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written by | August 10, 2022

What Is Standard Costing?: Definition and How it Works

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Standard costing is an alternative to the traditional cost layering systems such as LIFO (last-in, first-out) and FIFO (first-in, first-out). The main reason for adopting standard cost accounting is that it is time-consuming to collect details of the actual cost; therefore, standard costs are applied. To know about standard costing in detail, do read this article entirely. It will inform you about the types of standard costing, its formula, advantages and more. 

Did you know? Accountants establish standard costs at the beginning of each fiscal year.

What is Standard Costing?

Standard costing meaning is to account for the cost of production by assigning overhead costs to the products. Let’s look at the standard costing definition.

Standard costing is an accounting technique that assigns fixed manufacturing costs to specific products or product lines. This method lets companies know the production cost for a certain number of items. The main goal of standard costing is to simplify the process of assigning costs and identify areas where more resources are needed. It also helps in analysing the profitability of different product lines, and in some cases, the management can use standard costing as a pricing tool.

Also read: All Facts and Figures About the Nominal Account in Accounting

Standard Costing Formula

The formula to calculate standard costs:

Standard Cost = Material Cost + Direct Labour + Manufacturing Overhead 

Where,

Material Cost = Total Number of Units × Market Price Per Unit

Direct Labour = Employee Hourly Rate × Number of Hours Worked × Total Number of Units

Manufacturing Overhead = Fixed Overhead (Variable Manufacturing Overhead × Total Number of Units)

Advantages of Standard Costing

Let’s see some of the advantages of standard costing

Manufacturing companies use standard costing to create their budgets. Companies use standard costing because it is difficult to calculate a unit's production cost before manufacturing. To find out the difference amount, this information makes an accurate budget for the coming financial year.

  • Simplifies Inventory (Stock) Costing

Using standard costs makes the calculation of stock (inventory) easier. Usually, the production cost of one batch differs from the other. This is due to variation in the price of raw materials, production delays, changes in salaries/ wages, etc. Using the standard costing process, the stock can be calculated by multiplying actual inventory with the standard cost of each unit. This helps manufacturers to estimate the inventory cost. Under this process, the inventory cost is close to the actual cost.

  • Makes It Easy to Fix the Selling Price of the Product

This system helps fix the price of the finished product before the manufacturing process is complete. A clear idea of the estimated manufacturing, labour and overhead costs and others helps companies to fix the product price accurately. This method makes it easy to track production cost changes with different volumes while maintaining the price of the product in all the batches produced. 

  • Efficient Management of Financial Records 

Relying only on the actual cost of manufacturing makes it difficult to maintain the financial records of the company. Standard costing simplifies this process and makes it easy to calculate and maintain records. When a company has accurate estimated costs, it can focus on other activities like borrowing and overdrafts. 

  • Setting Production Benchmarks

Companies use standard costing to set goals. Comparing with the actual cost shows if the goals have been met. The budgeting is successful if the standard cost is similar to the actual cost incurred. In case the actual cost exceeds the standard cost, the company must revise its production policies and increase efficiency to reduce the costs in the future.

Also read: Different Types of Accounts in Accounting - 3 Types of Accounts

Disadvantages of Standard Costing

Following are the disadvantages of standard costing:

  • Not Applicable with Cost-Plus Contracts 

Under this contract, the manufacturers are paid by the clients according to the actual costs. In this case, the manufacturers cannot use standard costing to draft a contract with the client. 

  • Can Lead to Incorrect Measures

If there are unfavourable differences when the actual and standard costs are compared, the management may take an incorrect decision to fix the issue. E.g., purchasing raw material in bulk decreases the variance, which may lead to extra expenses and stock backup. 

  • Not Suitable for Fast-Paced Environments with Regular Price Fluctuation 

Under standard costing, the goal is for the price to remain constant. Products with a short lifespan and continuous fluctuation in price make it difficult and irrelevant to put standard costing to use. 

