Standard Costing

• A standard cost is a predetermined, measurable quantity set in defined conditions, expressed in monetary terms and built from an assessment of the value of cost elements.
• Standard costing is a control technique comparing standard costs and revenues with actual results to find variances, which then stimulate improved performance.
• Standard costing substitutes an expected cost for an actual cost in accounting records, with variances recorded to show the difference between expected and actual costs.
• It's a simplified alternative to cost layering systems like FIFO and LIFO, where large amounts of historical cost information must be maintained.
• Standard costs are used because collecting actual costs is too time-consuming in some applications, so standard costs are used as a close approximation.
• Cost accountants periodically calculate variances that break out differences caused by factors like labor rate changes and material costs and may periodically change the standard costs to better align with actual costs.

Types of Standards

• Standards may be set using a range of bases within a standard costing system, affected by the use to which the standards will be put.
• These include basic, ideal, attainable, and current standards.
• A basic standard is established for use over a long period, from which a current standard can be developed.
• An ideal (or potential) standard can be attained under the most favorable conditions, with no allowance for normal loss, waste, or machine downtime.
• Ideal standards remind management of the need for continual improvement but are not widely used because they may adversely affect employee motivation.
• An attainable standard can be attained if a standard unit of work is carried out efficiently, machines are operated properly, and materials are used effectively.
• Attainable standards allow for normal losses, waste, and machine downtime and represent future performance and objectives which are reasonably attainable.
• Current standards are established for use over a short period of time, related to current operating conditions.

Relationship Between Standard Costing and Budgetary Control

• Standard costing evolved as a parallel system to budgetary control but has become a subset of budgetary control in modern environments.
• Standard costing differs from other approaches to budgetary control because inventory is valued at standard cost, standard costs are incorporated into the ledger, and standard costs are set as unit costs.
• Budgets are outside the ledger accounts and tend to be set as total costs.
• Standard costing is most effective when output or production is routine and easily measured, enabling detailed comparison of individual inputs of materials, labor, and other production costs.
• Budgetary control can be used for all activities where costs and revenues can be predicted and actual results compared, making it useful in controlling overhead, service department costs, and sales activity.

Standard Cost Card Example

• Direct materials include Material P at 5kg at £2.00 per kg (£10.00) and Material Q at 3 liters at £1.50 per kg (£4.50), totaling £14.50.
• Direct labor includes Grade A at 4 hours at £4.00 per hour (£16.00) and Grade B at 1 hour at £5.50 per hour (£5.50), totaling £21.50.
• The standard direct cost is the sum of direct materials and direct labor (£36.00).
• Variable production overhead is 5 hours at £1.50 per hour (£7.50).
• The standard variable/marginal cost of production is £43.50.
• Fixed production overhead is 5 hours at £1.30 per hour (£6.50).
• The standard full cost of production/total absorption cost is £50.00.
• Administration and marketing overhead is £15.00.
• The standard cost of sale is £65.00.
• Standard profit at 25% is £16.25.
• The standard sales price is £81.25.

Advantages of Standard Costing

• Standard costing assists in budgeting, inventory costing, overhead application, and price formulation.
• Budgets are composed of standard costs because including the exact actual cost of an item on the day the budget is finalized would be impossible
• Standard costing can generate an ending inventory valuation by multiplying inventory balances by the standard cost of each item, though standard costs should be updated frequently if actual costs change.
• If aggregating actual costs into cost pools for allocation to inventory takes too long, a standard overhead application rate can be used instead, adjusting the rate periodically.
• Standard costs are used to compile the projected cost of a customer’s requirements for custom products, where the sales department uses a database of component costs that change depending on the quantity ordered.
• Standard costing provides a benchmark against which management can compare actual performance.

Problems with Standard Costing

• Standard costing is not viable in situations like cost-plus contracts, where actual costs must be used as per the contract terms.
• Actions taken to create favorable variances can drive inappropriate activities.
• Standard costing assumes that costs do not change much in the near term, and in a fast-paced environment where product lives are short or continuous improvement is driving down costs, a standard cost may become out-of-date quickly.
• Variance calculations are completed at the end of each reporting period, which is too late to be useful for immediate feedback and correction.
• Variance calculations are accumulated in aggregate for a company’s entire production department, and are unable to provide information about discrepancies at a lower level, such as the individual work cell, batch, or unit.