STANDARD COSTING

INTRODUCTION
Standard cost is the estimated cost of material, labor, overheads and other costs for each unit of production or purchase in a given accounting period. It is used as the benchmark against which cost variances and financial performance are measured, the valuation for inventory and a basis for pricing. 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. The Institute of Cost and Works Accountants defines standard costs as ³Standard costs are prepared and used to clarify the final results of a business, particularly by measurement of variations of actual costs from standard costs and the analysis of the causes of variations for the purpose of maintaining efficiency of executive action.´ Concept of Standard Costing Standard costing is a technique used for the purpose of determining standard cost and their comparison with the actual costs to find out the causes of difference between the two so that remedial action may be taken immediately. The Charted Institute of Management Accountants, London, defines standard costing as ³the preparation of standard costs and applying them to measure the variations from actual costs and analysing the causes of variations with a view to maintain maximum efficiency in production´. Thus, standard costing is a technique of cost accounting which compares the µstandard cost¶ of each product or service, with the actual cost, to determine the efficiency of the operation. When actual costs differ from standards the difference is called variance and when the size of the variance is significant a detailed investigation will be made to determine the causes of variance, so that remedial action will be taken immediately. Thus, standard costing involves the following steps: 1. 2. 3. 4. 5. Setting standard costs for different elements of costs Recording of actual costs Comparing between standard costs and actual costs to determine the variances Analysing the variances to know the causes thereof, and Reporting the analysis of variances to management for taking appropriate actions wherever necessary.

The system of standard costing can be used effectively to those industries which are producing standardised products and are repetitive in nature. Examples are cement industry, steel industry,

This can be done with accuracy with standard cost than the actual costs. Develops Cost Conscious Attitude: Another objective of standard cost is to make the entire organisation cost conscious. For this purpose it is more convenient using standard costing than actual costs because it is done on scientific and rational manner by taking into account all technical aspects. best possible prices for materials. 4. Cost Control: The most important objective of standard cost is to help the management in cost control. It also helps in formulating production policies. Fixing Prices and Formulating Policies: Another object of standard cost is to help the management in determining prices and formulating production policies. 3. The standard costing may not be suitable to jobbing industries because every job has different specifications and it will be difficult and expensive to set standard costs for every job. The ideal conditions may be maximum output and sales. It also helps the management in the areas of profit planning. It makes the employees to recognise the importance of efficient operations so that costs can be reduced by joint efforts. As these conditions do not . 6. TYPES OF STANDARDS The standard is the level of attainment accepted by management as the basis upon which standard costs are determined. Management by Exception: The second objective of standard cost is to help the management in exercising control over the costs through the principle of exception. Standard costs removes the reflection of abnormal price fluctuations in production planning. Thus. Fixation of Prices: To help the management in formulating production policy and helps in fixing the price quotations as well as in submitting tenders of various products. most satisfactory rates for labour and overhead costs. The standards are classified mainly into four types. It concentrates its attention on variations only. product-pricing and inventory pricing etc. Management Planning: Budget planning is undertaken by the management at different levels at periodic intervals to maximise the profit through different product mixes. They are: i) Ideal Standard: The ideal standard is one which is set up under ideal conditions. standard costing is not suitable in situations where a variety of different kinds of tasks are being done. OBJECTIVES OF STANDARD COSTING 1. It can be used as a yardstick against which actual costs can be compared to measure efficiency. 2. Standard cost helps to prescribe standards and the attention of the management is drawn only when the actual performance is deviated from the prescribed standards. The management can make comparison of actgual costs with the standard costs at periodic intervals and take corrective action to maintain control over costs.sugar industry etc. 5.

