In this article we will discuss about:- 1. Introduction to Standard Costing 2. Purposes and Advantages of a Standard Costing System 3. Limitations 4. Setting Standard Costs 5. Standard Hour- Variance Ratios 6. Standard Cost Book Keeping 7. Summary.
Standard Costing: Introduction , Advantages, Formula and Example!
Introduction to Standard Costing:
Standard costing system is not a distinct system of accounting. Standard costing is primarily a cost control technique. It is used either with the process or operation type, or with the specific order type of cost accounting system. Its main purposes are to provide bases for control through variance accounting. It may be used for valuation of stock and WIP and in some cases, for fixing selling prices.
Under standard costing system, a variance report, which reconciles the budget profit with actual profit, is placed before the management with explanations for variances. Variance reporting is a mechanism to provide feedback to managers on variances from target results.
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Definitions:
A 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. Standards are set based on engineering specifications.
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Standard cost is a pre-determined calculation of how much costs should be under specified working conditions. It is built up from standard quantity and estimates of prices and/or wage rates expected to apply during the period in which the standard cost is intended to be used.
Basically there are two groups of standards- quantity standards and price standards. Quantity standards are determined on the basis of engineering and technical specifications while price standards are set on the basis of forecast of market trends. To be meaningful, while quantity standards should not be revised frequently, price standards essentially require periodic revision.
Purposes and Advantages of a Standard Costing System:
(a) Standard costing system provides a constant unit of measurement of actual performance. In the absence of standard costs, actual costs are compared with the actual costs incurred in a previous period. The latter provides a very unsatisfactory criterion for measuring performance. Various operational inefficiencies are buried in it, and it does not reflect intervening changes in the methods of production, levels of activity, market trend, etc.
(b) Quantity standards provide a constant and unchanging unit of measurement as correctly established standards need revision only if the product itself has changed or the methods of production or the quality of materials used have changed.
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(c) Standard costing facilitates ‘Management by exception’. The manager’s time is the scarcest resource in any organization. The principle of exception assumes that performance which meets the standard does not require management attention and only, a below or above standard performance demands closer scrutiny by managers.
(d) Standards provide a motivating force necessary to achieve high performance. Attainable standards encourage workers to achieve or surpass the same because they know any performance below standard will have to be explained. Supervisor and managers show a keen interest in the accomplishment of standards because they know that their performance would be evaluated with reference to the established standards. Many plans for rewarding workers, supervisors, and managers make use of standards.
(e) Standard costing provides an opportunity for a continuous re-appraisal of the methods of production, levels of efficiency, product design, etc., leading to cost reduction.
(f) Standard costing is an economical way of costing. Much of the clerical work can be eliminated by maintaining stock records in quantitative terms. Similarly, pricing of bills of materials or requisitions takes much lesser time as compared to the time required in pricing at actual cost. Preparation of cost reports becomes easier under the standard costing system.
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Limitations of Standard Costing:
A standard costing system benefits most of the organization that produces identical items in large quantity. For example, standard costing system can be used by a firm producing consumer durables or by a firm that employs the process cost system. Standard costing, if applied in a non-repetitive production environment, might bring out misleading variances. However, the system can be employed in an organization producing tailor-made jobs only to a limited extent for ‘standard components’ which are used in a large number of jobs.
Variance analysis, an essential component of a standard costing system, cannot be applied on a product to product basis for administration, selling, and distribution overheads. It is very difficult to analyse such expenses for each product separately. Therefore, standard costing system covers production costs only.
Standard costing system cannot operate effectively in a condition of frequent changes in prices and in general price levels. A meaningful comparison under such a condition demands a frequent revision of standards, which may be a very expensive process.
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Setting Standard Costs:
Standards can be set at the following different levels:
(a) Ideal standards;
(b) Attainable standards; and
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(c) Basic standards.
Ideal standard is a standard which can be attained under most favourable conditions. No provision is made, for example, for shrinkage, spoilage, or machine breakdowns. Ideal conditions can seldom, if ever, be realized and so comparison of actual results with a standard set on this basis would result in large unfavourable variances. Ideal standards are not widely used in practice because they may influence employee motivation adversely.
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Attainable standard reflects ‘ought to be’ cost under normal conditions with acceptable wastages and attainable and reasonable efficiencies. Standards set at this level are more realistic, while ideal standards are totally unrealistic. This standard level is widely used because it is best suited for performance evaluation and positively influences employee motivation.
However, the expression ‘reasonable’ is vague; it is very difficult to assess at what point, above actual costs and below ideal costs, the standard should be set. The attainable standard is influenced by the subjective assessment of the person setting the standard.
This is a standard established for use over a long period from which a current standard can be developed. This standard is not in common use, because in the face of rapid changes in operating conditions, such a standard cannot be of any real help in developing current standards.
