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Variance Analysis

See Also:
Direct Labor Variance Formulas
Direct Material Variance Formulas
Asset Market Value versus Asset Book Value
Accounting Income vs Economic Income
ProForma Financial Statements

Variance Analysis

Variance analysis measures the differences between expected results and actual results of a production process or other business activity. Measuring and examining variances can help management contain and control costs and improve operational efficiency.

Prior to an accounting period, a budget is made using estimates of material and labor costs and amounts that will be required for the period. After the accounting period, compare the actual material and labor costs and amounts to the estimates to see how accurate the estimates were. The differences between the estimates and the actual results observed at the end of the period are called the variances.

Commonly measured variances include direct labor rate variance, direct labor efficiency variance, direct material price variance, and direct material quantity variance. These variance analyses compare expected results to actual results. The purpose is to see if budget targets were met. Or they see if the operations ended up being more expensive or less costly than originally planned.


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Variance Interpretation

Variance analysis will let managers and cost analysts see if the budgeted costs and requirements for an operation accurately forecasted the actual costs and requirements of the operation.

Often, you will find variance between the budgeted requirements and the actual requirements. It is then up to managers and cost analysts to determine if that variance was favorable or unfavorable.

When a variance is favorable, that means that the actual costs and requirements of the operations were less than the expected costs and requirements for the operations. In other words, they expected the production process to cost a certain amount and it ended up costing less. Hence, this is a favorable variance.

When a variance is unfavorable, that means that the actual costs and requirements of the operations were more than the expected costs and requirements for the operations. In other words, they expected the production process to cost a certain amount and it ended up costing more. In conclusion, this is an unfavorable variance.

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variance analysis

Source:

Hilton, Ronald W., Michael W. Maher, Frank H. Selto. “Cost Management Strategies for Business Decision”, Mcgraw-Hill Irwin, New York, NY, 2008.

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Standard Costing System

See Also:
Standard Costing Example
Process Costing
Activity Based Costing vs Traditional Costing
Absorption vs Variable Costing
Implementing Activity Based Costing
Cost Driver
Budgeting 101: Creating Successful Budgets
Analyzing Your Return on Investment (ROI)
Product Pricing Strategies

Standard Costing System

In accounting, a standard costing system is a tool for planning budgets, managing and controlling costs, and evaluating cost management performance.

A standard costing system involves estimating the required costs of a production process. But before the start of the accounting period, determine the standards and set regarding the amount and cost of direct materials required for the production process and the amount and pay rate of direct labor required for the production process. In addition, these standards are used to plan a budget for the production process.

At the end of the accounting period, use the actual amounts and costs of direct material. Then utilize the actual amounts and pay rates of direct labor to compare it to the previously set standards. When you compare the actual costs to the standard costs and examine the variances between them, it allows managers to look for ways to improve cost control, cost management, and operational efficiency.

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Advantages and Disadvantages of Standard Costing

There are both advantages and disadvantages to using a standard costing system. The primary advantages to using a standard costing system are that it can be used for product costing, for controlling costs, and for decision-making purposes.

Whereas the disadvantages include that implementing a standard costing system can be time consuming, labor intensive, and expensive. If the cost structure of the production process changes, then update the standards.

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standard costing system

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standard costing system

Source:

Hilton, Ronald W., Michael W. Maher, Frank H. Selto. “Cost Management Strategies for Business Decision”, Mcgraw-Hill Irwin, New York, NY, 2008.

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Standard Cost

Standard Costs Definition

Standard cost accounting is a goal or budget costs that is associated with variable costs. They are also used to measure the cost that management believes that it will incur over a period.

Standard Costing Explained

In short, standard costing takes the direct labor, direct materials, and manufacturing overhead, and estimates the cost over a quarter, year, or whatever the period may be. This is similar to budget costing, but is different in that budget costs account for a total cost while a standard cost estimate is on a per unit basis. Therefore, if a standard cost estimate turns out to be correct, then the total cost would turn out to be equal to the budget cost. But, this sort of thing never happens.

Standard Cost Formula

The standard cost method can be broken down using the following formula:

Standard Costs = Direct Labor * Direct Materials * Manufacturing Overhead

Where:
Direct Labor = Hours Worked * Hourly Rate

Direct Materials = amount of materials * market price

Manufacturing Overhead = Fixed Salary + (Machine hours * Machine rate)

Note: All but the fixed salary component of overhead must be predicted given the market conditions on demand and cost of the materials. It should also be noted that this is the same formula for the manufacturing costs, but the difference lies in the fact that Standard costs accounting is done on a predictive basis.

