Standard Costing and Setting Standards

Standard Costing

• Standard cost is used by manufacturers to create realistic budgets, standards can also be set for revenue
• Compares actual cost to standard cost. Differences are called variances
• Variances help managers assess and control costs, and identify areas for action
• Example: difference between actual and budgeted material cost might indicate a change in material purchase price since the budget was made
• Corrective action might involve reviewing suppliers or seeking discounts
• Standards must be realistic and updated regularly

Setting Standards

• Realistic standards are crucial for usefulness
• Standards need regular updates, for example, if new machinery is purchased, labor time for production needs updating
• Various standard types exist, including:
• Ideal Standards: Only achievable under ideal conditions. Unrealistic in practice, thus demotivating managers and hindering efficiency
• Current Standards: Based on current performance levels. Inappropriate for the future and do not motivate improved efficiency
• Attainable Standards: Recognize some unavoidable material and time wastage (idle time for example). Motivate workers towards greater efficiency in utilizing time and materials

Advantages and Disadvantages of Standard Costing

• Advantages: Easier budget preparation, more realistic budgets, easier identification of variances, highlighting activities causing variations, estimates and quotations for new products and orders
• Disadvantages: Time consuming data collection process for standard cost of a product, does not explain causes of variances requiring further investigation, external factors such as inflation might cause discrepancies

Flexible Budgets

• Actual output volume may differ from budgeted volume
• Flexing budget adjusts budgeted sales volume and variable expenses to actual output volume for accurate comparison
• Comparing actual costs and revenue to a flexible budget ensures a more meaningful comparison (fixed costs don't change with output)

Variances

• Difference between standard cost/revenue and actual cost/revenue
• Help management identify areas requiring attention to achieve budgeted profit or limit adverse profit impact
• Variances can be calculated for sales, direct materials, direct labor, variable and fixed overheads, analyzed further into sub-variances
• Favorable (F) or adverse (A) descriptions are used for variances

Direct Materials Cost Variances

• Total direct materials variance = difference between actual and flexible budget direct materials cost
• Sub-variances:
• Materials usage variance = difference between actual quantity of materials used and the quantity that should have been used (flexible budget), multiplied by the standard cost per unit.
• Materials price variance = difference between actual price paid and budgeted price, multiplied by the quantity used

Direct Labor Cost Variances

• Total direct labor variance = difference between actual and budgeted direct labor cost
• Sub-variances:
• Labor efficiency variance = difference between actual hours worked and the standard hours needed, multiplied by the standard wage rate.
• Labor rate variance = difference between actual wage rate and standard wage rate, multiplied by actual hours worked

Fixed Overhead Variances

• Aim to absorb fixed overhead into the overall cost of output, although actual costs and output levels may differ
• Sub-variances:
• Fixed overhead expenditure variance = difference between actual fixed overhead incurred and budgeted costs.
• Fixed overhead volume variance = difference between standard hours for actual output and budgeted hours (multiplied by budgeted fixed overhead absorption rate) - Formula will differ based on the basis used for absorption (e.g., labor hours, direct materials)
• Fixed overhead efficiency variance = difference between actual labor hours for actual output and standard labor hours for actual output (multiplied by budgeted fixed overhead absorption rate)
• Note: If fixed overhead is absorbed using machine hours instead of labor hours, the comment relating to the variances will apply to machine hours instead of labor hours.

Using Standard Costing for Decision Making

• Standard costing and variance information is beneficial for many business decisions.
• Different departments should discuss how to arrive at the best decisions, prioritizing most significant variances
• Steps:
• Identify significant variances
• Determine their causes
• Implement corrective action where appropriate, updating variances for future budgets