Chapter 7 : The Standard Cost Accounting System …

CHAPTER 7

Chapter 7 : The Standard Cost Accounting System Part I: Setting Standards

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

1. Describe the role of the modern management accountant and the CAS in cost management.

2. Define the components of a standard cost card, and list its benefits for cost management.

3. Calculate the standard price and quantity for direct materials and direct labor, and understand the issues involved in these calculations.

4. Calculate the standard costs for variable and fixed overhead, and understand the issues involved in setting these standards.

5. Discuss the need for a manufacturing cost equation.

6. Prepare a list of attributes needed in a relational database to capture Standard costing information in an REA environment.

INTRODUCTION

What does the management accountant do? The management accountant provides a product: information. Who are the management accountant's customers? People within organizations. Thus, management accounting is concerned with providing information for organizational members.

In running a business or providing a service, people in different specialties within the enterprise must make many different types of decisions. In doing so, they use cost accounting system (CAS) information. The fact that CAS information is used inside the organization has three implications:

1. People inside the company need more detailed and specific information than do people outside the firm who make investment decisions about the firm as a whole.

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2. Because so many different types of decisions are made within a company, cost management reporting formats have to be more flexible than the somewhat more rigid formats used for financial accounting.

3. When CAS information is used within the firm, no externally imposed rules and procedures are required as is the case when financial accounting reports are prepared.

The two preceding chapters presented cost accounting systems that mainly accumulated actual costs, either by job (JOCAS) or by department (PCAS). When production costs were assigned to jobs or departments, the actual direct materials and direct labor costs were used with an estimated amount of overhead (normal costing). The difference between actual and applied overhead (over/under applied ending overhead account balance) was closed to COGS at year-end. Thus, all actual costs ended up in COGS. Actual costs are required for financial and tax reporting purposes.

But, if this is all the information a CAS reports, it is not as useful as it could be in budgeting, controlling operations, and evaluating performance.1 Benchmarks, or standards, are needed to compare against actual costs. This need for more detailed information, which can be reported in various ways (flexibility), was demonstrated in the discussions of the ICBIS and construction cost estimates in Chapter 5, where job order cost reports were expanded to include budget, actual, and variance information.

The purpose of the remaining chapters in Parts II and III of this text is to investigate the CAS's role in modern cost management. This chapter examines the basis for creating standards. The next chapter shows how these standards can be used in designing a standard cost accounting system (SCAS) for cost management reporting. The following chapters build off this basic cost management framework, addressing more sophisticated aspects of modern cost management.

THE COST MANAGEMENT ENVIRONMENT AND THE ROLE OF THE MANAGEMENT ACCOUNTANT

LEARNING OBJECTIVE 1

Describe the role of the modern manage-

ment

accountant and

the CAS in cost

management.

One of the most difficult transitions the traditional management accountant will have to make is to remember that management accounting does not just provide information to managers. With the advent of new types of manufacturing technologies, many workers are required to perform cost management tasks that have traditionally been thought of as belonging within the roles of managers.

For example, JIT production lines and quality circles (dedicated production cells) require workers who make the product to also be involved in quality control and testing. When problems occur, workers should communicate with each other, even when they are in different departments or cells, and coordinate activities to solve the problems. Workers in these new production environments must now perform two types of tasks; (1) make the product and (2) control the production process. The latter has traditionally been considered management's task.

Before accountants can figure out what kind of information workers and managers need, they should understand the types of decisions made. Some decisions are automatic (e.g.,

1. Usability is one of the five characteristics of high-quality information discussed in Chapter 1.

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taking a breath versus not breathing), while others are semi-automatic (e.g., getting up when the alarm clock sounds versus pressing the "snooze" control for a few more minutes of sleep). Many decisions concerning cost management require thought, reasoning, and a choice of a specific action.

in making such decisions, the decision makers, whether workers or managers, have two objectives. First, each person in an organization needs to make good decisions individually. Second, each person needs to communicate and coordinate actions with others in the organization who might be affected. This second objective involves "group" decision making.

DECISION MAKING, RATIONALITY, AND GOAL CONGRUENCE

This section will set out some definitions and ideas that will be used throughout the remaining chapters to help evaluate what management accountants do and why. A decision is a choice of actions between two or more problem solution alternatives. A problem is simply the difference between what a person wants and what that person has. It is the difference between goals and reality. In cost management, a problem is called a cost variance; it is the difference between budgeted costs and actual costs. Technically speaking, a cost variance is the financial result of a problem.

Cost variance reports are simply reports about the problems of a department or JIT cell. Reporting about problems is part of the management accountant's role under a management-by-exception control philosophy. Management-by-exception involves focusing attention on one's problems. The basic premise is, "I don't need control information about what's going right. I don't need to fix those things. Instead, tell me about my problems. Identify and isolate them for me so that I can correct them and prevent them in the future."

Implementing this control philosophy, however, requires a balancing act by the management accountant, especially in world-class enterprises. Reporting cost variances to the shop floor can result in a short-run focus on achieving standards, but attention may not be given to improving on those standards. As Chapters 1 and 2 pointed out, kaizen, the philosophy of continuous improvement, is a fundamental characteristic of world-class enterprises. Instead of focusing only on what is wrong, the WCM shop floor believes nothing is right and everything can be improved. The implication for the modern management accountant is that reports (at least annually) measuring the improvement in standards over time are just as important as short-run reporting about cost variances. The long-run focus is especially necessary in planning and group decision-making (activities. The short-run focus on achieving current standards is important in both operational control and performance evaluation.2

Not all decisions are "good" decisions. Simply stated, a good decision is a "rational" decision. Rational decisions are goal-directed decisions. Thus, good (rational) decisions are actions (choices) that lead to accomplishing goals. Goals differ from objectives. Objectives are long-range statements of what is wanted; goals are short-run targets that

2. This topic will be discussed further in the "Revising Standards" section later in this chapter. Cost variance reports are discussed in Chapter 8. Other types of reports for long-run total quality management are discussed in Chapter 12.

