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Standard costs are predetermined costs, based on the estimated standards of efficient operations and the necessary expenditure, such as materials, labor, and overheads, for a selected period and for a prescribed set of working conditions. There are many advantages of standard costing.
Standard cost accounting techniques, are used to determine how much a product or service will cost under the given conditions. Comparing such standard costs with actual costs determined at the end of the production, establishes a variance, and managers take necessary corrective action to close the variance and thereby improve operational efficiency.
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Elements of Standard Costs
The elements of standard cost used in standard costing techniques include direct materials, direct labor, and overheads.
- Material costs: Direct material costs depend on the quantity and quality. Such costs require periodic revision to reflect the changes in prices, transportation and handling charges, ordering costs, cost of storage, and other conditions that may have taken place since the last time standard costs were set.
- Wages: Wages are direct or indirect. Assigning direct wages to the standard cost is straightforward. Assigning indirect costs to standard costs requires considering the different wage rates for different grades and type of labor, and allocating such wages based on the proportion of time each worker spends on the product or service. The basis of such an estimate includes experience, work-study, and trial runs, among other factors. Past wage rates may not always be a conclusive indicator of present wage levels, owing to differences in skill sets, technology, working environment, availability of labor, increased wage rate, and other factors.
- Overheads: Overheads fall into fixed, variable and semi-variable category. Fixed overheads, such as rent, remain the same irrespective of level of production. Variable overheads, such as energy consumption, change in proportion to production. Semi-variable overheads increase with the increase in production but at a lesser rate. The basis of determining standard overhead rates per product, is dividing total expenses incurred on overheads, by direct labor hours or units produced.
For instance, if an automobile engine manufacturing plant normally produces 400 automobiles per month, with a fixed cost of $20000/month and variable cost of $5000 per coach, each automobile incurs an overhead of $50 ($20000 / 400), and a full cost of $550 (adding the variable cost of $500 to the per unit fixed cost of $ 50), which may be assumed as the standard cost. Assuming the factory incurs an average cost of $560 in a month, then a variance of $10 exists, and managers try to analyze the sub-components of the fixed costs or variable costs, to determine the root cause of variance.
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Determining Standard Costs
How are standard costs developed? The standard costing methods, or the ways of determining standard costs in standard cost accounting techniques, include:
- Cost Center: A Cost center is any department, equipment, machinery, person, and or groups of people, where costs accumulate and where managers can exercise control. For instance, spending money to run machinery to produce an item, makes such machinery a cost center.
- Current Standards: Current standards are standards established for use over a short period, and related to a specific condition, normally a year, on assumption that conditions of production remain unchanged during such a period. For instance, standards require revision when wages rise. If the current standards period is one year, the assumption is that wages remain constant during that year, and that the revision takes place at the end of the period.
- Ideal Standard: Ideal standards involve costs fixed on the assumption of optimal conditions and reflect a high level of efficiency. Such standards assume the lowest material price, zero or negligible wastage, and lowest possible wages at maximum productivity. Ideal standards rarely translate to reality, but remain the standards to achieve.
- Basic Standard: Basic standards hold for an indefinite period, without adjustment to reflect actual realities, and change only to reflect changes in material specifications, or product specifications. Comparing basic standard to actual standards, allows measurement of change in costs over time, but does not show the measure of efficiency.
- Normal Standard: Normal standards are standards anticipated to cover one trade cycle. For instance, if a normal cycle of vicissitudes in sales and production of the industry is five years, then the normal standard is based on the average sales and production of these five years. This is again theoretical, and need not be an actual reflection of ground realities.
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Most managers set standard cost based on experience, or the actual costs of the previous production schedule in the applicable conditions.
The success of establishing a standard costing system, depends on the setting of proper standards. This requires involving the people behind the actual production process, such as the production manager, purchase manager, sales manager, chief engineer, and human resources manager along with the cost accountant.
There are of course, disadvantages of standard costing. Standards are subject to change, and standard cost accounting techniques require periodic revision of standards to accommodate organizational or environmental changes. Failure to make such changes when conditions change, makes such standards inaccurate and irrelevant. Standard costing techniques is a continued activity for the optimum utilization of resources.
A major limitation of standard costing techniques is that it does not recognize variability. It does not accommodate upper and lower limits of optimal costs, and rather provides an absolute figure which remains very hard to match at all times.
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Globusz.com “Standard Costing.” http://www.globusz.com/ebooks/Costing/00000014.htm.%20Retreived%2014%20January%202011.