A regular check on various expenditures is also ensured by standard cost system. based on current conditions. Efficiency measurement-. but is usually unattainable in practice. a decision about base period can be made with which actual performance can be compared.continue to remain ideal. 2. The basic standard is established for a long period and is not adjusted to the present conditions. 3. this standard is of little practical value. In this case. 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. iii) Normal Standard: This represents an average figure based on the average performance of the past after taking into account the fluctuations caused by seasonal and cyclical changes. It should be attainable and provides a challenge to the staff. some of the advantages of this tool are given below: 1. It is possible to take corrective measures at the earliest. But it cannot be used as a yard stick for measuring efficiency. .The targets of different individuals are fixed if the performance is according to predetermined standards.The comparison of actual costs with standard costs enables the management to evaluate performance of various cost centers. It is not proper to compare costs of different period because circumstance of both the periods may be different. Management is able to spot out the place of inefficiencies. The standards are set on expected performance after allowing a reasonable allowance for unavoidable losses and lapses from perfect efficiency. It serves as a tool for cost control purpose because the standard is not revised for a long period. It can fix responsibility for deviation in performance.The performance variances are determined by comparing actual costs with standard costs. Basic standard enables to measure the changes in cost. Still. Management by exception-. In the absence of standard costing system. actual costs of different period may be compared to measure efficiency. 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. iv) Basic Standard: This is the level fixed in relation to a base year. It is just like an index number against which subsequent price changes can be measured. Standards are normally set on short term basis and requires frequent revision. Finding of variance-. The attention of the management is drawn only when actual performance is less than the budgeted performance. In the light of various objectives of this system. It does provide a target or incentive for employees. there is nothing to worry. The principle used in setting the basic standard is similar to that used in statistics when calculating an index number. ii) Expected Standard: This is the standard which is actually expected to be achieved in the budget period. It allows management by exception. This standard is more realistic than ideal standard.

there are a number of preliminaries which are to be considered. the problem created by inflating. Cost control-. The variances are to be classified into controllable and uncontrollable variances. 6. The process of setting standard is a difficult task. DISADVANTAGES 1. 2. 3.4. the reasons are studied and immediate corrective measures are undertaken. then each job will involve different amount of expenditures. These studies require a lot of time and money.It enables and provides useful information to the management in taking important decisions. The determination of manufacturing expenses will require time and motion study for labor and effective material control devices for materials. The fixing of responsibility is not an easy task. Eliminating inefficiencies-. If the production is undertaken according to the customer specifications. The conditions under which standards are fixed do not remain static. A frequent revision of standards will become costly. Right decisions-. 5. administrative and selling expenses. For example. With the change in circumstances. if the standards are not revised the same become impracticable. Improved methods are used for setting these standards. Similar studies will be needed for finding other expenses. 4. These include: 1.Every costing system aims at cost control and cost reduction. For instance. Standard costing is applicable only for controllable variances. PRE-REQUISITES FOR SUCCESS In establishing a system of the standard costing. 4. There are no inset circumstances to be considered for fixing standards. Establishment of Cost Centres Classification of Accounts Types of Standards Setting Standard Costs . It cannot be used in those organizations where non-standard products are produced. The standards are set differently for manufacturing. 2. we will have to change or revise the standards. Whenever a variance occurs. as it requires technical skills. if the industry changed the technology then the system will not be suitable. rising prices. 3. All these studies will make it possible to eliminate inefficiencies at different steps. It can also be used to provide incentive plans for employees etc. The time and motion study is required to be undertaken for this purpose. The standards are being constantly analyzed and an effort is made to improve efficiency. In that case.The setting of standards for different elements of cost requires a detailed study of different aspects. The action taken in spotting weak points enables cost control system.

