STANDARD COSTING

Standard costing is an objective method of optimizing the use of resources in the provision of goods or services. This is a traditional method for monitoring the use of resources that was initially applied to basic inputs for only basic factory costs of production of goods. In the last two decades of the twentieth century, the technological capabilities of computers initiated innovative ways to identify and monitor costs, but the basic concepts of standard costing have continued to have relevance in many businesses.

Costing is the identification of the value of resources used for specified goods or services. One purpose of costing is to determine what resources, and in what quantities, are required to provide the goods or services. A second purpose is to provide a guide to resource usage monitoring. It is the second purpose that is considered in the following discussion.

METHODS OF COSTING IDENTIFIED IN BUDGETS

Budget figures may be based on actual, budgeted, or standard costs. These categories are not mutually exclusive. For example, while a standard cost is a budgeted cost, a budgeted cost is not always a standard cost. An actual cost for a prior year may be a budgeted cost for the forthcoming year and recorded in the budget.

Budgeted costs are generally described as the best estimate about what should be allowed for forthcoming activity. Some budgeted costs are based on actual costs of the previous year, information from supervisors about where resources might be more efficiently used, and subjective judgments about how much should be allowed for resources. Another basis for recording budgeted costs is to use standard costs.

STANDARD COSTS

Standard costs are determined costs that reflect the effective and efficient use of resources. Standard costs are costs established through identifying an objective relationship between specified inputs and expected outputs. Engineers in laboratories are often involved in establishing standards for manufacturing processes, for example. Standard costs are generally related to carefully analyzed phenomena both in the laboratory and in the workplace. For example, in a factory that produces personal computers, standard costs are often used for direct materials, direct labor, and variable overhead, at the unit level. Resource usage that can be traced exactly to what is to be produced is referred to as direct.

To establish the standard usage of a direct material for the production of the keyboard of the personal computer, the possibilities are analyzed in a laboratory, where conditions are maintained as optimum as possible. Prior attention has been given, generally, to the quality of the metal to be used. There are times, though, that alternative materials that meet company standards for quality have been selected and each is tested to find out if there are differences in quantities needed, since scrap and problems in cutting may not be the same for all the alternatives. At this point, the focus is not on how many minutes are needed by an experienced cutter to meticulously cut the metal so as to minimize usage, but rather on how much of the metal is to be allowed for each keyboard.

What is determined to be the optimum usage of material—the standard usage of material for the production of a single personal computer of a specified type—in the laboratory undergoes another assessment. This then answers the question: "What usage is to be allowed for an adequately qualified worker in the factory?" Often, a technically determined standard in laboratory testing is modified to take into account the conditions of the workplace, which might not be as ideal as those maintained in the laboratory.

The goal of the personnel responsible for setting standard costs is to provide realistic standards. Only standards perceived to be reasonable are likely to motivate workers to adhere to what is prescribed. Workers are motivated to achieve output by meeting specified standards. If standards are unreasonable, either too tight or too loose, the level of discipline expected is seriously undermined. If standards cannot be achieved with reasonable effort, workers may become discouraged and become so indifferent that their work quality deteriorates significantly. If standards are too easy to achieve, there may be an unnecessary waste of resources.

Standard costing has applications to any type of business activity. The process described briefly above can be applied, for example, for processing documents in an insurance company or in a financial services business, as well as in manufacturing firms.

MONITORING STANDARD COSTS

Standard costs are monitored as a basis for determining the extent to which expectations are realized. Before the widespread use of computer-based systems, typical reporting was done weekly or monthly. In contemporary companies, it is not uncommon for a company with factories or stores to monitor on a daily basis their resource usage, thereby allowing modifications, if judged necessary, to be introduced promptly. Computer-integrated production methods, for example, allow for maintaining both the actual cost/usage and the standard cost/usage figures in the records maintained.

