Standard Costing: Introduction, Advantages, Formula and Example

It is a target which is attainable and can be achieved if the expected conditions operate during the period for which the standard is set. It represents what should be achieved under actual conditions when plant and other facilities have been made by positive action, as efficient as possible. This is because of the fact that the standard does not represent what should be attained in the present period. Hence, not being useful for cost control, basic standard is rarely used except as a basis for preparing current standard. It is revised only Outsource Invoicing when new products are introduced or the existing ones are so modified as to be considered to be practically new. Although there is saving in clerical cost of setting the standard, basic standard cannot be used to highlight current efficiency or inefficiency.

Physical Standards – Purposes, Steps, Bases and Problems

The normal cost will be used over a period of time, usually the business cycle of the company. It bases on the average between the highest and lowest production over standard costs definition the cycle. The company expects that the cost will not change over the full cycle. Often favorable variances are not noted at all, and unfavorable variances are scrutinized.

Direct Materials Calculation

In a manufacturing organisation work done, i.e., production is expressed in physical terms only, but with the aid of standard hours it can be converted or expressed in allowed hours or minutes also. CIMA defines Standard hour or minute as “the quantity of work achievable at standard performance in aft hour or minute.” It is the media of converting production into allowed hours or minutes. It states in detail the standard relationship between time and output.

Tools & Services

Recall the following information in our Standards Table in Section 2. The system of standard costing, thus, involves various steps—from the setting up of standards to finally exercising control over costs. The cost accountant may periodically change the standard costs to bring them into closer alignment with actual costs. For example, Company A produced 1,000 units of Product A and spent $15,000 for direct materials. If the total standard cost of direct materials is $12,500 (as computed earlier), then there is an unfavorable variance of $2,500. It might be due to higher purchase price of the raw materials and/or excessive quantity used.

• Men, machines and materials are more effectively utilised and thus economies can be effected in business together with increased productivity.
• For example, McDonald’s has a standard for the amount of hamburger meat that should be in a Big Mac.
• The examples of such industries are chemical industries, distilleries, paper-making and metal processing etc.
• A standard costing system initially records the cost of production at standard.

Payment Processing

No more beginning of year inventory reval, impacting the P&L and Balance Sheet. Elimination of variances, particularly variances that make no logical sense and cause a loss of business trust in the system and finance function. Save weeks/months of time required to input, adjust, and validate standard cost inputs into the system. The advantages of standards are efficiency, cost control, decision-making, budgeting, and lower production costs. The disadvantages are slow feedback, low morale, and employee backlash. Standard cost systems aid management accountants in tracking business performance against budget assumptions.

New Business Terms

Standard costs aren’t set in stone, and treating them as a permanent benchmark will do your business more harm than good. Conduct periodic reviews to make sure you’re adapting to changes in material prices, labor rates, and overhead costs so you can keep your standards up to date. When cost accounting was developed in the 1890s, labor was the largest fraction of product cost and could be considered a variable cost.

• Work motivation – The standards provide incentive and motivation to work with greater effort and care for achieving the standard.
• Standard cost is still used today to track and control costs in manufacturing and other industries.
• The standard costing system can have the desired effects only when the system is acceptable both to the management as well as to the workers.
• This includes the cost of raw materials, direct labor, and overheads.
• A material’s quantity variance, for instance, would occur if you used more fabric than you anticipated when calculating your standard cost to make your clothing.
• One standard in particular that the consulting firm developed seemed too excessive to plant management.
• For example, purchasing substandard materials may lead to using more time to make the product and may produce more scrap.

Also, standard costs are often used when pricing decisions or determining product profitability. For example, a manufacturer may use standard costs to determine how much a particular item should cost based on the inputs required for its production. For example, when standard costs are higher than actual costs, the cost of goods is higher than expected, and profit is lower than expected. Actual costs lower than standard costs have the opposite effect, understating the cost of goods sold and reporting a higher profit.

The choice of the type of standard depends upon its effectiveness for control of costs. (b) Expected Standard – It reflects a level of attainment based on a high level of efficiency. In fixing the standards, realistic allowances are set for normal wastes. (iii) Current Standard – This standard is fixed on the basis of current conditions and remains in force for a short period of time. (7) The recording process of standard costs should be easy and clear.

The latter provides a very unsatisfactory criterion for measuring performance. Various operational inefficiencies are buried in it, and it does not reflect intervening changes in the methods of production, levels of activity, market trend, etc. One of the most powerful applications of standard costing is in performance evaluation through variance analysis. Variance is simply the difference between standard and retained earnings actual costs.

These metrics must be connected to your financial/accounting system to be helpful, even in complex systems. Critical information will be filtered out in the transfer if your financial system is not appropriately configured, creating significant issues when conducting a timely and efficient root-cause analysis. No business, especially manufacturers who buy materials from vendors whose prices fluctuate frequently, can predict every expense it will incur over a year.