Standard Costing

Standard Costing Definition of Standard and Standard Cost Types of Standard Cost Establishment of Standard Cost Standard Cost Setting and Learning Curve Strengths and Limitations of Standard Costing System Standard Costing and Variance Analysis

Definitions • Standard cost • Target costs are target costs for each operation that can be use built up to produce a product standard cost • Standard relates to a cost per unit of activity while budget relates to the cost for total activity

Operation of standard costing system • Most suited to a series of common or repetitive organisation • Variances are traced to responsibility centres (not products) • Actual costs are not required • Comparisons after the event provide information for corrective action or highlight the need to revise the standards

Overview of a standard costing system Standard cost of actual output recorded for each responsibility Actual costs traced to each responsibility centre Standard and actual costs compared And variance analysed and reported Variance investigated and Corrective action taken Standards monitored and adjusted to reflect changes in std usage and /or prices

Purposes of Standard Costing • To provide a prediction of future costs that can be used for decision making • To provide a challenging target that an individuals are motivated to achieve • To assist in setting budgets and evaluating performance • To act as a control device by highlighting those activities • To simplify the task of tracing costs to products for inventory valuation

Types of Standards • Ideal standards • Standard that demand maximum efficiency • Can be achieved only if everything operates perfectly • Basic cost standards (constant standards that are left unchanged for a long time) • Advantage: efficiency can be established • Currently attainable standard • Can be achieved under efficient operating conditions • Allowance made for normal breakdowns, interruptions • Kaizen standard • Continuous improvement standard • Reflect planned improvement • Type of currently attainable standard with a cost reduction focus

Establishing Standard Cost • Need to establish price and quantity standards fro inputs (direct materials, direct labour and overhead) • Sources of input for establishing standard • historical experience • Engineering studies • A detailed study of each operation is undertaken: • Direct material stds (std qty x std price) • Direct labour stds (std hrs x std rate) • Overhead stds: cannot be directly observed an studied and traced to units of output, analyse fixed and variable elements, fixed tend not to be controllable in the short term • Input from operating personnel (e.g production manager

Establishing standards • Potential sources of quantitative standards include historical experience, engineering studies and input from operating personnel • Historical experience should be used with caution because it may perpetuate operating inefficiencies • Engineering studies and input fro operating personnel help determine the most efficient level of input quantities • the use of an engineering study approach by itself may produce standards that are too rigorous

Responsibilities for establishing standard prices • Operation managers determine the quality of the inputs required • Personnel and purchasing have the responsibility to acquire the input quality at the lowest price that is limited by the market forces and trade union • Note: purchasing must consider discounts, freights and quality, personnel must consider payroll tax, fringe benefits and qualifications • Accounting is responsible for recording the price standards and for preparing reports

Standard Cost Sheet • A listing of the standard costs and standard quantities of direct material, direct labour and overhead that should apply to a single product

Standard Cost Sheet

Learning Curve • Learning curve effect should be take into account in estimating labour costs for relatively new products or production processes • As cumulative production output increases, the average labour time required per unit declines • A nonlinear curve that show how the labour hours decrease as the volume produced increases • Learning rate expressed as percent, gives the percentage of time needed to make the next unit, based on the time it took to make the previous unit

Tabular presentation of learning curve

Reasons for adopting standard costing system • Cost management • Standards help managers understand what needs to be done to improve current and future performance • Kaizen standards help firm implement continuous improvement and cost reduction • Planning and Control • Unit standards are a fundamental requirement for a flexible budgeting system • Budgetary control system compare actual costs with budgeted costs and compute variances

Reasons for adopting standard costing system (cont.) • Facilitate Decision making and product costing • E.g pricing decision • Under standard costing, cost are assigned to products using quantity and price standard for all three manufacturing costs elements

Behavioral Impact of Std Costing • Std costs, budgets and variance are used to evaluate performance of employees and departments • Comparison of performance with stds/budgets often used to determine salary increase, bonuses and promotion • Reward structure tied to attainment of budget may provide a powerful incentive (positive or negative) for the manager to keep costs under control

Behavioral Impact of Std Costing (cont..) • The desire for bonus may induce managers to seek the most economical material supplier and to watch more carefully for employee theft and waster • May also persuade manager to buy cheaper but lower quality material thus affecting the quality of the product • Need to understand how to use standards , budgets and variance to encourage best performance from employees

Strengths/Advantages of Standard Costing • Standard costs provide a good basis for comparison • Calculation of std costs and cost variances enables managers to use management by exception in order to concentrate on significant variances only • Variance can provide a convenient basis for performance evaluation and determining bonuses for employees

Strengths/Advantages of Standard Costing (cont..) • Participation in std setting, assigning responsibility for certain variances and the use of variance for performance evaluation can have motivational effect on employees • The use of std costs in product costing results in more stable product costs compared to actual costs; • Standard costs can also be used for external reporting

Weaknesses (Criticisms) of Standard Costing • Variances are too aggregated and concentrate on the consequence rather than the causes of problems • Variance reports are produced too late to be useful

Weaknesses (Criticisms) of Standard Costing (cont..) • Standard costing tend to focus too heavily on cost minimization • Std cost variance are reported along responsibility lines • May provide incentive to decrease costs, but actions taken to minimise costs may adversely affect other areas of strategic importance • Standard costing take a departmental perspective rather than a process perspective

Criticisms of Standard Costing (cont..) • Standard costing system place too much emphasis on the cost and efficiency of direct labour • Direct labour becoming less important with automation • Overhead variances in particular give limited information for cost control • High level of aggregation (eg variable overhead spending variance and fixed overhead budget variance) on total overhead item rather on activities /processes provide limited basis for controlling costs

Criticisms of Standard Costing (cont..) • Variance analysis does explicitly encourage continuous improvement • Standards costs become outdated quickly because of shorter product life cycles • Standards are relevant for only very short time when there is a rapid turnover of new products • Standard costing system are not defined broadly enough to capture the full costs of materials • Std costs of raw material do not capture the full costs of purchasing inventory

Standard Costing