Standard Costing: Meaning, Advantages and Variances

Standard Costing: Meaning, Advantages and Variances

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Chanchal
Chanchal Aggarwal
Senior Executive Content
Updated on Jul 17, 2024 18:07 IST

Standard costing is a cost accounting method in which predetermined standards for costs and performance are established. It compares actual costs and performance against these standards to analyze variances and improve cost control. Establishing a Standard costing system will be quite useful to management in planning and control.   2023_02_Standard-Costing.jpg

Imagine a manufacturing company striving to optimize its production costs and efficiency. Standard costing provides a framework for setting predetermined cost targets for materials, labor, and overhead. By comparing actual costs against these standards, the company can identify variances, pinpoint areas for improvement, and make informed decisions to enhance profitability.

Standard costing empowers the organization to control costs, measure performance, and drive continuous optimization. Let's understand standard costing in detail, an important cost accounting topic. 

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Table of Content

What is Standard Costing?

The term ‘standard cost’ consists of ‘ standard’ and ‘cost.’

Standard cost is the predetermined cost assigned to each unit of production. It is based on cost elements—expected material, labour, and overhead expenses. It serves as a benchmark for measuring actual performance, enabling managers to identify variances, streamline operations, and enhance cost efficiency in the production process.

Standard costing is a cost accounting method that assigns a predetermined or “standard” cost to each production unit. This cost is based on anticipated materials, labour, and overhead prices. Companies use it as a control tool to help managers understand cost variances, which are the differences between actual and standard costs. By analysing these variances, companies can make informed decisions to enhance operational efficiency and profitability.

Standard costs are the scientifically predetermined costs of manufacturing a single unit or several product units or rendering service during a specified future period. 

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“A standard expressed in money. It is developed from an assessment of the value of cost elements. It mainly provides bases for performance measurement, valuing stock, control by exception reporting, and establishing selling prices.” 

 

The Chartered Institute of Management Accountants, London

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Variances in Standard Costing

Variances in standard costing refer to the differences between actual costs and the predetermined or “standard” costs. There are two main variances in standard costing: the material cost variance and the labour cost variance.

Material cost variance: Material cost variance refers to the difference between actual and budgeted raw material costs. If the actual cost of raw materials is higher than the budgeted cost, this results in an unfavourable material cost variance. On the contrary, when the actual cost is lower than the budgeted cost, this results in a favourable material cost variance.

Labor cost variance: The labour cost variance is the difference between the actual cost of labour and the standard cost budgeted for a specific product. If the actual cost of labour is higher than the budgeted cost, this results in an unfavourable labour cost variance. If the actual cost of labour is lower than the budgeted cost, this results in a favourable labour cost variance.

Variances are important performance indicators, as they allow organizations to track their progress against budgeted costs and identify areas for improvement. By analysing variances, organizations can make informed decisions about optimizing their operations and improving efficiency.

It is important to regularly review and update standard costs as market conditions and production processes change over time. This helps to ensure that the standards remain relevant and accurate. Additionally, analysing variances and taking appropriate corrective action is important. This helps ensure the organization stays within budget and achieves its financial goals.

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Advantages of Standard Costing

Improved Cost Control

Standard costing is a beacon for cost control, establishing a clear, predefined benchmark for organizational expenses. It enables a meticulous comparison between actual and standard costs, highlighting areas where spending overshoots budgeted amounts. This insight empowers organizations to identify and rectify excessive expenditures swiftly. It ensures financial discipline and enhances cost efficiency.

Better Performance Evaluation

This system is instrumental for comprehensive performance assessment. It facilitates a detailed analysis of cost variances, offering a granular view of production efficiency. Managers can leverage this data to pinpoint operational bottlenecks, implement strategic improvements, and optimize production processes. This will streamline and make organizational operations cost-effective.

Budgeting and Planning

Standard costing is a linchpin in budgeting and planning, offering reliable cost estimates for comprehensive financial planning. It aids in the meticulous preparation of budgets, ensuring that financial resources are allocated optimally. This proactive approach to financial planning enables organizations to navigate fiscal challenges with agility and foresight, bolstering financial stability.

Better Pricing

It plays a pivotal role in the strategic pricing of products and services. Standard costing enables businesses to formulate pricing strategies that balance competitiveness and profitability by providing a clear insight into the cost structure. This informed approach to pricing enhances market position while ensuring sustained revenue generation.

Identifying Inefficiencies

Standard costing acts as a magnifying glass, revealing operational inefficiencies and suboptimal resource utilization. It guides organizations in implementing targeted improvements, ensuring that resources are leveraged to their fullest potential. This focus on operational excellence drives enhanced productivity, cost reduction, and heightened profitability.

Decision Making

It is a cornerstone for informed managerial decision-making. Standard costing offers a detailed breakdown of costs, equipping managers with the data needed to make strategic decisions regarding production scaling, cost management, and operational enhancements. This data-driven approach fortifies the organization’s financial health and long-term sustainability.

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Disadvantages of Standard Costing

Disadvantages of the standard include:

Inflexibility: It is the assumption that the same activity and production process will repeat every time. This approach may not be suitable for businesses that regularly adjust production processes due to changes in demand or new product introduction.

Lack of relevance: The cost data used in standard costing may not reflect current costs, leading to incorrect pricing and decision-making.

Lack of incentives for cost control: When actual costs are consistently higher than the standard, management may not see the need to control costs because they already account for these higher costs in the budget.

Complexity: Standard costing can be complex to implement and maintain, especially for businesses with multiple products and cost centres.

Emphasis on budgeting: Standard costing strongly emphasizes budgeting, which can detract from other important aspects of cost accounting, such as cost analysis and cost control.

Resistance to change: Once a standard costing system is established, there may be resistance to changing it. Even if it is no longer relevant or suitable for the business.

Conclusion!!

Standard costing is a robust financial and operational management tool, offering a framework for cost control, performance evaluation, and strategic decision-making. It aids in pinpointing and rectifying cost discrepancies, ensuring optimal resource utilization and operational efficiency. Facilitating informed pricing and budgeting contributes to enhanced profitability and market competitiveness. Embracing standard costing is a step towards financial discipline, operational excellence, and sustained organizational growth.

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FAQs

What is standard costing?

Standard costing is a cost accounting method where predetermined cost and performance standards are set for various aspects of production, such as materials, labor, and overhead.

Why use standard costing?

Standard costing helps companies monitor and control costs, identify variances between actual and expected costs, and make informed decisions to improve efficiency and profitability.

How are standard costs determined?

Standard costs are typically based on historical data, industry benchmarks, and analysis of expected future costs, considering factors like inflation and market conditions.

What is a standard cost variance?

A standard cost variance is the difference between actual costs and standard costs. It can be favorable (costs lower than standard) or unfavorable (costs higher than standard), helping companies pinpoint areas for improvement.

About the Author
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Chanchal Aggarwal
Senior Executive Content

Chanchal is a creative and enthusiastic content creator who enjoys writing research-driven, audience-specific and engaging content. Her curiosity for learning and exploring makes her a suitable writer for a variety ... Read Full Bio