  • Offers Slow Feedback

The calculation for the price variance is generally done at the end of each manufacturing cycle. If the manufacturing department needs immediate feedback to take corrective measures, this method will slow down feedback and become irrelevant. 

  • Does Not Offer Information on Each Unit

The price variance calculated is for the entire manufacturing department. Hence, it does not provide feedback for each production unit. In such a case, standard costing fails in pointing out discrepancies for each production unit.

Types of Standard Costing

There are three types of standard costs:

  • Ideal Standard Cost
  • Basic Standard Cost
  • Currently Attainable Standard Cost

Also read: What Are Different Types of Accounting Explained With Examples & Importance

Ideal Standard Costs

These show total performance with 100% efficiency. There are no losses incurred or idle time. So there is no reason for work interruption owing to mechanical failure, unavailability of raw material and other issues. It requires efficient and motivated employees and maximum use of facilities to achieve the set standards. 

Companies usually do not use or promote ideal standard cost, as it is demotivating for the employees. Some companies prefer to set ideal standard costs as goals as this may improve the level of performance of the company, thus, making it more efficient and competitive. 

Basic Standard Costs

Over the years, the cost of raw materials and labour has increased, and improved production methods have been adopted. So the basic standard cost does not represent the current costs anymore. Also, it does not predict the future of the company’s status accurately.

Currently Attainable Standard Costs

These standard costs are challenging but attainable. An efficient and motivated team can achieve the targets set by the organisations in currently attainable standard costs under normal working conditions. These costs have space for both man and machine failures and allow for machine breakdowns, wastage and loss of time. In this category, the goals are difficult but reachable. 

This is the best available method for organisations to adopt as the goals set are challenging but realistic. Owing to the normal work conditions, the employees feel motivated to attain the goal. Since the organisation takes note of all inefficiencies and setbacks, these costs can be used for planning inventories and forecasting cash flows.

Also read: What is an Accounting Transaction? Example & Types of Accounting Transaction

Conclusion

We hope this article was helpful in providing information about standard costing. Standard costing helps organisations set a pre-estimated cost for an actual cost in the book of account. This method helps in setting an accurate budget and judges if the set target can be achieved. It provides insight into the manufacturing lines by comparing the standard and actual costs. Standard accounting shows the discrepancies and inefficiencies (if any) and provides scope for improvement. 

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FAQs

Q: What are the disadvantages of standard costing?

Ans:

Following are the disadvantages of standard costing:

  • Not applicable with cost-plus contracts.
  • It can lead to incorrect measures.
  • Not suitable for fast-paced environments with regular price fluctuation.
  • Offers slow feedback.
  • Does not offer information on each unit.

Q: How are standard costs calculated?

Ans:

The formula to calculate standard costs:

Standard Cost = Material Cost + Direct Labour + Manufacturing Overhead.

Q: What are the advantages of standard cost accounting?

Ans:

Here are the advantages of standard costing:

  • Helps in setting an accurate budget.
  • Simplifies inventory (stock) costing.
  • Makes it easy to fix the selling price of the product.
  • Efficient management of financial records.
  • Setting production benchmarks.

Q: What are the types of standard costing?

Ans:

Here are three types of standard costs,

  • Ideal Standard Costs
  • Basic Standard Costs
  • Currently Attainable Standard Costs

Q: What is the need for standard costing?

Ans:

Companies use standard costing for preparing a budget. Unless the manufacturing process is complete, it is not possible to accurately predict the production costs and other expenses. Several unknown variables like an increase in the cost of raw material, changing labour costs, interruptions and delays in production, and others have an effect on the final cost of the finished product. Standard costing is not applied only for budgeting but also to decide the cost of manufactured goods.

Q: What is standard costing?

Ans:

Standard costing is the process of estimating manufacturing expenses in advance. Since it is not possible to correctly foretell the manufacturing costs in advance, the manufacturers use this method to estimate materials, labour, production and overhead expenses beforehand. With the help of the estimated expected costs, the manufacturers can prepare a budget and plan accordingly.

Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.
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Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.