A STUDY ON STANDARD COSTING

STANDARD COSTING Cost control, leading to cost reduction, should always be the objective of any firm or institution where scarce resources are used. Even if the firm can sell its goods of services at a very remunerative price, it should still try to reduce the use of factors of production, without jeopardizing the quality of the product or the services. The best way of doing this is to constantly think as to whether the cost can be further reduced, but the first step is to try to see that these do not go beyond a level determined before hand. If this approach is adopted ,i.e., if an attempt is made to ascertain beforehand what costs should be and further attempt is made to see that actual costs do not go beyond this level ,the approach will be that of standard costing. In fact ,it is the philosophy of standard which will bring the best result and not merely the mechanism of adopting standard costing techniques. The philosophy of standards , in a nutshell, means scrupulously separating all types of wastages and losses and not allowing that to cud the cost of production, at least for purposes of internal consumption. Suppose, a worker normally working 8 hours should produce 20 units for a wage of Rs 20; the proper labour cost of production is Rs 21 per unit. Suppose for any reason the worker produces only 12 units. Normally, the payment of Rs 20 will be spread over 12 unit and one would say that the labour cost per unit is Rs 1.67.But if the philosophy of standard is practiced, one would say that the proper labour cost of 12 units will still remain Rs 1 per unit of Rs12in all;8 units have not been produced and, therefore, at the rate or Rs1 per unit, there is loss of Rs8. This amount should be charged to a separate account. This account should be shown as a separate item in the revenue accounts of the firm so that management would know, at the end shown as a separate item in the revenue accounts of the firm so that management would know, at the end of each period, the extent of losses that have unnecessarily taken place. Of course, if extra efficiency has been obtained, the effect of that efficiency should be credited to a separate account and shown as a separate item in the revenue account. This really is the essence of standard costing- to set targets of cost, to try to achieve those targets, to compare the actual cost with the targets, to ascertain the reasons and to record the reasons in the books of account, or if a regular record is not maintained, at least to bring the monetary effects of various factors that have operated in the organization, to the notice of the management. Thus standard costing is an excellent system of control of costs and of measuring efficiency, and of improving upon it.

DEFINITION STANDARD COSTING may be defined basically as a technique of cost accounting which compares the standard cost of each product or service with the actual cost, to determine the efficiency of the operation, so that any remedial action may be taken immediately. The standard cost is a predetermined cost which determines what each product or service should cost under given circumstances.

MEANING CONCEPT Historical costs are the actual costs that are ascertained after they are incurred. During the initial stages of development of cost accounting, historical costing systems like process costing, contract costing, service costing etc. were available for ascertaining the costs. The historical costing methods are used to determine the cost incurred for the production of a particular products or completion of a particular job. The historical costing systems suffer from several limitations; some of them are as follows: * No basis for cost control * No yardstick for measuring efficiency * Delay in availability of information * Expensive Although standard costing attempts to overcome the limitations of historical costing system, it is not an alternative to the existing historical costing. Standard costing is the most widely used technique of controlling costs. Standard costing is a technique that establishes predetermined estimates of the cost of products and services and compares these costs with the actual costs as they incur. Standard costing can be considered as a yardstick to measure the efficiency with the actual cost incurred. Hence, standard costing is system of costing which makes a comparison between the standard cost of each product or service with its actual cost to determine the efficiency of the operation, with a view to take corrective actions at the earliest possible time.

TYPES OF STANDARD IDEAL EXPECTED ACTUAL NORMAL BASIC

Standard Costing System In accounting, a standard costing system is a tool for planning budgets, managing and controlling costs, and evaluating cost management performance. A standard costing system involves estimating the required costs of a production process. Before the start of the accounting period, standards are determined and set regarding the amount and cost ofdirect materials required for the production process and the amount and pay rate of direct laborrequired for the production process. These standards are used to plan a budget for the production process. At the end of the accounting period, the actual amounts and costs of direct material used and the actual amounts and pay rates of direct labor utilized are compared to the previously set standards. Comparing the actual costs to the standard costs and examining the variances between them allows managers to look for ways to improve cost control, cost management, and operational efficiency

Standard Costing Advantages and Disadvantages There are advantages and disadvantages to using a standard costing system. The primary advantages to using a standard costing system are that it can be used for product costing, for controlling costs, and for decision-making purposes. The disadvantages include that implementing a standard costing system can be time consuming, labor intensive, and expensive. Also, the standards often have to be updated if the cost structure of the production process changes.

