Standards can be set up for any kind of business activities but they are most useful to manufacturing because a manufacturing processing is quite complicated compared to a trading or a service concern business.
Using the physical and monetary factors above, let us illustrate the application of these theories We will utilize the costing of the new product of the Dollar Company BENGR.
1. Direct Materials:
In producing a quality wooden box, for example, based on the research department of the company, 6 pieces of plywood are used. Hence, the standard physical factor for materials, or the standard quality, is 6 pieces of plywood.
The standard monetary factor, or the standard price, can be established by determined the prevailing market prices. For product BENGR, let us assume that the standard price per piece of plywood has been set at $20.
Now that we have the data for standard quality and price, the standard cost of materials for this product can be computed as follows:
Standard Cost = physical factor multiplied by monetary factor
Standard Cost = Standard quantity multiplied by standard price
For BENGR: Standard cost = 6 pieces lumber multiplied by $20/material
Standard Cost = $120 unit of BENR – means that to finish one unit of BENGR, there is a need to use spend $120 for materials.
2. Direct Labor
The physical factor for direct labor is usually measured in terms of time or labor hours. The standard time to produce one unit of product can be established by conducting a time and motion study or by considering previous experiences in processing the same product. In a case where a new product is to be produced and the company has no previous experience, it can conduct a time and motion study for a pilot project, simulating all the processes involved in production under normal situations. After considering waste, breakdowns, and possible improvement in efficiencies, a standard physical factor can be established. In our example, let us assume that the workers can produce one unit of BENGR in 8 hours. Hence the standard labor time for each BENGR is 8 hours.
As regards to the monetary factor for labor called rate, it can be established by considering the prevailing wage rate in the area. Let us assume again that the workers are paid at an hourly rate of $7.50 per hour.
To summarize, the standard labor cost of BENGR can be computed as follows:
Standard Labor Cost = Standard Physical Labor multiplied by the Standard Monetary Factor
Standard labor cost = Standard time multiplied by standard rate
For BENGR - Standard labor cost = 8 hours multiplied by $7.50 per hour
Standard labor cost = $60 per unit of BENGR – means that for every one unit of BENGR, we have to pay the carpenter $60
3. Factory Overhead
Factory overhead is usually composed of a lot of cost items since this includes all manufacturing costs other than the direct materials and direct labor.
Examples of factory overhead include indirect materials (nails, rugby, sandpaper), indirect labor (the accounting clerk that records manufacturing costs; the plant supervisor), insurance, light, water, depreciation, taxes, and rent.
If we attempt to make individual standards monetary and physical factors for each of these cost items, the use of standards will just complicate and not simplify costing procedures. Hence for convenience and for practical reasons, a common denominator is simply used in the application of factory overhead to production. In most cases, the physical factor is computed based on labor hours, and the monetary factor is simply called rate per hour.
One thing to consider about factory overhead is that unlike materials and labor, which are assumed to be purely variable costs (costs that change with the change in sales or production), factory overhead is composed not only of such costs but also of mixed costs. To analyze better, there is a need to first segregate such mixed costs into their variable and fixed cost (cost that never changes in spite of a change in sales or production volume) components.
It is agreed then that for the current period, the fixed budget is to be implemented and the expected units to be produced will be 1,000 units with the allotment of $32,000 factory overhead cost.
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