Standard Costing: Definition, Features, Types, Advantages, Disadvantages

What is Standard Costing?

Standard costing is a perfect system of controlling the costs and measuring efficiency and its development. It is a technique of cost reduction and cost control. It helps to provide valuable guidance in several management functions such as formulating policies, determining price level, etc.

The essence of standard costing is to set objectives and targets to achieve them, to compare the actual costs with these targets. Standard Costing is used to ascertain the standard cost under each element of cost, i.e., materials, labours, overhead.

Standard Costing can eliminate all kinds of waste. Through the application of this costing it can be ascertained whether or not the activities of production are going on according as the pre‐determined plan.

Definition of Standard Costing

Features of Standard Costing

With the help of above definitions the following Features of Standard Costing can be pointed out:

1. In Standard Costing all costs are pre-determined in advance. These predetermined costs are compared with the actual costs incurred. The difference between the standard cost and the actual cost is known as the Variance. These variances are then analysed and reasons found out for taking corrective action.
   
   
2. The standards are set based on the past records and performances.
   
   
3. Comparison between actual performance and standard performance is shown by way of reports which are presented to the top management.
   
   
4. Analysis of variances are made for taking appropriate action according to the nature of expenses, i.e. controllable and uncontrollable.
   
   
5. In case of controllable costs if there is adverse variance, efforts are taken to prevent its recurrence. But in case of uncotrollable costs, the standards are revised.
   
   
6. Standard Costing may be applied to any industry.

Objectives of Standard Costing

The Objectives of Standard Costing technique are as follows:

1. Cost Control
2. Management by Exception
3. Develops Cost Conscious Attitude
4. Fixation of Prices
5. Fixing Prices and Formulating Policies
6. Management Planning

Cost Control

The most important objective of standard cost is to help the
management in cost control. It can be used as a yardstick against which actual costs can be compared to measure efficiency.

The management can make comparison of actgual costs with the standard costs at periodic intervals and take corrective action to maintain control over costs.

Management by Exception

The second objective of standard cost is to help the management in exercising control over the costs through the principle of exception.

Standard cost helps to prescribe standards and the attention of the management is drawn only when the actual performance is deviated from the prescribed standards. It concentrates its attention on variations only.

Develops Cost Conscious Attitude

Another objective of standard cost is to make the entire organisation cost conscious. It makes the employees to recognise the importance of efficient operations so that costs can be reduced by joint efforts.

Fixation of Prices

To help the management in formulating production policy and helps in fixing the price quotations as well as in submitting tenders of various products.

This can be done with accuracy with standard cost than the actual costs. It also helps in formulating production policies. Standard costs removes the reflection of abnormal price fluctuations in production planning.

Fixing Prices and Formulating Policies

Another object of standard cost is to help the management in determining prices and formulating production policies. It also helps the management in the areas of profit planning, product-pricing and inventory pricing etc.

Management Planning

Budget planning is undertaken by the management at different levels at periodic intervals to maximise profit through different product mixes.

For this purpose, it is more convenient using standard costing than actual costs because it is done on a scientific and rational manner by taking into account all technical aspects.

Advantages of Standard Costing

In the areas of Accounting, Cost Accounting and Management Accounting, Standard Costing enjoys a significant place in acting as a cost controlling and cost reducing managerial tool. The utility of standard costing is unlimited. The following are some important merits.

1. Proper Planning
2. Efficient Cost Control
3. Motivational Factor
4. Comparison of Forecasting and Outcome
5. Inventory Control
6. Economical System
7. Helpful in Budgeting
8. Helps Formulate Policies
9. Helps Distinguish Activities
10. Eliminates Wastage

Proper Planning

Standard Costing helps to apply the principle of “Management by exception”. That is, the management need not worry over those activities which proceed in tandem plans. It is only on the issues of exceptions that they have to concentrate.

Efficient Cost Control

Standard Costing is a tool for the management to gain reduction in the cost and control over it. Under this technique, differences are analyzed and responsibilities are determined.

