Standard costing is an accounting concept used to determine a standard for the cost of each element. It is a predetermined amount (a standard) for the costs of direct materials, direct labor, and factory overheads. Management uses a standard of costs to control overhead costs and measure and develop efficiency. The primary goal of calculating and using standard costs is to set objectives and reach specific targets. Standard cost help provide guidance for various managerial functions like formulating company policies and determining overall costs of operation.
The advantages of standard costing include improving cost control. It is also beneficial for helping management plan and makes decisions. By using standard costing, a company can measure inventory more effectively. The accounting tool can also help save costs in record-keeping as well as provide ways to possibly save on production costs.
Even though standard costing provides numerous benefits for management teams, it does have some limitations. The most prominent limitation is trying to determine cost standards for different items. It can also be a bit costly since it requires a highly skilled and competent person who knows what they are doing. But experts can be expensive. This makes it almost too expensive for smaller businesses to afford. Another disadvantage is setting unrealistic standards, which can yield misleading results.
What is Standard Costing?
Using a standard cost means an accountant substitutes an expected cost for the actual costs in accounting records. Of course, the variance between the actual cost and the expected cost will be recorded as well. This approach provides a simpler alternative to cost layers systems like the LIFO and FIFO methods. Both of these methods require large amounts of historical cost information to be maintained for all the items stocked in the company’s inventory.
For standard costing to work, an estimated cost is created for some or all of a company’s activities. The primary reason for using a standard cost method is to save time. There are many applications in which it is too time-consuming to stop and collect the actual cost. Standard costs or estimates are used instead. The biggest significance is improving efficiency.
Of course, the standard cost differs from the actual costs, even if by a small amount. The accounting will periodically calculate the differences between the two as well as variances in things like material costs and labor rate changes. Sometimes, an accountant must alter the standard cost to align them more closely with the actual costs.
Why do Companies Use Standard Costing?
Companies may use standard costing for different reasons. Some use them for budgeting purposes when actual costs are not yet determined. Sometimes during the manufacturing process, it’s not feasible to predict all the variables like product demand that affect manufacturing costs.
Companies that deal with adverse conditions may opt for applying standard costing. Many different industries have used it. Manufacturers of footwear, cement, sugar, and other items often use standard costing in their accounting systems. Public utilities such as electricity and water providers use standard costing to control costs and increase their efficiency.
What are the Advantages of Standard Costing?
Here are the main advantages for companies that use standard costing.
- Accuracy: Standard costing is more accurate than direct costing and helps build an understanding of cost variances. It is beneficial for projecting future costs and setting budgets accurately.
- Controls Cost: By setting standards for each of its cost types, a company can gain control of costs. Then, variances provide a starting point for where costs can be controlled.
- Aids Management in Making Decisions: Management can develop cost standards to help control production costs and plan for future costs. This aids when preparing budgets and estimating bids on future projects.
- Accurate Budgets: A company, especially one that manufactures products, cannot prepare a budget without standard costing. An accurate budget can be planned when labor, overhead, and materials are assigned values.
- Reduced Manufacturing Costs: Using a standard cost system can help employees be more conscious in looking for improved methods. Employees need to be active in reducing costs if a company wants to control costs successfully.
Standard costing offers advantages in some areas of accounting, such as management accounting and cost accounting. It plays a large role in helping to control costs and is beneficial as a managerial tool for reducing costs. Here are some of the main advantages for companies that use standard costing accounting.
Accounting professionals and management work together to create cost standards. All future actual costs are expected to be close to the estimates calculated for standard costs. As a result, management is able to use them to prepare more accurate budgets. Also, when they prepare bids for jobs and projects, cost estimations are more accurate. This makes a cost system extremely valuable for management, who plan and make financial decisions for the company.
2. Controls Cost
Companies set costs for each type of their incurred costs. Then using the standard cost they can find variances or exceptions. This helps identify where things didn’t go according to the plan. These variances help to judge effectiveness. Managers can then find areas where costs can be better controlled. This way, the standard costing system helps highlight areas of possible hazards.
3. Aids Management in Making Decisions
Standard costing in accounting provides managerial decision-makers with the detailed information they need to make better decisions for the company. When management is developing appropriate cost standards and they succeed in controlling the costs of production, future costs are likely to be close to the standard. This allows management to use the standard cost for preparing accurate budgets as well as estimating costs for bidding on upcoming projects.
