Chapter 3
Standard Cost
Learning Objectives
- To understand the meaning of standard costing, its
meaning and definition
- To learn its advantages and limitations
- To learn how to set of standards and determinations
- To learn how to revise standards
IntroductionYou know that management accounting is managing
a business through accounting information. In this process, management
accounting is facilitating managerial control. It can also be applied to your
own daily/monthly expenses, if necessary. These measures should be applied
correctly so that performance takes place according to plans. Planning is the
first tool for making the control effective. The vital aspect of managerial
control is cost control. Hence, it is very important to plan and control costs.
Standard costing is a technique which helps you to control costs and business
operations. It aims at eliminating wastes and increasing efficiency in
performance through setting up standards or formulating cost plans.
Meaning of Standard
When you want to measure
some thing, you must take some parameter or yardstick for measuring. We can
call this as standard. What are your daily expenses? An average of $50! If you
have been spending this much for so many days, then this is your daily standard
expense.
The word standard means
a benchmark or yardstick. The standard cost is a predetermined cost which
determines in advance what each product or service should cost under given
circumstances.
In the words of Backer
and Jacobsen, “Standard cost is the amount the firm thinks a
product or the operation of the process for a period of time should cost, based
upon certain assumed conditions of efficiency, economic conditions and other
factors.”
Definition
The CIMA, London has
defined standard cost as “a predetermined cost which is calculated from
managements standards of efficient operations and the relevant necessary
expenditure.” They are the predetermined costs on technical estimate of
material labor and overhead for a selected period of time and for a prescribed
set of working conditions. In other words, a standard cost is a planned cost
for a unit of product or service rendered.
The technique of using
standard costs for the purposes of cost control is known as standard costing.
It is a system of cost accounting which is designed to find out how much should
be the cost of a product under the existing conditions. The actual cost can be
ascertained only when production is undertaken. The predetermined cost is compared
to the actual cost and a variance between the two enables the management to
take necessary corrective measures.
Advantages
Standard costing is a
management control technique for every activity. It is not only useful for cost
control purposes but is also helpful in production planning and policy
formulation. It allows management by exception. In the light of various
objectives of this system, some of the advantages of this tool are given below:
1.
Efficiency
measurement-- The comparison of
actual costs with standard costs enables the management to evaluate performance
of various cost centers. In the absence of standard costing system, actual
costs of different period may be compared to measure efficiency. It is not
proper to compare costs of different period because circumstance of both the
periods may be different. Still, a decision about base period can be made with
which actual performance can be compared.
2.
Finding
of variance-- The performance
variances are determined by comparing actual costs with standard costs.
Management is able to spot out the place of inefficiencies. It can fix
responsibility for deviation in performance. It is possible to take corrective
measures at the earliest. A regular check on various expenditures is also
ensured by standard cost system.
3.
Management
by exception-- The targets of
different individuals are fixed if the performance is according to
predetermined standards. In this case, there is nothing to worry. The attention
of the management is drawn only when actual performance is less than the
budgeted performance. Management by exception means that everybody is given a
target to be achieved and management need not supervise each and everything.
The responsibilities are fixed and every body tries to achieve his/her targets.
4.
Cost
control-- Every costing system
aims at cost control and cost reduction. The standards are being constantly
analyzed and an effort is made to improve efficiency. Whenever a variance
occurs, the reasons are studied and immediate corrective measures are undertaken.
The action taken in spotting weak points enables cost control system.
5.
Right
decisions-- It enables and
provides useful information to the management in taking important decisions.
For example, the problem created by inflating, rising prices. It can also be
used to provide incentive plans for employees etc.
6.
Eliminating
inefficiencies-- The setting of
standards for different elements of cost requires a detailed study of different
aspects. The standards are set differently for manufacturing, administrative
and selling expenses. Improved methods are used for setting these standards.
The determination of manufacturing expenses will require time and motion study
for labor and effective material control devices for materials. Similar studies
will be needed for finding other expenses. All these studies will make it
possible to eliminate inefficiencies at different steps.
Limitations of Standard
Costing
1.
It cannot be used in
those organizations where non-standard products are produced. If the production
is undertaken according to the customer specifications, then each job will
involve different amount of expenditures.
2.
The process of setting
standard is a difficult task, as it requires technical skills. The time and
motion study is required to be undertaken for this purpose. These studies
require a lot of time and money.
3.
There are no inset
circumstances to be considered for fixing standards. The conditions under which
standards are fixed do not remain static. With the change in circumstances, if
the standards are not revised the same become impracticable.
4.
The fixing of
responsibility is not an easy task. The variances are to be classified into
controllable and uncontrollable variances. Standard costing is applicable only
for controllable variances.
