Standard Costs and Quality Costs

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STANDARD COSTS AND QUALITY COSTS

Meaning of Standards Establishing Cost Standards Components of Standard Cost Quality Cost
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Standard Cost
Standard costs represent a control technique. In a sense, they are a target, which the management attempts to achieve. The control process involves a comparison of the actual performance with the standards set by management. The extent of success would be revealed by the relationship between the actual and the standard. If the actual performance coincides with the target, the performance can be said to be satisfactory. In case of divergence or deviations, management would have to analyse the causes. These deviations are technically referred to as variance. Therefore, variance analysis is an important control concept related to standard costs. In other words, the variances which basically represent performance deviations are a significant element of the information base of an effective control system.
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Standard costs may be: (i) IDEAL, (ii) Expected, and (iii) Normal/Attainable.
Ideal standard cost The ideal standard cost refers to estimates of costs under ideal or perfect conditions. The assumption would be that there would be no waste, no scrap, no idle items, no machine breakdown, and so on.

Expected Standard Cost

The expected standard cost is based upon the most likely attainable result. Technically, it means what can happen and not what should happen.

Normal Standard Costs

Normal standard costs are costs which are attainable if operations/activities are efficient.
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ESTABLISHING COST STANDARDS

Engineering Estimates
Observed Behaviour Predicted Behaviour

Desired Behaviour.
The standard cost in a particular situation may be based on two or more of these techniques.
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Engineering Estimates One basis of setting up cost standards is engineering estimates. Technically, a standardised relationship between, say, a given unit of output and given units of input (say, raw materials) can be estimated fairly accurately depending upon the specifications of the machinery. Observed Behaviour Another technique to establish cost standards is past experience. Here, the approach is to treat the achievements of the past as standards for the future. If the processes and procedures of the past have not changed and are likely to operate in future also, this can provide a reliable guide for the future. If, however, changes occur in the processes and procedures, observed behaviour (what happened in the past) can certainly not provide a reliable basis for setting cost standards.

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Predicted Behaviour
It is also likely that certain changes, such as technological, may be in the offing. These are likely to have a bearing on the cost estimates. In such cases, what is most likely to happen, that is, predicted behaviour in terms of adjustment to the historical standard cost, can be used to set cost standards. Desired Behaviour Desired behaviour can also affect standard cost. The term desired behaviour means what management desires. The desire of the management may be based on the experience of similar concerns or the industry as a whole. This basis will bring the cost standards of the company in line with those of the industry as a whole.

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Components of Standard Cost

(i) Standard direct material cost

(ii) Standard direct labour cost

(iii) Manufacturing overheads

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Standard Direct Material Cost

Standard costs are costs that should be reasonably incurred in the manufacture of a product. Standard direct material cost = Price standards of direct material Quantity standard of direct material.

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Direct Materials Price Standard

One of the most important items of cost is the cost of direct materials used in the manufacture of goods. To exercise control over the cost, therefore, an important element of cost control is the price paid for the purchase of materials.

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Example 1
Hypothetical Ltd, on the basis of investigation of alternative sources of supply, decides to purchase raw materials from the most advantageous supplierABC Ltd which quotes a list price of Rs 1,820 per tonne, exclusive of freight charges. It also offers a quantity discount @ Rs 70 per tonne for orders exceeding 20 tonnes. It also allows 2 per cent cash discount for payment within 15 days. Moreover, freight charges are likely to be Rs 1,700 per carload (20 tonnes of materials) and payable directly to the carrier. Compute the standard materials price for Hypothetical Ltd. Solution: Computation of Standard Materials Price 1. List price (per tonne) 2. Less quantity discount (per tonne) Car load price 3. Less cash discount (0.02) 4. Add freight charges (Rs 1,700 20 tonnes) Standard price per tonne Rs 1,820 70 1,750 35 1,715 85 1,800
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Materials Quantity (Usage) Standard

The quantity of the materials used is the second factor affecting cost of material. Such standards can be determined on the basis of two factors: (i) The necessary input-output relationship between materials and products and also upon observation of actual experience, (ii) The inherent loss of materials in the production processes owing to factors such as weight losses due to scrapping and smoothing, shrinkage and evaporation, and so on.

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Example 2
Hypothetical Ltd of Example 1 produces a single product by using steel. Each finished product weighs 380 kgs. Past experience coupled with careful engineering studies show that a loss of 5 per cent occurs in the weight of the input material in the production process. What is the standard material usage per unit? Solution: Computation of Standard Materials Usage Per Unit Weight of finished product (kgs) Allowance for normal loss in the production process (0.05) Standard material usage 380 20 400

Two points in this connection are notable. First, there will be different quantity standards for different materials; and different standards may apply to the usage of a single material in different products/departments. Second, the material quantity standard does not provide for loss of materials due to: (1) Careless handling, (2) Damage to units in process, and (3) Other undesirable circumstances. In fact, the material usage standard is intended to eliminate such types of material losses.
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Total Material Cost Standard

The total material cost standard is computed by multiplying price standards by quantity standards.
Example 3 Continuing the case of Hypothetical Ltd of Examples 1 and 2, the standard price is Rs 1,800 per tonne; the standard quantity is 420 kgs per finished units of product. Compute the total standard material cost. Solution Standard material cost = (Standard usage Standard price per kg) Standard price per kg = Rs 1,800/ 2,000 = Rs 0.9 Standard material cost = Rs 0.9 400 = Rs 360

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Standard Direct Labour Cost

Standard direct labour cost is calculated by multiplying Labour rate standards by Labour time standards
Example 4 Assume that Hypothetical Ltd has two production departments. In the first, the current standard wage rate is Rs 48 per hour. In the second, the standard wage rate is Rs 50 per hour. This has to be related to the labour time standard to work out the total labour standard.

