In this article, we will cover the standard costing. This includes the definition, objectives, types of performance standard as well as the advantages and disadvantages of it. First, let’s go through the overview of standard costing.
Cost accounting is the branch of accounting which, as the name suggests, deals with the recording, analyzing and reporting of the costs of a business. Cost accounting is usually carried out by the management of the business for internal reasons. These reasons may include helping in the decision-making process of a business, increasing the efficiency and effectiveness of different processes and for the preparation of budgets. Since cost accounting is used internally and not shared with external parties, such as shareholders, cost accounting does not require to be reported using specific standards or rules. This makes it different from financial accounting where specific standards and rules need to be followed for reporting purposes.
Cost accounting mainly involves determining different costs of a business and classifying them using different methods. For example, it can be used to identify the variable, fixed, direct and indirect costs of a business. Once these costs are determined, cost accounting involves the use of different costing techniques to determine the costs of different products, departments or areas of the business. For example, it may include using marginal costing, absorption costing, activity-based costing, target costing, etc. to determine costs of a specific product and use the results obtained from these techniques for different reasons as mentioned above. Another particular method that is used within cost accounting is Standard Costing.
What is Standard Costing?
Standard costing is a costing technique in which standard costs are assigned to a product instead of its actual cost. In this technique the management of the business calculates a predetermined estimated cost for a product at the start of an accounting period. This cost is calculated based on the assumptions that the resources of the businesses are used efficiently and there are no wastage or inefficiencies within its processes that can be controlled. While standard costs are expected costs, the business still has to incur actual costs on the product which will often be different from the standard costs due to different reasons.
Standard cost of a product, as mentioned above, is the expected cost of that specific product based on the assumptions that all the processes of the business are running efficiently and there is no controllable wastage within these processes. The aim of calculating this cost of a product is to measure the performance of the business and control any deviations from the standard costs. This cost is used as a benchmark for monitoring and controlling the performance of the business in the future.
Standard cost can also be defined as the management’s desired cost. It determined by the management of a business using different factors to maximize the profits of a business by reducing the costs of the business while also maximizing its earnings. Standard costs are the costs that the management of the business wish to achieve in order to maximize the profitability of the business through efficient use of resources.
Objectives of Standard Costing
Below are the objectives of standard costing:
- To set standards for each type of cost
- Help to provide guidance for improving efficiency
- Act as a control device in implementing a feedback of control cycle
- Helps to motivate employees by providing challenge targets
- To establish the principle of management by exception
To Set Standards for each Type of Cost
There are many different objectives of standard costing. The main objective of standard costing is to set standards for each type of cost incurred for a particular product within the business. These costs include material costs, labor costs and overheads. This helps the management of the business analyze any variances between the expected costs of the business and the actual costs incurred by the business during its processes.
Help to Provide Guidance for Improving Efficiency
Similarly, another objective of standard costing is to help the management of the business in controlling the costs of the business. Not only can standard costing help control the expenses of the business as a whole but also help the management of the business identify any areas of the business where processes are inefficient and, thus, increase the costs incurred by the business. This will help to improve the efficiency and promote cost cutting within the business where applicable.
Act as a Control Device in Implementing a Feedback of Control Cycle
Another objective is to implement a feedback control cycle within a business. The management of a business implements standard costing and uses the results obtained from comparing the standard costs with actual costs to reduce costs and improve the efficiency of the processes of a business.
Helps to Motivate Employees by Providing Challenge Targets
Likewise, another objective of this costing technique is to motivate employees. When the employees of the business know the standards they must meet, they are motivated to work efficiently. However, these standards must be achievable and realistic or else they can have a negative effect on the motivation of employees. In addition, management shall need to distinguish the controllable and non-controllable factors for the evaluation of performance.
To Establish the Principle of Management by Exception
Standard cost is just a predetermined estimate cost of a product. It is an average expected unit cost that a business established. Because it is the expected average cost, the actual cost may vary. Actual cost may be above or below the predetermined estimate cost; however, only significant differences between the actual cost and standard should be reported.
Types of Performance Standard in Standing Costing
Performance standards are typically used in order to set efficiency targets of business. When setting the standard costs of a business, there are many different standards that the management can use. These standards are determined in the form of either quantity or monetary value. The management of the business have to decide which standard they must use that is suitable for the needs of the business. The different types of standards are as below.
Ideal standards, also known as perfection standards, are standards set with the assumption of maximum efficiency and no wastages within the processes for which costs are being determined. They represent an ideal point that can be reached if all the variables that affect the costs within a process go perfectly without any interruptions. Ideal standards are difficult to achieve in most work environments as interruptions within a process are bound to happen. These standards can have negative effects on employee motivation if the employees are forced to follow an ideal standard and be penalized for interruptions outside of their control.
