Case 10-44 Behavioral Effect of Standard Costs Merit Inc. has used a standard co

Question

Case 10-44 Behavioral Effect of Standard Costs

Merit Inc. has used a standard cost system for evaluating the performance of its responsibility center managers for 3 years. Top management believes that standard costing has not produced the cost savings or increases in productivity and profits promised by the accounting department. Large unfavorable variances are consistently reported for most cost categories, and employee morale has fallen since the system was installed. To help pinpoint the problem with the system, top management asked for separate evaluations of the system by the plant manager, that controller, and the human resources director. Their responses are summarized here.

Plant manager - The standards are unrealistic. They assume an ideal work environment that does not allow materials defects or errors by the workers or machines. Consequently, morale has gone down and productivity has declined. Standards should be based on expected annual prices and recent past averages for efficiency. Thus, if we improve over the past, we receive a favourable variance.

Controller - The goal of accounting reports is to measure performance against an absolute standard and the best approximation of that standard is ideal conditions. Cost standards should be comparable to "par" on a golf course. Just as the game of golf uses a handicap system to allow for differences in individual players' skills and scores, it could be necessary for management to interpret variances based on the circumstances that produced the variances. Accordingly, in one case, a given unfavorable variance could represent poor performance; in another case, it could represent good performance. The managers are just going to have to recognize these subtleties in standard cost systems and depend on upper management to be fair.

Human resources director - The key to employee productivity is employee satisfaction and a sense of accomplishment. A set of standards that can never be met denies managers of this vital motivator. The current standards would be appropriate in a laboratory with a controlled environment but not in the factory with its many variables. If we are to recapture our old "team spirit," we must give the managers a goal that they can achieve through hard work.

Required:

Discuess the behavioral issues involved in Merit Inc.'s standard cost dilemma. Evaluate eavh of the three responses (pros and cons) and recommend a course of action.

Explanation / Answer

Standard Costing

Standard Costing Overview

Standard costing is the practice of substituting an expected cost for an actual cost in the accounting records, and then periodically recording variances showing the difference between the expected and actual costs. This approach represents a simplified alternative to cost layering systems, such as the FIFO and LIFO methods, where large amounts of historical cost information must be maintained for items held in stock.

Standard costing involves the creation of estimated (i.e., standard) costs for some or all activities within a company. The core reason for using standard costs is that there are a number of applications where it is too time-consuming to collect actual costs, so standard costs are used as a close approximation to actual costs.

Since standard costs are usually slightly different from actual costs, the cost accountant periodically calculates variances that break out differences caused by such factors as labor rate changes and the cost of materials. The cost accountant may also periodically change the standard costs to bring them into closer alignment with actual costs.

Advantages of Standard Costing

Though most companies do not use standard costing in its original application of calculating the cost of ending inventory, it is still useful for a number of other applications. In most cases, users are probably not even aware that they are using standard costing, only that they are using an approximation of actual costs. Here are some potential uses:

Nearly all companies have budgets and many use standard cost calculations to derive product prices, so it is apparent that standard costing will find some uses for the foreseeable future. In particular, standard costing provides a benchmark against which management can compare actual performance.

Problems with Standard Costing

Despite the advantages just noted for some applications of standard costing, there are substantially more situations where it is not a viable costing system. Here are some problem areas:

The preceding list shows that there are a multitude of situations where standard costing is not useful, and may even result in incorrect management actions. Nonetheless, as long as you are aware of these issues, it is usually possible to profitably adapt standard costing into some aspects of a company’s operations.

Standard Cost Variances

A variance is the difference between the actual cost incurred and the standard cost against which it is measured. A variance can also be used to measure the difference between actual and expected sales. Thus, variance analysis can be used to review the performance of both revenue and expenses.

There are two basic types of variances from a standard that can arise, which are the rate variance and the volume variance. Here is more information about both types of variances:

Thus, variances are based on either changes in cost from the expected amount, or changes in the quantity from the expected amount. The most common variances that a cost accountant elects to report on are subdivided within the rate and volume variance categories for direct materials, direct labor, and overhead. It is also possible to report these variances for revenue.

