What is the standard cost?
A standard cost is a predetermined cost. It is a determination of the cost in advance of production.
The standard cost is the amount anticipated to be paid for materials or labour. The standard quantity is the estimated amount of materials or labour used. A standard cost may be derived from the history of industry standards. The firm may then analyse its efficiency by comparing the standard expenses to its actual outcomes.
It is essential to establish cost standards at the beginning of a period to construct a budget, control material, labour, and administrative expenses, and set a fair price for a product. A corporation often determines standard costs at the beginning of the fiscal year for prices paid and amounts utilised.
The technique is known as “standard costing” when standard costs are used for cost control.
Definition of Standard Cost and Standard Costing
The costing terminology of the Chartered Institute of Management Accountants, London, defines a standard cost and standard costing as follows:
“A determined calculation of how much costs should be under specified working conditions. It is built up from on assessment of the value of cost elements and correlates technical specifications and the quantification of material, labour and another cost to the prices and or wages rates expected to apply during the period in which the standard cost is intended to be used. Its main purposes are to provide bases for control through variance accounting for the valuation of stock and work in progress and in some cases, for fixing selling prices.”
The main points in the above definition are:
- It is a pre-determined calculation of what cost should be under specific working conditions.
- It is built up by correlating standard quantity (of machine time, the labour time and material) and forecasting the future market trend for price standards (I.e., prices for materials, wage rates and machine cost per hour etc.)
- It provides the basis for control through variance accounting.
- It provides the basis for stock valuation and works-in-progress and, in some cases, fixing selling prices.
Typically, standard costs are defined based on feasible productivity levels (production). They act as a benchmark and are important for inspiring average performance. Under the assumption that everything is perfect, machines do not break down, employees arrive on time, there are no flaws, no scrap, and materials are flawless, an ideal standard level is established.
Uses of standard costs
You may have referred to them as standards when you have set and attempted to reach goals.
Periodically, you may compare your actual performance to these standards and examine the discrepancies to determine your progress towards your objective. Similarly, management establishes objectives, such as standard expenses, and then compares actual costs to these objectives to discover potential issues.
Advantages of Standard Costs
Improved cost control
By establishing standards for each sort of expense spent and then emphasising exceptions or deviations — instances when things did not go as planned — businesses may achieve stronger cost management. Variances serve as a basis for evaluating the success of managers in controlling the expenditures for which they are accountable.
More information that managers can use to plan and make decisions
When management comes up with good cost standards and is able to keep production costs under control, future costs should be close to the standard. So, management can use standard costs to make budgets and estimates for bids on more accurate jobs. The top management can use a standard cost system to help them plan and make decisions.
More accurate and easier to use inventory measurement
A standard cost system makes inventory valuation more straightforward than an actual cost system. Under a system based on real costs, unit costs for batches of similar items may vary significantly. This variance can arise, for instance, if a machine fault occurs during a certain batch’s manufacturing, increasing the labour and overhead costs associated with that batch. Under a typical cost system, such unique charges would not be included in inventory. Rather, these excess expenses would be charged to variance accounts following comparison of actual costs to standard costs.
Consequently, in a standard cost system, an organisation thinks that all units of a specific product produced within a certain time period have the same unit cost. Identical physical units produced over the same time period should be accounted for at the same cost.
Cost savings in record-keeping
Although it may appear that a standard cost system requires more extensive documentation during the accounting period than an actual cost system, the opposite is really true. A system that collects only real costs, for instance, demonstrates cost flows between inventory accounts and, ultimately, cost of goods sold.
It documents the fluctuating quantities of real unit costs that must be computed over time. In a standard cost system, a business displays the cost flows between inventory accounts and the cost of products sold at consistent standard quantities. Actual unit costs for the time may be calculated without any further computations. Instead, organisations may print standard cost sheets in advance, which include the standard quantities and unit costs for the materials, labour, and overhead required to manufacture a particular product.
Meaning of Standard Costing
Standard costing is preparing standard costs and applying them to measure the variations from the actual cost and analysing the causes of these variations to maintain maximum production efficiency. It is a technique that uses standards for cost and revenues for control through variance analysis.
- Ascertainment of standard costs under each cost element, i.e., materials, labour, and overhead.
- Measurement of actual costs.
- There is a comparison of the actual costs with the standard costs to find out the variances.
- Analysis of variances for ascertainment of the reason for variances. The appropriate action where necessary so that maximum efficiency may be achieved.
Standard costs are used as a baseline against which real costs may be compared to determine the system’s source of inefficiency. The real costing system must always be considered, even if a traditional accounting method is employed.
This costing system may be advantageous in any business; however, it is most commonly used in industries that create comparable standard commodities. Therefore, standard costing is more common in the process and engineering sectors but is useless in the task order industry.
Even in jobbing industries where jobs vary significantly, there is a considerable possibility of implementing this costing system. While many businesses’ products may not be repetitive and standard, the activities required to do the task and standards can be established for the processes conducted.
The standard cost of the project can be determined by aggregating the standard costs of the job’s operations. Comparing the actual cost of operations to the standard cost of operations will assist in controlling the cost of operations and, thus, the work cost.
Advantages of Standard Costing
- Cost control – it would show variances and the underlying causes thereof. Thus, management can better control the cost.
- Easy identification of sources of losses and wastages – A well-functioning standard-costing system will track the expense heads leading to losses and wastages. Thus, appropriate steps can be taken.
- Proper inventory valuation – The effect of historical cost is eliminated in this costing approach, thus leading to a more accurate valuation.
- Enhanced efficiency of operations
- Integration of accounts