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.
Standard Costing Formula
The formula to calculate standard costs:
Standard Cost = Material Cost + Direct Labour + Manufacturing Overhead
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.
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
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.
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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