Standard Costing Systems: A standard costing system initially records the cost of production at standard. Units of inventory flow through the inventory accounts (from work-in-process to finished goods to cost of goods sold) at their per-unit standard cost. When actual costs become known, adjusting entries are made that restate each account balance from standard to actual (or to approximate such a restatement). The components of this adjusting entry provide information about the companys performance for the period, particularly with regard to production efficiency and cost control.

Reasons for using a Standard Costing System: There are several reasons for using a standard costing system: Cost Control: The most frequent reason cited by companies for using standard costing systems is cost control. One might initially think that standard costing provides less information than actual costing, because a standard costing system tracks inventory using budgeted amounts that were known before the first day of the period, and fails to incorporate valuable information about how actual costs have differed from budget during the period. However, this reasoning is not correct, because actual costs are tracked by the accounting system in journal entries to accrue liabilities for the purchase of materials and the payment of labor, entries to record accumulated depreciation, and entries to record other costs related to production. Hence, a standard costing system records both budgeted amounts (via debits to work-in-process, finished goods, and cost-of-goods-sold) and actual costs incurred. The difference between these budgeted amounts and actual amounts provides important information about cost control. This information could be available to a company that uses an actual costing system or a normal costing system, but the analysis would not be an integral part of the general ledger system. Rather, it might be done, for example, on a spreadsheet program on a personal computer. The advantage of a standard costing system is that the general ledger system itself tracks the information necessary to provide detailed performance reports showing cost variances. Smooth out short-term fluctuations in direct costs: Similar to the reasons given in the previous chapter for using normal costing to average the overhead rate over time, there are reasons to average direct costs. For example, if an apparel manufacturer purchases denim fabric from different textile mills at slightly different prices, should these differences be tracked through finished goods inventory and into cost-of-goods-sold? In other words, should the accounting system track the fact that jeans production on Tuesday cost a few cents more per unit than production on Wednesday, because the fabric used on Tuesday came from a different mill, and the negotiated fabric price with that mill was slightly higher? Many companies prefer to average out these small differences in direct costs. When actual overhead rates are used, production volume of each product affects the reported costs of all other products: This reason, which was discussed in the previous chapter on normal costing, represents an advantage of standard costing over actual costing, but does not represent an advantage of standard costing over normal costing. Costing systems that use budgeted data are economical: Accounting systems should satisfy a cost-benefit test: more sophisticated accounting systems are more costly to design,

implement and operate. If the alternative to a standard costing system is an actual costing system that tracks actual costs in a more timely (and more expensive) manner, then management should assess whether the improvement in the quality of the decisions that will be made using that information is worth the additional cost. In many cases, standard costing systems provide highly reliable information, and the additional cost of operating an actual costing system is not warranted.

