The standard costs are estimated in a company’s production process, as actual costs cannot be known in advance. This helps a company planning a budget. Later, when the actual costs are established, the company can see if it has a favorable budget variance (in other words, actual costs do not exceed standard costs) or unfavorable budget variance (the standard costs were exceeded).
Here is what we will cover in this article:
- Why do manufacturers use standard costs?
- Standard costing formula
- What are the characteristics of Standard Costing?
- Advantages of standard costing
- Disadvantages of standard costing
- Is a Standard Cost Different from a Budget?
Why do manufacturers use standard costs?
One reason for a manufacturer to use standard costs is to carefully plan its costs for the upcoming budgeting year and then compare the actual costs with those planned costs. If the actual costs are similar to the standard costs (the planned costs; what the costs should be), the company is on track to reach the cost part of its profit plan. If the actual costs deviate from the standard costs, management is alerted by the variances reported for materials, labor, and manufacturing overhead. Hence standard costs allow a manufacturer to practice management by exception. That is, if the actual costs are what they should be, management action is not required. If the actual costs are more than the standard costs, management must take action, or not achieve the planned profit.
The standard cost variances direct management’s attention to the area where the problems are occurring. If the problems cannot be solved easily, management may need to explore alternate materials or processes, attempt to increase selling prices, etc. Again, without reacting to the variances the company’s planned profit for the year will not be met.
Standard costing formula
Standard Cost = Direct Material + Direct Labor + Overhead Cost
Standard costing is more prevalent in the manufacturing industry and to calculate the same we need to follow the below steps:
- Step #1: Identify all the direct costs associated with the manufacturing cost, and these costs would be like if they don’t incur, then the manufacturing process would have impacted.
- Step #2: Calculate the standard quantity and standard hours based on actual output.
- Step #3: Categorize those costs into three significant buckets, which are Material, Labor, and Overheads, and then overheads can categorize into fixed and variable.
- Step #4: Take the total of the cost that you calculated in step 3 that shall be the total standard cost for the firm.
What are the characteristics of Standard Costing?
It usually has the following features :
- It is predetermined in the planning stage, which means that the company prepares this cost based on the design and product’s features even before the actual production.
- This method helps the management with selling price calculation. In business operations, we need to send a quotation which includes our selling price to the customer in advance. We cannot wait for the actual cost, which may differ due to various reasons and it will be too late to inform our customers. Therefore, the standard cost is the best tool for us to set the selling price.
- It will be a tool to assess management performance; the variance between actual and estimate can show how good they are performing. However, setting standard costs must be involved from various parts in order to ensure transparency. We have to ensure that it is not overestimated as it will not force the production team to save. On the other hand, setting too low a cost will put too much pressure on them to archive the result which will never happen, and in the end, they just let it go.
- The difference between standard and actual cost must be investigated and it will be used as the basis for future standard cost. In daily operations, there will change so our costing must be reflected with those changes from time to time.
Advantages of standard costing
Standard costing provides managers with several advantages that can help their business operate more efficiently. Here are a few examples:
A standard costing system provides a quick estimate of projected costs. Though accurate reports are nice to have, they are not timely. A good estimate of costs provided promptly is highly preferable.
Allows for cost control
In the event of variances, managers are allowed to rectify any discrepancies. This will then allow them to improve cost control. This means they can be more aware of spending habits in the future and strive for little to no variances.
Helps management make decisions
Standard costing can also affect the way a business operates as a whole. Once managers have determined any variances, this allows them to act and improve on current business practices and spending.
For example, if the actual cost of materials is $50,000 and exceeds the standard cost of $10,000, this would cause a variance of $40,000.
Managers can then begin to investigate why the variable occurred and how to prevent it from happening in the future. The large variance in this circumstance could be caused by several reasons such as inflation or the inefficient use of products purchased.
When managers have controlled costs through the use of the standard costing system, the actual costs in the future should be close to the standard costs. This outcome is highly favorable because this means that the profit plan went as projected. This can lead to more accurate budgets in the future.
Lower production costs
A lower amount of production costs could be a possible advantage when implementing a standard cost system. Because standard costing allows others to visualize spending habits, employees could end up being more cost-conscious, efficient and work on their performance. This could result in lower production costs overall.
Disadvantages of standard costing
Though standard costing can be beneficial for business operations, it also has some drawbacks. Here are some disadvantages of implementing a standard costing system:
Because variance reports are only prepared monthly and it takes time for this information to be released, by the time it finally is released, the information might not be of pertinent use anymore. This can be avoided by creating timely and more frequent reports.
Most managers tend to focus on problem areas rather than success. In regards to standard cost, they could be spending more time rectifying any variances than congratulating employees for a job well done. Employees need positive reinforcement to enjoy their work and know they’re an integral part of the business. Using a standard costing system could increase the potential for low employee morale.
Because of low morale, employees could potentially hide any unfavorable variance reports to avoid any future repercussions. This would give managers a false sense of their profit plan. Knowing the results of past variance reports could also lead employees to take actions that would affect the business. This could include employees putting in an increase in output at the end of the month to avoid an unfavorable report. This could then lead to a lower quality product.
Is a Standard Cost Different from a Budget?
A standard cost is not the same as a budget.
A budget is an estimate of expenditures for a specific accounting period, typically a quarter or year. Standard costs are estimates used for totals in some of the line items in that budget, as they related to manufacturing costs.