Developing standards and budgetary control | CMA Other budgeting concepts

Developing standards for direct materials and direct labor

The process of developing standards for direct materials (DM) and direct labor (DL) involves several steps. These standards provide benchmarks for budgeting and performance evaluation, ensuring that the organization operates efficiently. The following is a general step-by-step process for developing DM and DL standards:

Five-step flowchart for developing direct material and direct labor standards, from analysis to finalization. — Developing DM and DL Standards

Step 1. Analyze operational requirements

Begin by identifying the specific materials and labor required to complete a production process. This includes determining the types and quantities of materials needed for each unit of production and the types of labor (skilled, unskilled) necessary to complete each task.

Step 2. Estimate standard costs for DM and DL

Estimate the standard costs for direct materials (DM) and direct labor (DL). This involves determining:

The standard quantity of DM needed per unit of output and the expected cost per unit of material.
The standard time of DL required to complete each task and the expected labor rate per hour.

Two commonly used techniques for developing these cost standards are:

Activity analysis: This involves analyzing the specific activities that contribute to the production process and identifying where efficiencies or inefficiencies occur in order to develop standard costs.
Time and motion study: A time and motion study involves analyzing a process or task by observing the time taken for each step and the specific movements involved. This data helps pinpoint areas for optimization and allows for the development of more precise standards.

Other approaches, such as benchmarking against industry standards and lean manufacturing techniques, can also help set standards that are competitive and efficient.

Step 3. Incorporate waste and inefficiency factors

Adjust the standard quantities and times to account for normal levels of waste, downtime, and inefficiency. This ensures that the standards reflect real-world conditions and are not overly optimistic.

Example: Standard cost per unit

A product requires 4 lbs of usable material per unit, with normal waste equal to 20% of material input. Material costs $3.00 per lb. The product also requires 2 hours of direct labor per unit, plus 0.25 hours of normal downtime, at a labor rate of $20 per hour.

Standard quantity of input needed: $4 \div (1 - 0.20) = 5$ lbs

Standard material cost per unit: $5 \times $3.00 = $15.00$

Standard labor time per unit: $2 + 0.25 = 2.25$ hours

Standard labor cost per unit: $2.25 \times $20 = $45.00$

Answer: Standard prime cost per unit = $15.00 + $45.00 = $60.00

Notice that the waste allowance above is stated as a percentage of input, so it’s built into the standard by dividing by (1 − waste %) - not by multiplying by (1 + waste %), which would understate the standard quantity needed.

Step 4. Consult suppliers and historical data

For direct materials, consult suppliers to get up-to-date pricing and evaluate historical purchase data to refine material cost estimates. For direct labor, review historical payroll data and consider expected wage increases or adjustments.

Step 5. Review and finalize standards

Collaborate with relevant department managers and employees to review the proposed standards. Ensure that they are realistic, achievable, and aligned with operational goals before finalizing them for budgeting and performance evaluation.

Definitions

Ideal standard: A standard that assumes perfect efficiency, with no waste, downtime, or interruptions. Ideal standards are rarely met in practice, so they tend to produce unfavorable variances and can discourage employees.
Currently attainable standard: A standard that allows for normal waste, downtime, and inefficiency, like the one built in step 3 above. It’s realistic enough to motivate employees while still being achievable.
Authoritative standard: A standard set by management without input from the employees who must meet it. This is faster to set, but tends to get less buy-in from the people responsible for achieving it.
Participative standard: A standard set with input from the employees who must meet it. This usually improves buy-in, but creates a risk of budgetary slack if employees understate what they can achieve.

Budget revision policy

A successful budgeting process should include a policy that allows for budget revisions to accommodate significant changes in assumptions. Economic conditions, market shifts, and operational changes may require adjustments to the original budget. A budget process should allow for these revisions, ensuring that the organization can respond to new circumstances without losing sight of its objectives. By regularly revisiting the assumptions behind the budget, management can make timely adjustments and avoid disruptions that could impact financial performance or strategic initiatives.

Watch out: reserve revisions for significant, lasting changes in assumptions - revising too often undermines accountability, weakens financial discipline, and erodes trust in the budget as a planning tool.

Monitoring and controlling expenditures

Budgets serve as a powerful tool for monitoring and controlling expenditures by:

1. Setting financial targets

Budgets establish expected spending levels for each department or project, serving as a benchmark against which actual expenditures are compared.

2. Variance analysis

Regular comparison of actual spending to the budget allows for the identification of variances (differences between budgeted and actual costs), highlighting areas where costs are exceeding expectations.

For variable costs, compare actual spending to a flexible budget restated at the actual output level, not the original static budget - otherwise a change in volume looks like overspending or savings. We cover this comparison in detail in the chapters on flexible budgets and the sales volume variance.