The future role of standard costing

Critics of standard costing question the relevance of traditional variance analysis for cost control and performance appraisal in todays manufacturing and competitive environment. Nevertheless, standard costing systems continue to be widely used. This is because standard costing systems provide cost information for many other purposes besides cost control and performance evaluation. Standard costs and variance analysis would still be required for other purposes; particularly inventory valuation, profit measurement and decision-making even if they were abandoned for cost control and performance evaluation. For example, the detailed tracking of costs is unnecessary for decision-making purposes. Product costs for decision-making should be extracted from a data base of standard costs reviewed periodically (say once or twice a year). A periodic cost audit should be undertaken to provide a strategic review of the standard costs and profitability of a firms products. The review provides attention-directing information for signalling the need for more detailed studies to make cost reduction, discontinuation, redesign or outsourcing decisions. Standard costs thus provide the basis for such decisions and can be derived from a database of either traditional or activity-based systems. Many organizations have adapted their variance reporting system to report on those variables that are particularly important to them. These variables are company specific and cannot be found in textbooks. For example, some organizations that pursue a zero production defects policy have sought to measure the cost of quality by reporting quality variances. They define the quality variance as the standard cost of the output that does not meet specification. In traditional variance analysis this variance is buried in the efficiency variances of the various inputs. To illustrate the computation of the variances we shall simplify it by ignoring direct labour and overhead variances and concentrate on direct materials and assume that the standard usage for the production of a product is 5 kg and the standard price is 10 per kg. Actual usage for an output of 5000 units (of which 400 were defective) was 24 800 kg. Traditional variance would report an adverse usage variance of 18 000, being the difference between the standard quantity of 23 000 kg for the good output of 4600 units and the actual usage of 24 800 kg priced at 10 per kg. The variance analysis is modified to report an adverse quality variance of 20 000 (400 defective units 5 kg 10) and a favourable usage variance of 2000 reflecting the fact that only 24 800kg were used to produce 5000 units with a standard usage of 25 000 kg. The fact that 400 units were defective is reflected in the quality variance. In recent years there has been a shift from using variances generated from a standard costing system as the foundation for short-term cost control and performance measurement to treating them as one among a broader set of measures. Greater

emphasis is now being placed on the frequent reporting of non-financial measures that provide feedback on the key variables required to compete successfully in todays competitive environment. These non-financial measures focus on such factors as quality, reliability, flexibility, after-sales service, customer satisfaction and delivery performance. Recognition is also being given to the fact that periodic shortterm reporting may be inappropriate for controlling those costs that are fixed in the LEARNING NOTE 18.5: THE FUTURE ROLE OF STANDARD COSTING Learning Note 18.5: The future role of standard costing ADVANCED READING

Advantages of Standard Costing Though most companies do not use standard costing in its original application of calculating the cost of ending inventory, it is still useful for a number of other applications. In most cases, users are probably not even aware that they are using standard costing, only that they are using an approximation of actual costs. Here are some potential uses:

Budgeting. A budget is always composed of standard costs, since it would be impossible to include in it the exact actual cost of an item on the day the budget is finalized. Also, since a key application of the budget is to compare it to actual results in subsequent periods, the standards used within it continue to appear in financial reports through the budget period. Inventory costing. It is extremely easy to print a report showing the period-end inventory balances (if you are using a perpetual inventory system), multiply it by the standard cost of each item, and instantly generate an ending inventory valuation. The result does not exactly match the actual cost of inventory, but it is close. However, it may be necessary to update standard costs frequently, if actual costs are continually changing. It is easiest to update costs for the highest-dollar components of inventory on a frequent basis, and leave lower-value items for occasional cost reviews. Overhead application. If it takes too long to aggregate actual costs into cost pools for allocation to inventory, then you may use a standard overhead application rate instead, and adjust this rate every few months to keep it close to actual costs. Price formulation. If a company deals with custom products, then it uses standard costs to compile the projected cost of a customers requirements, after which it adds on a margin. This may be quite a complex system, where the sales department uses a database of component costs that change depending upon the unit quantity that the customer wants to order. This system may also account for changes in

the companys production costs at different volume levels, since this may call for the use of longer production runs that are less expensive. Nearly all companies have budgets and many use standard cost calculations to derive product prices, so it is apparent that standard costing will find some uses for the foreseeable future. In particular, standard costing provides a benchmark against which management can compare actual performance.

