Standard Costing

Definition of Standard Costing

“Standard costing is a system of accounting which makes use of predetermined standard costs for
direct material direct labour and factory overhead.”
Standard Costing is the second technique of cost control (the first being the Budgetary Control)
and is one of the most recently developed refinements of cost accounting. The standard costing
technique has been introduced in many industries on account of the limitations of Historical
Costing. Historical costing, which refers to the ascertainment of costs after they have been incurred,
provides the management with a record of what has happened. Thus, it is simply a postmortem of a
case and has its own limitations.

CONTROL through standards and standard costs is considered by Management to be a creative

program aimed at determining whether the resources of the organization are being used optimally or
not. Standard costs are usually determined during the budgetary control process because they are
useful in preparing the flexible budgets and in evaluating performance:
They help in setting realistic prices and in identifying the production costs that need to be controlled
comparison of the actual costs with the standard costs gives us the variance. Correctly analyzed,
various show how adverse tendencies can be corrected. The current category “Standard Costing and
Variance Analysis” discusses the technique of Standard Costing and Variance Analysis, which is
aimed at profit improvement mainly by reducing Materials, Labour and Overhead costs.

Meanings of Standard Cost

The various definitions of standard costing lay emphasis on the determination and use of standard
cost and hence it is desirable to understand the meaning of ‘Standard Cost’. Actually speaking,
standard costs are those costs which are determined in advance for a normal level of efficiency of
operation and which are used periodically as a basis for comparison with actual costs. These may
be termed as ‘commonsense costs’ reflecting the best judgment of management as to what costs
ought to be if the business operations are conducted with high degree of efficiency.

According to Brown & Howard — “The Standard Cost is a pre-determined cost which determines
what each product or service should cost under given circumstances.”
Blocker has defined ‘Standard Cost’ as “a pre-determined cost based upon engineering
specifications and representing highly efficient production for quality standard with a fixed amount
expressed in terms of Dollars’ for materials, labour and overhead for any estimated quantity of
production.”
The Institute of Cost and Management Accountants has defined Standard Cost’ as “a pre-
determined cost which is calculated from management’s standards of efficient operation and the
relevant necessary expenditure. It may be used as a basis for price fixation and for cost control
through variance analysis.”

In the above definition, the term ‘management’s standards of efficient operation’, is important since
standard cost will be ascertained on this basis. The standard of efficient operation may be
determined on the basis of past experience, study or experiments. The standard is generally that
which is attainable though only after a good effort. Standard cost serves as a measure against which
actual cost is compared. If actual cost does not exceed standard cost, the performance will be treated
as fully efficient.
Also Check:  Direct material quantity variance
Thus, standard cost is of great importance in judging the performance of people. Through an
analysis of the difference between the actual and standard costs, the management is in a position to
know the factors leading to such difference in costs. Standard costs also assist the management in
deciding the long term pricing matters.

Features of Standard Costing System

The main features of standard cost may be given as follows:

• Standard cost is a pre-determined cost.

• It is based on past experience and is termed as ‘common sense cost’ reflecting the best
judgment of the management
• It relates to a product, service, process or an operation.
• Standard cost is determined for a normal level of efficiency of operation.
• Standard cost is used for measuring the efficiency of future production or future operations
and thus provides a basis for cost control.
• Standard cost may be expressed in terms of money or quantity.

Advantage of standard cost

The following are some of the more important advantages of standard cost:
1. Standard costs serve as a yardstick against which actual costs can be compared. The
difference between standard cost and actual cost are called variances. For proper control and
performance measurement in the organization, variances should be measured and analyzed.
This also ensures that regular checks are made upon the expenditure incurred.
2. If immediate attention is taken of the various control over costs in greatly facilitated, A
proper standard costing system specifically helps in cost control and cost reduction.
3. Standard costs help in motivating the employees as the system can be used to provide an
incentive scheme to the employes where the variance is minimum.
4. Production and pricing policies are formulated with certainly. This helps to keep the costs in-
chek.
5. If the standards are constantly to being studied and revised they serve as a reliable basis for
evaluably performance and control costs.
Nature and Purpose of Standard Costing System
The main purpose of standard costs is to provide management with information on the day-to-day
control of operations. Standard costs are predetermined costs to provide a basis for more effective
control over costs. The standards costs provide an indication of the criterion by which something
can be analyzed. Actual costs are costs which have been incurred by the business.
The difference between actual costs and standard costs is known as variance. The variances are
identified and analyzed carefully and are reported to managers for taking suitable corrective action.