Motivational Factor

Labour efficiency is promoted and they are destined to be cost conscious. Standards provide incentives and motivation to work with greater effort. This increases efficiency and productivity.

Comparison of Forecasting and Outcome

A target of efficiency is set for the employees and the cost consciousness is stimulated. Since the process of standard costing allow an appraisal to be made of personnel, machines and method of working, current inefficiencies come to the notice and get eliminated.

Inventory Control

Standard costing facilitates inventory control and simplifies inventory valuations. This ensures uniform pricing of stocks in the form of raw materials, work‐in‐progress and finished goods.

Economical System

Standard costing system is economical system from the viewpoint that it does not require detailed records. It also des not require a big staff. It results in the reduction in paper work in accounting and needs very few records. Thus, there is saving of time as well as money.

Helpful in Budgeting

Budgets are prepared on the basis of standard costing. Standards which are set up in respect of materials, labour and overheads, are helpful in preparing various budgets. For example, flexible budget, sales budget, etc.

Helps Formulate Policies

This technique is a valuable aid to the management in determining prices and formulating production policies. Standard costing equips cost estimates while planning the production of new products.

Helps Distinguish Activities

Standard costing helps in distinguishing between skilled and unskilled activities. So the skilled worker only gives pays attention to improving the activities of the unskilled workers.

Eliminates Wastage

Through fixing standards, certain waste such as material wastage, idle time, lost machine-hours, etc. is reduced.

Disadvantages of standard costing

Following are some of the limitations or disadvantages of standard costing:

1. Costly System
2. Difficulties in Fixation of Standard
3. Constraint for Service Industry
4. Consistency of Standard
5. Unsuitable for Non‐standardised Products
6. Relatively Fixed Standards
7. Difficulties for Small Industries
8. Discouragement for Workers
9. Inaccurate Diverse Results

Costly System

Because the Standard Costing requires highly skillful and competent personnel, it becomes a costly system too. For the same experts are paid high remuneration.

Difficulties in Fixation of Standard

It is always difficult to determine precise standard costs in a given situation which will coincide with actual cost when operations are over. Standard cost are determined partly by the past experience and partly by the cost projections based on advanced statistical techniques. Thus, uncertainties revolve around standards.

Constraint for Service Industry

Standard costing is applied for planning and controlling manufacturing costs. Thus, it cannot be applied in a service industry.

Consistency of Standard

Consistency of Standard because the standards of marginal costing fluctuate and vary time to time, it is difficult to always sustain and continue the same standards.

Unsuitable for Non‐standardised Products

Standard costing is expensive and unsuitable for job manufacturing industries as they manufacture non standardized products such as catering, tailoring, printing, etc.

Relatively Fixed Standards

A business may not be able to keep standards up‐to‐date. In other words, a business may not revise standards to keep pace with the frequent changes in manufacturing conditions. Firms may avoid revising standards as it is a costly affair.

Difficulties for Small Industries

Difficulties for Small Industries’ establishment of standards and their implementation involve initial high costs. Standards have to be revised and new standards be fixed involving larger costs. Thus, small firms find it expensive to operate standard costing system. This system is not fit for each type of industries.

Discouragement for Workers

Sometimes the employees and workers are discouraged when the standards are fixed at a high level. The unreal high standards may adverse by effect the morale of workers rather than working as an incentive for better efficiency.

Inaccurate Diverse Results

Inaccurate and unreliable standards cause misleading results and thus may not enjoy the confidence of the users of this system.

Uses of Standard Costing

The standard costing method has been found quite useful in all industries and more so in the following industries:

• Processing units where the process of output and the nature of product are the same, such as chemical engineering, paper making and metal processing.
  
  
• In all those works where methods of manufacturing process are repetitive and products are homogeneous, such as food products and electricity.
  
  
• In service units where operating costing system is implemented, such as transport and gas.
  
  
• In industries where varieties of products are manufactured, such as textile and engineering works.
  
  
• Industries where extraction work is done, such as coal, oil and timber.
  
  
• All other manufacturing and services units where unit cost component is prevailing.
  
