In general, two approaches may be used when establishing standard costs, i) historical records and ii) engineering studies.

Historical records
With this approach, records of the company’s operations, purchase and use of materials and labour serve as a basis for establishing current standards. This approach is often used in practice. The advantages of this approach are that it is relatively inexpensive; it uses actual company data to compute standard costs and provides a reference for future improvement. The disadvantages of using past historical records are that there is the possibility that past inefficiencies will be incorporated in the standard costs; if the production process changes the historical data will be irrelevant and if the company introduces new products then using this approach to develop cost standards will not be possible.

Engineering studies
This approach requires a detailed study of each production operation to be conducted, so that standard costs are based on observed, recorded activity. Engineering studies may also require input from operating personnel to provide estimates about future activities and consumption levels. The advantages of this approach are that it is future-oriented; it aims to ensure that past inefficiencies are not incorporated in standard costs. In addition, this approach facilitates allowance for expected changes such as alterations to the production process or product redesign. The disadvantages of this approach are that it is time-consuming and expensive to employ. Engineering studies require a comprehensive team approach combining input from production, human resources, sales and finance staff. While such an approach may improve the reliability of cost estimates and increase commitment and motivation, there is the possibility of data bias to set easier to achieve standard costs.

Advantages that result from a business using a standard cost system are:

• Improved cost control: Companies can gain greater cost control by setting standards for each type of cost incurred and then highlighting exceptions or variances—instances where things did not go as planned. Variances provide a starting point for judging the effectiveness of managers in controlling the costs for which they are held responsible.
  Assume, for example, that in a production center, actual direct materials costs of GH¢52,015 exceeded standard costs by GH¢6,015. Knowing that actual direct materials costs exceeded standard costs by GH¢ 6,015 is more useful than merely knowing the actual direct materials costs amounted to GH¢52,015. Now the firm can investigate the cause of the excess of actual costs over standard costs and take action.
• More useful information for managerial planning and decision making: When management develops appropriate cost standards and succeeds in controlling production costs, future actual costs should be close to the standard. As a result, management can use standard costs in preparing more accurate budgets and in estimating costs for bidding on jobs. A standard cost system can be valuable for top management in planning and decision making.
• More reasonable and easier inventory measurements: A standard cost system provides easier inventory valuation than an actual cost system. Under an actual cost system, unit costs for batches of identical products may differ widely. For example, this variation can occur because of a machine malfunction during the production of a given batch that increases the labor and overhead charged to that batch. Under a standard cost system, the company would not include such unusual costs in inventory. Rather, it would charge these excess costs to variance accounts after comparing actual costs to standard costs.
  Thus, in a standard cost system, a company assumes that all units of a given product produced during a particular time period have the same unit cost. Logically, identical physical units produced in a given time period should be recorded at the same cost.
• Cost savings in record-keeping: Although a standard cost system may seem to require more detailed record-keeping during the accounting period than an actual cost system, the reverse is true. For example, a system that accumulates only actual costs shows cost flows between inventory accounts and eventually into cost of goods sold. It records these varying amounts of actual unit costs that must be calculated during the period. In a standard cost system, a company shows the cost flows between inventory accounts and into cost of goods sold at consistent standard amounts during the period. It needs no special calculations to determine actual unit costs during the period. Instead, companies may print standard cost sheets in advance showing standard quantities and standard unit costs for the materials, labour, and overhead needed to produce a certain product.
• Possible reductions in production costs: A standard cost system may lead to cost savings. The use of standard costs may cause employees to become more cost conscious and to seek improved methods of completing their tasks. Only when employees become active in reducing costs can companies really become successful in cost control.

(Any 3 points for 3 marks)

Disadvantages that result from a business using standard costs are:

• Controversial materiality limits for variances: Determining the materiality limits of the variances may be controversial. The management of each business has the responsibility for determining what constitutes a material or unusual variance. Because materiality involves individual judgment, many problems or conflicts may arise in setting materiality limits.
• No reporting of certain variances: Workers do not always report all exceptions or variances. If management only investigates unusual variances, workers may not report negative exceptions to the budget or may try to minimize these exceptions to conceal inefficiency. Workers who succeed in hiding variances diminish the effectiveness of budgeting.
• Low morale for some workers: The management by exception approach focuses on the unusual variances. Management often focuses on unfavorable variances while ignoring favorable variances. Workers might believe that poor performance gets attention while good performance is ignored. As a result, the morale of these workers may suffer.