Problems with Standard Costing Despite the advantages just noted for some applications of standard costing, there are substantially more situations where it is not a viable costing system. Here are some problem areas:

Cost-plus contracts. If you have a contract with a customer under which the customer pays you for your costs incurred, plus a profit (known as a cost-plus contract), then you must use actual costs, as per the terms of the contract. Standard costing is not allowed. Drives inappropriate activities. A number of the variances reported under a standard costing system will drive management to take incorrect actions to create favorable variances. For example, they may buy raw materials in larger quantities in order to improve the purchase price variance, even though this increases the investment in inventory. Similarly, management may schedule longer production runs in order to improve the labor efficiency variance, even though it is better to produce in smaller quantities and accept less labor efficiency in exchange. Fast-paced environment. A standard costing system assumes that costs do not change much in the near term, so that you can rely on standards for a number of months or even a year, before updating the costs. However, in an environment where product lives are short or continuous improvement is driving down costs, a standard cost may become out-ofdate within a month or two. Slow feedback. A complex system of variance calculations are an integral part of a standard costing system, which the accounting staff completes

at the end of each reporting period. If the production department is focused on immediate feedback of problems for instant correction, the reporting of these variances is much too late to be useful. Unit-level information. The variance calculations that typically accompany a standard costing report are accumulated in aggregate for a companys entire production department, and so are unable to provide information about discrepancies at a lower level, such as the individual work cell, batch, or unit. The preceding list shows that there are a multitude of situations where standard costing is not useful, and may even result in incorrect management actions. Nonetheless, as long as you are aware of these issues, it is usually possible to profitably adapt standard costing into some aspects of a companys operations.

Standard Cost Variances A variance is the difference between the actual cost incurred and the standard cost against which it is measured. A variance can also be used to measure the difference between actual and expected sales. Thus, variance analysis can be used to review the performance of both revenue and expenses. There are two basic types of variances from a standard that can arise, which are the rate variance and the volume variance. Here is more information about both types of variances:

Rate variance. A rate variance (which is also known as a price variance) is the difference between the actual price paid for something and the expected price, multiplied by the actual quantity purchased. The rate variance designation is most commonly applied to the labor rate variance, which involves the actual cost of direct labor in comparison to the standard cost of direct labor. The rate variance uses a different designation when applied to the purchase of materials, and may be called the purchase price variance or the material price variance. Volume variance. A volume variance is the difference between the actual quantity sold or consumed and the budgeted amount, multiplied by the standard price or cost per unit. If the variance relates to the sale of goods, it is called the sales volume variance. If it relates to the use of direct materials, it is called the material yield variance. If the variance relates to the use of direct labor, it is called the labor efficiency variance. Finally, if the variance relates to the application of overhead, it is called the overhead efficiency variance. Thus, variances are based on either changes in cost from the expected amount, or changes in the quantity from the expected amount. The most

common variances that a cost accountant elects to report on are subdivided within the rate and volume variance categories for direct materials, direct labor, and overhead. It is also possible to report these variances for revenue. It is not always considered practical or even necessary to calculate and report on variances, unless the resulting information can be used by management to improve the operations or lower the costs of a business. When a variance is considered to have a practical application, the cost accountant should research the reason for the variance in considerable detail and present the results to the responsible manager, perhaps also with a suggested course of action. Standard Cost Creation At the most basic level, you can create a standard cost simply by calculating the average of the most recent actual cost for the past few months. In many smaller companies, this is the extent of the analysis used. However, there are some additional factors to consider, which can significantly alter the standard cost that you elect to use. They are:

Equipment age. If a machine is nearing the end of its productive life, it may produce a higher proportion of scrap than was previously the case. Equipment setup speeds. If it takes a long time to setup equipment for a production run, the cost of the setup, as spread over the units in the production run, is expensive. If a setup reduction plan is contemplated, this can yield significantly lower overhead costs. Labor efficiency changes. If there are production process changes, such as the installation of new, automated equipment, then this impacts the amount of labor required to manufacture a product. Labor rate changes. If you know that employees are about to receive pay raises, either through a scheduled raise or as mandated by a labor union contract, then incorporate it into the new standard. This may mean setting an effective date for the new standard that matches the date when the cost increase is supposed to go into effect. Learning curve. As the production staff creates an increasing volume of a product, it becomes more efficient at doing so. Thus, the standard labor cost should decrease (though at a declining rate) as production volumes increase. Purchasing terms. The purchasing department may be able to significantly alter the price of a purchased component by switching suppliers, altering contract terms, or by buying in different quantities.