For instance, if the
industry changed the technology then the system will not be suitable. In that
case, we will have to change or revise the standards. A frequent revision of
standards will become costly.Setting Standards
Normally, setting up
standards is based on the past experience. The total standard cost includes
direct materials, direct labor and overheads. Normally, all these are fixed to
some extent. The standards should be set up in a systematic way so that they
are used as a tool for cost control.
Various Elements which
Influence the Setting of Standards
Setting Standards for
Direct Materials
There are several basic
principles which ought to be appreciated in setting standards for direct
materials. Generally, when you want to purchase some material what are the
factors you consider. If material is used for a product, it is known as direct
material. On the other hand, if the material cost cannot be assigned to the
manufacturing of the product, it will be called indirect material. Therefore,
it involves two things:
- Quality of material
- Price of the material
When you want to
purchase material, the quality and size should be determined. The standard
quality to be maintained should be decided. The quantity is determined by the
production department. This department makes use of historical records, and an
allowance for changing conditions will also be given for setting standards. A
number of test runs may be undertaken on different days and under different
situations, and an average of these results should be used for setting material
quantity standards.
The second step in
determining direct material cost will be a decision about the standard price.
Material’s cost will be decided in consultation with the purchase department.
The cost of purchasing and store keeping of materials should also be taken into
consideration. The procedure for purchase of materials, minimum and maximum
levels for various materials, discount policy and means of transport are the
other factors which have bearing on the materials cost price. It includes the
following:
- Cost of materials
- Ordering cost
- Carrying cost
The purpose should be to
increase efficiency in procuring and store keeping of materials. The type of
standard used-- ideal standard or expected standard-- also affects the choice
of standard price.
Setting Direct Labor
Cost
If you want to engage a
labor force for manufacturing a product or a service for which you need to pay
some amount, this is called wages. If the labor is engaged directly to produce
the product, this is known as direct labor. The second largest amount of cost
is of labor. The benefit derived from the workers can be assigned to a
particular product or a process. If the wages paid to workers cannot be
directly assigned to a particular product, these will be known as indirect wages.
The time required for producing a product would be ascertained and labor should
be properly graded. Different grades of workers will be paid different rates of
wages. The times spent by different grades of workers for manufacturing a
product should also be studied for deciding upon direct labor cost. The setting
of standard for direct labor will be done basically on the following:
- Standard labor time for producing
- Labor rate per hour
Standard labor time
indicates the time taken by different categories of labor force which are as
under:
- Skilled labor
- Semi-skilled labor
- Unskilled labor
For setting a standard
time for labor force, we normally take in to account previous experience, past
performance records, test run result, work-study etc. The labor rate standard
refers to the expected wage rates to be paid for different categories of
workers. Past wage rates and demand and supply principle may not be a safe
guide for determining standard labor rates. The anticipation of expected
changes in labor rates will be an essential factor. In case there is an
agreement with workers for payment of wages in the coming period, these rates
should be used. If a premium or bonus scheme is in operation, then anticipated
extra payments should also be included. Where a piece rate system is used,
standard cost will be fixed per piece. The object of fixed standard labor time
and labor rate is to device maximum efficiency in the use of labor.
Setting Standards of
Overheads
The next important
element comes under overheads. The very purpose of setting standard for
overheads is to minimize the total cost. Standard overhead rates are computed
by dividing overhead expenses by direct labor hours or units produced. The
standard overhead cost is obtained by multiplying standard overhead rate by the
labor hours spent or number of units produced. The determination of overhead
rate involves three things:
- Determination of overheads
- Determination of labor hours or units manufactured
- Calculating overheads rate by dividing A by B
The overheads are
classified into fixed overheads, variable overheads and semi-variable
overheads. The fixed overheads remain the same irrespective of level of
production, while variable overheads change in the proportion of production.
The expenses increase or decrease with the increase or decrease in output.
Semi-variable overheads are neither fixed nor variable. These overheads
increase with the increase in production but the rate of increase will be less
than the rate of increase in production. The division of overheads into fixed,
variable and semi-variable categories will help in determining overheads.
Determination of
Standard Costs
How should the ideal
standards for better controlling be determined?
1. Determination of Cost
Center
According to J. Betty,
“A cost center is a department or part of a department or an item of equipment
or machinery or a person or a group of persons in respect of which costs are
accumulated, and one where control can be exercised.” Cost centers are
necessary for determining the costs. If the whole factory is engaged in
manufacturing a product, the factory will be a cost center. In fact, a cost
center describes the product while cost is accumulated. Cost centers enable the
determination of costs and fixation of responsibility. A cost center relating
to a person is called personnel cost center, and a cost center relating to
products and equipments is called impersonal cost center.