Attainable standards, as the name suggests, are standards that are attainable. This attainable standards represent an optimal achievable standard and take into account predictable or expected wastage unlike ideal standards. However, the standard does not make any provisions for avoidable interruptions as these can be easily avoided by using improving the efficiency of the processes. This promotes a sense of accountability within the management and the employees of a business. Since attainable standards are developed with realistic goals, these can have a positive impact on the motivation of employees.
Basic standards are standards established for use within a business over a long period of time. This basic standards can be used in the preparation of current standards as well. Since these standards are used in a business over a long period of time, these can discourage the management to improve the efficiency of the processes since these standards can become outdated very quickly in volatile businesses. The advantage of basic standards is that they can provide better comparisons within the business, allowing present data to be easily comparable to past data.
While basic standards are used in a business over a long period of time, current standards are developed for a short period of time. These standards are developed and implemented in during specific circumstances and once these circumstances are over, the business reverts back to long-term standards. Current standards are similar to basic standards in that these do not encourage the management of the business to constantly improve processes to improve efficiency.
Features of Standard Costing System
There are many features of a standard costing system. The features of are related to the objectives of standard costing systems. These features are as below:
- Determining the predetermined estimate costs of various elements such as material, labor and overheads.
- Monitoring and controlling actual costs in accordance with the set standards.
- Comparing the standard costs calculated with the actual costs incurred.
- Finding variances between the actual and standard costs. These variances can either be favorable for the business or adverse.
- Analyzing the variances and finding the reasons for these variances. This is done through effective study of the variances.
- Reporting the variances to the management of the business.
- Taking corrective actions to fix any adverse variances and promoting favorable variances.
- If variances cannot be corrected, revising the standards to allow for more realistic comparisons.
Factors to be Considered before the Establishment of Standard Costing System
There are certain factors that need to be considered before establishing a standard costing system. The first factor to consider is when setting standards within a standard costing system, the standards should be specific, measurable, achievable, relevant and time-based. If the standards set do not meet any of these requirements, these standards cannot help the management of the business meet the objectives of standard costing. For example, if the standard set is not specific, then the management and the employees of the business will not realize what is expected of them.
Similarly, when establishing a standard costing system, the management of the business should establish different cost centers within the business. Cost centers are departments or areas of the business where costs are incurred. This allows standards to be set for specific cost centers that are relevant to those centers. Moreover, this allows costs to be easily traceable and comparable for that cost center with the standards set.
Furthermore, the management of the business, before setting up a standard cost system, should classify and codify all the relevant costs. This makes it easier for different costs to be traceable within the system. Furthermore, classifying costs can also help the management recognize high cost areas and reduce the costs within those areas.
There are many advantages of a standard costing system for businesses. These advantages are as below.
- Used in the preparation of budgets. It can help with the preparation of more accurate budgets.
- Can help the management identify areas and processes within the business that are inefficient. Therefore, it can help with increasing the efficiency and effectiveness of different processes by cutting inefficiencies.
- Can be used along with other tools to compare the actual costs of the business against standard costs to evaluate the performance of a business.
- Can be used as a performance appraisal tool for managers of different cost centers within the business.
- Standard costs can be used to value the inventory of a business and set the wages of employees within the business.
- Can be used as a feedback control tool as it highlights problematic areas within the business.
- Can help in the decision-making process of a business. The decisions may include decisions regarding the processes of the business or pricing decisions for different products.
- If implemented properly, it can be used as a motivation tool for the employees of the business.
- Helps in tracing costs to a single unit of product. This can be helpful in identifying the cost per unit of product which can be used in many other calculations within cost accounting.
- Can help simplify the accounting process of a business. Instead of using historical costs of material and labor, businesses can use the standard costs of these products.
- Can help with price formulation of custom products as the cost of these products can only be calculated after they have been incurred. However, through standard costing, the costs can be estimated beforehand.
There are many disadvantages of standard costing systems as well. Some of these disadvantages are as below:
- Cannot be used for cost-plus contract where customers pay the business for actual costs incurred along with a percentage of profits. This is because the actual costs of a product may be significantly different than its standard costs.
- May drive the management and employees of the businesses to use fraudulent ways to show actual performance is similar or close to standards. This also indicates that the standards set are not realistic.
- Used reactively, not proactively. Actual performance is measured against the standard after the costs have been incurred. It does not prevent costs from increasing in the first place.
- May cause low morale and hinder employee motivation if not formulated properly.
- Uses subjective judgement to set standards. These may not be realistic.
- Difficult to achieve right mix of standard costs to motivate employees while also achieving profits for the business.
Standard costing is used within cost accounting to calculate the expected costs of a product. The objective of this technique may include setting standards for different costs within a business and acting as a monitor and control tool. It can also be used to perform a variance analysis between standard costs and actual costs incurred to identify and inefficiencies within the processes of the business. There are different types of standards that can be set such as ideal, attainable, basic and current standards. The features of standard costing are related to the objectives of standard costing. Using a standard costing system may have its own advantages and disadvantages.