WHAT IS STANDARD COSTING? Definition and Advantages

standard costing

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, discuss its advantages and disadvantages, and show you the relation between variance analysis and standard cost accounting.

What is Standard Costing?

Standard costing is the practice of determining the cost of a manufacturing process. Standard costing is a type of cost accounting in which a manufacturer, for example, plans their costs for the following year on several expenses such as direct material, direct labor, and overhead. These producers will also be able to compare standard prices to actual prices.

A variance is a difference between the standard cost and the actual cost. Variance implies a divergence from what was recorded in the profit plan. If actual costs exceed standard expenses, management might predict a lesser profit than planned. However, if actual expenses are lower than standard costs, management may expect a bigger profit than they anticipated.

The Advantages of Standard Costing

Standard costing offers managers various benefits that might help their organization run more efficiently. Here are a couple of such examples:

#1. Efficiency

A standard costing system calculates anticipated costs quickly. While accurate reports are desirable, they are not timely. A good cost estimate supplied quickly is greatly preferred.

#2. Allows for cost management

Managers are allowed to correct any discrepancies if there are any. This will allow them to better cost control. This means individuals can be more conscious of their spending habits in the future and try for little to no variation.

#3. Aids management in making decisions

Standard costing can also have an impact on how a company functions as a whole. Once management has identified any deviations, they can act to enhance present business methods and spending.

For example, if the actual cost of materials is $50,000 and exceeds the standard cost of $10,000, there will be a $40,000 variance.

Managers can then start looking into why the variable occurred and how to avoid it in the future. The high variance in this situation could be due to a variety of factors, including inflation or improper utilization of acquired products.

#4. Accurate Budgets 

When managers utilize the standard costing system to control expenses, the real costs in the future should be close to the standard costs. This result is quite beneficial because it indicates that the profit strategy was followed exactly as planned. In the future, this could lead to more accurate budgets.

#5. Reduced production costs

When using a standard cost system, decreased production costs could be an advantage. Employees may become more cost-conscious, and efficient, and perform better as a result of standard costing, which allows others to visualize their spending habits. This could result in cheaper total production costs.

Standard Costing Disadvantages

Standard costing provides several advantages for company operations, but it also has some disadvantages. The following are some drawbacks of implementing a standard costing system:

#1. Slow response

Because variance reports are only created monthly and it takes time for this information to be disseminated, the information may be out of date by the time it is eventually released. This can be avoided by producing more regular and timely reports.

#2. Low Morale 

Most managers are more concerned with problems than with achievement. In terms of standard cost, they may be spending more time correcting any deviations than they are applauding staff on a job well done. Employees require positive reinforcement in order to enjoy their jobs and feel like they are an important part of the company. The use of a standard costing system may raise the likelihood of low staff morale.

#3. Employee retaliation

Employees may conceal any adverse variance reports to prevent future punishments due to low morale. This would mislead managers about their earnings projections. Knowing the outcomes of previous variance reports may also lead to employees making decisions that negatively impact the firm. Employees may raise output at the end of the month in order to prevent a bad report. This could result in a lower-quality product.

The Nature and Function of the Standard Costing System

The primary goal of standard cost is to give management information on day-to-day operation control.

Standard costs are preset costs that serve as a foundation for more effective cost control. Standard cost provides a benchmark against which actual business costs can be assessed and examined.

The gap between actual and standard expenses is referred to as variance. Variance is found and thoroughly examined before being reported to managers to determine appropriate remedial measures.

Applicability of Standard Costing

Standard costing is relevant in a variety of situations. It necessitates the following:

  • A sufficient volume of a standard product should be produced as an output.
  • Standardization should be possible for manufacturing methods, operations, and processes.
  • The costs should be manageable.

Standard costing approaches have been successfully implemented in all industries that manufacture standardized products or use process costing methodologies.

Sugar, fertilizers, cement, footwear, breweries and distilleries, and other sectors are examples.

Standard costing approaches can also be used by public utilities such as transportation corporations, energy supply companies, and waterworks to manage costs and boost efficiency.

The approach cannot be used advantageously in jobbing industries or industries that create non-standardized items.

The Goals of Using a Standard Costing System

There are various objectives that a standard costing system can help achieve inside an organization.

To begin, a standard costing system can be used to control expenses, primarily by establishing criteria for each type of cost incurred: material, labor, and overhead.

This also aids in the analysis of variance, allowing managers to be more effective in reducing the expenditures for which they are held accountable.

The second goal that a standard costing system can fulfill is to assist in budgeting. Third, such a system can give useful and precise data for managerial planning and decision-making.

Fourth, a standard costing system can be utilized to evaluate staff and management performance and efficiency.