(Any 2 points for 2 marks)

An ideal standard is one which can be attained under perfect operating conditions: no wastage, no inefficiencies, no idle time, and no breakdowns.
A basic standard is a standard which remains unchanged over the years and is used to show trends.

Effect on employee motivation:

• Ideal standards can be seen as long-term targets but are not very useful for day-to-day control purposes as they cannot be achieved. It is claimed that they provide employees with an incentive to be more efficient.However, they may have an unfavourable effect on employee motivation as variances will always be adverse.
• Basic standards may have an unfavourable effect on motivation as employees discover over time that they are easily able to achieve the standards.

Working:
W1: calculation of overhead absorption rate
Budget machine hours = (10,000*1.95) + (13,000*3.90) + (9,000*5.20) =117,000 hours
As company follows absorption costing method, fixed overheads are allocated on machine hours’ basis.
Overhead adsorption rate = GH¢526,500/117,000 hours = GH¢4.50 per machine hour.

Alternative approach to actual sales quantity in standard mix at standard profit
= Actual quantity * average standard profit per unit
=31,500 units* GH¢25.1875 per units
= GH¢793,403

ALTERNATIVE SOLUTION:

Alternative approach to actual sales quantity in standard mix at standard profit
= Actual quantity * average standard profit per unit
=31,500 units* GH¢25.1875 per units
= GH¢793,403

Alternative approach to actual sales quantity in standard mix at standard profit
= Actual quantity * average standard profit per unit
=31,500 units* GH¢25.1875 per units
= GH¢793,403

Alternative approach to actual sales quantity in standard mix at standard profit
= Actual quantity * average standard profit per unit
=31,500 units* GH¢25.1875 per units
= GH¢793,403

ALTERNATIVE SOLUTION:

ALTERNATIVE SOLUTION:

ALTERNATIVE SOLUTION:

ALTERNATIVE SOLUTION:

Therefore 25,000 x Hrs. = 65,512
Hrs. = 65,512/25,000 = 2.62hrs

ALTERNATIVE SOLUTION:

• Reports and information is prepared after the event on a historical basis.
• Standards used inappropriately, with a focus on negative impacts, can have a demotivational impact.
• Calculation of efficiency variances assume labour is always variable and that normally production is a factor of labour.
• Favourable and adverse variance can be difficult to understand.
• No consideration of qualitative factors.                                                             (Any 3 points)

ABS Limited: Budget/actual reconciliation statement

Budgeted production overhead expenditure = Normal production volume × Absorption rate per unit
.                                                                     = 16,000 units × GH¢20 = GH¢320,000.
Since expenditure occurs evenly throughout the year, the budgeted production overhead expenditure is GH¢160,000 in each six-month period.

This represents constant standard that are unchanged over long period. The main advantage of basic standard is that a base is provided for comparison with actual cost through a period of years with the same standard and efficiency trends can be established over time. When changes occur in the method of production, price levels or other relevant factors, basic standards are not very useful since they do not represent current target.

This represent perfect performance. Ideal standards are minimum cost that are possible under the most efficient operating condition. They are unlikely to be used because they may have negative impact on employee performance.

This standard represent those cost that should be incurred under efficient operating conditions. They are difficult but not impossible to achieve. Allowance are made for normal spoilage, machine breakdowns and idle cost.

i) Prediction of future cost that can be used for decision making.
ii) Provide a challenging target that can serve as a motivation for employee.
iii) Assist in setting target.
iv) Act as control device by highlighting exceptions
v) Simplifying the task of tracing cost to product for measuring profitability and inventory valuation.

i) Variance analysis concentrates on only a narrow range of costs, and does not give sufficient attention to issues such as quality and customer satisfaction.
ii) Standard costing pays too much emphasis on direct labour cost. Direct labour is only a small proportion of cost in modern manufacturing environment and so this emphasis is not appropriate.
iii) Many of the variances in standard costing system focus on the control of short term variable costs. In modern manufacturing environment majority of cost including direct labour cost tends to be fixed in the short run.
iv) The use of standard costing relies on existence of repetitive operations and relatively homogeneous output. Nowadays many Organisation are forced continually to respond to customers’ changing requirement, with the result that output and operations are not so repetitive.
v) Standard costing system were developed when the business environment was more stable and less prone to change. The current business environment is more dynamic and it is not possible to assume stable conditions.
vi) Standard costing system assumes that performance to standard is acceptable. Today’s business environment is more focused on continuous improvement.
vii) Most standard costing systems produce control statements weekly or monthly. The modern manager needs much more prompt control information in order to function efficiently in a dynamic business environment.                     (Any 4 points)