Question

a) How do standard costs are developed.

b) How do we calculate and interpret variances for direct materials.

c) What are the advantages and disadvantages of decentralization.

Answer 1

a)

Standard costs should be established by the authority or management so that the same may be acceptable. Establishment of standards may not be a simple task, depending on the nature of the product and the intricacies involved in its manufacture. In developing standards, the following should be taken into consideration:

1. The basic cost factors – physical and monetary. The physical factor relates to the unit of measurement of the cost elements involved in the production process, like the number of lumber units that are utilized to finish the boxes. The monetary factor relates to the amount paid for the physical factors, which in our illustration is the price per unit of lumber.

A formula is thereby formed from these cost factors:

Cost = Physical Factor multiplied by the Monetary Factor

Such formula will later be understood by presenting the data for Dollar Company.

2. Specification of the Product – this is necessary to determine the physical and monetary factors needed in the computation of the manufacturing elements, such as materials, labor, and factory overhead.

The following specifications are set up for BENGR:

Size of the Product: 2′ x 2′ x 2′ (2 feet long, 2 feet wide and 2 feet high)

Color : walnut (varnish)

The cost accountant therefore should remember that in creating standards for the elements of costs (direct material, direct labor and factory overhead) the two most important things are considered: the physical aspect (units of materials, number of hours worked) and the monetary factor (price per unit material and the labor rate per hour).

Standards can be set up for any kind of business activities but they are most useful to manufacturing because a manufacturing processing is quite complicated compared to a trading or a service concern business.

b)

The total direct materials variance is comprised of two components: the direct materials price variance and the direct materials quantity variance.

To compute the direct materials price variance, take the difference between the standard price (SP) and the actual price (AP), and then multiply that result by the actual quantity (AQ):

Direct materials price variance = (SP – AP) x AQ

To get the direct materials quantity variance, multiply the standard price by the difference between the standard quantity (SQ) and the actual quantity:

Direct materials quantity variance = SP x (SQ – AQ)

The total direct materials variance equals the difference between total actual cost of materials (AP x AQ) and the budgeted cost of materials, based on standard costs (SP x SQ):

Total direct materials variance = (SP x SQ) – (AP x AQ)

For example, Band Book’s standard price is $10.35 per pound. The standard quantity per unit is 28 pounds of paper per case. This year, Band Book made 1,000 cases of books, so the company should have used 28,000 pounds of paper, the total standard quantity (1,000 cases x 28 pounds per case). However, the company purchased 30,000 pounds of paper (the actual quantity), paying $9.90 per case (the actual price).

Based on the given formula, the direct materials price variance comes to a positive $13,500, a favorable variance:

Direct materials price variance = (SP – AP) x AQ = ($10.35 – $9.90) x 30,000 = $13,500 favorable

This variance means that savings in direct materials prices cut the company’s costs by $13,500.

The direct materials quantity variance focuses on the difference between the standard quantity and the actual quantity, arriving at a negative $20,700, an unfavorable variance:

Direct materials quantity variance = SP x (SQ – AQ) = $10.35 x (28,000 – 30,000) = –$20,700 unfavorable

This result means that the 2,000 additional pounds of paper used by the company increased total costs $20,700. Now, you can plug both parts in to find the total direct materials variance. Compute the total direct materials variance as follows:

Total direct materials variance = (SP x SQ) – (AP x AQ) = ($10.35 x 28,000) – ($9.90 x 30,000) = $289,800 – $297,000 = –7,200 unfavorable

Diagramming direct materials variances

The following figure provides an easier way to compute price and quantity variances. To use this diagram approach, just compute the totals in the third row: actual cost, actual quantity at standard price, and the standard cost.

The actual cost less the actual quantity at standard price equals the direct materials price variance. The difference between the actual quantity at standard price and the standard cost is the direct materials quantity variance. The total of both variances equals the total direct materials variance.

To apply this method to the Band Book example, take a look at the next diagram. Start at the bottom. Direct materials actually cost $297,000, even though the standard cost of the direct materials is only $289,800. The actual quantity of direct materials at standard price equals $310,500.