Applicability of Standard Costing

The technique of standard costing can be applicable under certain conditions which can be given as
follows:
(i) There should be output or production of sufficient volume of some standard product.
(ii) The methods, operations and processes of production should be capable of standardisation.
(iii) The costs should be capable of being controlled.
Also Check:  Variances Analysis Practical Questions and Answers
Standard costing technique can be applied successfully in all those industries which are engaged in
producing standardised products and following process costing method. Examples of such
industries are: sugar, fertilisers, cement, footwear, breweries and distilleries, etc. Public utility
concerns like transport undertakings, electricity supply undertakings, waterworks, etc., can also
apply this technique for controlling costs and increasing efficiency. In jobbing industries and
industries producing non-standardised products, this technique cannot be applied with advantage.

Objectives of using Standard Costing System

The various objectives of using a standard costing system in an organization are:-
1. To control costs mainly by setting standards for each type of cost incurred – material, labour
and overhead. It also helps in analyzing variances and hence judging the effectiveness of
managers in controlling the costs for which they are held responsible.
2. To help in setting Budgets.
3. To provide useful and detailed information for managerial planning and decision making.
4. Helps in assessing the performance and efficiency of the staff and management.
5. Standard costing is a control technique which follows the feedback control cycle. The
feedback system may help in eliminating unwanted costs in the future and hence a possible
reduction in the costs incurred can be achieved.

Preliminaries to be considered before the establishment of Standard Costing

System:
While introducing the technique of standard costing in a business concern, certain preliminaries
have to be taken into consideration. These preliminaries are:
1. Establishment of Cost Centres.
 2. Classification and Codification of Accounts.
3. Types of Standards.
4. Setting the Standards.

Establishment of Cost Centres

A cost centre is a location, person, or item of equipment (or a group of these) for which costs may
be ascertained and used for the purpose of cost control. Cost centres may be personal cost centres or
impersonal cost centres. Personal cost is related to a person while impersonal cost centre is related
to a location or item of equipment. Establishment of cost centres is necessary for the determination
of responsibilities and defining lines of authority.

Classification and Codification of Accounts

Classification or grouping of accounts is most essential for standard costing. Accounts should be
classified in such a way that cost elements of every cost centre are clearly and precisely reflected.
Codes and symbols are assigned to different accounts to make the collection and analysis of costs
more quick and convenient.

Types of Standards
A standard is pre-determined measure relating to material, labour or overhead and is a reflection of
what under stated conditions, is expected of plant and personnel. A standard is basically an
expression of quantity and a standard cost is its monetary expression i.e., quantity multiplied by
price. It shows what the cost should be. In setting standards, the cardinal question is to decide the
type of standard which is to be used in fixing the cost. Basically, there are following types of
standards viz.,

1. Ideal Standards:
Ideal Standards, also called perfection standards, are established on a maximum efficiency level
with no unplanned work stoppages. They are tight standards which in practice may never be
obtained. They represent the level of attainment that could be reached if all the conditions were
perfect all of the time. Ideal standards are effective only when the individuals are aware and are
rewarded for achieving a certain percentage (e.g., 90 percent) of the standard.
Also Check:  Direct materials price variance

2. Basic Standards:
Basic standards are long-term standards and they remain the same after being computed for the first
time. They are projections that are seldom revised or updated to reflect changes in products, prices
and methods. Basic standards provide the base for comparing actual costs over time with a constant
standard and are used primarily to measure trends in operating performance.

