Standard Costing 101 - Guide to Expected Cost Estimates
Standard costing is a cost accounting method that sets pre-established standards for costs and performance. Actual costs are compared with these standards to analyze variances.
Standard costing has different applications in business, including budgeting and cost control. Calculating and updating standard costs can be a complex job. For this reason, many small businesses outsource standard costing to small business accounting experts.
What Is Standard Costing?
Standard costing is a cost accounting method that utilizes predetermined costs to measure a business’s actual costs and variance. Standard costing is most typically used in manufacturing businesses for cost control purposes and to optimize inventory via the feedback provided by variances.
The purpose of a standard cost system is to provide a basis for comparison between the expected and actual costs in a company. The difference between the two highlights potential gaps or weaknesses in planning and execution and identifies inefficiencies. Management can then pinpoint places where greater efficiency is required and implement the necessary changes.
Please note: Businesses should be aware that cost accounting isn’t GAAP-compliant. It can therefore only be used for internal purposes.
Why Do Some Businesses Use Standard Costing?
Some businesses use standard costing to create a budget that is as accurate as possible. This is because a standard costing system offers a projected idea of spending costs. When managers compare standard costs to actual costs, they can determine where or if new, more efficient business practices are required.
Standard costing is also a time-efficient way of budgeting. Collecting actual costs for every process would be extremely time-consuming. Standard costs reflect a close approximation to the actual costs incurred.
Standard Costing Requires Regular Updates
Actual and standard costs will be slightly different and this discrepancy can change over time if the standard costs are not updated with changes in the cost of labor and materials. A small business accounting professional can periodically recalculate variances that cause large discrepancies.
Benefits of Standard Costing
The standard cost accounting method has two main benefits:
Efficient inventory costing: Standard costing gives businesses a good estimate of costs when conducting an inventory valuation. Producing an inventory report with a standard costing system is easy. However, updating standard costs regularly is necessary for accurate cost control.
Useful for price formulation: Consider a small manufacturing business in Jacksonville, Florida, that offers custom-made agricultural machinery. This business will benefit from using standard costs to generate a projected cost of a new customer's requested machine. This system will take different volume levels in the production process into account. This is important as longer production runs are more cost-effective than shorter ones.
In brief: Standard costing increases the efficiency of various accounting processes in manufacturing businesses. It also provides a benchmark against which management can compare estimated costs with the company’s actual performance.
Drawbacks of Standard Costing
The standard cost system has a few downsides to take into account:
It doesn't reflect a fast-paced environment: A standard costing system can’t factor in constant fluctuations in price. Failing to update standard costs when prices change means that companies stay with the same budgeted amounts for months or even up to a year. The gap between expected and actual costs could be much larger than anticipated.
Can lead to poor decision-making: Standard costing may not reflect realistic final costs. This can lead to incorrect pricing and other uninformed decisions.
Can be complex in large businesses: Businesses with multiple products and cost centers may find standard costing too complex to implement and maintain.
Overemphasis on budgeting: The focus on budgeting can detract from other fundamentals of cost accounting like cost analysis and cost control.
The takeaway: Companies must be willing to adapt the system to move with the realities of the business in order for standard costing to work.
Standard Cost Variances Explained
A variance is the difference between the actual cost and the standard cost against which it's measured. Variances can also be used to measure the difference between expected and actual sales. This metric is therefore useful for measuring the performance of both expenses and revenue.
There are three main types of variances that provide insights into different aspects of a business:
1. Direct Materials Variance
The direct materials variance can be broken down into two sub-metrics:
Material Price Variance: This is the price difference between the actual and standard cost of materials. Use the following formula to calculate the material price variance:
(standard price - actual price) x actual quantity of materials used
Material Usage Variance: This is the difference between the actual and standard quantity of materials used, using standard pricing. Use the following formula to calculate the material usage variance:
(standard quantity - actual quantity used) x standard price per unit
2. Direct Labor Variance
Direct labor variance includes:
Labor rate variance: This is the difference between the standard cost of labor and the actual wages paid. Use the following formula to calculate labor rate variance:
(actual hours x actual rate) - (actual hours x standard rate)
Labor efficiency variance: This is the difference between the actual number of labor hours worked and the expected number. Use the following formula to calculate labor efficiency variance:
(actual hours - standard hours) x standard rate
Companies that do payroll in QuickBooks will find it easier to do job costing as the software includes an “account payable” function that has built-in job costing. Many other operations are automatic, meaning accounting in your company becomes more efficient.
3. Variable Overhead Variance
Variable overhead variance is split into:
Variable overhead spending variance: This is the difference between the standard and actual variable overheads incurred, based on the actual hours worked. Use the following formula to calculate variable overhead spending variance:
(standard variable overhead rate - variable overhead rate) x actual labor hours
Variable overhead efficiency variance: This is the difference between the standard and actual time it takes to manufacture a product and the impact of the difference. Use the following formula to calculate variable overhead efficiency variance:
(actual labor hours - budgeted labor hours) x hourly rate for standard variable overhead
How to Interpret Variances
Variances can have two outcomes: favorable or unfavorable. A variance is considered favorable if actual costs are less than the standard costs or if actual revenues are greater than standard revenues. An unfavorable variance will reflect actual costs that exceed standard costs.
How to Calculate Standard Costs
Creating a standard cost can be as simple as calculating the average of the actual costs over the previous few months. However, several factors can alter the standard cost:
Condition of equipment: If the machines you use are coming to the end of their productive life, there may be a higher proportion of scrap recorded than in previous periods.
Changes in labor efficiency: Changes to the production process, for example installing new, automated equipment, will impact the amount of labor required to manufacture a product.
Changes in labor rate: Scheduled raises will raise the standard labor cost. Set up an effective date for the new standard that corresponds with the date the cost changes go into effect.
Purchase terms: Switching suppliers, changing contract terms, or increasing or reducing purchase quantities can alter prices significantly.
These factors can have a huge impact on standard costs. Larger companies will therefore need to spend a significant amount of time formulating—and re-formulating—standard costs.
Get Expert Assistance with Standard Costing
Standard costing offers a robust tool for financial and operational management and a solid framework on which businesses can base strategic decisions. Standard costing can help businesses rectify cost discrepancies and ensure optimal efficiency when used wisely.
Taking advantage of the benefits of standard costing is only possible if it's done correctly and with constant attention to detail. That's why many businesses work with accounting experts to make the necessary calculations and help them use this tool strategically to promote sustained profitability and growth.
