Standard Costing (Encyclopedia of Business and Finance)
Costing is the identification of the value of resources used for specified goods or services. One purpose of costing is to determine what resources were required to provide the goods or services. A second purpose is to provide a guide to resource usage through the use of budgets that clearly identify managers' responsibility. It is the second purpose that is considered in the following discussion.
METHODS OF COSTING IDENTIFIED IN BUDGETS
Budget figures may be based on actual, budgeted, or standard costs. These categories are not mutually exclusive. For example, while a standard cost is a budgeted cost, a budgeted cost is not always a standard cost. An actual cost may or may not be the budgeted cost.
Budgets based on actual costs reflect expenditures anticipated for the level of resource use. Budgeted costs are generally described as the best estimate about what should be allowed for forth coming activity. To establish budgeted costs, actual costs of the previous year, information from supervisors about where resources might be more efficiently used, and subjective judgments about the need to conserve resources are often considered. Standard costs are objectively determined costs that reflect the effective and efficient use of resources.
Standard costs are costs established through identifying an objective relationship between specified inputs and expected outputs. Therefore, standard costs are generally related to carefully analyzed phenomena both in the laboratory and in the workplace. For example, in the factory of a company that produces high-quality cotton shirts for men, standard costs are used for materials and labor. To establish the standard usage of fabric for a single shirt, the cutting possibilities are analyzed in the laboratory, where attention can be given to how much fabric must be used if the shirt is cut as specified. At this point, the focus is not on how many minutes are needed by an experienced cutter to meticulously cut the fabric so as to minimize usage. Rather, there is experimentation in the ways of cutting and the time required for each way considered. Experimentation continues until the most economical combination of fabric usage and cutting time is established. That combination is likely to be modified to take account of less than perfect conditions in the workplace.
The goal of the personnel responsible for setting standard costs is to provide realistic standards. Workers are to be motivated to achieve output with specified standards. If standards are unreasonableither too tight or too loosehe level of discipline expected is seriously undermined. If standards cannot be achieved with reasonable effort, workers may become discouraged and become so indifferent that their work quality deteriorates significantly. If standards are too easy to achieve, there may be an unnecessary waste of resources.
Standard costing has applications to any type of business activity. The process described briefly above can be applied, for example, for processing documents in an insurance company or in a financial services business.
MONITORING STANDARD COSTS
Standard costs are monitored as a basis for determining the extent to which expectations are realized. Typically, companies plan for reporting weekly or monthly. A commonly used method is to determine the difference between what the budget allowed and what was actually spent for the output achieved. This difference is called a variance. For example, assume that in the factory producing shirts, 12,000 shirts, requiring 30,500 yards of fabric, were cut in a month. The standard usage was 2.5 yards per shirt, for a total of 30,000 yards. The excess usage would indicate an unfavorable usage variance of 500 yards. Variances are generally presented as units standard cost for the fabric. Therefore, if the standard cost for the fabric was $4.75, the variance would be reported as 500 units $4.75 = $2,375. A policy must be established about the level of variance that is to be investigated. Some variation from expectations is allowed, and if standards are realistic, much of the variation is eliminated over the period of a yearhat is, insignificant favorable variances cancel out insignificant unfavorable variances.
Variances that are determined to be significant are investigated. Careful observation and discussion with those workers involved in producing the output that led to a variance will aid in assessing what circumstances appeared to be the explanation. Wise consideration of what should be done in the future can lead to the elimination of significant variances.
In an objective review of observations and discussions, questions may arise as to the appropriateness of the standards established. There may need to be a reconsideration of the earlier analyses that were the basis for the standards used in the budget followed by operational personnel.
For an organization to gain optimum value from standard costing, all employees involved must understand the motivation for such costing and understand the assessment that will be made. Imposing standard costs without communicating in an honest, candid manner will undermine much of the perceived value of such costing.
Developments such as continuous improvement, target costs, and push-through production have changed to some extent the usefulness of traditional standard costing. However, each of these developments has been implemented in some organizations with aspects of standard costing included. For example, continuous improvement, in a general way, introduces a review of what resources were used this year to identify where fewer resources might be used in the forthcoming year. The task of identifying fewer resources is a standard-setting task. Target costs are calculated by starting with the cost consumers are believed to be willing to pay for the completed good or service, then analyzing the cost in a backward fashion. This process can also involve the basic concept of standard costing. Push-through production, in which groups have responsibility for a number of processes, can profit from standard costing as a basis for monitoring resource usage.
One major barrier to implementation of standard costing in the twenty-first century is the speed of change in how tasks are performed and in the alternative materials available. Frequent change leads to insufficient time for the careful analyses of inputs and outputs. Decisions are based solely on judgments and observations. Such decisions may be close to those established systematicallyowever, they may not be.
The usefulness of the information provided from analysis of variances related to standard costs has been challenged. Attention to quality, some critics say, is inadequate in this traditional analysis. Others have proposed that quality considerations can be incorporated in standard costing assessment (see Cheatham and Cheatham, 1996).
Cheatham, Carole B., and Cheatham, Leo R. (1996). "Redesigning Cost Systems: Is Standard Costing Obsolete?" Accounting Horizons 10.4, (December): 23-31.
Drury, Colin. (1999). "Standard Costing: A Technique at Variance with Modern Management?" Management Accounting November: 56-58.
Fleischman, Richard K., and Tyson, Thomas N. (1998). "The Evolution of Standard Costing in the U.K. and U.S.: From Decision Making to Control." Abacus March: 92-119.
National Association of Accountants (now the Institute of Management Accountants). (1974). Standard Costs and Variance Analysis. New Jersey: Montvale.