Standard Costing: Meaning and Objectives | Cost Accounting

In this article we will discuss about:- 1. Meaning of Standard Costing 2. Objectives of Standard Costing 3. Types of Standards 4. Setting Standards 5. Standard Costing System during Inflation 6. Standard Costing and Activity Based Costing 7. Standard Cost Card 8. Responsibility for Setting Standards 9. Problems in Setting Standard Costs 10. Advantages of Standard Costing 11. Criticism on Standard Costing.

Meaning of Standard Costing:

Standard costing is a technique which uses standards for costs and revenues for the purpose of control through variance analysis. Standard is a predetermined measurable quantity set in defined conditions against which actual performance can be compared, usually for an element of work, operation or activity.

“Standard cost is a predetermined calculation of how much costs should be under specified working conditions. It is built up from an assessment of the value of cost elements and correlates technical specifications and the qualification of materials, labour and other costs to the prices and/or usage rates expected to apply during the period in which the standard cost is intended to be used. Its main purpose is to provide basis for control through variance accounting for the valuation of stock and work-in-progress and in some cases, for fixing selling prices.” – CIMA Official Terminology

Standard costing involves the setting of predetermined cost estimates in order to provide a basis for comparison with actual costs. A standard cost is a planned cost for a unit of product or service rendered. Standard costing is universally accepted as an effective instrument for cost control in industries.

Although the terms budgeted and standard costs are sometimes used interchangeably, budgeted costs normally describe the total planned costs for a number of products. Usually budgetary control is operated with a system of standard costing because both systems are interrelated but they are not interdependent.

From a summary of the above study, we can understand what a ‘standard’ means:

(a) Predetermined estimates.

(b) Established for inputs and outputs.

(c) Applicable to all routine aspects of an organization’s operations.

(d) Accounting for standard costs and obtaining variances.

(e) Reporting to management for taking appropriate action wherever necessary.

With the use of standard costing the organization achieves the objectives in a planned and systematic manner. Standard costing can be used in Direct costing, Absorption costing, Job costing, or Process costing. It is not a method of costing but a system which can be fitted in any method.

Objectives of Standard Costing:

The objectives of standard costing technique are as follows:

(a) To provide a formal basis for assessing performance and efficiency.

(b) To control costs by establishing standards and analysis of variances.

(c) To enable the principle of ‘management by exception’ to be practised at the detailed, operational level.

(d) To assist in setting budgets.

(e) The standard costs are readily available substitutes for actual average unit costs and can be used for stock and work-in-progress valuations, profit planning and decision making and as a basis of pricing where ‘cost-plus’ systems are used.

(f) To assist in assigning responsibility for nonstandard performance in order to correct deficiencies or to capitalise on benefits.

(g) To motivate staff and management.

(h) To provide a basis for estimating.

(i) To provide guidance on possible ways of improving performance.

One cannot have perfect and effective system of budgetary control without standard costing, and standard costing cannot be implemented without proper budgetary control system. The budgetary control system and standard costing are both supplementary and complementary to each other.

The use of standard costing is useful for MIS, profit planning, inventory control, product pricing, decision making, cost control etc. Both standards and budgets are concerned with setting performance and cost levels for control purposes. They are similar in principle although they differ in scope. Standards are unit concept, i.e., they apply to particular products, to individual operations or processes.

Budgets are concerned with totals they lay down cost limits for function and departments and for the firm as a whole. In order to enable an organization to set up or install standard costing system the management has to finalize and prescribe various forms, methods and systems keeping in mind the nature, size and technicalities of the business and motivate responsible persons.

Types of Standards:

1. Current Standard:

Current standard is a standard established for use over a short period of time, related to current conditions. The problem with this type of standard is that it does not try to improve on current levels of efficiency.

2. Basic Standard:

Basic standard is standard established for use over a long period from which a current standard can be developed. The main disadvantage of this type of standard is that because it has remained unaltered over a long period of time, it may be out of date. The main advantage is in showing the changes in trend of price and efficiency from year to year.

3. Ideal Standard:

Ideal standard is a standard which can be attained under the most favourable conditions. No provision is made, e.g., for shrinkage, spoilage or machine breakdowns. Users believe that the resulting unfavourable variances will remind management of the need for improvement in all phases of operations. Ideal standards are not widely used in practice because they may influence employee motivation adversely.

4. Attainable Standard:

Attainable standard is a standard which can be attained if a standard unit of work is carried out efficiently, on a machine properly utilized or material properly used. Allowances are made for normal shrinkage, waste and machine breakdowns. The standard represents future performance and objectives which are reasonably attainable.

Besides having a desirable motivational impact on employees, attainable standards serve other purposes, e.g., cash budgeting, inventory valuation and budgeting departmental perfor­mance. If correctly set attainable standards are the best type of standards to use, since they provide employees with a realistic target. Attainable standards have the greatest motivational impact on the workforce.

