Definition of Standard Costing
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.
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:
- 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.
- 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.
- 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.
- Production and pricing policies are formulated with certainly. This helps to keep the costs in-chek.
- 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.
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:-
- 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.
- To help in setting Budgets.
- To provide useful and detailed information for managerial planning and decision making.
- Helps in assessing the performance and efficiency of the staff and management.
- 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:
- Establishment of Cost Centres.
- Classification and Codification of Accounts.
- Types of Standards.
- 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.
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.