CONCEPT

OF
STANDARD COSTING

DR. AVIJIT ROYCHOUDHURY

INSPECTOR OF COLLEGES
VIDYASAGAR UNIVERSITY
Meaning of Standard Costing
Standard costing is a technique which uses standards for costs
and revenues for the purpose of control through variance analysis.
Standard is a predetermined measurable quantity set in defined
conditions against which actual performance can be compared,
usually for an element of work, operation or activity.
“Standard cost is a predetermined calculation of how much costs
should be under specified working conditions. It is built up from an
assessment of the value of cost elements and correlates technical
specifications and the qualification of materials, labour and other
costs to the prices and/or usage rates expected to apply during the
period in which the standard cost is intended to be used. Its main
purpose is to provide basis for control through variance accounting
for the valuation of stock and work-in-progress and in some cases,
for fixing selling prices.” – CIMA Official Terminology
The objectives of standard costing
a) To provide a formal basis for assessing performance and
efficiency.
b) To control costs by establishing standards and analysis of
variances.
c) To enable the principle of ‘management by exception’ to be
practised at the detailed, operational level.
d) To assist in setting budgets.
e) To assist in assigning responsibility for nonstandard
performance in order to correct deficiencies or to capitalise on
benefits.
f) To motivate staff and management.
g) To provide a basis for estimating.
h) To provide guidance on possible ways of improving
performance.
Process of Standard Costing
a) Establishing Standards: First and foremost, the standards are to
be set on the basis of management’s estimation, accurately
anticipating the cost. In general, while fixing the standard cost,
more weight is given to the past data, the current plan of
production and future trends. Further, the standard is fixed in
both quantity and costs.
b) Determination of Actual Cost: After standards are set, the actual
cost for each element, i.e. material, labour and overheads is
determined, from invoices, wage sheets, account books and so
forth.
c) Comparison of Actual Costs and Standard Cost: Next the
standard cost are to be compared with the actual figures to
ascertain the variance.
d) Determination of Causes: Once the comparison is done, the
next step is to find out the reason for the variances, to take
corrective actions and also to evaluate the overall performance.
e) Disposition of Variances: The last step of this process, is the
disposition of variances by transferring it to the costing profit
and loss account.
Types of Standards
Current Standard:
Current standard is a standard established for use over a short
period of time, related to current conditions. The problem with this
type of standard is that it does not try to improve on current levels
of efficiency.
Basic Standard:
Basic standard is standard established for use over a long period
from which a current standard can be developed. The main
disadvantage of this type of standard is it remains unaltered over a
long period of time, it may be out of date. The main advantage is in
showing regular changes in trend of price and efficiency from year to
year.
Ideal Standard:
Ideal standard is a standard which can be attained under the most
favourable conditions. No provision is made, e.g., for shrinkage,
spoilage or machine breakdowns. Users believe that the resulting
unfavourable variances will remind management of the need for
improvement in all phases of operations. Ideal standards are not
widely used in practice because they may influence employee
motivation adversely.
Attainable Standard:
Attainable standard is a standard which can be attained if a
standard unit of work is carried out efficiently, on a machine
properly utilized or material properly used. Allowances are made for
normal shrinkage, waste and machine breakdowns. The standard
represents future performance and objectives which are reasonably
attainable.
Besides having a desirable motivational impact on employees,
attainable standards serve other purposes, e.g., cash budgeting,
inventory valuation and budgeting departmental performance. If
correctly set attainable standards are the best type of standards to
use, since they provide employees with a realistic target. Attainable
standards have the greatest motivational impact on the workforce.
Technique of Setting Standards:
In order to use predetermined standard costs, standards have to be
set for each element of cost for each line of product produced or
service supplied. Standard cost shows what the cost should be
keeping in mind the most favourable production conditions, and on
the assumption that plant will operate at optimum efficiency.
The collaboration of all functional departments is a must in setting
standards. The quantities, price and rates, qualities or grades, terms
of purchase, product substitution etc. have to be kept in mind while
setting standards.
The success of standard cost system depends on the reliability,
accuracy and acceptance of the standards.
The methodology used in conventional approach to variance
analysis:
(a) Setting of standards and construction of a budget based on them.
(b) Comparison of actual with budgeted outcomes.
(c) Factoring the variance into individual components and
investigation of the significant differences.
In this approach the standards are related to expectations over the
budget period and do not necessarily reflect optimal performance.
Usually it is believed that standards should be reasonably attainable
in the circumstances envisaged.
Thus in this context conventional variance analysis is a postmortem
exercise. If the standards are tight then this will have a disincentive
effect, whereas if the standards are loose then this results in
complacency.
The behavioural aspects and implications are generally ignored
while setting the standards, which cause the arbitrary investigation
of variances. It does not give adequate guidance regarding cost-
benefit of variances investigated or cost of correcting errors. Thus
the conventional analysis is more a postmortem.
The following aspects need to be given consideration while
setting the standards:
(a) Standard setting and variance analysis should be sufficiently
refined to provide adequate information.
(b) Qualitative information is not given proper attention.
(c) The standard costing system should provide for opportunity
costs and profit forgone.
The conventional standard cost system is criticized because of using
crude variance classifications, in appropriate measurements,
calculation of redundant variances, ignoring variances related
