Standard Costing

What do you mean by standard costing?

Overhead costs are costs that cannot be traced directly to a specific product or unit. Overheads are of two main types: manufacturing (or factory) overheads and nonmanufacturing overheads.

Manufacturing overheads are overheads related to the production process (factory rent and electricity, for example), and they are allocated to units produced along with direct materials and direct labor. Under absorption costing, the production costs become a part of the cost of the units produced. That cost is held in inventory until the units it is attached to are sold, and then it becomes an expense on the income statement as cost of goods sold. Manufacturing overheads and manufacturing direct costs are the subject of the current discussion.

Nonmanufacturing overheads are not related to the production process. Examples of nonmanufacturing overheads are accounting, advertising, sales, legal counsel and general corporate administration costs. Nonmanufacturing overheads are expensed as they are incurred and are not the subject of this discussion.

Direct materials and direct labor are applied to production by multiplying the standard price or rate per unit of direct materials or direct labor by the standard quantity of direct materials or direct labor allowed for the actual output. For example, if three direct labor hours are allowed to produce one unit and 100 units are produced, the standard number of direct labor hours allowed for those 100 units is 300 hours (3 hours per unit × 100 units). The standard cost for direct labor for the 100 units is the standard hourly wage rate multiplied by the 300 hours allowed for the actual output, regardless of how many direct labor hours were actually worked and regardless of what actual wage rate was paid. The cost applied to the actual output is the standard cost allowed for the actual output.

In a standard cost system, the standard quantity of an input allowed for the actual output— not the actual quantity of the input used for the actual output—and the standard price allowed per unit of the input, not the actual price paid per unit of the input, are used to calculate the amount of the input’s cost applied to production. Some candidates find that a difficult concept to grasp, because it requires using the standard price per unit of the input and the standard quantity of the input allowed per unit of output with the actual number of units produced.

The standard cost of an input such as direct materials for one unit of output is:

Standard price per unit of the input × standard quantity of the input allowed per unit of output

The standard cost of an input such as direct materials for 100 units of output is:

Standard price per unit of the input × standard quantity of the input allowed per unit of output × 100

In a standard cost system, overhead is generally allocated to units produced by calculating a predetermined, or standard, manufacturing overhead rate (a volume-based method) that is applied to the units produced on the basis of the standard amount of the allocation base allowed for the actual output. When a traditional method of overhead allocation is used, the predetermined standard manufacturing overhead application rate is calculated as the budgeted overhead cost divided by the budgeted activity level of the allocation base.

The predetermined overhead application rate is calculated as follows:

The best cost driver to use as the allocation base is the measure that best represents what causes overhead cost to be incurred.

The most frequently used allocation bases are direct labor hours, direct labor costs, or machine hours. For a labor-intensive manufacturing process, the proper allocation base is probably direct labor hours or direct labor costs. For an equipment-oriented manufacturing process, number of machine hours is the better allocation base.

To apply overhead cost to production, the predetermined overhead rate is multiplied by the standard amount of the allocation base allowed for producing one unit of product, and then that standard overhead amount for one unit is multiplied by the actual number of units produced to calculate the standard overhead cost to be applied to the units produced.

the actual production will probably always be different from the budgeted production and the actual costs incurred will probably always be different from the budgeted costs used to determine the allocation of the overhead. The difference between the actual overhead cost incurred and the overhead cost applied to production is called an under-applied or over-applied overhead cost, also called a variance. At the end of each accounting period, variances are accounted for in one of two basic ways.

• If the variances are immaterial, they may be closed out 100% to cost of goods sold expense on the income statement.
• If the variances are material, they should be prorated among cost of goods sold and the relevant Inventory accounts on the balance sheet (generally finished goods and work-in-process inventories) according to the amount of overhead cost included in each that was allocated to the current period’s production.

If the variances are closed out 100% to cost of goods sold, the inventory cost of the units produced will be equal to the standard cost of the units only.

In a standard cost system, both direct inputs to production such as direct materials and direct labor as well as overhead are applied to units produced on the basis of the standard cost allowed per unit multiplied by the actual number of units produced.

Standard costing enables management to compare actual costs with what the costs should have been for the actual amount produced. Moreover, it permits production to be accounted for as it occurs. Using actual costs incurred for manufacturing inputs would cause an unacceptable delay in reporting, because those costs may not be known until well after the end of each reporting period, when all the invoices have been received.

The emphasis in standard costing is on flexible budgeting, where the flexible budget for the actual production is equal to the standard cost per unit of output multiplied by the actual production volume.

Standard costing can be used in either a process costing or a job-order costing environment.

The standard cost for each direct input per completed unit is the standard rate per unit of input multiplied by the amount of inputs allowed per completed unit, not multiplied by the actual amount of inputs used per completed unit.

Standard costing is applicable to manufacturing companies but also to other companies such as retail or service companies.

• Manufacturing companies use standard costing with flexible budgeting to control direct inputs to production—direct materials and direct labor and their costs—as well as manufacturing overhead costs.
• Retailers and service companies use standard costs to control their direct inputs and overhead, too. For example, direct inputs for a fast-food restaurant include food costs and labor. Examples of overhead costs for a fast-food restaurant are the manager’s salary, rent for the premises, utilities, and janitorial costs

Benefits of Standard Costing

• Standard costing enables management to compare actual costs with what the costs should have been for the actual production.
• It permits production to be accounted for as it occurs, since standard costs are used to apply costs to units produced.
• Standard costing prescribes expected performance and provides control. Standard costs establish what costs should be, who should be responsible, and what costs are under the control of specific managers. Therefore, standard costs contribute to management of an integrated responsibility accounting system.
• Standards can provide benchmarks for employees to use to judge their own performance, if the employees view the standards as reasonable.
• Standard costing facilitates management by exception, because as long as the costs remain within standards, managers can focus on other issues. Variances from standard costs alert managers when problems require attention, which enables management to focus on those problems.

Limitations of Standard Costing

• Using a predetermined factory overhead rate to apply overhead cost to products can cause total overhead applied to the units produced to be greater than the actual overhead incurred when production is higher than expected; and overhead applied may be less than the amount incurred if actual production is lower than expected.
• If the variances from the standards are used in a negative manner, for instance to assign blame, employee morale suffers, and employees are tempted to cover up unfavorable variances and to do things they should not do in order to make sure the variances will be favorable.
• Output in many companies is not determined by how fast the employees work but rather by how fast the machines work. Therefore, direct labor quantity standards may not be meaningful.
• The use of standard costing could lead to overemphasis on quantitative measures. Whether a variance is “favorable” or “unfavorable” and the amount of the variance is not the full story.
• There may be a temptation on the part of management to emphasize meeting the standards without considering other non-financial objectives such as maintaining and improving quality, on-time delivery, and customer satisfaction. A balanced scorecard can be used to address the non-financial objectives as well as the financial objectives.
• In environments that are constantly changing, it may be difficult to determine an accurate standard cost.
• • The usefulness of standard costs is limited to standardized processes. The less standardized the process is, the less useful standard costs are.