Standard costing is a cost accounting measurement basis that predicts unit costs and production quantities based on predetermined standards before the production even begins and as such it is an alternative method to historical cost accounting.
It is suitable for production, which is standardized and mass or repetitive.
Standard costing serves as an important input for the budget and can be used within various costing methods (full costing method, variable costing method, throughput costing etc.).
Basic steps in standard costing:
- Select a standard (see below)
- Estimate standard unit costs and production quantity
- Ascertain actual unit costs and production quantity
- Variance analyses, during which standard costs are compared with actual costs
- Analyses of significant variances and their reporting to management
- Taking a corrective action
Standard cost is estimated and predetermined cost of direct materials, direct labor and production overhead expressed usually in the form of unit costs.
Standard costs shall be revised when inherent conditions change or/and the variances of standard costs with actual are significant.
How estimate standard costs
Calculation shall begin with the average past costs over a few past months or years. Nevertheless, all the factors that influence costs must be considered.
Examples of factors to consider during creating standard material costs
- Price (unit cost) of raw material
- Purchasing terms – i.e. not only currently agreed prices, but also results of ongoing/expected negotiations with existing or new suppliers
- Expected market changes in prices of raw materials
- Required changes in quality – higher quality materials are more expensive
- Expected changes in transport conditions (e.g. by the entity or by suppliers)
- Age of property and equipment – old assets can produce higher losses (which increase unit price)
- Expected inflation
- Budgeted units are usually also important for setting the price – e.g. for the possibility to achieve discount for buying in bulk
- Units of material consumed per a single product
Examples of factors to consider during creating standard labor costs
- Existing wages and salaries and their expected rises
- Expected changes in the labor market
- Expected changes of the social and health insurance rate paid by the employer
- Expected inflation
- Labor hours required to produce cost unit
- Budgeted production volume
- Expected labor efficiency (e.g. the effect of learning curve)
- Expected automation, which may reduce the number of hours worked
- Idle time (e.g. due to machine breakdowns or lack of customer orders)
Examples of factors to consider during creating standard production overhead costs
- Production overhead costs
- Purchasing terms and expected market changes
- Expected inflation
- Budgeted production volume (including expected normal losses such as natural wastage)
→ overhead absorption rate obtained by dividing budgeted production overheads and production volume or other level of activity
Types of standards used in standard costing
- Ideal standard assumes that all possible favorable conditions (low prices for inputs, minimum new competitors etc.) and no unfavorable will happen (no losses, inefficiencies or idle time).
- Theoretically is ideal standard possible, but it will almost always be unachievable. As the result, the variances between standard and actual costs will almost be negative, which may be very frustrating (staff may think “why would we bother to work harder, if the result will be adverse anyway”).
- This standard is thus not very useful.
- Attainable standard is set to be realistic and challenging at the same time with a reasonable allowance for losses, inefficiency and idle time.
- This most frequently used standard is the best for employee motivation.
- Current standard is based on existing working conditions
- and as such, it does not motivate employees to improve their performance.
- Basic standard is based on the working conditions over long period of time.
- It thus reflects trend and does not change much over time.
- This may have adverse impact on employee motivation again.
Advantages of standard costing
- Facilitates planning and cost control
- If standard costing system is linked with staff evaluation, it can enhance employee motivation (however, if reasonable standards are used)
Disadvantages of standard costing
- Implementation of standard costing and its maintenance may be time consuming and expensive
- There are number of cases, when standard costing does not make much sense:
- In industries with rapid changes – standards become easily out-of-date.
- The production process is highly automatized and inefficiencies are thus not so frequent. In this case, there are not many possibilities to influence labor costs (this is where standard costing is most useful).
- Manufactured products are not at least a little standardized.
- Cost-plus contracts, where customers are committed to pay the costs incurred plus agreed profit margin. As the result, actual costs must be used in this case. Although the customer pays all the costs, lower costs (achieved by their effective management e.g. by using standard costing) means a lower price for the customer and as such more competitiveness for the organization.