3. Currently Attainable Standards:

A currently attainable standard is one that represents optimum attainable performance. It can be
achieved with reasonable effort, i.e., if the firm operates with a “high” degree of efficiency and
effectiveness. These
standards make proper allowances for normal recurring interferences such as machine breakdown,
delays, rest periods, unavoidable waste, etc. It is assumed that these are unavoidable interferences
and are a fact of life. However, allowances are not made for any avoidable interferences with
output.
The currently attainable standard is the most popular standard and they are acceptable to employees
as they provide a definite goal and challenge to them.

Setting the Standards or Establishment of Standard Costing System

Establishment of standard costing system for each element viz. , material, labour and overhead, is a
complex task and requires the collaboration of a number of executives. For this purpose, a
Standards Committee is set up. The Standards Committee generally consists of:
• Production Manager,
• Purchase Manager,
• Personnel Manager,
• Production Engineer,
• Sales Manager, and
• the Cost Accountant.
The Budget Committee and the Standards Committee can also be combined into one committee.
The Standards Committee is responsible for fixing standards. It also assists in the effective
application of the standards and to make changes therein that may be necessary as the new
circumstances render previous standards obsolete.
Before fixing standards, a detailed study of the functions involved in the manufacture of the product
will be necessary. While fixing standard costs, the fundamental principle to be observed is that the
set standards are attainable so that these are taken as yardsticks for measuring the efficiency of
actual performances. The setting up of standard costs requires the consideration of quantities, price
or rates and qualities or grades for each element of cost entering into a product i.e., material, labour
and overhead.

Variance Analysis
Variance Analysis deals with an analysis of deviations in the budgeted and actual financial
performance of a company. The causes of difference between the actual outcome and the
budgeted numbers are analyzed to showcase the areas of improvement for the company. At times,
it is also a sign of unrealistic budgets and therefore in such cases budgets can be revised.
In other words, variance analysis is a process of identifying causes of variation in the income and
expenses of the current year from the budgeted values. It helps to understand why fluctuations
happen and what can / should be done to reduce the adverse variance. This eventually helps in
better budgeting activity.
A variance in management accounting may be favourable (costs lower than expected or revenues
higher than expected) or adverse (costs higher than expected or revenues lower than expected).
Either positive variance or negative variance is reflected negatively on the budgeting efficiency
unless caused by extreme events.

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Variance Analysis Formula

Variance = Actual Income/Expense – Budgeted Income/Expense
Let us look at the need and importance of variance analysis:

Need and Importance of Variance Analysis

• Variance analysis aids efficient budgeting activity as management wishes to have lower
deviations from the planned budgets.  Wanting a lower deviation usually leads managers to
make detailed and forward-looking budgetary decisions.
• Variance analysis acts as a control mechanism. Analysis of large deviation on key items
helps the company in knowing the causes and it helps management look into possible ways
of how such deviation can be avoided.
 • Variance analysis facilitates assigning responsibility and engages control mechanism on
departments where it is required. For example, if labour efficiency variance is seen to be
unfavourable or procurement of raw material cost variance is unfavourable, the management
can enhance control of these departments to increase efficiency.

Limitations of Variance Analysis

The variance analysis is been of large use to corporations; however it comes with its own set of
limitations as follows:
• Variance analysis as an activity is based on financial results which are released much later
after quarterly closing; there may be a time gap which may affect the remedial action taking
an ability to a certain extent. Also, not all sources of variance may be available in accounting
data which makes acting upon variances difficult.
• If the budgeting is not made taking into consideration the detailed analysis of each factor,
the budgeting exercise may be loosely done which is bound to deviate from the actual
numbers. Thereafter analyzing variances may not be a useful activity.

List of Variances
Variances could occur due to change in one or many items of the budgeted list and hence we can
have various types of variance to be analyzed. Let us look at some of the common types of
variances as tabulated below:
Conclusion
The widely used types of variances that are analyzed by management are given above. Apart from
these, the management may also use the variance analysis on other variables like direct cost yield
variance, fixed overhead efficiency variance, variable overhead efficiency variance, fixed overhead
capacity variance, fixed overhead total variance among many others. However, it is important to
understand that it is not necessary to track all variances; it may be sufficient to track a few
important ones depending upon the nature of the company, the life cycle and industry profile.