Standard Cost and Standard Costing

Historical Costing and Standard Costing

Historical Costing

In the early development of cost accounting, historical costing was the primary method for determining costs. It focuses on ascertaining actual costs—those incurred in the past. These costs are recorded after they have been incurred.

• Key Feature: Ascertainment of actual costs after they have been incurred.

Limitations of Historical Costing

1. Lack of Cost Control Basis: Historical costing provides limited opportunity for cost control. Since costs are recorded after they've been incurred, there's little chance to influence or manage them proactively.

2. No Efficiency Yardstick: Without predetermined benchmarks, it's difficult to assess the efficiency of operations. Historical costs alone don't provide a basis for comparison or performance evaluation.

3. Delayed Information Availability: Cost information is available only after the costs have been incurred, making it less useful for timely decision-making. This delay hinders proactive management.

4. Potentially Expensive System: Tracking and recording actual costs can be resource-intensive, potentially making it an expensive system to maintain.

Standard Cost

"Standard" refers to a norm or criterion. A standard cost is a predetermined or target cost that should be incurred under efficient operating conditions. It serves as a benchmark against which actual costs are measured.

• Key Feature: Predetermined costs or target costs established before actual costs are incurred.

• CIMA (Chartered Institute of Management Accountants) Definition: "Standard Cost is a predetermined cost based on technical estimates for material, labor, and overhead for a selected period of time for a prescribed set of working conditions."

• Core Objective: To look forward and assess what costs should be, rather than simply recording what costs have been.

Standard Costing

Standard costing is a technique where standard costs are calculated and then compared with actual costs to identify the difference between the two. These differences, known as variances, are then analyzed to determine their causes, providing a basis for cost control and performance improvement.

• Brown & Howard Definition: "A technique of cost accounting which compares the standard cost of each product or service with the actual costs, to determine the efficiency of the operation so that any remedial action may be taken immediately."

Steps in Standard Costing and its Applicability

Standard costing is a powerful cost management technique that involves several key steps and is best suited for specific types of industries.

Steps in Standard Costing

The standard costing process typically involves the following five steps:

1. Setting Standard Costs: This involves establishing predetermined target costs for each cost element:

   • Material Standards: Standards are set for material prices (how much should be paid for materials) and material usage (how much material should be used per unit of output). These standards consider factors like market conditions, supplier agreements, and production efficiency.
   • Labor Standards: Standards are set for labor rates (how much should be paid per hour of labor) and labor efficiency (how many labor hours should be required per unit of output). These standards consider factors like wage rates, labor agreements, and worker skill levels.
   • Overhead Standards: Standards are set for both variable and fixed overhead costs. Overhead rates are typically applied based on a predetermined activity level (e.g., direct labor hours or machine hours).

2. Ascertaining Actual Costs: This step involves tracking and recording the actual costs incurred for materials, labor, and overhead during the production period. Accurate data collection is crucial for this step.

3. Comparing Standard and Actual Costs (Variance Analysis): The standard costs are compared with the actual costs to calculate the differences, known as variances. Variances can be favorable (actual costs are lower than standard costs) or unfavorable (actual costs are higher than standard costs).

4. Analyzing Variances: This is the most critical step. The calculated variances are investigated to determine the underlying causes. This involves analyzing factors such as material price fluctuations, labor efficiency issues, changes in production processes, or unexpected overhead costs. Root cause analysis is essential for effective cost control.

5. Reporting and Management Action: The variance analysis results, along with explanations for significant variances, are reported to management. Management then takes appropriate action, which may include:

   • Correcting inefficiencies in production processes.
   • Revising standards if they are no longer realistic.
   • Negotiating better prices with suppliers.
   • Improving labor training.
   • Implementing cost-saving measures.

Applicability of Standard Costing

Standard costing is most effective in industries that meet certain criteria:

• Standardized Products: Industries producing standardized or homogeneous products that are repetitive in nature are ideal candidates for standard costing. This is because it's easier to set consistent standards for products that are similar.