It is not always considered practical or even necessary to calculate and report on variances, unless the resulting information can be used by management to improve the operations or lower the costs of a business. When a variance is considered to have a practical application, the cost accountant should research the reason for the variance in considerable detail and present the results to the responsible manager, perhaps also with a suggested course of action.

Standard Cost Creation

At the most basic level, you can create a standard cost simply by calculating the average of the most recent actual cost for the past few months. In many smaller companies, this is the extent of the analysis used. However, there are some additional factors to consider, which can significantly alter the standard cost that you elect to use. They are:

Any one of the additional factors noted here can have a major impact on a standard cost, which is why it may be necessary in a larger production environment to spend a significant amount of time formulating a standard cost.

Balanced Scorecard Approach to Performance Evaluation:

Selected non-financial metrics should also be employed in performance evaluation. This is sometimes referred to as maintaining a balanced scorecard, meaning that performance assessment should take a holistic approach. Long-term business success will not be achieved if the focus is only on near-term financial outcomes. With the balanced scorecard approach, an array of performance measurements is developed. Each indicator should be congruent with the overall entity objectives. Further, each measure should be easily determined and understood. These measurements can relate to financial outcomes, customer outcomes, or business process outcomes. Although a balanced scorecard approach may include target thresholds that should be met, the primary focus is on improvement.

Blue Rail had a number of financial goals that could be included in a balanced scorecard assessment. Examples include the standard cost for material, the standard labor hours per rail set, the expected production level, and so forth. Examples of potential customer outcomes include results of a customer satisfaction survey, product returns/warranty work rates, estimated market share, and the frequency that customer bids lead to customer orders. Examples of potential business process outcomes include defect-free units as a proportion of total production, time from order receipt to shipment, size of customer order backlogs, and employee turnover rates.

The metrics are intended to measure progress toward fulfillment of the corporate objectives, and the managerial accountant is apt to be heavily involved in gathering the necessary data for inclusion in the balanced scorecard performance reports. These reports are often graphical in nature to facilitate easy use and interpretation, with particular emphasis on timely identification of trends. Sometimes, the metrics are prominently posted in the workplace. By prominent display of such data, employees are constantly reminded of, and encouraged to meet, key performance goals.

1. Understand the importance of strategic management to a small business.

Small companies that lack clear strategies may achieve some success in the short run, but as soon as competitiveconditions stiffen or an unanticipated threat arises, they usually “hit the wall” and fold. Without a basis for differentiating itself from a pack of similar competitors, the best a company can hope for is mediocrity in the marketplace. In today’s intensely competitive global environment, entrepre-neurs who are not thinking and acting strategically are putting their businesses at risk. Strategic management is the mechanism for operating successfully in a chaotic competi-tive environment.

2. Explain why and how a small business must

create a competitive advantage in the market. The goal of developing a strategic plan is to create for the small company a competitive advantage—the aggregation of factors that sets the small business apart from its competitors and gives it a unique position in the market. Every small firm must establish a plan for creating a unique image in the minds of its potential customers. A company builds a competitive edge on its core competencies, which are a unique set of capabilities that a company develops in key operational areas, such as quality, service, innovation, team building, flexibility, responsiveness, and others, that allow it to vault past competitors. They are what the company does best and are the focal point of the strategy. This step must identify target market segments and determine how to position the firm in those markets. Entrepreneurs must identify some way to differentiate their companies from competitors.

3. Develop a strategic plan for a business using the nine steps in the strategic planning process.

Small businesses need a strategic planning process designed to suit their particular needs. It should be relatively short, be informal and not structured, encourage the participation of employees, and not begin with extensive objective setting. Linking the purposeful action of strategic planning to an entrepreneur’s ideas can produce results that shape the future.

Step 1 Develop a clear vision and translate it into a meaningful mission statement. Highly successful entrepreneurs are able to communicate their vision to those around them. The firm’s mission statement answers the first question of any venture: What business am I in? The mission statement sets the tone for the entire company.

