Table of Content:-
- Definition of Standard Costing
- Meaning of Standard Costs
- Objectives of Standard Costing
- Establishing Various Cost Standards
- Essential Conditions of an Effective System of Standard Costing
- Advantages of Standard Costing
Meaning and Definition of Standard Costing
Standard costing is the preparation of standard costs and applying them to measure the variations from standard costs and analyzing the causes of variations to maintain maximum production efficiency.
The terminology of Cost Accountancy defines Standard costing as “The preparation and use of standard costs, their comparison with actual costs, and the analysis of variance to their causes, and points of incidence”.
According to the Institute of Cost and Works Accountants, London defines standard costing as “An estimate cost, prepared in advance of production or supply correlating a technical specification of material, and labour to the price and wage rates estimated for a selected period, with an addition of the apportionment of overheads expenses estimated for the same period within a prescribed set of working conditions”.
Meaning of Standard Costs
Standard cost is a pre-determined quantity set in defined conditions against which actual performance may be compared, usually for an element of work, operation or activity.
According to the Chartered Institute of Management Accountants, London defines standard cost as “A predetermined cost which is calculated from management’s standards of efficient operation and the relevant necessary expenditure”.
According to Backer and Jacobsen, “Standard cost is the amount the firm thinks a product or the operation of a process for some time should cost, based upon certain assumed conditions of efficiency, economic conditions and other factors”.
Objectives of Standard Costing
The objectives of standard costing are as follows:
1) Controlling and Reducing Costs
Standard costs refer to normal standard costs. They provide for normal wastage, normal breakdown, normal idle capacity, normal mistakes and so on. This will control and reduce costs.
2) Promoting and Measuring Efficiencies
Standard cost promotes and measures efficiency. It offers a yardstick for the measurement of performance. Actual cost below standard cost indicates efficient performance and actual costs exceeding standard cost indicate inefficiency.
3) Valuing Inventories
Time and energy are saved in maintaining the store’s ledger if the issue of materials and valuation of stock is done based on standard costs. The value of stocks on standard cost can be easily ascertained by multiplying the quantity of stock in hand by the standard price.
4) Fixing the Selling Price
Actual costs are not a very good basis for price fixation because actual costs may fluctuate widely due to several reasons while the prices cannot be allowed to fluctuate so fast in most cases. Therefore, standard cost plus a profit margin considered reasonable in a given situation, is a far superior basis for price fixation.
5) Simplifying Costing Procedure
Standard costing is always product specific. It is done for a particular product, process, job, etc. Standard costs are generally established through collaboration between cost management accountants, relevant technical experts, and management. It simplifies the process of costing.
Establishing Various Cost Standards
Standards are set up for each element of cost, viz, direct material, direct labour, variable overheads and fixed overheads. The work of standards setting may be carried out by a special committee called standards committee, comprising a cost accountant, work-study engineer, production engineer, purchase manager, etc.
1) Direct Material Cost Standard
The process of determining direct material cost standards involves the following:
i) Determination of Price Standards: To establish standard prices for all materials, it is important to carefully evaluate various factors. These factors include prevailing market prices, anticipated price fluctuations, foreseeable economic and political influences, as well as the current stock, materials in transit, and pending orders.
ii) Determination of Quantity Standards: To establish material quantity standards for each input material used in the product, it is necessary to develop a product design and material specification scientifically based on experiments/test runs. These specifications should be strictly followed except in special circumstances when any modification is required. If quantity standards are being set for the process industry, then standard (normal) process loss, if any, should also be decided based on experience or scientific analysis.
2) Direct Labour Cost Standard: Establishing standard labour costs for each product would require the following:
i) The labour hour rate for each type of labour (skilled, semi-skilled, unskilled, etc.) may be fixed by evaluating wages, pay scales, remuneration, etc, of each category of personnel.
ii) Ascertainment of various labour grades and requirements of their labour hours for each product. The standards of performance may be determined based on time and motion study.
3) Variable Overhead Standard: As the name indicates, overheads fluctuate by production volume. This means that the variable overhead per unit or hour will remain constant regardless of the production volume. Consequently, the variable overhead standard is expressed in terms of per unit or hour. These standards are set up through meticulous scientific analysis.