• Repetitive Production Processes: Repetitive production processes, where the same or similar operations are performed repeatedly, make it more practical to develop and apply standard costs. The consistency of the process facilitates standard setting and variance analysis.

• Examples of Suitable Industries:

  • Fertilizer
  • Cement
  • Steel
  • Sugar
  • Chemicals
  • Textiles
  • Mass-produced consumer goods

Advantages of Standard Costing

Standard costing offers several significant advantages for businesses that implement it effectively. Here's a breakdown of these benefits:

1. Effective Cost Control

Standard costing provides a framework for effective cost control. By setting predetermined targets, businesses can:

• Identify Deviations: Compare actual costs with standards to pinpoint areas where costs are exceeding targets.
• Investigate Variances: Analyze the reasons for cost variances (differences between actual and standard costs) to understand the root causes of cost overruns.
• Take Corrective Action: Implement measures to address unfavorable variances, improve efficiency, and bring costs back in line with standards.
• Promote Cost Consciousness: Encourage a culture of cost awareness and responsibility throughout the organization.

2. Helps in Planning

Standard costs are essential for planning and budgeting:

• Budgeting: Standard costs provide a basis for developing realistic budgets. They allow businesses to project costs for different levels of activity and make informed decisions about resource allocation.
• Forecasting: Standard costs can be used to forecast future costs, which is crucial for financial planning and decision-making.
• Performance Evaluation: Standards serve as benchmarks for evaluating performance against planned targets.

3. Provides Incentives

Standard costing can be used to motivate employees and promote efficiency:

• Performance Targets: Standards can be used to set performance targets for individuals and departments.
• Incentive Schemes: Incentive programs can be linked to the achievement of standard cost targets, encouraging employees to strive for cost reduction and efficiency improvements.
• Motivation: Clear performance expectations and the opportunity to earn rewards can boost employee morale and motivation.

4. Fixing Price and Formulating Policies

Standard costs are valuable inputs for pricing decisions and policy formulation:

• Pricing Decisions: Standard costs provide a basis for determining appropriate selling prices that cover costs and generate a desired profit margin.
• Policy Formulation: Standard cost information can be used to develop policies related to purchasing, production, and other operational areas. For example, variance analysis can highlight areas where existing policies need to be revised.

5. Facilitates Delegation of Authority

Standard costing can support decentralization and delegation:

• Clear Expectations: Standards provide clear expectations for performance, allowing managers at different levels to make decisions within defined parameters.
• Accountability: Managers are held accountable for achieving standard cost targets within their areas of responsibility.
• Empowerment: Delegation of authority empowers managers to take ownership of cost control and performance improvement.

6. Facilitates Coordination

Standard costing can improve coordination across different departments:

• Shared Goals: Standard costs can serve as shared goals for different departments, aligning their efforts towards common objectives.
• Interdepartmental Communication: Variance analysis can highlight areas where interdepartmental coordination is needed to address cost issues.
• Improved Efficiency: Better coordination can lead to smoother operations, reduced bottlenecks, and improved overall efficiency.

Limitations of Standard Costing

Standard costing, while a valuable tool, has several limitations that can hinder its effectiveness and make it unsuitable for certain situations. Here's a breakdown of these limitations:

• Cost and Complexity: Implementing and maintaining a standard costing system can be expensive.

• Inapplicability to Job Order Industries: Standard costing is best suited for industries producing standardized products in large volumes. It is generally not suitable for job order industries that manufacture non-standardized or customized products.

• Staffing and Expertise: Operating a standard costing system requires skilled personnel who understand the system, can collect and analyze data accurately, and can interpret the results effectively.

• Maintaining Up-to-Date Standards: Standards need to be regularly reviewed and updated to reflect changes in factors like material prices, labor rates, manufacturing processes, and technology.

• Accuracy and Reliability of Standards: The effectiveness of standard costing depends heavily on the accuracy and reliability of the standards themselves.