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Standard Costs
An estimated or predetermined cost of performing an operation or producing a good or service, under normal conditions. Standard costs are used as target costs (or basis for comparison with the actual costs) and are developed from historical data analysis or from time and motion studies.
A standard cost has been described as a predetermined cost, an estimated future cost, an expected cost, a budgeted unit cost, a forecast cost, or a “should be” cost. Standard costs are often a part of a manufacturer’s annual profit plan and operating budgets. Standard costs will be established for the following year’s direct materials, direct labour, and manufacturing overhead. If standard costs are used, there will be:
- a standard cost for each unit of input (e.g., $20 per hour of direct labour)
- a standard quantity of each input for each unit of output (e.g., 2 hours of labour for each product)
- a standard cost for each unit of output (e.g., $20 X 2 hours = $40 of direct labour per product)
Standard Costing
Standard costing is the practice of substituting an expected cost for an actual cost in the accounting records, and then periodically recording variances showing the difference between the expected and actual costs. This approach represents a simplified alternative to cost layering systems, such as the FIFO and LIFO methods, where large amounts of historical cost information must be maintained for items held in stock.
Standard costing involves the creation of estimated (i.e., standard) costs for some or all activities within a company. The core reason for using standard costs is that there are a number of applications where it is too time-consuming to collect actual costs, so standard costs are used as a close approximation to actual costs.
Advantages of Standard Costing
Though most companies do not use standard costing in its original application of calculating the cost of ending inventory, it is still useful for a number of other applications. In most cases, users are probably not even aware that they are using standard costing, only that they are using an approximation of actual costs. Here are some potential uses:
- Budgeting. A budget is always composed of standard costs since it would be impossible to include in it the exact actual cost of an item on the day the budget is finalized. Also, since a key application of the budget is to compare it to actual results in subsequent periods, the standards used within it continue to appear in financial reports through the budget period.
- Inventory costing. It is extremely easy to print a report showing the period-end inventory balances (if you are using a perpetual inventory system), multiply it by the standard cost of each item, and instantly generate an ending inventory valuation. The result does not exactly match the actual cost of inventory, but it is close. However, it may be necessary to update standard costs frequently, if actual costs are continually changing. It is easiest to update costs for the highest-dollar components of inventory on a frequent basis and leave lower-value items for occasional cost reviews.
- Overhead application. If it takes too long to aggregate actual costs into cost pools for allocation to inventory, then you may use a standard overhead application rate instead, and adjust this rate every few months to keep it close to actual costs.
- Price formulation. If a company deals with custom products, then it uses standard costs to compile the projected cost of a customer’s requirements, after which it adds on a margin. This may be quite a complex system, where the sales department uses a database of component costs that change depending upon the unit quantity that the customer wants to order. This system may also account for changes in the company’s production costs at different volume levels, since this may call for the use of longer production runs that are less expensive.
Nearly all companies have budgets and many use standard cost calculations to derive product prices, so it is apparent that standard costing will find some uses for the foreseeable future. In particular, standard costing provides a benchmark against which management can compare actual performance.
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