  
• In construction work, contract work, ship building and erection work.

Types of Standard Costing

Types of standards are as follow:

• Ideal Standards
• Normal Standards
• Basic or Bogey Standards
• Current Standards

Ideal Standards

These represent the level of performance attainable when prices for material and labour are most favourable, when the highest output is achieved with the best equipment and layout and when the maximum efficiency in utilisation of resources results in maximum output with minimum cost.

These types of standards are criticised on three grounds:

1. Since such standards would be unattainable, no one would take these seriously.
   
2. The variances disclosed would be variances from the ideal standards. These would not, therefore, indicate the extent to which they could have been reasonably and practically avoided.
   
3. There would be no logical method of disposing of these variances.

Normal Standards

These are standards that may be achieved under normal operating conditions. The normal activity has been defined as “the number of stand- ard hours which will produce at normal efficiency sufficient good to meet the average sales demand over a term of years”.

These standards are, however, difficult to set because they require a degree of forecasting. The variances thrown out under this system are deviations from normal efficiency, normal sales volume, or normal production volume.

If the actual performance is found to be abnormal, large variances may result and necessitate revision of standards.

Basic or Bogey Standards

These standards are used only when they are likely to remain constant or unaltered over a long period. According to this standard, a base year is chosen for comparison purposes in the same way as statisticians use price in- dices. Since basic standards do not represent what should be attained in the present period, current standards should also be prepared if basic standards are used.

Basic standards are, however, well suited to businesses having a small range of products and long production runs. Basic standards are set, on a long-term basis and are seldom revised. When basic standards are in use, variances are not calculated. Instead, the actual cost is expressed as a percentage of basic cost.

The current cost is also similarly expressed and the two percentages are compared to find out how much the actual cost has deviated from the current standard. The percentages are next compared with those of the previous periods to establish the trend of actual and current standard from basic cost.

Current Standards

These standards reflect the management’s anticipation of what actual costs will be for the current period. These are the costs which the business will incur if the anticipated prices are paid for the goods and services and the usage corresponds to that believed to be necessary to produce the planned output.

The variances arising from expected standards represent the degree of efficiency in usage of the factors of production, variation in prices paid for materials and services and difference in the volume of production.

Difference between Standard Cost and Estimated Cost

These are important point of Difference between standard cost and estimated cost:

Process of Standard Costing

1. Setting of Standards
2. Ascertainment of actual costs
3. Comparison of actual cost with standard cost
4. Investigate the reasons for variances
5. Disposition of variances

Setting of Standards

The first step is to set standards which are to be achieved, the process of standard setting is explained below.

Ascertainment of actual costs

Actual cost for each component of cost is as- certained. Actual costs are ascertained from books of account, material invoices, wage sheet, charge slip etc.

Comparison of actual cost with standard cost

Actual costs are compared with the standards costs and variances are determined.

Investigate the reasons for variances

Variances arises are investigated for fur- ther action. Based on this, performance is evaluated and appropriate actions are taken.

Disposition of variances

Variances arise are disposed off by transferring it the relevant accounts (costing profit and loss account) as per the accounting method (plan) adopted.

Factors Determining Standards Under Each Cost Component

Let us now understand in brief various factors responsible for fixing standards at operational level:

Direct raw material cost: Standard direct material cost involves separate standards to be fixed for quantity and price of raw material. For fixing standards of quantity of material, it is always considered as one unit of production. A firm uses services of production department to determine such standards. It also considers quality of the product; quantity and quality of raw material; material consumed per unit; wastage of materials and other materials processing factor like input/ output analysis. Sometimes more than one material is used to process a product. In that case, a standard mix of different materials is also considered.

Accordingly, standard price of raw materials is determined based on present market price and expected inflation. The purchase manager, cost manager and materials store department are usually involved in this process. The other considerations are arranging of purchase and procurement policy, production policy and economic order quantity.

Direct labor cost

It involves two important components: time required to complete a job and wages per hour to be paid. The combination of both will decide the standard labor cost per unit. Therefore, we consider the standard time and standard wages to complete a unit of product. Hence, the product of the standards set for time and wages rate will be the standard direct labor cost.