STANDARD COSTING - LIMITATIONS VARIATION IN PRICE VARYING LEVELS OF OUTPUT CHANGING STANDARD OF TECHNOLOGY ATTITUDE OF TECHNICAL PEOPLE MIX OF PRODUCTS DO NOT REFLECT THE TRUE VALUE AND EXCHANGE BASED ON THEORETICAL MAXIMUM EFFICIENCY, ATTAINABLE GOOD PERFORMANCE & AVERAGE PAST PERFORMANCE

Limitations of Standard Costing Standard costing has certain limitations which are as follows : (1) Setting of standard is a very difficult task and it involves a high degree of technical skill. Therefore it is costly and will be expensive from the point of view of small concern. (2) Conditions of the business are charging. Hence berevised from time to time otherwise they lose importance. , standard must

(3) Fixation of standard is not possible for every type of work or operation. It cannot be implemented in those industries which do not produce any standard product. (4) Sometimes it creates adverse psychological effects. if the it is set at a high level its non-achievement results in frustration and builds up resistance. It acts as a discouragement rather than incentive for better efficiency.

(5) It is partly determined on the basis of past experience and partly on the basis of forecast of future expenses. Thus uncertainties are around standard and determination of correct standard is very difficult. (6) Too much care and attention are required to introduce as well as to keep up-to-date the system otherwise the very purpose of the system will be frustrated.

Home Standard Costing and Variance Analysis Advantages and Disadvantages of Standard Costing andVariance Analysis

Advantages and Disadvantages of Standard Costing and Variance Analysis: Learning Objective of the article: 1. What are the advantages / benefits and disadvantages / problems / limitations of standard costing system and variance analysis? Advantages / Benefits of Standard Costing System: Standard costing System has the following main advantages or benefits: 1. The use of standard costs is a key element in a management by exception approach. If costs remain within the standards, Managers can focus on other issues. When costs fall significantly outside the standards, managers are alerted that there may be problems requiring attention. This approach helps managers focus on important issues. 2. Standards that are viewed as reasonable by employees can promote economy and efficiency. They provide benchmarks that individuals can use to judge their ownperformance. 3. Standard costs can greatly simplify bookkeeping. Instead of recording actual co0sts for each job, the standard costs for materials, labor, and overhead can be charged to jobs. 4. Standard costs fit naturally in an integrated system of responsibility accounting. The standards establish what costs should be, who should be responsible for them, and what actual costs are under control.

Disadvantages / Problems / Limitations of Standard Costing System: The use of standard costs can present a number of potential problems or disadvantages. Most of these problems result from improper use of standard costsand the management by exception principle or from using standard costs in situations in which they are not appropriate. 1. Standard cost variance reports are usually prepared on a monthly basis and often are released days or even weeks after the end of the month. As a consequence, the information in the reports may be so stale that it is almost useless. Timely, frequent reports that are approximately correct are better than infrequent reports that are very precise but out of date by the time they are released. Some companies are now reporting variances and other key operating data daily or even more frequently. 2. If managers are insensitive and use variance reports as a club, morale may suffer. Employees should receive positive reinforcement for work well done. Management by exception, by its nature, tends to focus on the negative. If variances are used as a club, subordinates may be tempted to cover up unfavorable variances or take actions that are not in the best interest of the company to make sure the variances are favorable. For example, workers may put on a crash effort to increase output at the end of the month to avoid an unfavorable labor efficiency variance. In the rush to produce output quality may suffer. 3. Labor quantity standards and efficiency variances make two important assumptions. First, they assume that the production process is labor-paced; if labor works faster, output will go up. However, output in many companies is no longer determined by hw fast labor works; rather, it is determined by the processing speed of machines. Second, the computations assume that labor is a variable cost. However, direct labor may be essentially fixed, then an undue emphasis on labor efficiency variances creates pressure to build excess work in process and finished goods inventories. 4. In some cases, a "favorable" variance can be as bad or worse than an "unfavorable" variance. For example, McDonald's has a standard for the amount of hamburger meat that should be in a Big Mac. A "favorable" variance would mean that less meat was used than standard specifies. The result is a substandard Big Mac and possibly a dissatisfied customer. 5. There may be a tendency with standard cost reporting systems to emphasize meeting the standards to the exclusion of other important objectives such as maintaining and improving quality, on-time delivery, and customer satisfaction. This tendency can be reduced by using supplemental performance measures that focus

