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Standard costing

Standard costing - What is standard costing?

Standard costing is a method of assigning costs to a product by reviewing the resources used to produce the product and the costs associated with the resources.

There are a number of different types of cost accounting. While standard costing allocates resources to products, the ABC method allocates specific overhead costs to related products or services. Read more on our article about activity-based costing.

Standard costing, also known as standard cost accounting, is used to set budgets and plan for future expenses. It is a type of cost accounting mainly used in the manufacturing sector because it is easier to allocate costs directly to products being produced.

How does the standard costing system work?

Standard costing assigns ‘standard costs’ to a product rather than the actual cost of producing the product. Standard costs include any resources used in normal operations to manufacture the product. This may include expenses linked to materials, labour, and overhead.

After reviewing the standard costs, the business will estimate the required cost of manufacturing the product, essentially, the overall operating cost. It will then use these estimated costs to budget and plan for a period, and later review the actual costs occurring to see if there is a difference.

Standard costing variance analysis

Standard costing uses the ‘standard costs’ rather than the ‘actual costs’. The difference between the two is called the variance analysis. It is essentially comparing the estimated cost with the actual cost.

If the actual cost is greater than the standard cost, then this is an unfavourable variance. If the standard cost exceeds the actual cost then this means that the business is spending less than expected, and is favourable.

For example, let’s say that a company uses the standard costing method and estimates that it costs £5 in labour to produce one product. After a few months, the company compares the actual cost with the estimated standard cost and notices that the actual cost is £5.50 in labour per product.

Since the actual cost exceeds the standard cost, the company discusses ways to improve efficiency and to decrease the actual cost involved.

Standard costing example

As an example, let’s say that a company makes computer keyboards. Based on the previous year’s data, the company estimates that is costs £1 in materials and £5 (30 minutes) in labour to produce each keyboard.

The business plans on producing 5,000 keyboards in the next quarter. Based on their standard labour and material costs, it will cost £5000 in materials, and £25,000 in labour, for a total production cost of £30,000 in the quarter.

After the quarter, the management team wants to see if they stayed within their budget. After running the numbers, they notice that the total production cost was in fact £35,000 rather than the estimated £30,000. The management team will then review the production processes to figure out why the cost was higher than initially expected.

The advantages of standard costing

Standard costing is a common way to set a budget for projects, and there are a number of reasons why. Here are some advantages to using a standard costing method.

  • Provides a starting point for your budget: You can start creating your budget with the overall estimated cost rather than the actual cost. It provides information on the efficiency of your performance.
  • Drives management decisions: This method will help the management team make important decisions to improve efficiency and cut costs.
  • Can help you set prices: This method can help you effectively set prices for products and estimate a profit margin.
  • Production costs & employee success: Standard costing can make employees more cost-aware, and motivate them to improve their methods of completing tasks, ultimately making the process more cost-effective.

The disadvantages of standard costing

As with any costing method, there are bound to be some downsides. Here are a few disadvantages of standard costing:

  • It’s time-consuming: Having to estimate the standard costs can be time-consuming. It may involve examining previous reports, interviewing employees, reviewing and changing certain processes and procedures, and regularly reviewing the variance analysis.
  • Not applicable for smaller businesses: Establishing a standard costing system takes a lot of time and skill. This process may be too costly to implement for small businesses.
  • Variance analysis accuracy: In order for standard costing to work, employees and management must be on the same page and report any exceptions and random factors that may influence the budget. For instance, if there is a machine fault, and some products are destroyed, there must be a clear reporting process in order for this to be accounted for in the budget.