Understanding Quantity and Price Standards in Management Accounting
What are Quantity and Price Standards?
A standard is a benchmark or “norm” used to measure performance. In management accounting, two types of standards exist:
- Quantity standards specify how much of an input should be used to make a product or provide a service.
- Price (cost) standards specify how much should be paid for each unit of the input.
Actual quantities and costs are compared to these standards. Deviations from standards deemed significant are brought to the attention of management, a practice known as management by exception.
Ideal vs. Practical Standards
Ideal standards can be attained only under the best circumstances. They allow for no machine breakdowns or other work interruptions, and they call for a level of effort that can be attained only by the most skilled and efficient employees working at peak effort 100% of the time. Practical standards are standards that are “tight but attainable.” They allow for normal machine downtime and employee rest periods, and they can be attained through reasonable, though highly efficient, efforts by the average worker. Variances from practical standards typically signal a need for management attention because they represent deviations that fall outside of normal operating conditions. Furthermore, practical standards can serve multiple purposes. In addition to signaling abnormal conditions, they can also be used in forecasting cash flows and in planning inventory. By contrast, ideal standards cannot be used for these purposes because they do not allow for normal inefficiencies and result in unrealistic forecasts.
Impact of Unattainable Standards on Productivity
When managers set ideal standards instead of practical ones, employees may become discouraged. Managers may argue that even though employees know they will rarely meet the standard, it is a constant reminder of the need for ever-increasing efficiency and effort. However, few organizations use ideal standards. Most managers feel that ideal standards tend to discourage even the most diligent workers, decreasing their productivity. Moreover, variances from ideal standards are difficult to interpret. Large variances from the ideal are normal, making it difficult to “manage by exception.”
Standard vs. Budget
Standards and budgets are very similar. The major distinction is that a standard is a unit amount, whereas a budget is a total amount. For example, if the standard cost for direct materials is $12 per pair of bookends, and 1,000 pairs of bookends are to be made, then the budgeted cost of direct materials would be $12,000. In effect, a standard can be viewed as the budgeted cost for one unit of product.
What is a Variance?
Differences between standard prices and actual prices, and between standard quantities and actual quantities, are called variances. The act of computing and interpreting variances is called variance analysis.
What is Management by Exception?
Management by exception is a system in which standards are set for various activities, with actual results compared to these standards. Significant deviations from standards are flagged as exceptions. Quantity and cost standards are set for each major input, such as raw materials and labor time. If either the quantity or the cost of inputs departs significantly from the standards, managers investigate the discrepancy to find the cause of the problem and eliminate it.
Why Compute Separate Price and Quantity Variances?
Quantity and price standards are determined separately for two reasons:
- The purchasing manager is responsible for raw material purchase prices, and the production manager is responsible for the quantity of raw material used.
- The buying and using activities occur at different times. Raw material purchases may be held in inventory for a period before being used in production.