Standard Cost Example

For example, Jenny is an accountant. Her boss, Craig the CFO, gave her a task to calculate the standard cost of the company for the upcoming year 2010. She was given the following past information for Wawadoo Co. to try and calculate the standard cost for Wawadoo’s product (widget).

Direct Labor-2009
AVg. Labor Hours= 1,960 hours per employee
Avg. Hourly Wage – $10
Number of employees = 47
Total Costs= $92,120

Direct Materials-2009
Material Units=20,000
Avg. Market Price= $20
Total Cost= $400,000

Overhead-2009
Fixed Salary per Manager= $80,000
Number of Managers= 5
Number of Machine hours= 1,000
Hourly Machine rate= $2
Total Cost=$410,000

Jenny’s Boss, Craig, believes that the overall demand for widgets will increase by 5% and the price and number of units needed will increase by the same amount. He also believes that there will be a need for 8 new employees as well as a new manager.

Jenny finds the following:

Direct Labor= 1,960 hrs.* $10/hr* 55 employees= $1,078,000
Direct Material = $21 mkt price* 21,000 units= $441,000
Overhead= ($80,000* 6) + (1,000 hrs.* $2/hr* 6) = $492,000

Total Standard Cost= $2,011,000 cost for the year

standard cost

See Also:
Manufacturing Cost
Cost of Goods Sold (COGS)
Overhead Definition
Direct Cost vs. Indirect Cost
Variable Cost

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Product Costs vs Period Costs

See Also:
Product Pricing Strategies

Product Costs vs Period Costs

In accounting, all costs incurred by a company can be categorized as either product costs or period costs. The two types of costs are recorded differently.

Product costs are applied to the products the company produces and sells. Product costs refer to all costs incurred to obtain or produce the end-products. Examples of product costs include the cost of raw materials, direct labor, and overhead. Before the products are sold, these costs are recorded in inventory accounts on the balance sheet. They are treated like assets. Product costs are sometimes referred to as “inventoriable costs.” When the products are sold, these costs are expensed as costs of goods sold on the income statement.

Period costs are the costs that cannot be directly linked to the production of end-products. Essentially, a period cost is any cost that is not a product cost. Examples of period costs include sales costs and administrative costs. Period costs are always expensed on the income statement during the period in which they are incurred.

In sum, product costs are inventoried on the balance sheet before being expensed on the income statement. Period costs are just expensed on the income statement.

Product Costs vs Period Costs

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Predetermined Overhead Rate

Predetermined Overhead Rate Definition

A company uses a predetermined overhead rate to allocate overhead costs to the costs of products. Indirect costs are estimated, a cost driver is selected, cost driver activity is estimated, and then indirect costs are applied to production output based on a formula using these data.

Predetermined Overhead Rate Example

For example, imagine a company that makes widgets. In order to make the widgets, the production process requires raw material inputs and direct labor. These two factors comprise part of the cost of producing each widget; however, ignoring overhead costs, such as rent, utilities, and administrative expenses that indirectly contribute to the production process, would result in underestimating the cost of each widget. Therefore overhead costs are allocated to production output via predetermined overhead rates, or rates that determine how much of the overhead costs are applied to each unit of production output.

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Predetermined Overhead Rate Usage

Traditional costing systems apply indirect costs to products based on a predetermined overhead rate. Unlike ABC, traditional costing systems treat overhead costs as a single pool of indirect costs. Traditional costing is optimal when indirect costs are low compared to direct costs. There are several steps for computing the predetermined overhead rate in the traditional costing process, including the following:

1. Identify indirect costs.
2. Estimate indirect costs for the appropriate period (month, quarter, year).
3. Choose a cost-driver with a causal link to the cost (labor hours, machine hours).
4. Estimate an amount for the cost-driver for the appropriate period (labor hours per quarter, etc.).
5. Compute the predetermined overhead rate (see below).
6. Apply overhead to products using the predetermined overhead rate.

Calculating Predetermined Overhead Rate

First, use the following formula to calculate overhead rate.

Predetermined Overhead Rate = Estimated Overhead Costs / Estimated Cost-Driver Amount

See the following calculation example:

$30/labor hr = $360,000 indirect costs / 12,000 hours of direct labor

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predetermined overhead rate

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Labor Costs

See Also:
Absorption vs Variable Costing
Agency Costs
Operating Capital
Replacement Costs

Labor Costs Definition

The labor costs definition is the total cost of all labor used in a business. It is one of the most substantial operating costs. These are particularly important in any business which experience heavy human resource labor costs: construction, manufacturing, and other industries which have partially or non-automated operations. These costs include 2 main subcategories. The direct labor costs definition is summarized as the cost of labor which is used directly to make products. Meanwhile, the indirect labor costs definition is simply explained as the cost of labor which is used to support or make direct labor more efficient.