Setting Standards:

In order to use predetermined standard costs, standards have to be set for each element of cost for each line of product manufactured or service supplied. Standard cost shows what the cost should be keeping in mind the most favourable production conditions, and on the assumption that plant will operate at maximum possible efficiency.

The collaboration of all functional departments is a must in setting standards. The quantities, price and rates, qualities or grades, terms of purchase, product substitution etc. have to be kept in mind while setting standards.

The success of standard cost system depends on the reliability, accuracy and acceptance of the standards. Standards must be set and the system implemented whatever may be faults or delay or cost, otherwise the whole exercise will go waste.

The methodology used in conventional approach to variance analysis is as follows:

(a) Setting of standards and construction of a budget based on them.

(b) Comparison of actual with budgeted outcomes.

(c) Factoring the variance into individual components and investigation of the significant differences.

In this approach the standards are related to expectations over the budget period and do not necessarily reflect optimal performance. Usually it is believed that standards should be reasonably attainable in the circumstances envisaged.

Thus in this context conventional variance analysis is a postmortem exercise. If the standards are tight then this will have a disincentive effect, whereas if the standards are loose then this results in complacency.

The behavioural aspects and implications are generally ignored while setting the standards, which cause the arbitrary investi­gation of variances. It does not give adequate guidance regarding cost-benefit of variances investigated or cost of correcting errors. Thus the conventional analysis is more a postmortem.

The following aspects need to be given consideration while setting the standards:

(a) Standard setting and variance analysis should be sufficiently refined to provide adequate information.

(b) Qualitative information is not given proper attention.

(c) The standard costing system should provide for opportunity costs and profit forgone.

The conventional standard cost system is criticized because of using crude variance classifications, in appropriate measurements, calculation of redundant variances, ignoring variances related important control areas. The standard costing system should give due importance to interdependence between different responsibility centres rather than traditional variance analysis.

Standard Costing System during Inflation:

The inflationary tendency in the economy will cause fall in purchasing power of money thereby affects the accounting for real value. In inflationary conditions the results shown in financial statements do not represent the correct view of activities carried on in the business concern. Any decision taken or estimates made without inflation would not be correct. The expectations of the investors are more in the inflationary conditions.

If an investor expects 8% in an inflation free world, he would expect 12% rate of return on investment in a world subject to inflation pressures. The rate of inflation will have its impact on future cash-flows and profitability of the concern. Before any estimates made or standards set, the difference between money rate of interest and real rate of interest, the difference between them should be taken as rate of inflation.

The practical approach for adjusting inflation is as follows:

(a) Predict the cash-flows in nominal rupees and use the nominal discount rate.

(b) Predict cash-flows in real rupees and use a nominal discount rate.

The correct treatment of inflation, therefore, requires the assumptions about inflation which enter the cash-flow forecasts and discount rate calculations. Uncertainty in standard costing can be caused by inflation, technological change, economic and political factors etc. Standards, need to be continually updated and revised.

Standard Costing and Activity Based Costing:

The traditional standard costing system is not compatible with activity based costing system due to the following reasons:

(a) Product costing based on manufacturing costs alone today represents an unacceptably low proportion of total cost.

(b) Non-manufacturing product costs such as product selling and distribution expenses are ignored for product costing purposes.

(c) ABC system addresses the treatment of all overhead related costs linking with cost drivers and cost pools.

(d) Material cost will be treated as direct costs both in ABC and standard costing system, except that all costs incurred in bringing the product to its current state and location will be included in ABC system.

(e) Labour, as a basis for assigning manufacturing overhead, is irrelevant as it is significantly less than overhead and many overheads do not bear any relationship to labour cost or labour hours.

(f) The cost of technology is treated as product cost and consequently expensed on a straight line basis, irrespective of use.

(g) Service related costs like professional services, banking services, insurance services have increased considerably in the last few decades.

(h) Customer related costs like finance charges, discounts, selling and distribution costs, after sales service costs etc., are not related to product cost object. Customer profitability has become as crucial as product profitability.

(i) Direct labour is also replaced to some extent by information technology and systems. These costs are treated similarly to organizational overheads and not related to products or other cost objects, such as customers.

(j) Costs affected or driven by time (interest and inflation) have increased significantly, yet time does not feature in traditional cost systems as a cost driver. Interest cost is treated as another period cost, whereas it may contribute significantly towards bringing the product (or customer) to its current status.

(k) The traditional short-term focus of the financial year (12 months) is still intact, yet most products and technologies have life cycles exceeding many accounting periods.

(l) Vastly increased competition worldwide, mainly brought about by increased productivity, economies of scale, better communication technology, improved transportation and mar­keting skills, have led to substantially increased marketing costs.