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if accomplished will lead to the realization of an objective. Goals are for a specified time period, and goal-related performance can be measured. Reporting this information is one of the management accountant's tasks.

For example, an accounting major may have the objective of becoming a certified management accountant (a CMA). One goal is passing the CMA exam. Successfully finishing this course, as it is part of the educational base needed to become a CMA, is rational, because it leads to realizing this goal. But rational decision making is not an end in itself. Consider the example on the next page.

In the Johnson Foundry example, it's rational to cancel the maintenance because this will lead to the goal of remaining within budget. However, cancelling maintenance is not in the best interests of the company in the long run.

This is an example of what is called a "myopic focus" on short-run profits. Overemphasis on short-run profits (like minimizing cost variances) is not always in the best interests of the organization. Instead, the firm wants workers and foremen to make goal-congruent decisions and take actions that lead to its goals. Choices that lead to an individual's goals, but not to the organization's goals, are called suboptimal or dysfunctional. This issue, first discussed in Chapter 1, is probably the key problem faced by the management accountant in designing an SCAS for cost management.

The role of the management accountant in this case is to provide enough flexibility and detail in performance reports so that suboptimal behavior does not occur. For example, a Johnson Foundry report for Mike Himes's department showing a budget of $100,000 and actual expenditures of $100,000, with no cost variance, would not be professionally ethical. The cost variance report should show a $5,000 "unfavorable" variance for labor usage (assume that was the real problem) and a $5,000 "favorable" variance for maintenance. Thus, both problems, if they occurred, would be reported.

Good decisions are rational decisions, but because each manager is a member of a larger organization, rationality must be tempered with goal congruence and ethics throughout all of the managers' and workers' decision-making functions. These include planning (for the future), monitoring and controlling (the present), and evaluating (past performance). The role of the management accountant, then, is to provide information that helps people in an organization (individually and as team members) to plan, control, and evaluate their areas of responsibility better.

THE STANDARD COST ACCOUNTING SYSTEM'S ROLE IN RESPONSIBILITY ACCOUNTING

Responsibility accounting has two aspects: functional and behavioral. From the functional perspective, responsibility accounting is concerned with measuring how well organizational members are achieving the organization's goals. From the behavioral perspective, responsibility accounting systems are a subset of the organizational control system. The control system's role is to provide the rewards that will motivate individuals to make goal-congruent decisions.

THE FUNCTIONAL SIDE OF RESPONSIBILITY ACCOUNTING. As explained earlier, people within organizations share two common decision-making objectives (individual and group), and they all have three decision-making functions (planning, control, and evaluation). The specific types of

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INSIGHTS & APPLICATIONS

Goal-Congruent versus Suboptimal Behavior at Johnson Foundry

Mike Himes is one of the factory foremen at Johnson Foundry. His budget to produce 1,000 casings this week is $100,000. Every Friday afternoon, maintenance work on the production machinery should be done, which costs $5,000. There have been some cost variances this week, and Mike is considering canceling the maintenance work. Because he is evaluated with cost variance reports, saving the $5,000 in maintenance costs will get him back within his budget. What should he do?

decisions they make, though, depend on their responsibilities. By looking at the management hierarchy, three basic responsibility levels can be identified:

? Cost centers. Cost center employees are responsible for planning, controlling, and evaluating activities that create costs. A factory foreman, or a JIT cell's work team, are good examples. Mike Himes is responsible for budgeting, controlling, and evaluating the costs of his department. His responsibilities are to hit a production quota,3 produce quality output, and do this within budgeted costs (minimize cost variances).4 He does not have any responsibilities for sales and marketing decisions, though. Thus, this responsibility level is not concerned with revenue (and profit) creation, but only with cost management.

? Profit centers. Profit center managers are one step above cost center managers in the firm's hierarchy. These managers have an added level of responsibility. In addition to controlling costs, they also are responsible for generating revenues. A product line manager is a good example. At this level, obtaining budgeted revenues, while containing costs within budget, leads to the achievement of target profits.

? Investment centers. Investment center managers can be considered the top management in a firm. The new responsibility added at this level is over investment decisions. At this level, responsibilities include obtaining budgeted profits, capital budgeting, and financing asset acquisitions.5

Since all three levels must ultimately be concerned with cost management, the SCAS has a multiple reporting obligation. In other words, there are multiple users, with different information needs. How cost variance reports can be designed to serve these different needs will be illustrated in the next chapter. All levels need to be involved in the setting of standards, though. This process has many behavioral implications that require the involvement of all workers and all levels of management, from the shop floor worker to the CEO.

BEHAVIORAL DIMENSIONS TO RESPONSIBILITY ACCOUNTING. If the responsibility accounting system is to function properly in its motivational role, it must be accepted by the people being evaluated. This means that employees must internalize

3. In a process system, this quota may be in terms of production runs. In a job order system, it refers to production volume within each job. In a JIT, it means keeping the kanban containers full or, it all containers are full, keeping the production process running smoothly within the cell. 4. This is not to imply that cost variance minimization is, or should be, the primary responsibility used in evaluating his performance. If it is, the possibility for suboptimal behavior exists, as the Johnson Foundry example illustrated. Actually, Mike Himes's cost variances are the result of production problems. Thus, minimizing cost variances results from minimizing production problems. This will be discussed in greater detail later and in the next chapter. 5. Profit center management accounting is covered in Part IV of this text, and investment centers are covered in Part V.

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