STANDARD COST: Definition, Benefits, and Limitations

standard cost

Standard cost accounting can be a very useful technique for managers trying to build a more realistic budget. At the end of the day, accurate budgets could lead to a more successful and efficient business. This is because a standard costing system gives managers an indication of predicted expenditure costs. These managers will be able to assess whether new business practices are required once they can compare standard expenses to actual costs. In this post, we will explain standard costing in accounting, discuss its pros and downsides, and show you how to compute a standard cost.

What is a Standard Cost?

Standard cost is an expected cost calculated by the company for the manufacture of products and services or the performance of an operation under normal conditions and is derived by the company using historical data analysis or time and motion studies. The company’s predetermined costs are used as the goal expenses.

The variance will be calculated by the company after comparing it to actual costs.

The generated variance is then used by the company’s management to determine and remedy the reason, make further projections for the next years, and make business decisions. It virtually always differs from the actual price since the situation is always changing, incorporating several uncontrollable elements. It is sometimes referred to as the standard cost.

Standard Cost Components

There are three main components in a manufacturing setup, which are as follows:

  • Direct Materials: It is calculated by multiplying the quantity of each material by the material cost per unit.
  • Direct labor: It is calculated by multiplying the quantity of each work by the per hour labor cost.
  • Overhead: It includes both fixed and variable overhead costs, which are computed by multiplying the standard amount by the standard variable overhead rate.

How to Create a Standard Cost

Knowing how to compute a standard cost is the first step toward creating one. When developing a standard cost, consider the following steps:

#1. Determine the direct material, direct labor, and overhead costs.

To calculate these charges, multiply the rate of each by the quantity (in units or hours).

For instance, if the direct supplies cost $10 and the standard amount is 20 pounds per unit, multiply $10 by 20 to get $200. This is the standard cost for solely the direct materials. Assume the direct labor rate is $15 and the standard hours per unit is 10 hours. This means that the standard cost of direct labor is $150. Assume the overhead is $10 and the number of hours is 5. This means that the standard overhead cost is $50 because $10 multiplied by 5 equals $50.

#2. Determine the standard cost

Once you’ve found the standard cost for each of them, add them all up to get the total standard cost.

Following the example above, the standard cost for this production is $400 since $200 (direct materials standard cost) + $150 (direct labor standard cost) + $50 (overhead standard cost) = $400. (standard cost).

Why Do Businesses Use Standard Costs?

Companies budget using standard expenses since actual costs cannot yet be identified. This is because it is impossible to forecast a product’s demand or all of the variables that will affect its manufacturing costs during the manufacturing process.

This is not to say that actual costs will never be used; normally, a company’s accountant will update the variances on a regular basis as new information becomes available.

Standard costs not only assist a corporation in budgeting its spending but also in establishing product prices. Standard expenses are also known as “pre-determined costs,” “pre-set costs,” and “anticipated costs.”

If the standard costs are greater than the actual spending at the end of the fiscal year (or accounting period), the company is said to have a favorable variance. If the company’s actual costs were higher, the variance would be disadvantageous. These deviations can be broken down to find out exactly where in the production process the actual cost discrepancies between standard and actual are; for example, labor cost variances, material cost variances, and so on.

How Do You Calculate Standard Cost?

A corporation must conduct the following to determine the standard cost of a product:

Standard Cost Calculation Formula

Direct Labor + Direct Materials + Manufacturing Overhead = Standard Cost

Standard Cost Formula
  • Calculating Direct Labor

Hourly Rate x Hours Worked = Direct Labor

  • Direct Materials Calculation

Raw Materials x Market Price = Direct Materials

  • Calculating Manufacturing Overhead

Fixed Salary + Manufacturing Overhead (Machine hours x Machine rate)

Except for the hourly rates, all of these figures will have to be guessed.

Advantages of Standard Cost

There are several advantages to employing the standard cost technique. Standard pricing:

#1. Allows a business to budget

Without standard costing, it is impossible to build a budget for a company that manufactures a product. The budget can be finalized once a dollar amount is allotted to labor, materials, and manufacturing overhead.

A budget is always an estimate that is afterward compared to the actual amounts spent in order to create a more realistic budget for the following year. Assuming no significant product or manufacturing changes occur year after year, the sizes of the variations can be reduced.

#2. It means that a company can assign a monetary value to its inventory.

To calculate inventory value, a corporation simply multiplies the amount of real inventory by the standard cost of each item. Because the “standard” cost is being used in the computation, the amount will not be exact, but it will be near to the actual cost if the company has been conducting this type of production for a while.

It is simpler to calculate inventory using standard costs than actual expenses. This is because, in actuality, one batch of a product may cost more to make than another batch of the identical product. Perhaps there were manufacturing delays on the line, requiring personnel to work overtime to complete the second batch. Imagine these kinds of issues occurring all the time, making it impossible to keep track of the facts.