Actual costs of the periods which pre-date the standard cost system cannot be relied on as a basis for determining standards because those incorporate the inefficiencies and wastes which are expected to be revealed under the standard costing system. Engineering specifications and production plans should be the basis for setting quantity standards.
Past records can be used only to assess ‘normal’ wastes, machine breakdown, level of efficiency, etc. Attainable standard includes wastes, machine breakdown, etc., which cannot be prevented.
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The following difficulties arise in setting standards:
(a) Forecasting market trends for material prices and wage rates;
(b) Estimating inflation;
(c) Deciding ‘acceptable’ or ‘reasonable’ wastes, idle time, inefficiencies, etc.;
(d) Deciding the normal production;
(e) Securing the confidence of lower level management who perceive the standard costing technique as a ‘spying process’.
Standard Hour- Variance Ratios:
A standard hour represents the quantity of output or the amount of work which should be performed in one hour. The standard hour is a measure of output which can be used conveniently to measure the output of different types of products which are usually measured in different units (e.g. kilograms, litres, etc.).
Example- Standard time allowed 6 minutes per unit of a product. Actual production was 300 units. The production was equal to 30 standard hours. The actual time taken to produce 30 standard hours may be more or less than 30 hours.
Standard Cost Book Keeping:
The basic principles of double entry in cost control account for both standard and non-standard costing systems are the same.
The only difference is in the treatment of variances.
The following are the three important methods of accounting within a standard costing system:
1. Partial plan or output plan
2. Single plan or input plan
3. Dual plan
This method is often termed as output plan.
The following are the important features of this plan:
i. Work-in-progress (WIP) control account is debited with actual costs and credited with standard costs of completed units. Year-end WIP is evaluated at standard cost. Thus, opening and the closing balances of WIP control account show values of beginning and year-end incomplete units at standard cost.
ii. The difference between debit side total and credit side total of WIP control account before adjustment for variances represents cost variance. Cost variance is analysed separately with the help of additional information not recorded in the accounts and is transferred to respective variance accounts.
Thus, material, labour, and overhead costs as well as the inventory of raw materials are shown at actual costs; the cost of goods sold and inventory of finished goods and WIP are shown at standard costs.
We may summarize the plan as follows:
The advantage of a partial plan is that it is easy to understand and it involves less clerical expenditure. However, it is not widely used because variances are computed only after the evaluation of year-end WIP, and this delay defeats the very purpose of variance accounting.
Under this plan WIP control account is both debited and credited at standard costs and inventory of raw material, WIP and finished stock is valued at standard cost.
Variances can be computed at any stage with the information available from subsidiary records. Many firms compute rate and expenditure variance as and when costs are incurred. Usage and efficiency variances are computed at the time of crediting control accounts.
Formula and Example
The plan can be summarized as follows:
3. Dual Plan:
Under this plan stores ledger control A/c, WIP ledger control A/c and Finished Stock A/c are debited and credited both at actual and standard costs. In each of these three accounts, two parallel columns are provided on the debit and credit sides, one column is used to enter actual costs while standard costs are entered in the other column. The cost of sale account and financial statements record only the actual costs.
In this plan variances are expressed as percentages and not in absolute monetary terms. This plan provides the same information as is provided by the single plan. The only difference between the two is that while the single plan takes variances to financial statements, the dual plan does not take variances to financial statements and uses them for control purposes only.
The following are the main limitations of this method:
(i) It is costly to operate as it involves more clerical work as compared to the other two methods,
(ii) Computation of variances is a complicated and time taking task, and
(iii) Variances are not available as quickly as they are available under the single plan.
Summary:
Firms use the standard costing technique, in conjunction with an appropriate product costing method, for managing costs. Engineering-driven standards for usage of resources are set, which are translated into monetary value by using budgeted prices. Therefore, while standard quantities are not revised unless warranted by changes in product specification, design or process of manufacturing, standard prices are revised on yearly basis.
A firm may set standards at an ideal level or at the attainable level or at the basic level depending on the objective it desires to achieve through the standard costing system. The key to a standard costing system is variance reporting. Variances between actual and standard are reported for investigation and corrective actions are taken to remove the causes of adverse variances. Favourable variances must also be investigated and standards are reviewed and revised, if necessary.
Sales variances are presented either in terms of variances in margin or in terms of variances in turnover. Usually a comprehensive report, which reconciles the actual profit and the budgeted profit, is presented showing sales and cost variances. Many firms maintain cost ledger within a standard costing system.
The three important methods of accounting are- partial plan or output plan, single plan or input plan and dual plan. These methods treat variances differently while basic principles of book keeping are the same in all the three methods.