sell 10% of its merchandise for cash. Of the remaining 90% of the sales on account, 60% are expected to be collected in the month of the sale and the remainder in the next month.

Using this information, we prepare the schedule of collections from sales, shown in Exhibit 15. The cash receipts from the sales on account are determined by adding the amounts collected from credit sales earned in the current period (60%) and the amounts accrued from sales in the previous period are accounts receivable (40%).

EXHIBIT 15 Schedule of Collections from Sales

Estimated Cash Payments

Estimated cash payments are planned reductions in cash from manufacturing costs, selling and administrative expenses, capital expenditures, and other sources, such as buying securities or paying interest or dividends. A supporting schedule can be used in estimating the cash payments for manufacturing costs. To illustrate, the schedule shown in Exhibit 16 is based on the following information for Elite Accessories:

Accounts payable, January 1, 2023 ………….     $190,000

EXHIBIT 16 Schedule of Payments for Manufacturing Costs

Depreciation expense on machines is estimated to be $24,000 per month and is included in the manufacturing costs. The accounts payable were incurred for manufacturing costs. Elite Accessories Inc. expects to pay 75% of the manufacturing costs in the month in which they are incurred and the balance in the next month.

In Exhibit 16, the cash payments are determined by adding the amounts paid from costs incurred in the current period (75%) and the amounts accrued as a liability from costs in the previous period (25%). The $24,000 of depreciation must be excluded from all calculations, since depreciation is a non-cash expense that should not be included in the cash budget.

Completing the Cash Budget

To complete the cash budget for Elite Accessories Inc., as shown in Exhibit 17, assume that Elite Accessories Inc. is expecting the following:

EXHIBIT 17  Cash Budget

In addition, monthly selling and administrative expenses, which are paid in the month incurred, are estimated as follows:

We can compare the estimated cash balance at the end of the period with the minimum balance required by operations. Assuming that the minimum cash balance for Elite Accessories Inc. is $340,000, we can determine any expected excess or deficiency.

The minimum cash balance protects against variations in estimates and for unexpected cash emergencies. For effective cash management, much of the minimum cash balance should be deposited in income-producing securities that can be readily converted to cash. U.S. Treasury Bills or Notes are examples of such securities.

Capital Expenditures Budget

The capital expenditures budget summarizes plans for acquiring fixed assets. Such expenditures are necessary as machinery and other fixed assets wear out, become obsolete, or for other reasons need to be replaced. In addition, expanding plant facilities may be necessary to meet increasing demand for a company's product.

The useful life of many fixed assets extends over long periods of time. In addition, the amount of the expenditures for such assets may vary from year to year. It is normal to project the plans for a number of periods into the future in preparing the capital expenditures budget. Exhibit 18 is a five-year capital expenditures budget for Elite Accessories Inc.

EXHIBIT 18 Capital Expenditures Budget

The capital expenditures budget should be considered in preparing the other operating budgets. For example, the estimated depreciation of new equipment affects the factory overhead cost budget and the selling and administrative expenses budget. The plans for financing the capital expenditures may also affect the cash budget.

Budgeted Balance Sheet

The budgeted balance sheet estimates the financial condition at the end of a budget.. The budgeted balance sheet assumes that all operating budgets and financing plans are met. It is similar to a balance sheet based on actual data in the accounts. For this reason, a budgeted balance sheet for Elite Accessories Inc. is not illustrated. If the budgeted balance sheet indicates a weakness in financial position, revising the financing plans or other plans may be necessary. For example, a large amount of long-term debt in relation to stockholders' equity might require revising financing plans for capital expenditures. Such revisions might include issuing equity rather than debt. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 886-889*

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Accounting: The Language of Business - Vol. 1 (Part 132)

I took some classes in accounting, but I don’t know anything about accounting. You know, when my accountant tells me all the things he does, it’s a foreign language to me.
Ray Romano

 Budgeting (Part E)

by

Charles Lamson

Direct Labor Cost Budget

The production budget also provides the starting point for preparing the direct labor budget. For Elite Accessories Inc., the labor requirements for each unit of product are estimated as follows:

Based on these data and the production budget, Elite Accessories Inc. prepares the direct labor budget. As shown in the budget in Exhibit 10, for Elite Accessories Inc. to produce 520,000 wallets, 52,000 hours (520,000 units * 0.10 hour per unit) of labor in the Cutting Department are required. Likewise, to produce 292,000 handbags, 43,800 hours (292,000 units * 0.15 hour per unit) of labor in the Cutting Department are required. In a similar manner, we can determine the direct labor hours needed in the Sewing Department to meet the budgeted production. Multiplying the direct labor hours for each department by the estimated department hourly rate yields the total direct labor cost for each department.

EXHIBIT 10 Direct Labor Cost Budget

The direct labor needs should be coordinated between the production and personnel departments. This ensures that there will be enough labor available for production. 

Factory Overhead Cost Budget

The estimated factory overhead costs necessary for production make up the factory overhead cost budget. This budget usually includes the total estimated cost for each item of factory overhead, as shown in Exhibit 11.

EXHIBIT 11 Factory Overhead Cost Budget

A business may prepare supporting departmental schedules, in which the factory overhead costs are separated into their fixed and variable cost elements. Such schedules enable department managers to direct their attention to those costs for which they are responsible and to evaluate performance.

Cost of Goods Sold Budget

The direct materials purchases budget, direct labor cost budget, and factory overhead cost budget are the starting point for preparing the cost of goods sold budget. To illustrate, these data are combined with the desired ending inventory and the estimated beginning inventory data below to determine the budgeted cost of goods sold shown in Exhibit 12.

EXHIBIT 12  Cost of Goods Sold Budget

Selling and Administrative Expenses Budget

The sales budget is often used as the starting point for estimating the selling and administrative expenses. For example, a budgeted increase in sales may require more advertising. Exhibit 13, below, is a selling and administrative expenses budget for Elite Accessories Inc.

EXHIBIT 13 Selling and Administrative Expenses Budget

Detailed supporting schedules are often prepared for major items in the selling and administrative expenses budget. For example, an advertising expense schedule for the marketing department should include the advertising media to be used (newspaper, direct mail, television), quantities (column inches, number of pieces, minutes), and the cost per unit. Attention to such details results in realistic budgets. Effective control results from assigning responsibility for achieving the budget to department supervisors. 

Budgeted Income Statement

The budgets for sales, cost of goods sold, and selling and administrative expenses, combined with the data on other income, other expense, and income tax, are used to prepare the budgeted income statement. Exhibit 14 is a budgeted income statement for Elite Accessories Inc.

The budgeted income statement summarizes the estimates of all phases of operations. This allows management to assess the effects of the individual budgets on profits for the year. If the budgeted net income is too low, management could review and revise operating plans in an attempt to improve income. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 882-885*

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