A commonly used method is to determine the difference between what was allowed by standard costs, which are the budget allowances, and what was actually spent for the output achieved. This difference is called a variance. For example, assume that the factory producing personal computers completed 10,000 computers where the standard usage of one type of metal, as a direct material, was 2 pounds per computer, or 20,000 pounds. The actual usage of the output achieved, 10,000 units, was 20,430 pounds. Since actual usage of the direct material was greater than the standard allowed, the excess usage is called an unfavorable variance, or 430 pounds unfavorable. The monetary cost of this variance is then determined: The variance in units is multiplied by standard cost per unit for the metal. Therefore, if the standard cost for the metal was $2.95 per pound, the variance would be reported as __BODY__,268.50 unfavorable (430 pounds × $2.95, the standard price).

What has been described for a direct material is the process that is used for each component of production. Resources monitored include, in addition to direct material and direct labor, variable factory overhead and fixed factory overhead. Both standard usage of resources and standard costs for each are established and monitored. The process for variable overhead is somewhat more complex because the components of variable overhead are multiple indirect resources that are related to volume of production processed. For example, while a chain of fast food restaurants may consider ground beef as a direct material, they will consider the wrapping used for the cooked hamburger an indirect material. Such a chain's controller's office has determined the material costs that cannot be directly tied to each unit and/or those material costs which individually are not significant for direct tracing. This collection of material costs is then analyzed to determine the most appropriate basis for allocating to the goods produced.

Standards are developed for fixed overhead costs, too. Fixed costs are costs incurred in production that are not a function of volume produced. Though in the long run all costs can vary, fixed costs are costs that do not change as activity levels change.

A REVIEW OF ACTUAL RESULTS

Companies have policies about the level of variance that is to be investigated. Some variation from expectations is allowed, and if standards are realistic, much of the variation is eliminated over the period of a year; insignificant favorable variances cancel out insignificant unfavorable variances. Companies monitor the extent to which standards appear to be reasonable by assessing the end-of-year balances in variance accounts.

Variances that are determined to be significant are investigated. Careful observation and discussion with those workers involved in producing the output that led to a significant variance will aid in determining an explanation. The explanation is the basis for considering what changes need to be made.

In an objective review of observations and discussions, questions may arise as to the appropriateness of a standard, if the actual result is unreasonably different from the standard. There may need to be a reconsideration of the earlier analyses that were the basis for the standards used in the budget followed by operational personnel.

For an organization to gain optimum value from standard costing, all employees involved must understand the motivation for such costing and also understand the assessment that will be made. Imposing standard costs without communicating in an honest, candid manner will undermine much of the perceived value of such costing.

CONTEMPORARY DEVELOPMENTS

An Ernst & Young survey in 2003 found that 76 percent of U.S. manufacturing companies reported that they used standard costs. Developments in the global business world, however, are influencing many companies to make changes. For example, in the twelfth edition of a popular German textbook, Flexible Plankostenrechnung und Deck-ungsbeitragsrechnung (Flexible plan cost accounting and contribution margin accounting), a cost system that is widely used in Germany and other European countries is outlined. It can be described as a direct or variable costing system, commonly referred as Grenzplankostenrechnung, or in the United States as GPK. A subsidiary of a Germany company in the United States began reporting on a GPK basis by December 31, 2004.

Developments beginning in the twenty-first century reflect the continuing need for more effective methods in cost accounting. Lean accounting, modified activity-based costing, along with GPK, were all getting considerable attention at seminars and conferences attended by practitioners in mid-2005. Considerably more careful studies are needed to determine most effective strategies for costing. There is evidence, though, to support the fundamental concept of standard costing as relevant for effective monitoring of resource usage. Yet, the scope of the fundamental concept requires reconsideration as newer strategies are proposed.

STANDARD COSTING

METHODS OF COSTING IDENTIFIED IN BUDGETS

STANDARD COSTS

MONITORING STANDARD COSTS

A REVIEW OF ACTUAL RESULTS

CONTEMPORARY DEVELOPMENTS

BIBLIOGRAPHY