Standard Costing
Standard costing is the cost accounting method that determines the expected cost for each product as a part of production planning or budgeting. It includes direct material, direct labor, and manufacturing overhead costs. It is called the predetermined cost, estimated cost, expected cost, or the budgeted cost.
The company usually conduct the testing to estimate a proper standard cost of each production unit. With this cost, they will be able to calculate the inventory valuation, cost of goods sold, which will impact the profit during the period. More important, it helps the management to set a proper price and compete in the market.
Standard Costing Formula
| Standard Cost = Direct Material + Direct Labor + Overhead Cost |
What is the Process of Standard Costing?
| Costing Process | |
|---|---|
| 1. Set the Standard Cost | The company starts to calculate the standard cost per unit, which result from the experience, engineering & design team, and the management estimation. The estimated cost also includes the percentage of wastage, which also arrives from the prior year, machine quality, and worker experience. |
| 2. Calculate the Actual Cost | The actual cost will be monitored and record base on each cost classification. The actual cost must separate the same as the standard cost so that it will be easy to compare. |
| 3. Compare the standard cost and actual cost | We need to compare the estimated cost with actual result. Any variance needs to investigate in the next step. |
| 4. Investigate the variance | Any actual cost which higher than the standard need to investigate. The managers need to provide the most appropriate reasons which respond to the difference. |
| 5. Record to financial statement | Any negative variance need to record to statement of profit and loss |
Example of Standard Costing
Company A produces product X. The manager has conduct meeting with the engineering, design, and purchase department, after the meeting they conclude the cost as following:
| Classification | Cost |
|---|---|
| Direct Material | $ 5 per unit |
| Direct Labor | 4 hours per unit |
| Overhead | $ 3 per unit |
During the year, Company A has produced 20,000 units with the following cost:
- Direct Material: $ 105,000
- Direct Labor: 75,000 hours
- Overhead: $ 70,000
Management has conducted a meeting with related departments to investigate the variance, there are some reasons below:
- The material cost is higher than standard $ 5,000 (5,000/100,000 = 5%), which due to the market price change. It has nothing to do with company efficiency.
- Direct labor is less than expected 5,000 hours (5,000/80,000 = 6.25%), which due to the learning curve of workers.
- Overhead cost is higher than expected $ 10,000 (10,000/60,000= 16.66%), which due to the production level below the full capacity. The overhead cost per unit will decrease when the production level increase.
Impact on the Financial Statement
- The direct material cost will be added to the statement of profit and loss as a part of the cost of goods sold. It will deduct the net income.
- The labor variance is favorable, it will deduct the cost of goods sold and increase the net income.
- The overhead cost will also include in the statement of profit and loss and reduce the net income.
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 base on the design and product’s feature even before the actual production.
- This method helps the management to calculate selling price. In business operation, we need to send a quotation which includes 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 access 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 reduce cost. On the other hand, setting too low cost will put too much pressure on them to archive the result which will never happen.
- The difference between standard and actual cost must be investigated and it will use as the basis for future standard cost. In daily operations, there will change so our costing must be reflected with those changes.
What are the Advantages of Standard cost?
| Advantage of Standard Costing | |
|---|---|
| Production Planning | It is easy for the company to prepare the production planning or budgeting. We cannot have the actual cost during the budgeting stage, so the best way is to use the standard one. |
| Inventory valuation | Using standard cost is easy to have a valuation on inventory at a specific period. We just multiply the inventory quantity with its cost. It may be different from the actual production, but it is not much different as it usually updates to reflect the change in the prior year. |
| Price calculation | It is impossible to have the actual cost when we submit the quote to the customer. Only the standard cost can help us with price calculation. The selling price can get from the cost plus a profit margin. |
| Improve cost control | With Standard cost, we have a basis for benchmark and the manager will try his best to control the cost. The manager needs to provide an appropriate reason if the actual cost is higher. |
| Cost deduction | The company can motivate the manager and employees to improve their work efficiency which leads to cost reduction. |
What are the Disadvantages of Standard Cost?
| Disadvantage of Standard Cost | |
|---|---|
| Hard to set Standard Cost | Setting standard cost is a very difficult task which requires time, experience, and industry knowledge. It is almost impossible to set the perfect one which is exactly matched with the actual cost. |
| Difficult for multi production | If the manufacturer produces more than one unit, it is difficult to set a specific standard cost especially the overhead. The company with a complex structure will find it impossible to separate this overhead beside the estimation. Anything wrong with standard costs will lead to inappropriate decision including pricing. |
| Demotivate the staff | Variance analysis will focus on the unfavorite, not the favorable variance. The employees think that their efficiency is ignored. |
| Less flexible | Every time the company prepares standard costs, it will not be changed at least within a specific time period (usually one year). There are many factors that will impact the production cost, however, it will not reflect with them. We need to use it one more year, it will be very hard even the company wants to update. |
| Unrealistic standard cost | If the standard cost is too low, it will never hit by the actual cost. There will always be variance. If it is too high, the managers will not worry and focus on cost-cutting. They will try to increase the actual cost to meet the standard and prevent any deduction next year. |
Difference Between Standard Costing and Budgetary Control
Budgetary control is the system which the company set their financial goal (budget) and compare the actual profit and taking responsive actions if required. It might sound similar to standard cost; however, these are the two separate concepts which we can differentiate as following:
| Basic | Standard Costing | Budgetary Control |
|---|---|---|
| Meaning | The costing method which calculates the product’s expected cost and compares with actual cost. | The system that prepares expected total revenues and expenses and compare with actual. |
| Basic | It bases on each product design and feature. | We prepared budget base on past data. |
| Scope |
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| Responsibilities | Production managers are mainly the responsible person to ensure actual cost align with standard. | The CEO is the highest responsible person to make sure that financial results adhere to the plan. |
| Report | The variance analysis must report to the top management and use it as the basis for future use. | The is no requirement for the report. |
| Account | It predetermines the direct material, direct labor, and overhead. | The budget needs to estimate all accounts in the financial statement. |
Type of Standard Costing
Ideal, Perfect or Theoretical standards
This type of standard costing believes the perfect condition when there is no interruption and wastage during production. They believe that there is no machine breakdown, worker tea break, or any error in the production process. Therefore, the production will be able to maximize their capacity which almost impossible to happen in real life.
Normal standards
The normal cost will be used over a period of time, usually the business cycle of the company. It bases on the average between the highest and lowest production over the cycle. The company expects that the cost will not change over the full cycle.
Basic standards
As the name suggests, it bases on the assumption of the basic nature of company business over a long period of time. Therefore, this cost will only change when the core business of company changes.
Current standards
This method will always update to reflect on current business operations. So they can use over a long or short time based on how fast the change in business.