3. Accountability

By assigning specific budgetary responsibilities to department managers, budgets help ensure that individuals are accountable for managing their resources effectively.

This works best when managers are judged only on costs they can control (controllable costs), rather than costs allocated to them from elsewhere.

4. Cost control

Budgets encourage managers to monitor their spending closely and make adjustments when actual costs begin to exceed budgeted amounts, helping to avoid unnecessary expenses.

5. Resource allocation

Budgets provide a framework for deciding how to allocate financial resources, ensuring that funds are directed toward priority areas that align with the organization’s strategic goals.

Budgetary slack and goal congruence

Definitions

Budgetary slack: This occurs when managers intentionally overestimate costs or underestimate revenues in their budgets to make targets easier to achieve. While this might provide a buffer for the department, it can lead to inefficiencies and misallocation of resources.

Slack is most likely to arise under participative budgeting, particularly when manager bonuses depend on beating the budget. Organizations can limit it through top-management review of submitted budgets, comparison against historical data and industry benchmarks, and incentives that reward forecast accuracy rather than just beating targets.

Budgetary slack undermines goal congruence, which is the alignment of individual managers’ goals with the overall objectives of the organization. If managers prioritize their departmental interests over the organization’s strategic goals, it can distort the budgeting process and hinder the company’s ability to achieve its long-term objectives.

Developing standards for direct materials and direct labor

Step 1. Analyze operational requirements

Step 2. Estimate standard costs for DM and DL

Estimate the standard costs for direct materials (DM) and direct labor (DL). This involves determining:

The standard quantity of DM needed per unit of output and the expected cost per unit of material.
The standard time of DL required to complete each task and the expected labor rate per hour.

Two commonly used techniques for developing these cost standards are:

Activity analysis: This involves analyzing the specific activities that contribute to the production process and identifying where efficiencies or inefficiencies occur in order to develop standard costs.
Time and motion study: A time and motion study involves analyzing a process or task by observing the time taken for each step and the specific movements involved. This data helps pinpoint areas for optimization and allows for the development of more precise standards.

Other approaches, such as benchmarking against industry standards and lean manufacturing techniques, can also help set standards that are competitive and efficient.

Step 3. Incorporate waste and inefficiency factors

Example: Standard cost per unit

A product requires 4 lbs of usable material per unit, with normal waste equal to 20% of material input. Material costs $3.00 per lb. The product also requires 2 hours of direct labor per unit, plus 0.25 hours of normal downtime, at a labor rate of $20 per hour.

Standard quantity of input needed: $4 \div (1 - 0.20) = 5$ lbs

Standard material cost per unit: $5 \times $3.00 = $15.00$

Standard labor time per unit: $2 + 0.25 = 2.25$ hours

Standard labor cost per unit: $2.25 \times $20 = $45.00$

Answer: Standard prime cost per unit = $15.00 + $45.00 = $60.00

Step 4. Consult suppliers and historical data

Step 5. Review and finalize standards

Definitions

Ideal standard: A standard that assumes perfect efficiency, with no waste, downtime, or interruptions. Ideal standards are rarely met in practice, so they tend to produce unfavorable variances and can discourage employees.
Currently attainable standard: A standard that allows for normal waste, downtime, and inefficiency, like the one built in step 3 above. It’s realistic enough to motivate employees while still being achievable.
Authoritative standard: A standard set by management without input from the employees who must meet it. This is faster to set, but tends to get less buy-in from the people responsible for achieving it.
Participative standard: A standard set with input from the employees who must meet it. This usually improves buy-in, but creates a risk of budgetary slack if employees understate what they can achieve.

Budget revision policy

Monitoring and controlling expenditures

Budgets serve as a powerful tool for monitoring and controlling expenditures by:

1. Setting financial targets

Budgets establish expected spending levels for each department or project, serving as a benchmark against which actual expenditures are compared.

2. Variance analysis

3. Accountability

By assigning specific budgetary responsibilities to department managers, budgets help ensure that individuals are accountable for managing their resources effectively.

This works best when managers are judged only on costs they can control (controllable costs), rather than costs allocated to them from elsewhere.

4. Cost control

Budgets encourage managers to monitor their spending closely and make adjustments when actual costs begin to exceed budgeted amounts, helping to avoid unnecessary expenses.

5. Resource allocation

Budgets provide a framework for deciding how to allocate financial resources, ensuring that funds are directed toward priority areas that align with the organization’s strategic goals.

Budgetary slack and goal congruence

Definitions

Budgetary slack: This occurs when managers intentionally overestimate costs or underestimate revenues in their budgets to make targets easier to achieve. While this might provide a buffer for the department, it can lead to inefficiencies and misallocation of resources.