Standard Costing: Definition, Advantages, Disadvantages

What is Standard CostingStandard costing compares the standard costs and revenues with the actual results of the process, finds the reasons for the variances, provides information about deviations to management for taking steps to improve it.

A standard costing system initially records the cost of production at standard.

Units of inventory flow through the inventory accounts (from work-in-process to finished goods to cost of goods sold) at their per-unit standard cost.

When actual costs become known, adjusting entries are made that restate each account balance from standard to actual (or to approximate such a restatement).

The components of this adjusting entry provide information about the company’s performance for the period, particularly about production efficiency and cost control.

What is ‘Standard’?

A standard is a benchmark for measuring performance. Another way of defining standard is that it is something that- is predetermined or planned and management wishes that actual results equate to standards.

Standards are one of the important quantitative tools in the hand of management to control and measure the performance of business operations.

However, it heavily depends on the type of standards used to decide about the control actions and to measure the performance.

Purpose of Standard Costing

Standard cost systems aid in planning operations and gaining insights into, the probable impact of managerial decisions on cost levels and profits. Standard costs are used for:

  1. Establishing budgets.
  2. Controlling costs, directing and motivating employees and measuring efficiencies.
  3. Promoting possible cost reduction.
  4. Simplifying costing procedures and expediting cost reports.
  5. Assigning costs to materials, work in process, and finished goods inventories.
  6. Forming the basis for establishing bids and contracts and for setting sales prices

Advantages / Benefit / Importance of Standard Costing System

Standard costing system has the following main advantages or benefits:

Helps in Management

The use of standard costs is a key elemental a management by exception approach. If costs remain within the standards, Managers can focus on other issues.

When costs fall significantly outside the standards, managers are alerted that there may be problems requiring attention. This approach helps managers focus on important issues.

Promote Economy and Efficiency

Standards that are viewed as reasonable by employees can promote economy and efficiency. They provide benchmarks that individuals can use to judge their performance.

Greatly Simplify Accounting and Bookkeeping

Standard costs can greatly simplify bookkeeping. Instead of recording actual costs for each job, the standard costs for materials, labor, and overhead can be charged to jobs.

Standard costs fit naturally in an integrated system of responsibility accounting. The standards establish what costs should be, who should be responsible for them, and what actual costs are under control.

Disadvantages / Problems / Limitations of Standard Costing System

The use of standard costs can present several potential problems or disadvantages.

Most of these problems result from improper use of standard costs and the management by exception principle or from using standard costs in situations in which they are not appropriate.

Can produce Infrequent and Useless Information

Standard cost variance reports are usually prepared every month and often are released days or even weeks after the end of the month. As a consequence, the information in the reports may be so stale that it is almost useless.

Timely, frequent reports that are approximately correct are better than infrequent reports that are very precise but out of date by the time they are released.

Some companies are now reporting variances and other key operating data daily or even more frequently.

Management’s Lack of Sensitivity

If managers are insensitive and use variance reports as a club, morale may suffer. Employees should receive positive reinforcement for work well done. Management by exception, by its nature, tends to focus on the negative.

If variances are used as a club, subordinates may be tempted to cover up unfavorable variances or take actions that are not in the best interest of the company to make sure the variances are favorable.

For example, workers may put on a crash effort to increase output at the end of the month to avoid an unfavorable labor efficiency variance. In the rush to produce output quality may suffer.

Problem with Labor and their Output-rate

Labor quantity standards and efficiency variances make two important assumptions.

First, they assume that the production process is labor-paced; if labor works faster, the output will go up.

However, output in many companies is no longer determined by how fast labor works; rather, it is determined by the processing speed of machines.

Second, the computations assume that labor is a variable cost.

However, direct labor may be essentially fixed, and then an undue emphasis on labor efficiency variances creates pressure to build excess work in process and finished goods inventories.

Problem with Misunderstanding Standards

In some cases, a “favorable” variance can be as bad or worse than an “unfavorable” variance. For example, McDonald’s has a standard for the amount of hamburger meat that should be in a Big Mac.

A “favorable” variance would mean that less meat was used than standard specifies. The result is a substandard Big Mac and possibly a dissatisfied customer.

Exclusion of Other Important Objectives

There may be a tendency with standard cost reporting systems to emphasize meeting the standards to the exclusion of other important objectives such as maintaining and improving quality, on-time delivery, and customer satisfaction.

This tendency can be reduced by using supplemental performance measures that focus on these other objectives.

Just Meeting Standards is not Sufficient

Just meeting standards may not be sufficient; continual improvement may be necessary to survive in the current competitive environment.

For this reason, some companies focus on the trends in the standard cost variances – aiming for continual improvement rather than just meeting the standards.

In other companies, engineered standards are being replaced either by a rolling average of actual costs, which is expected to decline or by very challenging target costs.

Ideal Standards

Ideal standards are those that 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.

Some managers feel that such standards have a motivational value.

These managers argue that even though employees know that they will rarely meet the standards, it is a constant reminder of the need for ever-increasing efficiency and effort.

Few firms use ideal standards. Most managers feel that ideal standards tend to discourage even the most diligent workers.

