What is Standard Costing?

Standard Costing

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Standard Costing

Standard costing is a management accounting method that assigns predetermined (or “standard”) costs to products and services. These predetermined costs are based on historical data, engineering estimates, or other reliable benchmarks. Once these standard costs are set, they act as a benchmark against which actual costs are compared.

Standard costing serves several purposes:

  • Budgeting: It helps companies set budgets by estimating the costs of goods or services in advance.
  • Performance Evaluation: By comparing actual costs with standard costs, managers can assess the efficiency and effectiveness of operations.
  • Variance Analysis: The difference between actual costs and standard costs is referred to as a variance. Analyzing these variances can help in identifying areas of inefficiency or other problems that need management attention.
  • Pricing: Understanding the standard cost of a product can help in setting product prices that ensure profitability.
  • Inventory Valuation: Standard costing can be used to value inventory rather than using actual costs, which may fluctuate more frequently.
  • Cost Control: By identifying deviations between standard and actual costs, management can take corrective actions to control costs.

The standard costing process involves the following steps:

  1. Setting Standard Costs: This is based on historical data, industry benchmarks, or engineering studies.
  2. Recording Actual Costs: As production occurs, actual costs are recorded.
  3. Comparing Actual Costs to Standard Costs: At the end of a period (like a month or quarter), actual costs are compared to standard costs to compute variances.
  4. Analyzing Variances: Management analyzes the variances to understand the reasons behind them.
  5. Taking Corrective Actions: Based on variance analysis, management may take corrective actions, such as retraining workers, renegotiating supplier contracts, or revising the production process.
  6. Reviewing and Revising Standard Costs: Periodically, standard costs are reviewed and revised to reflect changes in the business environment or operational processes.

It’s worth noting that while standard costing provides valuable insights, it’s most effective in businesses with consistent and repetitive production processes. In industries where production is highly customized or where there are frequent changes in production processes, standard costing might be less applicable or require more frequent updates to remain relevant.

Example of Standard Costing

Let’s consider a fictional company, “BikeMaster Inc.”, which manufactures bicycles.

BikeMaster Inc. – Standard Costing for a Basic Bicycle Model

Setting the Standard Costs:

  • Direct Materials:
    • Frame: 1 unit @ $50 = $50
    • Tires: 2 units @ $20 each = $40
    • Chain: 1 unit @ $15 = $15
    • Seat: 1 unit @ $25 = $25
    • Total Direct Materials Standard Cost = $130
  • Direct Labor:
    • Assembly time: 2 hours @ $15/hour = $30
    • Testing time: 0.5 hours @ $15/hour = $7.50
    • Total Direct Labor Standard Cost = $37.50
  • Overheads (Based on Machine Hours):
    • Machine operation: 1.5 hours @ $10/hour = $15

Total Standard Cost for One Bicycle: $182.50 ($130 + $37.50 + $15)

Actual Costs Incurred in June (for 100 Bicycles):

  • Direct Materials:
    • Frame: 100 units @ $52 = $5,200
    • Tires: 200 units @ $21 = $4,200
    • Chain: 100 units @ $16 = $1,600
    • Seat: 100 units @ $24 = $2,400
    • Total Direct Materials Actual Cost = $13,400
  • Direct Labor:
    • Assembly time: 220 hours @ $16/hour = $3,520
    • Testing time: 55 hours @ $14/hour = $770
    • Total Direct Labor Actual Cost = $4,290
  • Overheads:
    • Machine operation: 160 hours @ $11/hour = $1,760

Total Actual Cost for 100 Bicycles in June: $19,450

Variance Analysis:

  • Direct Materials Variance:
    • Total Variance = Actual Cost – (Standard Cost x Actual Quantity)
    • Total Variance = $13,400 – ($130 x 100) = $1,400 Unfavorable
  • Direct Labor Variance:
    • Total Variance = $4,290 – ($37.50 x 100) = $790 Unfavorable
  • Overhead Variance:
    • Total Variance = $1,760 – ($15 x 100) = $260 Unfavorable

Based on the variance analysis, BikeMaster Inc. has incurred higher costs in all three categories compared to their standard costs. Management would need to investigate the reasons for these unfavorable variances. Possible reasons could include increased raw material prices, wage hikes, machine breakdowns leading to longer production times, or inefficiencies in the production process.

This example demonstrates how standard costing provides a clear framework for identifying deviations from expected costs. By understanding these variances, management can take targeted actions to address inefficiencies and control costs.

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