CHAPTER 5

An activity base (also called a cost driver) is a measure of what causes the incurrence of
variable costs. As the level of the activity base increases, the total variable cost increases
proportionally.

• Units produced (or sold) is not the only activity base within companies. A cost can be
considered variable if it varies with activity bases such as miles driven, machine hours, or
labor hours.

Here are some examples of variable costs that are likely present in many types of businesses.

• Merchandising companies − cost of goods sold.

• Manufacturing companies − direct materials, direct labor, and variable overhead.

• Merchandising and manufacturing companies − commissions, shipping costs, and clerical

costs such as invoicing.

• Service companies − supplies, travel, and clerical.

The amount of a true variable cost used during the period varies in direct proportion to the
activity level.

Direct material is an example of a cost that behaves in a true variable pattern. Direct materials
purchased but not used can be stored and carried forward to the next period of inventory.

A step-variable cost is a resource that is obtainable only in large chucks and whose
costs change only in response to fairly wide changes in activity. For example,
maintenance workers are often considered to be a variable cost, but this labor cost does not
behave as a true variable cost.

The mixed cost line can be expressed with the equation Y = a + bX. This equation should look
familiar, from your algebra and statistics classes.

In the equation, Y is the total mixed cost; a is the total fixed cost (or the vertical intercept
of the line); b is the variable cost per unit of activity (or the slope of the line), and X is the
actual level of activity.

A standard is a benchmark or “norm” for measuring performance. In managerial

accounting, two types of standards are commonly used by manufacturing, service, food and not-
for-profit organizations:

CHAPTER 11 Standard Costs and Operating Performance Measures

1. Quantity standards specify how much of an input should be used to make a product or
provide a service. For example:

a. Auto service centers like Firestone and Sears set labor time standards for the
completion of work tasks.

b. Fast-food outlets such as McDonald’s have exacting standards for the quantity of
meat going into a sandwich.

2. Price standards specify how much should be paid for each unit of the input. For example:

a. Hospitals have standard costs for food, laundry, and other items.

b. Home construction companies have standard labor costs that they apply to sub-
contractors such as framers, roofers, and electricians.
 c. Manufacturing companies often have highly developed standard costing systems
that establish quantity and price standards for each separate product’s material,
labor and overhead inputs. These standards are listed on a standard cost card.

Management by exception is a system of management in which standards are set for

various operating activities, with actual results compared to these standards. Any deviations
that are deemed significant are brought to the attention of management as “exceptions.”

• This chapter applies the management by exception principle to quantity and price
standards with an emphasis on manufacturing applications.

Six Sigma advocates argue that waste and spoilage should not be tolerated. If allowances for
waste and spoilage are built into the standard quantity, the level of those allowances should be
reduced over time.

The price standard for variable manufacturing overhead comes from the variable portion of the
predetermined overhead rate.

The quantity standard for variable manufacturing overhead is expressed in either direct labor
hours or machine hours depending on which is used as the allocation base in the predetermined
overhead rate.

Price and quantity standards are determined separately for two reasons:

1. Different managers are usually responsible for buying and for using inputs. For example:
The purchasing manager is responsible for raw material purchase prices and the
production manager is responsible for the quantity of raw material used.

2. The buying and using activities occur at different points in time. For example: Raw
material purchases may be held in inventory for a period of time before being used in
production.

Differences between standard prices and actual prices and standard quantities and actual
quantities are called variances. The act of computing and interpreting variances is called
variance analysis.

Material Quantity Variance = Selling Price (Actual Qty – Selling Qty)

Material Price Variance = Actual Qty (Actual Price – Selling Price)

Labor Rate Variance = Actual Hour (Actual Rate – Selling Rate)

labor efficiency variance = SR(AH - SH)