Labor Costs Explanation

These costs are explained by many as the most important cost a company will face, is a key factor in almost any business. This is due to the fact that employee turnover is one of the main factors which causes a business to fail. To begin, it is in the best interest of any owner that unit labor costs and inflation are minimized to maximize profits.

The importance of labor costs does not stop here. They are a variable cost. As such, they must also occur in a predictable cycle to avoid cash flow problems. If a firm is seasonal and requires additional labor at peak times, business controllers must have the cash on hand to afford this increase in cost. If a business plans properly it will avoid many cash issues associated with the cost of labor.

Labor Costs Formula

A single formula will not serve the many different needs associated. Despite this, a common and simple formula is included below:

Labor Costs = (total sales x labor %) / average hourly rate of labor

Labor Costs Calculation

To perform a simple labor costs calculation follow the process outlined below:

If:
Total Sales = $1,000,000
Labor % = 15%
Average hourly rate of labor = $10

Labor Costs = ($1,000,000 x .15) / $10 = (150,000) / $10 = $15,000

Labor Costs Example

For example, Leann is the owner of a clothing store in the largest mall in her city. Leann, a fashion aficionado from birth, knows the popular styles better than any designer in Milan. She works diligently to make sure her store stays in pace with the trends of today as well as the future.

Leann is gearing up for her peak season. Additionally, she is concerned because her off-season sales have slumped slightly. She sees the new season as a great opportunity to move inventory and regain the ground. That is, if she has enough cash to get by.

Leann will need to increase hours for sales and backroom staff during these peak times. To balance that, she will also have to make sure she can pay for these employees. The slump in her off-peak season has made Leann plan more for the future. She now wants to calculate cost of labor for her peak period to make sure she can afford the cash needed to get by.

Example Calculation

Leann performs this simple calculation to find her cost of labor:

If:
Total Sales = $1,000,000
Labor % = 15%
Average hourly rate of labor = $10

Then:
Labor Costs = (total sales x labor%) / average hourly rate of labor
Labor Costs = ($1,000,000 x .15) / $10 = (150,000) / $10 = $15,000

For Leann’s retail business cost of labor total $15,000 for the period she is studying. This is more than she expected and can afford. Luckily, Leann has excellent credit. Leann decides to apply for a small business loan to help her company survive the first month of peak demand. From here she will make the cash necessary to continue.

Leann also decides to pay more attention to her company finances. She was not surprised by this situation, but still wants to be able to predict the problems that her business will face better. Her drive and insight will achieve this and many future goals.

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Labor Costs, Labor Costs Definition

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Labor Costs, Labor Costs Definition

 

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Joint Costs

See Also:
Sunk Costs
Inventoriable Costs
Financial Distress Costs
Agency Costs
Bankruptcy Costs

Joint Costs Definition

In accounting, a joint cost is a cost incurred in a joint process. Joint costs may include direct material, direct labor, and overhead costs incurred during a joint production process. A joint process is a production process in which one input yields multiple outputs. It is a process in which seeking to create one type of output product automatically also creates other types of output product.

Joint Process Examples

Joint processes are production processes in which the creation of one product also creates other products. It is a process in which one input yields multiple outputs. Joint production processes are common in the agriculture industry, the food manufacturing industry, and the chemical industry.

For instance, let’s consider a poultry plant. The plant takes live chickens and turns them into chicken parts used for food. The chickens yield chicken breasts, drumsticks, livers, gizzards, and other parts of the chicken that are used for human consumption. They also yield miscellaneous chicken byproducts that are used for hotdogs, jerky sticks, or animal provender.

Similarly, let’s consider an oil refinery. The refinery takes crude oil and refines it into a substance that may be used for auto gasoline, motor oil, heating oil, or kerosene. All of these various outputs come from a single input – crude oil. In both of these examples, a single input yields multiple outputs. These are both examples of joint production processes.

Joint Cost Allocation

Allocate joint costs to the primary output products of the joint process, not the incidental byproducts or scrap. Allocate them using a physical measure or a monetary measure.

The physical measure allocates joint costs to primary products based on a physical characteristic, such as units produced, or pounds or tons produced, barrels produced, or some other physical measure that is appropriate for the volume of output of the primary products. To use this method, simply divide the total production cost by the appropriate measure of output volume to yield the cost per unit of output.

One type of monetary measure of joint cost allocation is the sales value method. Using the sales value method, separate and differentiate the primary products according to sales value. Then divide them into proportions of sales value that add up to 100%. Then multiply the percentage proportions by the total production cost to yield the allocated cost per primary product type.

Joint Costs

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