Finally, standard costing is a control strategy that is applied after the feedback control cycle. As a result, the feedback system may help to reduce undesired costs in the future, perhaps resulting in cost savings.

Considerations Before Implementing a Standard Costing System

Several preliminary considerations must be made before considering whether to employ standard costing in a business. These preliminary measures are:

#1. Creating Cost Centers

A cost center is a location, person, or piece of equipment (or a set of these) for which costs can be calculated and utilized for cost control.

Personal cost centers and impersonal cost centers are both possible. Personal cost centers are those that are associated with a person, whereas impersonal cost centers are those that are associated with a location or piece of equipment.

To allocate duties and identify lines of authority, cost centers must be established.

#2. Account classification and codification

Account classification or grouping is required for standard costing.

Accounts should be classified in a way that clearly and precisely reflects the cost elements of each cost center. To make cost collecting and analysis more efficient and convenient, distinct accounts are allocated codes and symbols.

#3. Types of Standards

A standard is a predetermined measurement of materials, labor, or overhead costs. It reflects what is expected of plant and employees under given situations.

A standard is fundamentally a quantity expression, whereas a standard cost is its monetary equivalent (i.e., quantity multiplied by price). It indicates what the cost should be.

The fundamental question in establishing standards is determining the type of standard to be used in cost determination. Ideal, fundamental, and currently attainable standards are the three main types of standards.

#1. Ideal Standards

Ideal standards, often known as perfection standards, are based on maximum efficiency and no unscheduled work stoppages.

They are high criteria that may never be met in practice. They indicate the level of achievement that could be attained if all conditions were ideal all of the time.

Ideal standards are only successful when persons are aware of them and are rewarded for meeting a particular proportion (e.g., 90%) of the standard.

#2. Basic Standards

Basic standards are long-term standards that do not change when they are computed for the first time. They are forecasts that are rarely altered or modified to account for changes in products, prices, and processes.

Basic standards serve as a foundation for comparing actual expenses over time to a consistent standard. They are generally used to track trends in operational performance.

#3. Currently Attainable Standards 

A standard that is now attainable is one that represents the best feasible performance. It is doable with reasonable effort (that is, assuming the company performs at a “high” level of efficiency and effectiveness).

These criteria provide for common recurring interferences like machine breakdowns, delays, rest intervals, inevitable waste, and so forth.

It is considered that these are unavoidable and inevitable interruptions. However, no concessions are made for any avoidable output interferences.

The most common standard is the currently attainable standard, and standards of this type are attractive to employees since they provide a concrete objective and challenge to them.

#4. Creating Standards or Creating a Standard Costing System

Establishing a standard costing system for goods, labor, and overheads is a difficult process that necessitates the involvement of several executives.

A Standards Committee has been formed for this purpose. The Standards Committee is made up of the following individuals: Production Manager, Purchase Manager, Personnel Manager, Production Engineer, Sales Manager, and a Cost Accountant.

The Budget and Standards Committees can be consolidated into a single committee.

The Standards Committee is in charge of standardization. It also aids in the successful application of standards, as well as the implementation of essential revisions when new circumstances render prior standards outdated.

Before establishing standards, a thorough examination of the functions involved in the product’s manufacture is required.

The essential criterion to be observed when setting standard prices is that the specified standards are reachable so that they can be used as yardsticks for measuring the efficiency of actual performances.

Standard costs necessitate the consideration of quantities, prices or rates, and quality or grades for each cost factor that enters a product (i.e., materials, labor, and overheads).

Variance Analysis and Standard Costing

The creation of cost standards for operations and their periodic analysis to find the reasons for any variations is referred to as standard costing. Standard costing is a tool that assists management in cost control.

For example, a corporation forecasts that labor costs should be $2 per unit at the start of the year. Such standards are developed through either a cost trend analysis or an estimation by any engineer or management scientist. After a period of time, say one month, the corporation compares the actual cost per unit, say $2.05, to the standard cost and assesses whether or not it has succeeded in cost management.

Variance analysis compares real costs to standard costs and is critical for cost control and discovering ways to improve efficiency and profitability. An unfavorable variance occurs when the actual cost exceeds the standard costs. A positive variance occurs when the actual cost is less than the standard cost.

Direct material costs (price and quantity variances); Direct labor costs (wage rate and efficiency variances); and Overhead expenditures are typically subjected to variance analysis.

Analysis of the variance between planned and actual sales, as well as sales margin, is also necessary to assure profitability.

In Conclusion,

Standard costing can help determine the profitability of a corporation at any level of production. It is also helpful in practical management activities such as planning and controlling.

Frequently Asked Questions

What is standard cost example?

Examples of standard cost include rent payable, utilities payable, insurance payable, salaries payable to office staff, office supplies

What is another name for standard cost?

Another name for standard cost is preset cost

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