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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* end |
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