Standard Costing: Definition
Standard costing is a system of accounting that uses predetermined standard costs for direct material, direct labor, and factory overheads.
Standard costing is the second cost control technique, the first being budgetary control. It is also one of the most recently developed refinements of cost accounting.
The standard costing technique is used in many industries due to the limitations of historical costing. Historical costing, which refers to the task of determining costs after they have been incurred, provides management with a record of what has happened.
For this reason, historical costing is simply a post-mortem of a case and has its own limitations.
For managers within a company, exercising control through standards and standard costs is a creative program aimed at determining whether the organization’s resources are being used optimally.
Standard costs are typically determined during the budgetary control process because they are useful for preparing flexible budgets and conducting performance evaluations.
The use of standard costs is also beneficial in setting realistic prices. Along with this, standard costs help to identify any production costs that need to be controlled.
Importantly, comparison of actual cost with standard cost shows the variance. When correctly analyzed, this shows how to correct adverse tendencies.
The current category “Standard Costing and Variance Analysis” discusses the technique of standard costing and variance analysis, which is aimed at profit improvement mainly by reducing materials, labor, and overhead costs.
Standard Cost: Definition
There are different definitions of standard costing, all of which emphasize the use and determination of standard cost. Hence, it is useful to understand the meaning of standard cost.
A standard cost is one that a company expects at the outset of a year under a normal level of operational efficiency. Standard costs are used periodically as a basis for comparison with actual costs.
Standard costs may be termed commonsense costs. This reflects the view that a standard cost represents the best judgment of management about what costs the business operations will involve when undertaken efficiently.
According to Brown & Howard, “standard cost is a pre-determined cost which determines what each product or service should cost under given circumstances.”
Blocker defined standard cost as follows:
A pre-determined cost based upon engineering specifications and representing highly efficient production for quality standard with a fixed amount expressed in terms of dollars for materials, labor, and overhead for any estimated quantity of production.
The Institute of Cost and Management Accountants (ICMA) defined standard cost in the following way:
A pre-determined cost which is calculated from management’s standards of efficient operation and the relevant necessary expenditure. It may be used as a basis for price fixation and for cost control through variance analysis.
In ICMA’s definition of standard cost, the phrase “management’s standards of efficient operation” is important. This is because standard cost is ascertained on this basis.
The standard of efficient operation is decided based on previous experience, research findings, or experiments. The standard is generally defined as that which is attainable but only after substantial effort.
Standard cost serves as a measure against which actual cost is compared. If actual cost does not exceed standard cost, performance is treated as fully efficient.
Standard cost also plays a role in evaluating staff performance. For example, by analyzing the difference between actual costs and standard costs, management can identify the factors leading these differences.
Standard costs also assist the management team when making decisions about long-term pricing.
Features of Standard Costing System
Standard cost is a predetermined cost. It is based on past experience and is referred to as a common sense cost, reflecting the best judgment of management.
Standard cost relates to a product, service, process or an operation. It is also determined for a normal level of efficiency of operation.
Standard cost is used to measure the efficiency of future production or future operations. For this reason, it provides a useful basis for cost control.
Also, standard cost may be expressed in terms of money or other exact quantities.
Advantages of Standard Cost
This section highlights the most important advantages of standard cost.
First, standard costs serve as a yardstick against which actual costs can be compared.
The difference between standard cost and actual cost are called variances. For proper control and performance measurement in an organization, variances should be measured and analyzed. This also ensures that regular checks are made on expenditures.
The second advantage is that if immediate attention is taken, control over costs is greatly facilitated. A proper standard costing system assists in achieving cost control and cost reduction.
Standard cost also helps to motivate employees. This is because the system can be used to provide an incentive scheme wherein variance is minimized.
Production and pricing policies are formulated with certainty when standard cost systems are in place. This helps to keep costs in check.
The last advantage of using standard cost is that even when other standards and guidelines are constantly being revised, standard cost serves as a reliable basis for evaluating performance and control costs.
Nature and Purpose of Standard Costing System
The main purpose of standard cost is to provide management with information on the day-to-day control of operations.
Standard costs are predetermined costs that provide a basis for more effectively controlling costs. Standard cost offers a criterion against which actual costs incurred by the business can be measured and analyzed.
The difference between actual costs and standard costs is known as variance. Variance is identified and carefully analyzed, and it is reported to managers to inform suitable corrective actions.
Applicability of Standard Costing
Standard costing is applicable under diverse conditions. It requires the following:
- There should be an output or the production of a sufficient volume of a standard product
- The methods, operations, and processes of production should be capable of standardization
- The costs should be controllable
Standard costing techniques have been applied successfully in all industries that produce standardized products or follow process costing methods.
