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The Chartered Institute of Management Accountants (CIMA) defines standard cost as the predetermined cost based on technical estimates for materials, labor, and overhead for a selected period; for a prescribed set of working conditions. Standard costing pre-determines all costs, compares them with actual costs, and analyzes the reasons for variance. The management then either takes steps to eliminate the variance, or revise standard costs based on new realities.
The standard costing methodology offers many advantages, and many companies prefer this costing method over others methods such as process costing, or historical costing. Here we look at 4 advantages of standard costing.
Image Credit: Wikimedia Commons/Marie-Lan Nguyen
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One of the direct advantages of standard costing lies in cost control. Comparing standard costs with actual costs pinpoint areas where costs have gone out of control, allowing management to take remedial actions. The variance provides management with a fixed quantifiable target when undertaking such remedial actions.
The emphasis on variations from standard costs promotes cost consciousness and a culture of thrift and efficiency-orientation across the board, helping organizations control costs.
Standard costing also provides management with a measure of the latest developments such as rising prices, allowing revision of selling prices or making process adjustments.
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Standard costing indirectly contributes to process efficiency. Fixing standard costs requires a detailed study of different aspects of the business and its processes. For instance, determining manufacturing expenses requires a time and motion study, and determining standard inventory costs mandates of study of material control processes. Very often, such studies bring to light various inefficiencies and defects, providing managers with a ready opportunity to correct such mistakes and promote efficiency.
The standard costing methodology of comparing actual costs with standard costs enables a reliable evaluation of the performance of various cost centers. The alternative method of determining performance by comparing costs in different periods is inherently faulty as it does not consider the varying circumstances during both periods.
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3. Price Fixing
A major advantage of standard costing is that it helps determine prices and formulates production policies in advance. It also allows making estimates during product planning or the pre-manufacturing phase.
Standard costing simplifies valuation of stock by transferring the difference between standard costs and actual costs to a separate variance account.
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Standard costing promotes management by exception, where management provides a fixed target and does not interfere as long as the targets are adhered to or achieved; management intervention comes only in cases of deviations. Standard costing management by exception frees the management from routine chores and places the focus on core issues.
Standard costing identifies the cost of individual processes or products, thereby making possible an informed and scientific approach toward budget planning or profit maximization through various product mixes.
Standard costing provides ready made targets that make goal setting and institution of an incentive system easy.
Finally, standard costing benefits extends to the concerns of profitability and efficiency in a rank-and-file activity rather than exclusive management functions. Standard costing places responsibility for identifying variance with line managers and thereby, integrates product or process efficiency interventions as a routine line activity rather than make it a specialized staff management intervention.
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Standard costing is a valuable tool, the benefits of which extends to much more than better accounting. Companies can reap the advantages of standard costing depending on how correctly they approach it, and how well they use it.