(m) Greater variety, diversity and complexity of products are not taken into consideration in traditional systems.

(n) A much more sophisticated market, which calls for the production of goods and rendering of services desired by the customer/client, and not those thought proper by the supplier, accentuates the lack of customer focus in traditional systems.

Standard Cost Card:

After setting standard for each element of cost, a standard cost card is prepared showing therein the unit standard cost for each element of cost. Standard margin per unit and standard selling prices, standard materials, labour and factory overhead costs are kept on a standard cost card that shows the itemized cost of each materials and labour operation as well as the overhead cost. A standard cost card gives the standard unit cost of a product.

Responsibility for Setting Standards:

The line managers who have to work with and accept the standards must be involved in establishing them. There are strong behavioural and motivational factors involved in this process. The line managers must be involved in the critical part of standard setting. The human aspects of budgeting apply equally to standard costing.

The Cost Accountant has to determine the units of products to be made by producing cost centres and work to be performed by service cost centres. After application of service cost centres rates to production cost centres, a standard overhead rate has to be determined for each production cost centre.

After the standards have been fixed, the management is interested in calculation of variance from the standards with the purpose of making the members of various management levels to know what the variances are, and who is responsible for it.

The purpose of setting standards is to fix yardsticks for measuring the performance of various activities and helps in responsibility accounting. Overhead recovery rates has to be determined in advance and applied on that basis to product/cost centres. There is always a difference in actual expenditure and overheads absorbed.

Problems in Setting Standard Costs:

The problems involved in setting standard costs, apart from the inevitable problems of forecasting errors, include the following:

(a) Deciding how to incorporate inflation into planned unit costs.

(b) Agreeing a labour efficiency standard for example should current times, expected times or ideal times be used in the labour efficiency standard?

(c) Deciding on the quality of materials to be used, because a better quality of material will cost more, but perhaps reduce material wastage.

(d) Deciding on the appropriate mix of component materials, where some change in the mix is possible.

(e) Estimating materials prices where seasonal price variations or bulk purchase discounts may be significant.

(f) Possible behavioural problems. Managers responsible for the achievement of standards might resist the use of a standard costing control system for fear of being blamed for any adverse variances.

(g) The cost of setting up and maintaining a system for establishing standards.

Advantages of Standard Costing:

A standard costing system has many advantages which include the following:

a) Budgets are compiled from standards.

b) Standard costing highlights areas of strengths and weaknesses.

c) Actual costs can be compared with standard costs in order to evaluate performance.

d) The setting of standards should result in the best resources and methods being used and thereby increase efficiency.

e) Standard costs can be used to value stock and provide a basis for setting wage incentive schemes.

f) Standard costing simplifies bookkeeping, as information is recorded at standard, instead of a number of historic figures.

g) It acts as a form of feed forward control that allows an organization to plan the manufacturing inputs required for different levels of output.

h) It act as a form of feedback control by highlighting performance that didn’t achieve the standard predicted, thus altering decision makers to situations that may be out of control and in need of corrective action.

i) It motivates workers by acting as challenging, specific goals that are intended to guide behaviour in the desired directions.

j) It helps to trace/allocate manufacturing costs to each individual unit produced.

k) It operates via the management by exception principle, where only those variances (differ­ences between actual and expected results) which are outside certain tolerance limits are investigated, thereby economizing on managerial time and maximizing efficiency.

l) Control action is immediate, e.g., as soon as material is issued from stores to production it can be compared with the standard material which should have been used for the actual production.

m) Transfer prices are based on standard rather than actual costs. If the latter were used inefficiencies in the form of excess costs might be passed on from one division to another division.

n) The process of setting, revising and monitoring standards encourages reappraisal of methods, materials and techniques so leading to cost reductions.

Criticism on Standard Costing:

The following criticism is levelled against standard costing:

(a) A lot of input data is required which can be expensive.

(b) Standard costing is usually confirmed to organizations whose processes or jobs are repeti­tive.

(c) Unless standards are accurately set any performance evaluation will be meaningless.

(d) Uncertainty in standard costing can be caused by inflation, technological change, economic and political factors etc. Standards, therefore, need to be continually updated and revised.

(e) It may be difficult to set standards at a level which both motivates the workforce and achieves the corporate goals.

(f) The maintenance of the cost data base is expensive.

(g) The research evidence shows that overly elaborate variances are imperfectly understood by line managers and thus they are likely to be ineffective for control purposes.

(h) Virtually all aspects of setting standards involves forecasting and subjective judgments with inherent possibilities of error and argument.

(i) The usefulness of a number of variances relating to overheads, sales margins, mix and yield is questionable.

(j) All forms of variance analysis are post mortem on past events. Obviously the past cannot be altered so the only value variances can have is to guide management if identical or similar circumstances occur in the future.