Standard time is determined after analyzing and considering different aspects of time and motion study, idle time, past experience, technological changes and future policy considerations. The standard wage rate is set for different types of workers required to complete a product. The product completion requires different types of labor force: skilled, non-skilled and semi-skilled. Standard wages are decided based on current wage rates, current labor laws, minimum wages, provisions of the act, availability of workers and future changes.

Overhead cost

All other expenses other than materials and labor are called overheads. Overheads are classified as fixed overhead and variable overhead. Fixed overhead remains fixed up to a particular level of production. The total fixed overhead for the period are decided based on budgeted production. This has two components: number of units and standard hours to produce them. On the other hand, variable overhead vary directly with the level of production.

Standard hour (SH) measures the amount of work that should be performed in an hour under standard conditions. This is decided based on time and motion study. The fundamental for decision on allocation of overheads is the output of a process in each hour. Standard cost involves different elements of costs, such as material, labor and overheads, in respect of a product.

Setting Standards

The process of setting standards is a valuable activity in itself. The success of standard costing system depends on the reliability, accuracy and acceptance of the standards.

If standards have been properly set and maintained, they are a sound basis for determining cost for various purposes. While setting the standards, the following points should be taken into consideration: duration of use of standard, reasonable standard of performance, level of activity.

For the given units standard sets for the following items are:

1. Direct Material Cost
2. Direct Wage Cost
3. Direct Expense
4. Factory Variable Overhead Cost
5. Selling and Distribution Variable Cost
6. Selling Price and Sales Margin

Standards for Material

It includes (1) Determination of standard quantity of material required, and (2) Determination of standard price per unit of material.

Material Quantities

After establishing the standard quality of material, it is more important and necessary to establish the standard regarding quantity of each material. Generally, quantities are expressed in terms of kilograms, feet, units and so forth.

Standards for Labour

This standard is determined with regard to the current rate of pay and any anticipated variations. It should be fixed for each grade of labour and for each operation involved. The standard hours are fixed for all categories of labour i.e., for skilled and unskilled labour. In these standards, number of hours and workers are established.

Material Prices

This is a forecast of the average prices of material during the future period. This standard is quite difficult to establish because prices are regulated more by the external factors than by the company management. While setting standard prices, the past experiences, existing prices and anticipations should closely examine.

Price of material in the past, current prices and fluctuating trends are the base for determining standard of price.

Setting for Overheads

Setting standard for overheads is more complex than the development of material and labour standards. It is estimated for variable overheads and fixed overheads.

• Variable Overheads: It may be recalled that variable overhead has been defined as a cost which tends to vary directly with the volume of output. It is assumed that the overhead rate per unit is invariable, irrespective of the quantity produced, so it is necessary to calculate only a standard cost per unit or per hour.
  
• Fixed Overheads: Fixed overhead tends to be unaffected by variations in the volume of output. Therefore it is required to determine total fixed overhead for the period and budgeted production in units.

Standard Hour

Production is usually articulated in physical units such as tons, pounds, gallons, numbers, kilograms, liters, etc. When a company is manufacturing different types of products, it is almost impossible to increase the production, which cannot be expressed in the same unit.

Standard hour means a hypothetical hour, which represents the amount of work that should be performed in one hour under standard conditions.

Problems in Setting Standard Costs

The problem involved in setting standard costs include the following:

1. Deciding how to incorporate inflation into planned unit costs.
   
   
2. Agreeing a labour efficiency standard (e.g. whether current times, expected times or ideal times should be used in labour efficiency standard).
   
   
3. Deciding on the quality of materials to be used, because a better quality of material will cost more, but perhaps reduce material wastage.
   
   
4. Deciding on the appropriate mix of component materials, where some change in the mix is possible.
   
   
5. Estimating materials prices where seasonal price variations or bulk purchase discount may be significant.
   
   
6. Possible ‘behavioural’ problems.
   
   
7. The cost of setting up and maintaining a system for establishing standards