4. Accurate Budgets
A standard cost system is commonly used to budget for projects, manage production costs on a particular run, and evaluate the costs once the production is done. It provides a business with hard numbers they can use to create estimates for their customers. Standard cost budgets are the cost for producing a single unit of an item. Budgetary control is more effective when used along with standard costing. It is also useful in planning various operations.
5. Reduced Manufacturing Costs
Implementing a standard cost system can lead to reduced production costs. When production costs can be reduced, it can help increase the volume of sales, which also adds to the company’s profits. Standard costing helps minimize production and manufacturing costs because proper care is given to identifying and correcting areas of waste and inefficient processes.
These are just a few of the numerous ways standard costing benefits a company. It’s useful in the manufacturing industry, but it is beneficial for most companies. The entire company benefits from top management to the production line workers. In the long run, it can mean greater ROI for a company with conscientious management and employees.
What are the disadvantages of standard costing?
Listed below are the disadvantages of standard costing.
- Feedback is slow: It takes time to get feedback since it is often not reported until the end of a period.
- Morale is low: Workers may associate variances with poor performance. This means their morale on the job may decline.
- Employee relation: Workers may choose not to report or hide abnormal variances. This affects budgeting and effectiveness.
DISADVANTAGES OF STANDARD OF COSTING
The disadvantages of standard costing include slow feedback. Another disadvantage of standard costing is that workers’ morale can be affected negatively. Thirdly, workers may retaliate by hiding abnormal variances.
1. Feedback is slow.
One of the integral parts of using a standard costing system is a complex system of variance calculations. The accounting staff will complete the calculations at the end of each reporting period. A production department that is focused on receiving immediate feedback about problems so that they can correct them quickly will be disappointed. Reporting of the variances is often too late to be useful.
2. Morale is low.
The managerial approach focuses on variances that are abnormal or unusual. Since management’s mind only investigates variances that are the exceptions, workers may try to conceal their inefficiencies. When workers feel that poor performance gets more attention than good performance, it can affect their morale negatively.
3. Employee retaliation.
Workers may not always report variances or exceptions. Why? Management will only look into unusual variances, so workers may retaliate by not reporting negative exceptions. They may also try to minimize negative exceptions to hide their own inefficiency. However, workers who are successful at hiding variances in retaliation will diminish the effectiveness standard costing has on budgeting.
What are the components of Standard Costing?
There are three components of standard costing: direct materials, direct labor, and overhead. The cost of direct materials is calculated by multiplying the quantity of each material by the per-unit cost. Direct labor is calculated by multiplying the quantity of each labor factor with the per-hour cost of labor. Overhead has some variable and some fixed costs. To calculate overhead, multiply the rate of variable overhead by the standard quantity.
How to Create a Standard Cost
Calculating standard costs is straightforward. Here are the two steps to creating a standard cost.
- Calculate the costs of direct materials, direct labor, and overhead. Each of these will be calculated separately. The standard cost will contain an itemization of each of these three types of costs.
- Add them all up to obtain the total cost. Once you have the three totals from the first step, add them all together. This will be your first estimate for your standard cost.
Creating standard costing is a basic calculation. However, it must be done in a certain order and correctly. The first step is three calculations. Once the three calculations have been done, they are all added together to create a single standard cost for the company.
1. Calculate the cost of direct materials, direct labor, and overhead.
To determine each of these three costs, multiply the rate of each one by the quantity. The quantity can be either units or hours. When calculating direct materials, for example, take the price of direct materials and multiply it by the standard quantity. To calculate direct labor, multiply the direct labor rate by the direct labor standard hours per unit. Finally, multiply the standard overhead by the number of hours. This gives you three totals to add in the next step.
2. Add them all up to obtain the total cost.
In this step, take the three standard cost totals from step one, the overhead total, direct materials total, and the direct labor total. Then add the three totals together. Adding the three standard costs together gives you the overall standard cost.
What Industries Made Use of Standard Costing?
Most companies have budgets, and many of them use standard costing calculations to arrive at their product prices. For most, calculating standard cost provides a benchmark that allows management to compare with actual performance. Standard costing is most suitable for process industries and industries that use repetitive manufacturing processes. Some service industries that incorporate an operating costing system may also use a standard costing system.
What is the Difference Between Standard Cost and Standard Costing?
The standard cost is a predetermined amount. It is an advance cost estimate determined before production. It is the anticipated amount that will be paid for both materials and labor. Standard costing is a technique that is used for controlling costs with standard costs. Standard costing is just a method used to control costs at various stages of production. The primary difference is that standard costs are pre-planned cost set before actual production even begins; standard costing is an accounting method.