The ideal conditions may be maximum output and sales. It should be attainable and provides a challenge to the staff. most satisfactory rates for labour and overhead costs. But it cannot be used as a yard stick for measuring efficiency. . This standard is more realistic than ideal standard. Basic standard enables to measure the changes in cost. It does provide a target or incentive for employees. each machine may be classified as a cost centre. It serves as a tool for cost control purpose because the standard is not revised for a long period. Standards are normally set on short term basis and requires frequent revision. The standards are classified mainly into four types. person or an item of equipment (or group of these) in respect of which costs may be ascertained and related to cost units. While establishing cost centres it should be noted that who is responsible for which cost centre. based on current conditions. It is just like an index number against which subsequent price changes can be measured. They are: i) Ideal Standard: The ideal standard is one which is set up under ideal conditions. but is usually unattainable in practice. For example. this standard is of little practical value. Classification of Accounts: Accounts are classified to meet a required purpose. The standards are set on expected performance after allowing a reasonable allowance for unavoidable losses and lapses from perfect efficiency. Types of Standards: The standard is the level of attainment accepted by management as the basis upon which standard costs are determined. 2. there may be six machines in a manufacturing department. Cost centres are set up for cost ascertainment and cost control. best possible prices for materials. Classification may be by function. Codes and symbols are used to facilitate speedy collection and analysis of accounts. 3. In many cases each department or function will form a natural cost centre but there may also have a number of cost centres in each department or function. iii) Normal Standard: This represents an average figure based on the average performance of the past after taking into account the fluctuations caused by seasonal and cyclical changes. iv) Basic Standard: This is the level fixed in relation to a base year. Establishment of Cost Centres: A cost centre is a location. ii) Expected Standard: This is the standard which is actually expected to be achieved in the budget period. A centre which relates to persons is referred to as a personal cost centre and a centre which relates to location or to equipment as an impersonal cost centre. Cost centres are essential for establishing standards and analysing the variances. The principle used in setting the basic standard is similar to that used in statistics when calculating an index number. The basic standard is established for a long period and is not adjusted to the present conditions. As these conditions do not continue to remain ideal. revenue item or asset and liabilities item.1.

PURPOSE OF STANDARD COSTING Standard cost systems aid in planning operations and gaining insights into the probable impact of managerial decisions on cost levels and profits. Standard costs are used for: 1.4. These standards are listed on a standard cost card that provides the manager with a great deal of information concerning the inputs that are required to produce a unit and their costs. all these are fixed to some extent. Assigning costs to materials. Therefore. Forming the basis for establishing bids and contracts and for setting sales prices SETTING STANDARDS Manufacturing companies often have highly developed standard costing systems in which standards relating to direct materials. The total standard cost includes direct materials. The number of people involved with the setting of standards will depend on the size and nature of the business. The standards should be set up in a systematic way so that they are used as a tool for cost control. direct labor and overheads. directing and motivating employees and measuring efficiencies. Personnel Manager. The committee consists of Production Manager. Normally. work in process. every case should be taken into account while establishing standards. Production Engineer. He must ensure that the standards set are accurate and present the statements of standard cost in most satisfactory manner. direct labor and overhead are developed in detail for each separate product. The cost accountant is an important person. Simplifying costing procedures and expediting cost reports. Normally. and finished goods inventories. setting up standards is based on the past experience. 2. 3. In a big concern a Standard Costing Committee is formed for this purpose. 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. Controlling costs. who has to supply the necessary cost figures and coordinate the activities of budget committee. when you want to purchase some material what are the factors you . Setting Standard Costs: The success of a standard costing system depends upon the reliability and accuracy of the standards. Generally. Establishing budgets. 6. Sales Manager. The responsibility for setting standards should be entrusted to a specific person. Promoting possible cost reduction. 4. 5. Cost Accountant and other functional heads.

The standard quality to be maintained should be decided. Different grades of workers will be paid different rates of wages. The time required for producing a product would be ascertained and labor should be properly graded. this is known as direct labor. The second largest amount of cost is of labor. The procedure for purchase of materials. It includes the following: y y y Cost of materials Ordering cost Carrying cost The purpose should be to increase efficiency in procuring and store keeping of materials. Therefore. these will be known as indirect wages. discount policy and means of transport are the other factors which have bearing on the materials cost price. If material is used for a product. The second step in determining direct material cost will be a decision about the standard price. On the other hand. if the material cost cannot be assigned to the manufacturing of the product. and an average of these results should be used for setting material quantity standards. it will be called indirect material. Material¶s cost will be decided in consultation with the purchase department. This department makes use of historical records. it involves two things: y y Quality of material Price of the material When you want to purchase material. The times spent by different grades of workers for manufacturing a product should also be studied for deciding upon direct labor cost.ideal standard or expected standard-. it is known as direct material. this is called wages.also affects the choice of standard price. A number of test runs may be undertaken on different days and under different situations. The type of standard used-. minimum and maximum levels for various materials.consider. the quality and size should be determined.  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. If the wages paid to workers cannot be directly assigned to a particular product. and an allowance for changing conditions will also be given for setting standards. The quantity is determined by the production department. If the labor is engaged directly to produce the product. The setting of standard for direct labor will be done basically on the following: y y Standard labor time for producing Labor rate per hour . The benefit derived from the workers can be assigned to a particular product or a process. The cost of purchasing and store keeping of materials should also be taken into consideration.

