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Standard costing

This refers to a costing technique that is used to establish the predetermined cost of products or services and compares the predetermined cost with actual cost incurred to determine any variances.

Standard cost is used as the basis of standard costing and variance analysis. Standard Cost can be defined as a predetermined unit cost of a product or service which is expected to be incurred under efficient operating conditions.

It must be noted that standard cost is different from budgeted cost. This is because whilst standard cost is a predetermined unit cost, budgeted cost is a predetermined total cost of an activity which is compiled from the totals of standard costs.

Standard costs are normally established for all the elements of cost (i.e., material, labour and expenses) and finally summed up to constitute a budget.

Processes Involved in Standard Costing
The following steps must be followed when operating a Standard Costing System:
  1. Establishment of standard costs for each element of cost.
  2. Measurement or recording of actual results.
  3. Comparison of actual results with standard costs to measure any variances which have occurred.
  4. Analysis of variances (i.e., into price, usage, efficiency, etc variances).
  5. Investigation of variances and the taking of remedial or corrective actions.                                    
 Remedial action must be taken in all instances when standard performance and actual performance are not equal. That is whether a particular variance is favourable or adverse, it must be investigated.

Cost Variance refers to the difference between actual cost and budgeted/standard cost. Variance is said to be favourable if it will lead to an increase in profit. It is however said to be unfavourable or adverse if it reduces profit.

Variance Analysis refers to the examination of the difference between actual and standard/budgeted results so as to take a corrective action on time.

Types of Standard
  1. Ideal Standards: These standards that can be attained under the most favourable conditions, with no allowance for normal losses, waste and machine down time. Ideal standards are not widely used in practice because they may demotivate employees. They are also called Potential Standards. Japanese companies normally use this type of standards to identify areas where efficient use of resources can lead to large savings in cost.

  1. Basic Standards: These are standards established for use over a long period from which current standards can be developed. The main purpose is to use them to show trends over a period of time.

  1. Current Standard: It is a standard established for use over a short period of time and relates to current conditions.

  1. Attainable Standards: This is any level of measurement that be attained if a standard unit of work is carried out efficiently, a machine properly operated or material properly used. It is also called Expected Standard. This type of standard makes allowances for normal losses, waste and machine down time or machine breakdown. Attainable standard motivates employees since it is realistic. It is therefore used to prepare budgets.

Objectives of Standard Costing
The objectives include the following
  1. Provide a basis for cost control. That is it indicates what is attainable and what is being attained.
  2. Expose operations or areas of a business where efficiency or inefficiency is being attained.
  3. Assist in the evaluation of performance variations or deviations for the purpose of revising estimates or standards.
  4. Enable corrective action to be taken on time.
  5. Provide a basis for stack valuation.
  6. Provide a basis for the preparation of budgets

  7. Assist in the establishment of selling prices.
  8. Encourage participation of all employees in setting standards and establishing budgets.

Advantages of Standard Costing
  1. It serves as a basis for budgeting and planning.
  2. It promotes management by exception. That is management can focus on only activities which are not proceeding significantly according to plan.
  3. Variance analysis may result in cost reduction techniques being proposed and followed up. That is, it stimulates cost consciousness.
  4. It provides basis for product pricing and stock valuation.
  5. Standard cost provides a yard stick against which actual cost or performance can be measured.
  6. Full participation of all employees and the setting of realistic standards will lead to motivation of staff.

Disadvantages of Standard Costing
  1. It may be time consuming and expensive to operate.
  2. It may concentrate on only aspects of a business which can be quantified in monetary terms.
  3. It may stifle initiative.
  4. Standards set will be rendered out of date in volatile conditions i.e., where prices, production methods, etc are changing rapidly.
  5. The system may be so complex that it will be difficult to understand by line managers.
  6. It does not allow for flexibility.
  7. It is difficult to use where non-standardized products or operations are involved.
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