To compute the direct materials price variance, subtract the actual cost of direct materials ($297,000) from the actual quantity of direct materials at standard price ($310,500). This difference comes to a $13,500 favorable variance, meaning that the company saves $13,500 by buying direct materials for $9.90 rather than the original standard price of $10.35.

To compute the direct materials quantity variance, subtract the actual quantity of direct materials at standard price ($310,500) from the standard cost of direct materials ($289,800), resulting in an unfavorable direct materials quantity variance of $20,700. Because the company uses 30,000 pounds of paper rather than the 28,000-pound standard, it loses an additional $20,700.

This setup explains the unfavorable total direct materials variance of $7,200 — the company gains $13,500 by paying less for direct materials, but loses $20,700 by using more direct materials.

c)

Decentralization refers to a specific form of organizational structure where the top management delegates decision-making responsibilities and daily operations to middle and lower subordinates. The top management can thus concentrate on taking major decisions with greater time abundance. Business houses often feel the requirement of decentralization to continue efficiency in their operation. Today, we are going to take a look at the basic advantages and disadvantages of decentralization from an organizational point of view.

Advantages and Disadvantages Of Decentralisation

Advantages of Decentralisation

Motivation of Subordinates

Decentralization improves the level of job satisfaction as well as employee morale, especially amongst the lower level managers.

Furthermore, it strives to satisfy the varying requirements for participation, independence, and status. Decentralization also promotes a spirit of group cohesiveness and spirit.

Growth and Diversification

Under decentralization, every single product division attains sufficient autonomy to exercise their creative flair. In this way, the top-level management can create healthy competition amongst different divisions.

While carrying out a discussion on the advantages and disadvantages of decentralization, it is imperative to note that it aids subordinates in exercising their own judgment.

They even develop managerial skills and help in solving the succession problem which ultimately ensures the growth and continuity of an organization.

Quick Decision Making

Another important pointer in the advantages and disadvantages of decentralization is that decisions are taken and executed by authorized personnel. This, in turn, results in faster and accurate decisions which are well aware of the real scenario.

Efficient Communication

The wider span of management under decentralization leads to fewer hierarchical level. This makes the communication system more efficient as intimate relationships develop between superiors and subordinates.

Ease of Expansion

Decentralization can add inertia to the expansion process of a growing business. This might often result in the opening of new business units in varying geographical locations.

Decentralization unleashes the fullest potential of the organization and can react easily to area-specific requirements.

Better Supervision And Control

Lower level managers can alter production schedules and work assignments with adequate authority. They can even take disciplinary actions and recommend the promotion of their peers.

This, in turn, leads to greater efficiency in supervision. Performance evaluation of each decentralized unit helps in exercising adequate control.

Satisfaction of Human needs

Decentralization serves as an important tool for satisfying our basic need of independence, power, prestige, and status. A cadre of satisfied manager is build up by this satisfaction as they feel responsible towards the company’s betterment.

Relief to top executives

Top executives can focus more on more on the executive level work like planning and decision making if the lower level employees take all the responsibilities on their own. This relieves their workload which eventually is for the greater good of the organisation.

Disadvantages of Decentralization

Difficult To Co-Ordinate

While talking about the advantages and disadvantages of decentralization, it is imperative to note that substantial autonomy is enjoyed by every single division. This, in turn, makes it difficult to coordinate the overall activity.

External Factors

The trade union movement, market uncertainties, and government intervention might make it impossible to benefit the most out of decentralization.

Narrow Product Lines

Decentralized product lines need to be adequately broad so that autonomous units can flourish within the same. This might not be of much help in small business houses having narrow product lines. Lower levels in the organization also lack competent managers thus adding to the difficulty quotient.

Expensive

In decentralisation, every employee takes responsibility for the better of the organisation so they work harder to achieve all the organisational objective. In return, they have to be paid more which sometimes proves to be very expensive for the company.