2. Current Standards
A current standard is a
standard which is established for use over a short period of time and is
related to current condition. It reflects the performance that should be
attained during the current period. The period for current standard is normally
one year. It is presumed that conditions of production will remain unchanged.
In case there is any change in price or manufacturing condition, the standards
are also revised. Current standard may be ideal standard and expected standard.
3. Ideal Standard
This is the standard
which represents a high level of efficiency. Ideal standard is fixed on the
assumption that favorable conditions will prevail and management will be at its
best. The price paid for materials will be lowest and wastes etc. will be
minimum possible. The labor time for making the production will be minimum and
rates of wages will also be low. The overheads expenses are also set with
maximum efficiency in mind. All the conditions, both internal and external,
should be favorable and only then ideal standard will be achieved.
Ideal standard is fixed
on the assumption of those conditions which may rarely exist. This standard is
not practicable and may not be achieved. Though this standard may not be
achieved, even then an effort is made. The deviation between targets and actual
performance is ignorable. In practice, ideal standard has an adverse effect on
the employees. They do not try to reach the standard because the standards are
not considered realistic.
4. Basic Standards
A basic standard may be
defined as a standard which is established for use for an indefinite period which
may a long period. Basic standard is established for a long period and is not
adjusted to the preset conations. The same standard remains in force for a long
period. These standards are revised only on the changes in specification of
material and technology productions. It is indeed just like a number against
which subsequent process changes can be measured. Basic standard enables the
measurement of changes in costs. For example, if the basic cost for material is
Rs. 20 per unit and the current price is Rs. 25 per unit, it will show an
increase of 25% in the cost of materials. The changes in manufacturing costs
can be measured by taking basic standard, as a base standard cannot serve as a
tool for cost control purpose because the standard is not revised for a long
time. The deviation between standard cost and actual cost cannot be used as a
yardstick for measuring efficiency.
5. Normal Standards
As per terminology,
normal standard has been defined as a standard which, it is anticipated, can be
attained over a future period of time, preferably long enough to cover one
trade cycle. This standard is based on the conditions which will cover a future
period of five years, concerning one trade cycle. If a normal cycle of ups and
downs in sales and production is 10 years, then standard will be set on average
sales and production which will cover all the years. The standard attempts to
cover variance in the production from one time to another time. An average is
taken from the periods of recession and depression. The normal standard concept
is theoretical and cannot be used for cost control purpose. Normal standard can
be properly applied for absorption of overhead cost over a long period of time.
6. Organization for
Standard Costing
The success of standard
costing system will depend upon the setting up of proper standards. For the
purpose of setting standards, a person or a committee should be given this job.
In a big concern, a standard costing committee is formed for this purpose. The
committee includes production manager, purchase manager, sales manager,
personnel manager, chief engineer and cost accountant. The cost accountant acts
as a co-coordinator of this committee.
7. Accounting System
Classification of
accounts is necessary to meet the required purpose, i.e. function, asset or
revenue item. Codes can be used to have a speedy collection of accounts. A
standard is a pre-determined measure of material, labor and overheads. It may
be expressed in quality and its monetary measurements in standard costs.
Revision of Standards
For effective use of
this technique, sometimes we need to revise the standards which follow for
better control. Even standards are also subjected to change like the production
method, environment, raw material, and technology.
Standards may need to be
changed to accommodate changes in the organization or its environment. When
there is a sudden change in economic circumstances, technology or production
methods, the standard cost will no longer be accurate. Standards that are out
of date will not act as effective feed forward or feedback control tools. They
will not help us to predict the inputs required nor help us to evaluate the
efficiency of a particular department. If standards are continually not being
achieved and large deviations or variances from the standard are reported, they
should be carefully reviewed. Also, changes in the physical productive capacity
of the organization or in material prices and wage rates may indicate that
standards need to be revised. In practice, changing standards frequently is an
expensive operation and can cause confusion. For this reason, standard cost
revisions are usually made only once a year. At times of rapid price inflation,
many managers have felt that the high level of inflation forced them to change price
and wage rate standards continually. This, however, leads to reduction in value
of the standard as a yardstick. At the other extreme is the adoption of basic
standard which will remain unchanged for many years. They provide a constant
base for comparison, but this is hardly satisfactory when there is
technological change in working procedures and conditions.
Summary
Basically, standard
costing is a management tool for control. In the process, we have taken
standards as parameters for measuring the performance. Cost analysis and cost
control is essential for any activity. Cost includes material labor and
overheads. Sometimes, we need to revise the standards due to change in uses,
raw material, technology, method of production etc. For a proper organization,
it is required to implement this under a committee for the activity. It is a
continued activity for the optimum utilization of resources.
NIC
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