Q. 2. What Are the Advantages and Limitations of Standard Costing?
Advantages of Standard Costing
1. Measurement of efficiency: Standard costs can be compared with actual costs. When actual costs are equal to or less than standard costs, this reflects the organization’s efficiency.
When standard costs are less than actual costs, this indicates a degree of inefficiency in the organization. Therefore, standard costing enables a company’s management team to learn about whether the company operates reliably or not.
2. Determination of employee responsibilities: Standards are determined separately for various activities and sub-activities, which helps the management determine whether employees are working efficiently or not.
If an activity shows an unfavorable variance, the related employee may be held responsible for that loss. The employee in question cannot avoid or shift their responsibility due to the clear-cut data showing the unfavorable variance.
3. Helpful to determine production costs: Most of the time, production prices are quoted and advertised by producers in the market even before production is completed.
Under this situation, prices are determined on the basis of standard costing because, by that time, the producer does not know the actual cost of production.
4. Standardization of activities: Due to standard costing, standards are fixed for various activities. This helps the employees to work efficiently.
5. Helpful in managerial activities: Standard costing enables management to exercise effective control over production activities, helping them make decisions regarding the various elements of cost (e.g., materials purchases and wages).
6. Opportunities to improve production quality: Under standard costing, the emphasis is on cost-effectiveness and quality. Proper emphasis is given to improving the quality of production.
Prices are minimized under standard costing because proper care is dedicated to identifying and rectifying all possible wastages and inefficiencies.
8. Easy accounting: When the standard costing method is applied, the accounting process becomes significantly easier. This is because standards are determined for every transaction well in advance and compared to actual costs.
9. Quality improvement: In a standard costing system, all wastages are identified and, as such, efficiency is promoted, which further results in quality improvement and price reduction.
10. Cost reduction: Standard costing helps managers to estimate the costs of new products accurately, which can lead to significant cost reductions.
11. Comparison: Standard costing is useful for comparing standard costs to actual costs, thereby illuminating where wastage occurs and how to control it.
12. Economy: Standard costing is economical and needs less attention from management and executives compared to other approaches.
Limitations of Standard Costing
Although standard costing is a useful technique for a company’s management team, it suffers from limitations. Therefore, when using standard costing, management should remember these. The following are the important limitations of standard costing:
1. Difficulties determining standards: The most important limitation of standard costing is the difficulty associated with determining standards for different activities.
For this purpose, management must take great care to study past information and data. If standards are not determined correctly, all further analysis, interpretation, and decisions will lead to confusion, conflicts, and losses.
2. Expensive: To determine standard costs, research is conducted into various aspects of production, past information is collected and analyzed, and expert opinions are considered.
All these activities require significant expenditures, which considerably increase the overall expenditures of the organization.
3. Need for revised standards: Management should not think that the job is done after determining standard costs once. These standards must be revised from time to time due to changes in technology, marketing conditions, and consumer habits.
Therefore, the revision of standards should happen periodically, whenever it is needed.
4. Not suitable for all producers: Standard costing is not suitable for all industries. It is suitable only for companies in which production is uniform and of standard quality. This is because standardization is only possible in such a context.
If every unit of production is different in nature and quality, then standard costing is unsuitable. This is because, in such cases, standardization of various elements of cost is not possible.
5. Depends upon budgetary costing: Standard costing is a viable option only when budgetary techniques are used.
6. Needs experts: When setting standard costs, the services and guidance of specialists and experts are needed. Therefore, standard costing can only be used in companies that can afford to employ experts of this kind.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.