CASE STUDY 1 - SETTING STANDARD COSTS

Samel and Melsa are both managers of a manufacturing company. They are discussing the issue of setting cost standards for their products which would be used as a basis for cost control and measuring performance. Whereas they agree on the importance of setting the correct standards, they disagree on what constitutes a correct standard.

Melsa believes that cost standard must be ideal (perfection) that is must be one that can be attained only under nearly perfect operating conditions. She believes that standards must assume peak efficiency, the lowest possible input prices, the best-quality materials obtainable, and no disruptions in production due to such causes as machine breakdowns or power failures. She is convinced that perfection standards help achieve the lowest production cost by motivating employees to achieve the lowest cost possible. She claims that since the standard is theoretically attainable, employees will have an incentive to come as close as possible to achieving it.

Samel disagrees with Melsa as he feels that perfection standards discourage employees, since they are so unlikely to be attained. He believes that setting unrealistically difficult standards may encourage employees to sacrifice product quality to achieve lower costs. He contends that by skimping on raw-material quality or the attention given to manual production tasks, employees may be able to lower the production cost. However, this lower cost may come at the expense of a higher rate of defective units. Thus, the firm ultimately may incur higher costs than necessary as defective products are returned by customers or scrapped upon inspection.

Required

You have just finished studying a Management course and they have called upon you to assist them to arrive at a decision. Critique the positions for each manager and provide your recommendation on setting of standard costs.