Examples of such industries include sugar, fertilizers, cement, footwear, breweries and distilleries, and others.
Public utilities such as transport organizations, electricity supply companies, and waterworks can also apply standard costing techniques to control costs and increase efficiency.
In jobbing industries, as well as industries that produce non-standardized products, it is not possible to apply the technique advantageously.
Objectives of Using Standard Costing System
Within an organization, there are several objectives that a standard costing system may be established to help achieve.
First, a standard costing system may be used to control costs, which is achieved mainly by setting standards for each type of cost incurred: material, labor, and overhead.
This also helps to analyze variance and, hence, enables managers to be effective in controlling the costs for which they are held responsible.
The second objective that a standard costing system may be used to achieve is to help in setting budgets. Third, such a system may be used to provide useful and detailed information for managerial planning and decision-making.
Fourthly, a standard costing system may be used to assess the performance and efficiency of staff and management.
Finally, standard costing is a control technique that follows the feedback control cycle. Therefore, the feedback system may help to eliminate unwanted costs in the future, leading to a potential reduction in costs.
Preliminaries to Consider Before Using a Standard Costing System
When deciding whether to use standard costing in a business, several preliminaries have to be considered. These preliminaries are:
- Establishing cost centers
- Classification and codification of accounts
- Types of standards
- Setting the standards
Establishing Cost Centers
A cost center is a location, person, or item of equipment (or a group of these) for which costs may be ascertained and used for the purpose of cost control.
Cost centers may be personal cost centers or impersonal cost centers. Personal cost centers are related to a person, while impersonal cost centers are related to a location or item of equipment.
Establishing cost centers is needed to allocate responsibilities and define lines of authority.
Classification and Codification of Accounts
Classification or grouping of accounts is essential for standard costing.
Accounts should be classified in such a way that the cost elements of every cost center are clearly and precisely reflected. Codes and symbols are assigned to different accounts to make the collection and analysis of costs more quick and convenient.
Types of Standards
A standard is a predetermined measure relating to materials, labor, or overheads. It is a reflection of what is expected, under specific conditions, of plant and personnel.
A standard is essentially an expression of quantity, whereas a standard cost is its monetary expression (i.e., quantity multiplied by price). It shows what the cost should be.
In setting standards, the key question is to decide on the type of standard to be used in fixing the cost. The main types of standards are ideal, basic, and currently attainable standards.
1. Ideal Standards
Ideal standards, also called perfection standards, are established on a maximum efficiency level with no unplanned work stoppages.
They are tight standards which in practice may never be obtained. They represent the level of attainment that could be reached if all the conditions were perfect all of the time.
Ideal standards are effective only when the individuals are aware and are rewarded for achieving a certain percentage (e.g., 90%) of the standard.
2. Basic Standards
Basic standards are long-term standards and they remain the same after being computed for the first time. They are projections that are rarely revised or updated to reflect changes in products, prices, and methods.
Basic standards provide the basis for comparing actual costs over time with a constant standard. They are used primarily to measure trends in operating performance.
3. Currently Attainable Standards
A currently attainable standard is one that represents the best attainable performance. It can be achieved with reasonable effort (i.e., if the company operates with a “high” degree of efficiency and effectiveness).
These standards make proper allowances for normal recurring interferences such as machine breakdown, delays, rest periods, unavoidable waste, and so on.
It is assumed that these are unavoidable interferences and are a fact of life. However, allowances are not made for any avoidable interferences with output.
The currently attainable standard is the most popular standard, and standards of this kind are acceptable to employees because they provide a definite goal and challenge to them.
Setting the Standards or Establishing a Standard Costing System
Establishing a standard costing system for materials, labor, and overheads is a complex task, requiring the collaboration of a number of executives.
For this purpose, a Standards Committee is established. The Standards Committee generally consists of:
- Production Manager
- Purchase Manager
- Personnel Manager
- Production Engineer
- Sales Manager
- Cost Accountant
The Budget Committee and Standards Committee can be combined into one committee.
The Standards Committee is responsible for fixing standards. It also assists in the effective application of standards, as well as making necessary changes as new circumstances render previous standards obsolete.
Before fixing standards, a detailed study of the functions involved in the manufacturing of the product is necessary.
While fixing standard costs, the fundamental principle to be observed is that the set standards are attainable so that these are taken as yardsticks for measuring the efficiency of actual performances.
The setting up of standard costs requires the consideration of quantities, price or rates, and qualities or grades for each element of cost that enters a product (i.e., materials, labor, and overheads).