Step 2 Assess the company’s strengths and weaknesses.Strengths are positive internal factors; weaknessesare negative internal factors.

Step 3 Scan the environment for significant opportunities and threats facing the business. Opportunities are positive external options; threats are negative external forces.

Step 4 Identify the key factors for success in the business.In every business, key factors that determine the success of the firms in it, and so they must be an integral part of a company’s strategy. Key success factors are relationships between a controllable variable and a critical factor influencing the firm’s ability to compete in the market.

Step 5 Analyze the competition. Business owners should know their competitors’ business almost as well as they know their own business. A competitive profile matrix is a helpful tool for analyzing competi-tors’ strengths and weaknesses.

Step 6 Create company goals and objectives. Goals are the broad, long-range attributes that the firm seeks to accomplish. Objectives are quantifiable and more precise; they should be specific, measurable, assignable, realistic, timely, and written down. The process works best when managers and employees are actively involved.

Step 7 Formulate strategic options and select the appropriate strategies. A strategy is the game plan the firm plans to use to achieve its objectives and mission. It must center on establishing for the firm the key success factors identified earlier.

Step 8 Translate strategic plans into action plans. No strategic plan is complete until the owner puts it into action.

Step 9 Establish accurate controls. Actual performance rarely, if ever, matches plans exactly. Operating data from the business assembled into a comprehensive scorecard serve as an important guidepost for determining how effective a company’s strategy is. This information is especially helpful when plotting future strategies. The strategic planning process does not end with these nine steps; rather, it is an ongoing process that an entrepreneurwill repeat.

The characteristics of three basic strategies—low cost, differentiation, and focus—and know when and how to employ them.

Three basic strategic options are cost leadership, differentiation, and focus. A company pursuing a cost leadership strategy strives to be the lowest-cost producer relative to its competitors in the industry. A company following a differentiation strategy seeks to build customer loyalty by positioning its goods or services in a unique or different fashion. In other words, the firm strives to be better than its competitors at something that customers value. A focus strategy recognizes that not all markets are homogeneous. The principal idea of this strategy is to select one or more segments, identify customers’ special needs, wants, and interests, and approach them with a good or service designed to excel in meeting these needs, wants, and interests. Focus strategies build on differences among market segments.

Understand the importance of controls such as the balanced scorecard in the planning process. Just as a pilot in command of a jet cannot fly safely by focusing on a single instrument, a entrepreneur cannot manage a company by concentrating on a single measurement. The balanced scorecard is a set of measurements unique to a company that includes both financial and a balanced scorecard of financial and operational measures gives managers a quick yet comprehensive picture of the company’s total perform.

Objectives.

Objectives should be specific goals that are quantifiable and measurable. Setting measurable objectives will enable you to track your progress and measure the results.

Keys to success.

Virtually every business has critical aspects that make the difference between success and failure. These may be brief bullet point comments that capture key elements that will make a difference in accomplishing your stated objectives and realizing the mission.

Value proposition.

A value proposition is a clear and concise statement that describes the tangible value based result a customer receives from using your product or service. The more specific and meaningful this statement is from a customer’s perspective, the better. Once you have your value proposition, look at your organization—and your business plan—in terms of how well you communicate the service proposition and fulfill your promise to your customers or clients.

Strategy and implementation.

This is a section that you will build on and, for now, make comments that capture your plans for the business. This describes the game plan and provides focus to realize your venture’s objectives and mission. Based on your initial strategic analysis, which of the three business strategies—low cost, differentiation, or focus—will you use to giveyour company a competitive advantage? How will this strategy capitalize on your company’s strengths and appeal to your customer’s need? You will later build on this information as you formulate action plans to bring this strategic plan to life.

SWOT analysis.

What are the internal strengths and weaknesses of your business? As you look outside the organization, what are the external opportunities and threats? List these and then assess what this tells you about your business. How can you leverage your strengths to take advantage of the opportunities ahead? How can you further develop or minimize the areas of weaknesses?

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