Total Labour Cost Standard The total labour cost standard is equal to
labour rate standard multiplied by labour time standard. (a) (b) (c) For Department 1 : Rs 48 1/4 hour For Department 2 : Rs 50 1/2 hour Total = Rs 12 = 25 = (a + b) 37

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Overheads Standards
The third component of cost standard is overheads. There is a basic difference between overheads standard and material and labour standards.

Overheads are, for purposes of planning and control, classified into: (i) Variable, and (ii) Fixed. The standard variable rate is set directly per unit of volume just as a normal variable rate. The volume measure is some measure of input, such as direct labour cost or hours. The determination of the standard fixed overhead is slightly different from that of the normal fixed overhead.

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Example 5
Assume that Hypothetical Ltd uses direct labour-hours as the basis to allocate overheads to production. The variable overhead is budgeted at Rs 16 per direct labour-hour in Department 1. The fixed manufacturing overhead is budgeted at a total of Rs 16,00,000 per year and normal production volume has been established at 4,00,000 direct labour-hour per year. In Department 1, variable manufacturing overhead is budgeted at Rs 10 per direct labour-hour and fixed overhead at Rs 12,00,000 per year. Normal production volume is 8,00,000 labour-hours per year. Compute the standard overhead rates. Solution Computation of Standard Overhead Rates Department 1
1. Standard fixed overhead rate per Labour-hour (Fixed overheads Normal production volume) 2. Variable overhead per unit (Standard labour time Variable overhead) 3. Fixed overhead per unit (Standard labour time Standard fixed overhead rate) Rs 4 (Rs 16,00,000/4,00,000)

Department 2
Rs 1.5 (Rs 12,00,000/8,00,00)

(1/4 hour Rs 16)

5.0

(1/2 hour Rs 10)

(1/4 hour Rs 4)

0.75 (1/2 hour Rs 1.5)

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Standard Cost Sheet

A summarised view of total standard cost is presented in the form of a standard cost sheet or standard cost card. The information about Hypothetical Ltd is presented in Table 1. Table 1: Hypothetical LimitedStandard Cost Sheet a) Direct material (400 kgs Rs 0.9) b) Direct labour: Department 1 Rs 12 Department 2 25 c) Variable manufacturing overhead: Department 1 4 Department 2 5 d) Fixed manufacturing overhead: Department 1 1.00 Department 2 0.75

Rs 360.00

37.00

9.00

1.75 407.75
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Quality Costs
Quality is the total features and characteristics of a product/service made/performed according to specifications to satisfy customers at the time of purchase and during use. Costs of quality are costs incurred to prevent or the cost arising as a result of, producing a low quality product. Such costs are categorised into prevention costs, quality appraisal (detection) costs, internal failure costs and external failure costs.
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Prevention Costs

Prevention costs are incurred to prevent defects and other quality problems/to preclude the production of goods that do into conform to specifications.
Quality Appraisal (Detection) Costs Quality appraisal costs are incurred to detect which individual unit of a product does not conform to specifications. Internal Failure Costs These costs are incurred as a result of the appraisal activities. These are incurred on a defective product before it is despatched to customers.

External Failure Costs

External failure costs are costs of making things right when a quality problem has occurred after the product has been delivered to the customer.
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Quality Costs Illustrated

Step 1: Identify the Chosen Product. Step 2: Select Cost-Allocation Base for Allocating Indirect Costs of Quality. Step 3: Identify Indirect Costs Associated With Each Cost-Allocation Base. Step 4: Compute the Rate Per Unit of Each Cost Allocation Base Used to Allocate Indirect Costs of Quality to Product. Step 5: Compute the Indirect Costs of Quality Allocated to the Product. Step 6: Compute the Total Costs of Quality by Adding All Costs of Quality Assigned to the Product. This is shown in Column 5 of Exhibit 1.
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Exhibit 1
Analysis of Activity-based Cost of Quality of Photocopying Machines of Modi Xerox Ltd. Cost of Quality Activities Rate (1) Prevention Costs: Design Engineering Process Engineering Total Appraisal Costs: Inspection Total Internal Failure Costs: Rework Total External Failure Costs: Customer support Transportation Warranty repair Total Total Cost of Quality (2) Rs 400 per hour 300 per hour 200 per hour 500 per hour 250 per hour 1,200 per hour 550 per hour Allocation Base/Cost Driver Quantity (3) 20,000 hours 22,500 hours 1,20,000 hours 50,000 hours 6,000 hours 1,500 hours 60,000 hours Total costs [(2) (3)] (4) Rs 80,00,000 67,50,000 1,47,50,000 2,40,00,000 2,40,00,000 2,50,00,000 2,50,00,000 15,00,000 18,00,000 3,30,00,000 3,63,00,000 10,00,50,000 Percentage of revenue [(4) Rs 70 crore] % (5) 1.1% 1.0 2.1 3.4 3.4 3.6 3.6 0.2 0.3 4.7 5.2 14.3 18-22

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Non-Financial Measures of Quality and Customer Satisfaction

Financial measures of quality focus on the short-run. Non-financial measures indicate the future needs and preferences of customers as well as the specific areas that need improvement.
The non-financial measures of customer satisfaction, inter-alia, include the following: Market research information on customer preferences/satisfaction with specific product features. Number of defective units delivered to customers as percentage of total units delivered. Number of customer complaints. Percentage of products that fail soon/often. Delivery delays in terms of differences between the scheduled delivery date and the date requested by the customers. On-time delivery rate (i.e. percentage of delivery made on/before the scheduled delivery date). Surveys to measure customer satisfaction.
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