Moreover, variances from ideal standards are difficult to interpret. Large variances from the ideal are normal and it is difficult to manage by exceptions.

Practical Standards

Practical standards are those standards that are tight but attainable. They allow for normal machine downtime and employee rest period. They can be attained through reasonable, though highly efficient, efforts by the average worker.

Variances from such standards represent deviations that fall outside of normal operating conditions and signal a need for management attention. 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 in forecasting and planning; they do not allow for normal inefficiencies, and therefore they result in unrealistic planning and forecasting figures.

Comparison of Budgets and Standards

The budget is one method of securing reliable and prompt information regarding the operation and control of an enterprise.

When manufacturing budgets are based on standards for materials, labor, and factory overhead a strong team for possible control and reduction of costs is created.

Standards are almost indispensable in establishing a budget.

Because both standards and budgets aim at the same objective-managerial control it is felt that the two are the same and cannot function independently.

This opinion is supported by the fact that both use predetermined costs for the coming period.

Both budgets and standard costs make it possible to prepare reports which compare actual costs and predetermined costs for management.

Building budgets without the use of standard cost figures can never lead to a real budgetary control system.

The principle difference between budgets and standard costs lies in their scope. The budget, as a statement of expected costs, acts as a guidepost which keeps the business on a charted course.

Standards, on the other hand, do not tell what costs are expected to be, but rather what they will be if certain performances are achieved.

A budget emphasizes the volume of business and the cost level which should be maintained if the firm is to operate as desired. Standard stress the level to which costs should be reduced. If costs reach this level, profit will be increased.

Similarities of budgetary control and standard costing

The following are the similarities of budgetary control and standard costing:

  • Both systems deploy predetermined figures
  • Both systems are useful accounting tools to management in controlling costs
  • Both systems require proper administration. The actual results must be compared with budgets or standards and any variances should be investigated. There should be a continuous study of the cost control problems and corrective actions are taken where necessary. Where appropriate the budgets or standards need to be revised so that they are realistic

It is interesting to note that both systems can operate independently but since both systems involve the estimation of costs, most firms often operate both systems together.

Budgets set can be used as guides in setting standard costs. Vice versa, the standard costs already determined can be used as aids in the preparation of budgets.

Difference between Standard Cost and Budgetary Control

Budgetary ControlStandard Cost
1. It is used as statistical data and leads to a lot of guesswork.1. It is a predetermined cost. It is an ideal cost.
2. It is extensive in its application, as it deals with the operation of the department or business as a whole. Budgets are prepared for sales, production, cash, etc.2. It is intensive, as it is applied to the manufacturing of a product or providing a service. It is determined by classifying recording and allocating expenses to the cost unit.
3. It is a part of a financial account, a projection of all financial accounts.3. It is a part of the cost account, a projection of all cost accounts. Variances are revealed through different accounts.
4. Budgeting can be applied in parts4. It cannot be applied in parts.
5. It is more expensive and broad, as it relates to production, sales, finance, etc.5. It is not expensive because it relates to only elements of cost.
6. Budgets can be operated without standards.6. This system cannot be operated without budgets.

Variance Analysis

Answer: Variance analysis is usually associated with explaining the difference (or variance) between actual costs and the standard costs allowed for the good output.

For example, the difference in materials costs can be divided into a materials price variance and a materials usage variance. The difference between the actual direct labor costs and the standard direct labor costs can be divided into a rate variance and an efficiency variance.

The difference in manufacturing overhead can be divided into spending, efficiency, and volume variances. Mix and yield variances can also be calculated.

Variance analysis helps management to understand the present costs and then to control future costs.

Variance analysis is also used to explain the difference between the actual sales dollars and the budgeted sales dollars.

Examples include sales price variance, sales quantity (or volume) variance, and sales mix variance. A difference in the relative proportion of sales can account for some of the difference in a company’s profits.

Material cost variance

The name of the variance is self-explanatory, denoting the differences between the standard cost of Materials and the actual cost of materials. The materials cost variance is between the standard material cost for actual production in units and actual cost.

Material cost variance = (standard cost of material – Actual cost of material used)

Define material cost variance? Classify the material cost variance. Is a favorable variance always an indicator of efficiency in operation?

In a standard costing system, some favorable variances are not indicators of efficiency in operations.

For example, the materials price variance, the labor rate variance, the manufacturing overhead spending and budget variances, and the production volume variance are generally not related to the efficiency of the operations.

On the other hand, the materials usage variance, the labor efficiency variance, and the variable manufacturing efficiency variance are indicators of operating efficiency.

However, a few variances could result from standards that were not realistic.

For example, if it takes 2.4 hours to produce a unit of output, but the standard is set for 2.5 hours, there should be a favorable variance of 0.1 hours.

This 0.1-hour variance results from the unrealistic standard, rather than operational efficiency.

Conclusion

In sum, managers should exercise considerable care in their use of a standard cost system.

Managers must go out of their way to focus on the positive, rather than just on the negative, and to be aware of possible unintended consequences.

Nevertheless, standard costs are still found in the vast majority of manufacturing companies and many service companies, although their use is changing.

For evaluating performance, standard cost variances-may be supplanted in the future by a particularly interesting development known as the balanced scorecard.

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