technology or production methods. The expenses increase or decrease with the increase or decrease in output. and technology. The determination of overhead rate involves three things: y y y 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. Standards that are out of date . while variable overheads change in the proportion of production. variable overheads and semi-variable overheads. the standard cost will no longer be accurate. The division of overheads into fixed. If a premium or bonus scheme is in operation. In case there is an agreement with workers for payment of wages in the coming period. Standards may need to be changed to accommodate changes in the organization or its environment. standard cost will be fixed per piece. we normally take in to account previous experience. When there is a sudden change in economic circumstances. The labor rate standard refers to the expected wage rates to be paid for different categories of workers. REVISION OF STANDARDS For effective use of this technique. Standard overhead rates are computed by dividing overhead expenses by direct labor hours or units produced. test run result.Standard labor time indicates the time taken by different categories of labor force which are as under: y y y Skilled labor Semi-skilled labor Unskilled labor For setting a standard time for labor force. Even standards are also subjected to change like the production method. past performance records. The very purpose of setting standard for overheads is to minimize the total cost. The standard overhead cost is obtained by multiplying standard overhead rate by the labor hours spent or number of units produced. Past wage rates and demand and supply principle may not be a safe guide for determining standard labor rates. raw material. Semi-variable overheads are neither fixed nor variable. then anticipated extra payments should also be included. variable and semivariable categories will help in determining overheads. work-study etc. these rates should be used. environment. The fixed overheads remain the same irrespective of level of production.  Setting Standards of Overheads The next important element comes under overheads. The object of fixed standard labor time and labor rate is to device maximum efficiency in the use of labor. These overheads increase with the increase in production but the rate of increase will be less than the rate of increase in production. sometimes we need to revise the standards which follow for better control. The anticipation of expected changes in labor rates will be an essential factor. Where a piece rate system is used.

method of production etc. we have taken standards as parameters for measuring the performance. If standards are continually not being achieved and large deviations or variances from the standard are reported. and to be aware of possible unintended consequences. technology. it is required to implement this under a committee for the activity. At the other extreme is the adoption of basic standard which will remain unchanged for many years. Also. It is a continued activity for the optimum utilization of resources. In sum. we need to revise the standards due to change in uses. For this reason. standard costing is a management tool for control. raw material. Nevertheless standard costs are still found in the vast majority of manufacturing companies and in many service companies. they should be carefully reviewed. In practice. but this is hardly satisfactory when there is technological change in working procedures and conditions. Cost analysis and cost control is essential for any activity. standard cost variances may be supplanted in the future by a particularly interesting development known as the balanced scorecard. however. They will not help us to predict the inputs required nor help us to evaluate the efficiency of a particular department.will not act as effective feed forward or feedback control tools. rather than just on the negative. leads to reduction in value of the standard as a yardstick. changing standards frequently is an expensive operation and can cause confusion. For evaluating performance. CONCLUSION Basically. In the process. Sometimes. It is particularly important that managers go out of their way to focus on the positive. Cost includes material labor and overheads. 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. standard cost revisions are usually made only once a year. managers should exercise considerable care in their use of a standard cost system. changes in the physical productive capacity of the organization or in material prices and wage rates may indicate that standards need to be revised. ************************************* . They provide a constant base for comparison. although their use is changing. For a proper organization.

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