important control areas. The standard costing system should give
due importance to interdependence between different responsibility
centres rather than traditional variance analysis.
Standard Cost Card:
After setting standard for each element of cost, a standard cost card
is prepared showing therein the unit standard cost for each element
of cost. Standard margin per unit and standard selling prices,
standard materials, labour and factory overhead costs are kept on a
standard cost card that shows the itemized cost of each materials
and labour operation as well as the overhead cost. A standard cost
card gives the standard unit cost of a product.
Responsibility for Setting Standards:
The line managers who have to work with and accept the standards
must be involved in establishing them. There are strong behavioural
and motivational factors involved in this process. The line managers
must be involved in the critical part of standard setting. The human
aspects of budgeting apply equally to standard costing.
The Cost Accountant has to determine the units of products to be
made by the producing cost centres and work to be performed by
service cost centres. After application of service cost centres rates to
production cost centres, a standard overhead rate has to be
determined for each production cost centre.
After the standards have been fixed, the management may be
interested in calculating variance from the standards with the
purpose of informing the members of various management levels
about it and to fix the responsibility.
The purpose of setting standards is to fix yardsticks for measuring
the performance of various activities and helps in responsibility
accounting. Overhead recovery rates has to be determined in
advance and applied on that basis to product/cost centres. There is
always a difference in actual expenditure and overheads absorbed.
Problems in Setting Standard Costs:
Apart from forecasting errors, the problems include :
(a) Deciding how to incorporate inflation into planned unit costs.
(b) Agreeing a labour efficiency standard for example should
current times, expected times or ideal times be used in the labour
efficiency standard?
(c) Deciding on the quality of materials to be used, because a
better quality of material will cost more, but perhaps reduce
material wastage.
(d) Deciding on the appropriate mix of component materials,
where some change in the mix is possible.
(e) Estimating materials prices where seasonal price variations or
bulk purchase discounts may be significant.
(f) Possible behavioural problems. Managers responsible for the
achievement of standards might resist the use of a standard costing
control system for fear of being blamed for any adverse variances.
(g) The cost of setting up and maintaining a system for establishing
standards.
Advantages of Standard Costing:
a) Improved cost control
Companies can gain greater cost control by setting standards for
each type of cost incurred and then highlighting exceptions or
variances. Variances provide a starting point for judging the
effectiveness of managers in controlling the costs for which they
are held responsible.
a) More useful information for managerial planning and decision
making
When management develops appropriate cost standards and
succeeds in controlling production costs, future actual costs
should be close to the standard. As a result, management can use
standard costs in preparing more accurate budgets and in
estimating costs for bidding on jobs.
 A standard cost system can be valuable for top management in
planning and decision making.
c) More reasonable and easier inventory measurements
A standard cost system provides easier inventory valuation than
an actual cost system. Under an actual cost system, unit costs for
batches of identical products may differ widely. For example, this
variation can occur because of a machine malfunction during the
production of a given batch that increases the labour and
overhead charged to that batch. Under a standard cost system, the
company would not include such unusual costs in inventory.
Rather, it would charge these excess costs to variance accounts
after comparing actual costs to standard costs.
 Thus, in a standard cost system, a company assumes that all
units of a given product produced during a particular time
period have the same unit cost. Logically, identical physical units
produced in a given time period should be recorded at the same
cost.
(d) Cost savings in record-keeping
Although a standard cost system may seem to require more
detailed record-keeping during the accounting period than an
actual cost system, the reverse is true. For example, a system
that accumulates only actual costs shows cost flows between
inventory accounts and eventually into cost of goods sold. It
records these varying amounts of actual unit costs that must be
calculated during the period. In a standard cost system, a
 company shows the cost flows between inventory accounts and
into cost of goods sold at consistent standard amounts during
the period. It needs no special calculations to determine actual
unit costs during the period.
Instead, companies may print standard cost sheets in advance
showing standard quantities and standard unit costs for the
materials, labour, and overhead needed to produce a certain
product.
(e) Possible reductions in production costs
A standard cost system may lead to cost savings. The use of
standard costs may cause employees to become more cost
conscious and to seek improved methods of completing their
tasks. Only when employees become active in reducing costs
can companies really become successful in cost control.
Disadvantages of Standard Costing:
(a) Controversial materiality limits for variances
Determining the materiality limits of the variances may be
controversial. The management of each business has the
responsibility for determining what constitutes a material or
unusual variance. Because it involves individual judgment.
(b) Non reporting of certain variances
Workers do not always report all exceptions or variances. If
management only investigates unusual variances, workers may
not report negative exceptions to the budget or may try to
minimize these exceptions to conceal inefficiency. Workers who
succeed in hiding variances diminish the effectiveness of
budgeting.
(c) Low morale for some workers
The management by exception approach focuses on the unusual
variances. Management often focuses on unfavourable variances
while ignoring favourable variances. Workers might believe that
poor performance gets attention while good performance is
ignored. As a result, the morale of these workers may suffer.