4) Fixed Overhead Standard: The main purpose of setting standards for fixed overheads is to minimize the total cost. It requires:
i) Budgeted output in units or standard hours for the designated period.
ii) The expected number of hours to be worked during the specified period.
iii) Determining the budgeted fixed overhead for a specific period is an important task in financial planning.
With the help of the above information, the standard fixed overhead cost for each unit of product can be determined.
Essential Conditions of an Effective System of Standard Costing
The essential conditions of an effective system of standard costing are as follows:
1) Preparation of Manual
A detailed manual should be prepared to guide the staff. The manual should briefly describe the system to be implemented and outline its associated benefits. The manual should provide a concise description of the system to be implemented and outline its associated benefits. Various activities must be detailed and the whole procedure of the system outlined.
2) Setting up Standards for Each Element of Cost
Standards should be set up for each element of cost, viz, direct material, direct labour and overhead.
3) Setting Physical Standards
Standards of physical activity guidelines should be worked out across different departments. For direct materials, standard quantity has to be determined concerning the quality and size of material required for each unit of production. The standard quantities of material are developed by the technical sections, drawing office or laboratory following a comprehensive product or engineering study. These studies thoroughly analyze the material specifics and plant conditions.
4) Study of Labour and Machine Operations
To ensure optimal manufacturing processes, it is imperative to thoroughly examine each item of production, meticulously identifying the various operations that need to be executed by both labour and machines.
5) Study of Market Conditions
For developing cost standards, the study of market conditions and the trend of prices for a definite period in future are made. This study will greatly assist in establishing material price standards. The labour cost standards can be determined by analyzing data on wage rates.
6) Training of Staff
The office staff required to operate the system should be properly trained. When the system comes into force, several alterations would be required in the process of recording accounting entries and the flow of documents.
Advantages of Standard Costing
There are several advantages associated with standard costing, some of which are given as follows:
- Measuring Efficiency
- Formulation of Production and Price Policy
- Determination of Variance
- Reduction of Work
- Facilitates Cost Control
- Eliminating Inefficiencies
- Helpful in Taking Important Decisions
- Management by Exception
1) Reduction of Work
In historical costing, records are maintained for determining the costs. Standard costing reduces clerical work to a considerable extent and management is supplied with useful information. In this system, only necessary information will be recorded, while unnecessary data will be avoided.
2) Determination of Variance
Variances are determined by comparing the actual costs to the standard costs. Management can spot the place of inefficiencies. It can assign responsibility for deviation in performance. It is possible to implement corrective measures at the earliest.
3) Formulation of Production and Price Policy
Standard costing helps formulate production policies. The standards are set by analysis of all prevailing conditions. Formulating production plans becomes effortless when standard costs are taken into consideration. Additionally, It is also helpful for determining the prices of diverse products.
4) Measuring Efficiency
Standard costing serves as a reliable benchmark for measuring efficiency. By comparing actual costs to standard costs, management gains valuable insights into the performance of various cost centres.
5) Facilitates Cost Control
Every cost system aims to achieve cost control and cost reduction. Standard costing helps in achieving these aims. Continuous analysis of the standards is undertaken with a dedicated focus on enhancing efficiency. Whenever a variance occurs, the reasons are thoroughly analyzed, and prompt corrective actions are implemented.
6) Eliminating Inefficiencies
The standards for manufacturing, administrative, and selling expenses are set differently. Enhanced techniques are used for setting and upholding these standards. To determine manufacturing expenses, it is necessary to conduct item and motion studies for labour as well as implement effective material control devices for materials, etc. A similar study would also be required to identify additional expenditures.
7) Helpful in Taking Important Decisions
Standard costing provides useful information to the management for making critical decisions. The problem created by inflation and escalating prices can be efficiently addressed through the utilization of standard costing. Additionally, It can also be used to provide enticing incentive plans for employees, among other uses.
8) Management by Exception
In a professional setting, the concept of management by exception entails assigning specific targets to individuals, thereby eliminating the need for constant supervision by management.