Standard Costing Overview
Standard costing is the practice of substituting an expected cost for an actual cost in the accounting records, and then periodically recording variances showing the difference between the expected and actual costs. This approach represents a simplified alternative to cost layering systems, such as the FIFO and LIFO methods, where large amounts of historical cost information must be maintained for items held in stock.
Standard costing involves the creation of estimated (i.e., standard) costs for some or all activities within a company. The core reason for using standard costs is that there are a number of applications where it is too time-consuming to collect actual costs, so standard costs are used as a close approximation to actual costs.
Since standard costs are usually slightly different from actual costs, the cost accountant periodically calculates variances that break out differences caused by such factors as labor rate changes and the cost of materials. The cost accountant may also periodically change the standard costs to bring them into closer alignment with actual costs.
Advantages of Standard Costing
Though most companies do not use standard costing in its original application of calculating the cost of ending inventory, it is still useful for a number of other applications. In most cases, users are probably not even aware that they are using standard costing, only that they are using an approximation of actual costs. Here are some potential uses:
- Budgeting. A budget is always composed of standard costs, since it would be impossible to include in it the exact actual cost of an item on the day the budget is finalized. Also, since a key application of the budget is to compare it to actual results in subsequent periods, the standards used within it continue to appear in financial reports through the budget period.
- Inventory costing. It is extremely easy to print a report showing the period-end inventory balances (if you are using a perpetual inventory system), multiply it by the standard cost of each item, and instantly generate an ending inventory valuation. The result does not exactly match the actual cost of inventory, but it is close. However, it may be necessary to update standard costs frequently, if actual costs are continually changing. It is easiest to update costs for the highest-dollar components of inventory on a frequent basis, and leave lower-value items for occasional cost reviews.
- Overhead application. If it takes too long to aggregate actual costs into cost pools for allocation to inventory, then you may use a standard overhead application rate instead, and adjust this rate every few months to keep it close to actual costs.
- Price formulation. If a company deals with custom products, then it uses standard costs to compile the projected cost of a customer’s requirements, after which it adds on a margin. This may be quite a complex system, where the sales department uses a database of component costs that change depending upon the unit quantity that the customer wants to order. This system may also account for changes in the company’s production costs at different volume levels, since this may call for the use of longer production runs that are less expensive.
Nearly all companies have budgets and many use standard cost calculations to derive product prices, so it is apparent that standard costing will find some uses for the foreseeable future. In particular, standard costing provides a benchmark against which management can compare actual performance.
Problems with Standard Costing
Despite the advantages just noted for some applications of standard costing, there are substantially more situations where it is not a viable costing system. Here are some problem areas:
- Cost-plus contracts. If you have a contract with a customer under which the customer pays you for your costs incurred, plus a profit (known as a cost-plus contract), then you must use actual costs, as per the terms of the contract. Standard costing is not allowed.
- Drives inappropriate activities. A number of the variances reported under a standard costing system will drive management to take incorrect actions to create favorable variances. For example, they may buy raw materials in larger quantities in order to improve the purchase price variance, even though this increases the investment in inventory. Similarly, management may schedule longer production runs in order to improve the labor efficiency variance, even though it is better to produce in smaller quantities and accept less labor efficiency in exchange.
- Fast-paced environment. A standard costing system assumes that costs do not change much in the near term, so that you can rely on standards for a number of months or even a year, before updating the costs. However, in an environment where product lives are short or continuous improvement is driving down costs, a standard cost may become out-of-date within a month or two.
- Slow feedback. A complex system of variance calculations are an integral part of a standard costing system, which the accounting staff completes at the end of each reporting period. If the production department is focused on immediate feedback of problems for instant correction, the reporting of these variances is much too late to be useful.
- Unit-level information. The variance calculations that typically accompany a standard costing report are accumulated in aggregate for a company’s entire production department, and so are unable to provide information about discrepancies at a lower level, such as the individual work cell, batch, or unit.
The preceding list shows that there are a multitude of situations where standard costing is not useful, and may even result in incorrect management actions. Nonetheless, as long as you are aware of these issues, it is usually possible to profitably adapt standard costing into some aspects of a company’s operations.
Standard Cost Variances
A variance is the difference between the actual cost incurred and the standard cost against which it is measured. A variance can also be used to measure the difference between actual and expected sales. Thus, variance analysis can be used to review the performance of both revenue and expenses.
There are two basic types of variances from a standard that can arise, which are the rate variance and the volume variance. Here is more information about both types of variances:
- Rate variance. A rate variance (which is also known as a price variance) is the difference between the actual price paid for something and the expected price, multiplied by the actual quantity purchased. The “rate” variance designation is most commonly applied to the labor rate variance, which involves the actual cost of direct labor in comparison to the standard cost of direct labor. The rate variance uses a different designation when applied to the purchase of materials, and may be called the purchase price variance or the material price variance.
- Volume variance. A volume variance is the difference between the actual quantity sold or consumed and the budgeted amount, multiplied by the standard price or cost per unit. If the variance relates to the sale of goods, it is called the sales volume variance. If it relates to the use of direct materials, it is called the material yield variance. If the variance relates to the use of direct labor, it is called the labor efficiency variance. Finally, if the variance relates to the application of overhead, it is called the overhead efficiency variance.
Thus, variances are based on either changes in cost from the expected amount, or changes in the quantity from the expected amount. The most common variances that a cost accountant elects to report on are subdivided within the rate and volume variance categories for direct materials, direct labor, and overhead. It is also possible to report these variances for revenue.
It is not always considered practical or even necessary to calculate and report on variances, unless the resulting information can be used by management to improve the operations or lower the costs of a business. When a variance is considered to have a practical application, the cost accountant should research the reason for the variance in considerable detail and present the results to the responsible manager, perhaps also with a suggested course of action.
Standard Cost Creation
At the most basic level, you can create a standard cost simply by calculating the average of the most recent actual cost for the past few months. In many smaller companies, this is the extent of the analysis used. However, there are some additional factors to consider, which can significantly alter the standard cost that you elect to use. They are:
- Equipment age. If a machine is nearing the end of its productive life, it may produce a higher proportion of scrap than was previously the case.
- Equipment setup speeds. If it takes a long time to setup equipment for a production run, the cost of the setup, as spread over the units in the production run, is expensive. If a setup reduction plan is contemplated, this can yield significantly lower overhead costs.
- Labor efficiency changes. If there are production process changes, such as the installation of new, automated equipment, then this impacts the amount of labor required to manufacture a product.
- Labor rate changes. If you know that employees are about to receive pay raises, either through a scheduled raise or as mandated by a labor union contract, then incorporate it into the new standard. This may mean setting an effective date for the new standard that matches the date when the cost increase is supposed to go into effect.
- Learning curve. As the production staff creates an increasing volume of a product, it becomes more efficient at doing so. Thus, the standard labor cost should decrease (though at a declining rate) as production volumes increase.
- Purchasing terms. The purchasing department may be able to significantly alter the price of a purchased component by switching suppliers, altering contract terms, or by buying in different quantities.
Any one of the additional factors noted here can have a major impact on a standard cost, which is why it may be necessary in a larger production environment to spend a significant amount of time formulating a standard cost.
Episode 111 of the Accounting Best Practices podcast discusses horizontal analysis. Listen now.