Yes, those extra costs will eventually be accounted for by being added to the variance cost, but in order to keep things simple, an inventory valuation will normally use the standard costing technique.

#3. Allows a company to set its own product price

It would be impossible to set a price for a product without the information provided by standard costing. This is because the pricing is based in part on the costs of creating those goods (including labor, materials, and overhead costs).

#4. Allows for the faster and easier production of financial records

Taking the time to update actual costs on a regular basis entails a lot of numerical adjustments for a company’s accountant. Standard costs are based on the assumption that prices do not fluctuate. As a result, financial reports for a company’s management can be prepared more easily and quickly.

#5. Benchmarking is possible.

The standard costs connected with a company’s products enable management to establish benchmarks against which actual costs can be compared. That’s fantastic if the benchmarks are reached. If not, and there is an adverse variance, the corporation might attempt to identify savings in the manufacturing process to reduce such costs in the future.

Disadvantages of Standard Cost

Standard costing has certain drawbacks as well. Standard cost:

#1. Assumes very minor changes to the estimated costs

The standard costing technique expects that the budgeted amounts will change little in the near future. However, if a product is unexpectedly withdrawn or a new one is introduced, or if there are new efficiencies or weaknesses in the manufacturing process, large deviations from the projections can occur.

#2. Frequently fails to provide enough information to differentiate product units

When a corporation has a very complicated production system that produces several things, it is often impossible to isolate the standard costs for one product unit. Analyzing a product unit can assist a corporation in determining its worth; however, it must be done using actual costs rather than standard costs.

#3. Concentrates on Unfavorable Variances

Favorable variations are frequently overlooked, while negative deviations are investigated. This can cause issues with employees because the manufacturing process, including how labor is used, is frequently reviewed when adverse variations occur. Staff may believe their performance is being questioned when it is feasible that the projections were too low to begin with and that the line is already running efficiently.

Standard Cost Variance

The difference between the actual cost incurred and the standard cost against which it is compared is referred to as a variance. A variance can also be used to calculate the difference between actual and anticipated sales. As a result, variance analysis can be used to evaluate both revenue and expense performance.

There are two primary sorts of deviations from a standard that might occur: rate variation and volume variance. More information on both types of variations may be found here:

#1. Rate variance:

A rate variance (sometimes known as a pricing variance) is the difference between the actual and projected price of something multiplied by the actual quantity purchased. The term “rate” variation is most usually used to refer to the labor rate variance, which compares the actual cost of direct labor to the standard cost of direct labor. When applied to the purchase of materials, the rate variance is referred to as the buy price variance or the material price variance.

#2. Volume Variance

A volume variation is defined as the difference between the actual amount sold or consumed and the budgeted amount multiplied by the standard price or cost per unit. When the variance is related to the sale of goods, it is referred to as the sales volume variance. When it comes to the usage of direct materials, it is referred to as material yield variance. The labor efficiency variance is used when the variable is related to the usage of direct labor. Finally, if the variance is related to the use of overhead, it is referred to as the overhead efficiency variance.

As a result, variations are based on either change in cost or changes in quantity from the predicted amount. The most typical deviations reported by a cost accountant are separated into rate and volume variance categories for direct materials, direct labor, and overhead. These differences might also be reported as revenue.

Calculating and reporting on deviations is not always deemed realistic or even necessary unless the resulting information can be used by management to improve a company’s operations or cut its expenses. When a deviation is thought to have a practical application, the cost accountant should thoroughly investigate the cause of the variance and submit the findings to the appropriate manager, possibly along with a suggested course of action.

Is there a Distinction Between a Standard Cost and a Budget?

A budget is not the same as a standard cost.

A budget is a projection of spending for a particular accounting period, usually a quarter or year. Standard costs are estimations that are used for totals in some of the budget’s line items since they are tied to manufacturing costs.

Conclusion

It is the cost that the corporation estimates will occur during the production of goods or services, i.e., the amount the company intends to spend on production. It is used by management to plan the process of future output, strategies to boost efficiency, and to determine the reasonableness of the period’s real expenses. However, determining the standard cost of production is a complex task that necessitates a high level of technical skill as well as the efforts of the person in charge of doing so.

Standard Cost FAQs

What is a standard cost for material?

The standard materials cost of any product is simply the standard quantity of materials required multiplied by the standard price of those materials.

Why do companies use standard costs?

Companies budget using standard costs since actual costs cannot yet be identified. This is because it is impossible to forecast a product’s demand or all of the variables that will affect its manufacturing costs during the manufacturing process.

What is a disadvantage of using standard costs?

The downsides include the time, work, and cost involved in developing a standard costing method.

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