Published On:Saturday 24 December 2011
Posted by Muhammad Atif Saeed
Standard Costing Overview
Standard costing is the process of creating and using estimated costs for production activities, usually under the assumption of normal operating conditions. Since standard costs do not necessarily match actual costs incurred, the cost accountant must calculate variances between actual and standard costs, and charge the variances to the cost of goods sold. By doing so, an entity is essentially recording actual costs. Standard costing has the following advantages:
A variance is said to be a favorable variance if the actual cost incurred is lower than the budgeted or standard cost. For example, a component part has a $100 favorable purchase price variance if it cost $300, rather than the budgeted $400. A variance is said to be an unfavorable variance if the actual cost incurred is higher than the budgeted or standard cost. For example, fixed overhead has a $1,000 unfavorable variance if the actual amount incurred is $150,000, rather than the budgeted $149,000.
- Value inventory. It is time-consuming to accumulate actual inventory costs at the end of each accounting period, so companies instead create standard costs for valuation purposes. This is especially effective for companies having large inventories.
- Budgeting. A budget is essentially a baseline against which actual results are compared, and standard costs are also a baseline for comparison against actual costs - thus, standard costs and budgets are a perfect match, and standard costs should always be included in budgets.
- Product pricing. When customers ask for a price estimate on a unique product configuration, it is much easier to create a price based on a database of standard costs than to research actual costs.
- Forecasting. Standards are used in a manufacturing resources planning system (MRP II), which creates forecasts for production and purchasing based on standard amounts of labor and materials.
- Management by exception. Variance analysis identifies which actual costs were different from their planned costs, which allows you to manage by exception; if an actual cost matches the expected (standard) cost, then there is no need to investigate it. Only costs causing large variances are worthy of investigation, so management can focus its attention on a small number of items each month.
The Demise of Standard Costing
Standard costing originated in the first half of the twentieth century, primarily as an easy substitute for the vast amount of data accumulation required to aggregate actual cost information when computer systems were not yet available. Since computer systems are now quite capable of aggregating actual cost information, there is certainly less need for standard costing. However, it is still useful as a benchmark against which to measure actual results, as well as to provide a rough substitute for actual costs, as is the case in budgeting and product pricing. Consequently, the usage of standard costing has declined, but it retains sufficient usefulness to be a viable costing system for the foreseeable future.
Standard Cost Variances
A variance can be either a price variance or a quantity variance. A price variance arises when the cost to purchase an item differs from its standard price. A quantity variance occurs when the number of units actually required to build a product varies from the amount specified in the standard costing system. More specifically, here are the variances that you can calculate from a standard costing system (they are linked to more complete descriptions, as well as examples):
- Purchase price variance. The actual price paid for materials used in the production process, minus the standard cost, multiplied by the number of units used
- Labor rate variance. The actual price paid for the direct labor used in the production process, minus its standard cost, multiplied by the number of units used.
- Variable overhead spending variance. Subtract the standard variable overhead cost per unit from the actual cost incurred and multiply the remainder by the total unit quantity of output.
- Fixed overhead spending variance. The total amount by which fixed overhead costs exceed their total standard cost for the reporting period.
- Selling price variance. The actual selling price, minus the standard selling price, multiplied by the number of units sold.
- Sales volume variance. The actual unit quantity sold, minus the budgeted quantity to be sold, multipled by the standard selling price.
- Material yield variance. Subtract the total standard quantity of materials that are supposed to be used from the actual level of use and multiply the remainder by the standard price per unit.
- Labor efficiency variance. Subtract the standard quantity of labor consumed from the actual amount and multiply the remainder by the standard labor rate per hour.
- Variable overhead efficiency variance. Subtract the budgeted units of activity on which the variable overhead is charged from the actual units of activity, multiplied by the standard variable overhead cost per unit.
These variances track price, efficiency, and volume variances for the cost types noted in the following table:
| Variance Type | Material | Labor | Variable Overhead | Fixed Overhead |
| Price Variance | Yes | Yes | Yes | Yes |
| Efficiency Variance | Yes | Yes | Yes | No |
| Volume Variance | No | No | No | Yes |
A variance is said to be a favorable variance if the actual cost incurred is lower than the budgeted or standard cost. For example, a component part has a $100 favorable purchase price variance if it cost $300, rather than the budgeted $400. A variance is said to be an unfavorable variance if the actual cost incurred is higher than the budgeted or standard cost. For example, fixed overhead has a $1,000 unfavorable variance if the actual amount incurred is $150,000, rather than the budgeted $149,000.
Standard Cost Creation
In order to have a standard costing system that operates properly, a company must first develop standard costs, which follows these steps:
- Initial standard setting. The industrial engineering staff is directed to create direct labor standard costs, while the purchasing staff creates standard costs purchased goods, and the cost accountant coordinates the development of a set of standard overhead costs. If there are sub-assemblies created during the production process that may be valued at the end of each accounting period, then the industrial engineering staff calculates these standards.
- Periodic updates. Cost standards must be periodically reviewed. The timing of reviews depends upon how rapidly actual costs change. If there are minimal changes to a manufacturing process, reviews may be only at long intervals. However, if there is an aggressive continuous improvement process in place, then standard costs must be updated more frequently in order to keep pace with the changes in actual costs.
There are a number of assumptions to consider when deriving standard costs, which include:
- Equipment configuration. A standard cost is based on the expected production equipment configuration to be used, since this has a considerable impact on overhead costs incurred and the assumed speed with which parts are produced.
- Production volume. A large assumed production run will spread its setup cost over many units, whereas a short production run will result in higher setup costs on a per-unit basis.
- Equipment condition. A poorly maintained machine will be in operation for fewer hours than would otherwise be the case, resulting in less available capacity.
- Production system. A manufacturing resources planning system has a different impact on costs than a just-in-time system, since they have a different focus on the flow of materials.
- Union negotiations. Any upcoming union negotiations may result in a significant change in labor rates.
- Training and experience. A highly trained work force is very efficient, so if there is an expectation for increased production hiring, assume that efficiency levels will decline until the new people can be properly trained.
A final factor to consider when creating standard costs is the level of attainability of the costs. One option is to devise an attainable standard, which is a cost that does not depart very much from the existing actual cost. This results in reasonable cost targets that employees know they can probably meet. Another alternative is to use historical costs as the basis for a standard cost. This is generally not recommended, for the resulting costs are no different from a company’s existing actual cost structure, and so gives employees no incentive to attempt to reduce costs. The diametrically opposite approach is to create a set of theoretical standards, which are based on costs that can only be achieved if the manufacturing process runs absolutely perfectly. Since employees cannot possibly meet these cost goals for anything but very short periods of time, it tends to result in lower employee morale. Thus, of the potential range of standard costs that can be set in a standard costing system, the best approach is to set moderate stretch goals that are achievable.
