Standard Costing

Standard Costing: Detailed Explanation

Standard costing is a cost management technique used to estimate and control costs by setting predetermined, standard costs for materials, labor, and overhead. It helps businesses compare actual costs to these standards and analyze variances to improve cost control and decision-making.

Process of Standard Costing

• Establishing Standard Costs:
  • Direct Materials: Predetermined cost for the materials needed to produce one unit.
  • Direct Labor: Predetermined cost for labor required to produce one unit.
  • Manufacturing Overhead: Predetermined costs for indirect expenses related to production (e.g., utilities, depreciation).
• Example: If it takes 2 pounds of material at $5 per pound to make one unit, the standard cost for materials is $10 per unit.
• Recording Actual Costs:
  • Track actual expenditures on materials, labor, and overhead during production.
  • Actual costs are recorded separately to allow comparison with standard costs.
• Calculating Variances:
  • Variances are differences between actual costs and standard costs.
  • Common variances include:
    • Material Price Variance: Difference between the actual price paid for materials and the standard price, multiplied by the actual quantity used.
    • Material Quantity Variance: Difference between the actual quantity used and the standard quantity, multiplied by the standard price.
    • Labor Rate Variance: Difference between the actual wage rate and the standard rate, multiplied by the actual hours worked.
    • Labor Efficiency Variance: Difference between the actual hours worked and the standard hours, multiplied by the standard wage rate.
    • Overhead Variances: Differences between actual and standard overhead costs.
• Analyzing Variances:
  • Investigate reasons behind variances to determine their causes (e.g., inefficiencies, price changes).
  • Use variance analysis to identify areas needing improvement.
• Adjusting Future Estimates:
  • Use insights from variance analysis to refine future cost estimates and improve budgeting accuracy.

Advantages of Standard Costing

• Identifies Inefficiencies:
  • Highlights areas where actual costs deviate from standards, signaling inefficiencies in production or operations.
• Cost Control:
  • Provides a basis for managing and controlling costs by setting benchmarks and monitoring performance.
• Performance Evaluation:
  • Facilitates performance evaluation through variance analysis, helping to assess departmental or individual performance.
• Consistency:
  • Offers a consistent basis for making financial decisions and comparisons over time.
• Improves Budgeting:
  • Enhances future budgeting accuracy by providing historical data and insights from variance analysis.

Disadvantages of Standard Costing

• Setup Complexity:
  • Establishing standards can be time-consuming and costly, requiring significant initial effort.
• Potential Inaccuracy:
  • Standards may not always reflect actual production costs, especially if there are significant changes in the production environment.
• Focus on Cost Reduction:
  • Emphasis on meeting cost standards might lead to cost-cutting measures that compromise product quality or customer service.
• Inflexibility:
  • May not adapt well to rapid changes in production conditions or market dynamics.
• Non-financial Factors:
  • May overlook important factors like employee morale, which can affect costs indirectly.

Types of Variances

• Material Price Variance:
  • Formula: (Actual Price - Standard Price)×Actual Quantity
  • Purpose: Measures the cost impact of differences in material prices.
• Material Quantity Variance:
  • Formula: (Actual Quantity - Standard Quantity)×Standard Price
  • Purpose: Assesses the cost impact of differences in the amount of material used.
• Labor Rate Variance:
  • Formula: (Actual Rate - Standard Rate)×Actual Hours
  • Purpose: Evaluates the impact of differences in wage rates on labor costs.
• Labor Efficiency Variance:
  • Formula: (Actual Hours - Standard Hours)×Standard Rate
  • Purpose: Assesses the impact of differences in labor efficiency.
• Overhead Spending Variance:
  • Formula: (Actual Overhead - Budgeted Overhead)×Actual Activity
  • Purpose: Measures differences in actual versus budgeted overhead costs.
• Overhead Efficiency Variance:
  • Formula: (Actual Activity - Standard Activity)×Standard Overhead Rate
  • Purpose: Evaluates the impact of differences in production activity levels on overhead costs.

Example

Company: ABC Ltd.

Budgeted Data:

• Direct Materials Cost per Unit: $20
• Direct Labor Cost per Unit: $10
• Variable Overhead Cost per Unit: $5
• Fixed Overhead Cost per Unit: $5
• Budgeted Production: 10,000 units

Actual Data:

• Production: 9,800 units
• Actual Overhead: $49,500
• Actual Direct Materials Cost: $195,000
• Actual Direct Labor Cost: $98,000

Calculations:

• Standard Cost per Unit:
  • Direct Materials: $20
  • Direct Labor: $10
  • Variable Overhead: $5
  • Fixed Overhead: $5
  • Total Standard Cost per Unit: $20 + $10 + $5 + $5 = $40
• Total Standard Cost for Budgeted Production:
  • $40×10,000 = $400,000
• Overhead Variance:
  • Standard Overhead Rate: $5 per direct labor hour
  • Budgeted Direct Labor Hours: 10,000 hours
  • Overhead Cost Applied: $5×9,800 = $49,000
  • Overhead Variance: $49,500−$49,000 = $500

Setting Standards

• Identify Cost Elements:
  • Determine which cost elements (e.g., materials, labor, overhead) will be standardized.
• Determine Standard Quantity and Price:
  • Establish the expected quantity and cost for each element based on historical data or industry benchmarks.
• Calculate Standard Costs:
  • Multiply standard quantity by standard price to obtain standard costs for each element.
• Review and Update Standards:
  • Regularly update standards to reflect changes in market conditions, technology, and production processes.

By using standard costing, businesses can set benchmarks for performance, control costs, and make more informed financial decisions.