Friday, 20 January 2012

Standard Costing System

Standard Costing System:
In accounting, a standard costing system is a tool for planning budgets, managing and controlling costs, and evaluating cost management performance.

A standard costing system involves estimating the required costs of a production process. Before the start of the accounting period, standards are determined and set regarding the amount and cost of
direct materials required for the production process and the amount and pay rate of direct labor required for the production process. These standards are used to plan a budget for the production process.

At the end of the accounting period, the actual amounts and costs of direct material used and the actual amounts and pay rates of direct labor utilized are compared to the previously set standards. Comparing the actual costs to the standard costs and examining the variances between them allows managers to look for ways to improve cost control, cost management, and operational efficiency.

Standard Costing – Advantages and Disadvantages:
There are advantages and disadvantages to using a standard costing system. The primary advantages to using a standard costing system are that it can be used for product costing, for controlling costs, and for decision-making purposes.

The disadvantages include that implementing a standard costing system can be time consuming, labor intensive, and expensive. Also, the standards often have to be updated if the cost structure of the production process changes.

Standard Costing Example:
Here is a simple standard costing example. Let’s take a company that makes widgets. Based on historical data, a cost analyst determines that producing one widget typically requires 1 pound of raw material costing $2 dollars and 1 hour of labor costing $20 dollars. These are the standard amounts and costs for material and labor.

The company expects to produce 1,000 widgets in the upcoming quarter. Based on this sales forecast, and using the standards determined by the cost analyst, the company can plan a budget for the production costs required for the upcoming quarter. The budget includes 1,000 pounds of raw material costing $2,000 dollars and 1,000 hours of labor costing a total of $20,000 dollars. So the total production costs for the upcoming quarter are expected to be $22,000 dollars.

At the end of the quarter, the company analyzes the production process to see how well they stuck to the budget. As it turns out, the company produced 1,000 widgets at a total cost of $35,000 dollars. Clearly, the production process turned out to be more expensive than they had planned. The cost analyst can then compare the standard budgeted costs to the actual costs to see what the differences were and then the managers can analyze the production process to find out why the differences occurred.

Let’s say, as it turns out, the company actually used 1,000 pounds of raw material costing $2,000 dollars and 1,000 hours of labor costing $33,000 dollars. Clearly the variance occurred in the pay rate. For some reason, the labor ended up costing $13,000 dollars more than they had planned. Maybe this is because the original estimates were off, or maybe some of the workers were working on overtime, or maybe somebody made a mistake. By comparing the standard cost and the actual costs the company can analyze the situation and dig deeper to find out what went wrong.

Hilton, Ronald W., Michael W. Maher, Frank H. Selto. “Cost Management Strategies for Business Decision”, Mcgraw-Hill Irwin, New York, NY, 2008.

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