How Are Standard Costs Developed?

written by: madel57•edited by: Linda Richter•updated: 10/1/2010

A design consultant tells the company CEO, "Using Standard Costing for your products will increase their market. A 10% increase on the prime cost is still smaller than the 35% increase on your sales. The public will be aware of your quality product later on." How is this calculated?

• slide 1 of 9

Let's Drop In on the Dollar Company

CEO Ronald McQueen of the Dollar Company studies the predetermined costs (see below) of its wooden boxes named BENGR. He asks wooden box designer Mr. David if the material and labor components are already substantial enough to emerge as a new competitive product in the market. Mr. David expresses his idea to add one piece of lumber for durability and an additional half-hour of labor for the said additional material. They agree that 1,000 units are expected to be produced and a fixed budget of \$32,000 is allotted for the factory overhead.

For CEO McQueen, working with Dollar Company is quite a feat. Dollar invited him to join the company five years ago offering a six-figure compensation because of his excellent performance as CEO of a steel manufacturer in the south. He is familiar with several budgeting tools.

The cost sheet for one product of BENGR is presented as:

Direct Material Lumber - 5 pieces at \$20 per piece, \$100

Direct Labor Carpenter Wages - 6 hours at \$5/hr, \$30

Factory Overhead (20% of \$30, \$6

Standard Manufacturing Cost per Unit, \$136

As you see in the cost sheet, it contains the elements of production – variables that contribute to the completion of a product. The term 'direct materials' refers to the tangible component of the product, which is lumber for a wooden box. Direct labor refers to the carpenter wages that are directly involved with the completion of the product. The factory overhead represents those costs that you cannot classify as direct material or direct labor. Factory overhead is also named as manufacturing overhead and, aside from indirect material and labor, it also includes costs like light and water plus depreciation of fixed assets that are related to the completion of the product, like plant equipment. Mr. David emphasizes that the probable increase in prime cost (direct materials plus direct labor) is still smaller than the probable 35% increase in sales volume if this idea is to be implemented.

The cost sheet that Mr. McQueen has just finalized with Mr. David is a measuring tool called standard costing for BENGR. This is used to guide the production department in the production of BENGR. The current month is October.

• slide 2 of 9

What is Standard Costing and What are Its Benefits?

Standard Costs are carefully (or scientifically) predetermined costs established by management to be used as a basis for comparison with actual costs.

The benefits that the manufacturing company can obtain are:

1. Avoidance of waste on raw materials.

• The standard units of lumber specified for BENGR are the exact number of lumber units that can be issued to carpenters.

2. The company is updated with material price increases.

3. The standard can be used as a tool in evaluating worker performance.

• Workers will be conscious of their time in doing their jobs because to work beyond the limits affects their performance. It also induces productivity.

4. Savings in labor cost.

5. Efficiency in allocating factory overhead.

• slide 3 of 9

How are Standard Costs Developed?

Standard costs should be established by the authority or management so that the same may be acceptable. Establishment of standards may not be a simple task, depending on the nature of the product and the intricacies involved in its manufacture. In developing standards, the following should be taken into consideration:

1. The basic cost factors - physical and monetary. The physical factor relates to the unit of measurement of the cost elements involved in the production process, like the number of lumber units that are utilized to finish the boxes. The monetary factor relates to the amount paid for the physical factors, which in our illustration is the price per unit of lumber.

A formula is thereby formed from these cost factors:

Cost = Physical Factor multiplied by the Monetary Factor

Such formula will later be understood by presenting the data for Dollar Company.

2. Specification of the Product - this is necessary to determine the physical and monetary factors needed in the computation of the manufacturing elements, such as materials, labor, and factory overhead.

The following specifications are set up for BENGR:

Size of the Product: 2' x 2' x 2' (2 feet long, 2 feet wide and 2 feet high)

Color : walnut (varnish)

The cost accountant therefore should remember that in creating standards for the elements of costs (direct material, direct labor and factory overhead) the two most important things are considered: the physical aspect (units of materials, number of hours worked) and the monetary factor (price per unit material and the labor rate per hour).

• slide 4 of 9
If you have questions such as, "how are standard costs developed?" or "what do price variances mean?" then you must read this comprehensive explanation of the standard costing process.
• slide 5 of 9

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

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.

• slide 6 of 9
How are standard costs developed? You must consider the direct product costs, labor costs, and factory overhead. This article takes a look at those factors and shows you how to calculate and understand variances in order to make sound pricing decisions.
• slide 7 of 9

How are standard costs developed?

The standard cost system is effective when compared to actual cost which will result in either favorable or unfavorable variance. The variance should be analyzed carefully by management to implement appropriate actions..

The data below refer to the actual amounts for the three elements of cost (direct materials, direct labor and overhead):

Direct materials, \$113,904.25

Direct labor, \$53,200

The above actual costs are compared with the following standards:

Direct Materials, \$108,000

Direct Labor, \$54,000

Factory overhead, \$32,000 (based on a fixed budget for 1,000 unit capacity)

To obtain the variances, let us take a look at this formula:

Standard Costs - Actual Costs = Variance

(Note: The variance is favorable if actual costs are lesser than the standard costs and unfavorable if actual costs are bigger than the standard costs.

Applying the formula: Standard Costs - Actual Costs = Variance

For materials the variance is: \$108,000 - \$113,904.25 = \$5,904.25 (Unfavorable)

Direct labor variance: \$54,000 - \$53,200 = \$800 (Favorable)

Factory Overhead: \$32,000 - \$35,000 = \$3,000 (unfavorable)

• slide 8 of 9

What is the Benefit of Determining Possible Causes of Variances?

It is not enough to know the amounts for standard and actual cost. The variances that resulted from deducting the actual from the standard should be categorized as favorable or unfavorable.

Whether favorable or unfavorable, as long as the variance is significant in amount, it should be carefully analyzed and investigated so that management will know the possible causes of such variances and that the necessary corrective action can be taken.

In the case of Dollar, material variance is unfavorable due to the following reasons: unexpected material price increase and a change in the physical components, adding one unit of lumber to increase its durability, which really happened to this case.

It is a favorable variance for direct labor because of the increased efficiency of the worker and an unfavorable variance for the overhead because of the unused capacity.

• slide 9 of 9

SUMMARY

Understanding the causes of these variances will give management a better evaluation of its material usage and cost, labor usage and cost, manufacturing overhead budget, and actual cost. If possible, responsibility for such variances should be established, so management can immediately take the necessary and appropriate course of action.

Book and Image Credits:

Management Advisory Services by Rodelia S. Roque, 1990

Tapemeaures http://www.freeimages.co.uk/

Drill3 http://www.freeimages.co.uk/

Screwdrivers http://www.freeimages.co.uk/