on these other objectives. 6. Just meeting standards may not be sufficient; continual improvement may be necessary to survive in the current competitive environment. For this reason, some companies focus on the trends in the standard cost variances - aiming for continual improvement rather than just meeting the standards. In other companies, engineered standards are being replaced either by a rolling average of actual costs, which is expected to decline, or by very challenging target costs. In sum, managers should exercise considerable care in their use of a standard cost system. It is particularly important that managers go out of their way to focus on the positive, rather than just on the negative, and to be aware of possible unintended consequences. Nevertheless standard costs are still found in the vast majority of manufacturing companies and in many service companies, although their use is changing. For evaluating performance,standard cost variances may be supplanted in the future by a particularly interesting development known as the balanced scorecard. Comparison of Budgets and Standards: The budget is one method of securing reliable and prompt information regarding the operation and control of an enterprise. When manufacturing budgets are based on standards for materials, labor, and factory overhead a strong team for possible control and reduction of costs is created. Standards are almost indispensable in establishing a budget. Because both standard and budgets aim at the same objective-managerial controlit is felt that the two are the same and cannot function independently. This opinion is supported by the fact that both use predetermined costs for the coming period. Both budgets and standard costs make it possible to prepare reports which compare actual costs and predetermined costs for management. Building budgets without the use of standard cost figures can never lead to a real budgetary control system. The principle difference between budgets and standard costs lies in their scope. The budget, as a statement of expected costs, acts as a guidepost which keeps the business on a charted course. Standards, on other hand, do not tell what costs are expected to be, but rather what they will be if certain performances are achieved. A budget emphasizes the volume of business and the cost level which should be maintained if the firm is to operate as desired. Standard stress the level to which costs should be reduced. If costs reach this level, profit will be increased.

Purpose of Standard Costing: Standard cost systems aid in planning operations and gaining insights into the probable impact of managerial decisions on cost levels and profits. Standard costs are used for: 1. Establishing budgets. 2. Controlling costs, directing and motivating employees and measuring efficiencies. 3. Promoting possible cost reduction. 4. Simplifying costing procedures and expediting cost reports. 5. Assigning costs to materials, work in process, and finished goods inventories. 6. Forming the basis for establishing bids and contracts and for setting sales prices.

VARIANCE ANALYSIS Variance is the difference between a budgeted or standard amount and the actual amount during a given period. Variance Analysis is defined to be an analysis of the cost variances into its component parts and the explanation of the same. It is that part of the process of control which involves the calculation of a variance and interpretation of results for identifying the causes thereof and also for pinpointing responsibility. Variances are normally calculated for all the cost components such as Materials, Labour and Overheads. Variances are also calculated for Revenues, i.e., Sales and also for Net profits (Sales - Costs). Profit or Sales Margin Method : The basic concept of the above method is to analyse the Profit margin by removing the Standard Cost from the Selling Prices. Conceptually, any increase in Selling price increases the profit absolutely. Therefore, even from the actual Selling price, only the Standard cost is removed for analysing the Margin variances. However, it should be noticed that for a full comprehensive analysis of variances, the Cost variances will have to be analysed separately apart from the Sales Margin variances. To derive

the formula e for Sales Margin variances, the same figure used for Sales variances on the basis of Turnover will be retained with the removal of the Standard cost from each of the Selling Prices. Further, the prefix Margin will be given.