Standard Cost Accounting: Meaning, Purpose, and Variance

Standard Costing

Standard costing is a technique of cost accounting that allocates standard costs to goods or services, serving as a benchmark in assessing the business’s performance. It aims to provide an estimated cost to the components of production like raw material, direct labor, overheads, etc. These standard costs are then compared with actual costs that are incurred during the production process to establish variances. 

Standard Costing aids businesses in controlling costs, simplifying and optimizing the budgeting process, and improving the decision-making process regarding variances between anticipated and actual results. One of the classes of managerial costing is standard costing; it is commonly applied in manufacturing and service industries for effectiveness and profitability.

Purpose and Importance of Costing

Standard costing provides several important functions in the field of business, and the first one is related to budgeting and financial planning.

• From a business point of view, cost estimation helps in developing a budget and in the correct allocation of resources.
• Standard costing also serves as a guideline to pricing, whereby, firms can set correct prices from which they can cover the costs incurred and obtain the targeted levels of operating profit.
• It also assists in the evaluation of the performance by making comparisons between actual and standard costs to enable the management to gain an understanding of cost problems.
• Standard costing helps in decision-making as it provides information on the costs and profit to be made from a product, thus helping organizations to align their decisions and work towards the achievement of maximum competitiveness.

Advantages of Standard Costing

Standard costing in cost accounting offers many benefits.

Let’s Explore a few of them:

• Improved Cost Management: Standard costing is a perfect tool for showing particular costs as standards and allows directing the management of costs.
• Efficiency Enhancement: It helps to compare the real costs with the standards and define how to improve the efficiency of the operation.
• Informed Decision-Making: Standard costing assists management in improved decision-making since accurate cost information is provided, concerning management’s strategic planning.

Drawbacks of Standard Costing

While standard costing offers multiple advantages, there are a few drawbacks the business should keep in mind:

• Complexity and Time Consumption: Typically, standard costs may be set hard and time-consuming because of the need to identify the fluctuating costs and ever-evolving processes in industries.
• Rigidity: It is rigid because it tends towards not being able to incorporate current market realities or new technologies, hence it tends to develop old standards.
• Potential for Inaccuracy: If standard costs have not been updated frequently, they would prove to be less relevant and therefore the variance analyses that you get are misleading and management could end up making wrong decisions.

Components of Standard Costing

Standard Costs for Materials: These are the anticipated expenses that are required in the production process of the final product and they include costs of raw materials as estimated by history and current market trends. 

The formula for calculating standard costs for material is: 

Material Cost = Market Price per Unit x Total number of Units

Standard Costs for Labor: These include the wages that have been estimated to be paid and the time it takes to complete the production which is benchmarked as the cost of labor.

The formula for calculating the standard cost of Labor is:

Direct Labour = Employee Hourly Rate x Hours Worked x Total number of Units

Standard Variable Overhead Costs: These include the variable overhead costs that consist of the expenses that vary with the level of activity for instance the expenses on electricity and certain employees.

Standard Fixed Overhead Costs: These are the factory overheads that do not vary with the amount of output and can include such things as, depreciation, rent, and salaries.

The formula for calculating standard overhead costs is:

Standard Overhead Costs = Fixed Overheads + (Variable Manufacturing Overheads x Total Number of Units) 

Formula for Standard Costing

The formula for standard costing:

Standard Cost = Direct Material Cost + Direct Labor Cost + Variable Overhead Cost + Fixed Overhead Cost

Standard costing calculation is done with this formula that assists the business in predicting the feasible overall production cost in terms of acquiring materials, human resources, and overheads. With this approach, one can arrive at a cost base from which cost control and cost variances can be well-checked.

Standard Costing Example with Solution

Standard costing examples are usually based on getting an idea of the total cost of production.

Let’s understand it with a simple example:

Below are the expenses borne by the company for the production of school bags:

Expected No of Production: 10,000

Expected Total hours per unit: 6

Standard Direct Material Cost Per Unit: $150

Standard Labor Material Cost Per Hour: $80

Standard Variable Overhead Cost Per Unit: $35

Standard Fixed Cost: $500,000

Solution:

Type of Cost	Rate	Hour	Cost Per Unit	Unit Produced	Total Cost
Direct Material	150	_	150	10000	1500000
Labor Material	80	6	480	10000	4800000
Variable Overheads	35	_	35	10000	350000
Fixed Overheads	500000	_	_	_	500000
Total Cost of Production					7150000

Variance in Standard Costing

Variance in standard costing is the difference between the standard cost and the actual cost of production. This brings out performance gaps to show that there is a mismatch. Variance in standard costing can be favorable or unfavorable; they show that actual costs are less than planned (favorable) or greater than planned (unfavorable). It contains the material variances that reflect the variation between anticipated and actual amount of material cost and secondly, it has labor variances that compare between the standard labor cost and the actual labor cost. 

Overhead variances generally evaluate the differences in fixed as well as variable overhead expenses. Understanding these variances would give useful information in the fight against excessive cost and the improvement of efficiency in operations as spotted by the management for correction where necessary.

Types of Variance

Variance in standard costing can be related to different components like material, labor, overheads, etc.

Let’s understand them below:

1. Material Variance: This compares the standard cost of materials, to the actual cost, to point out cost variations in material cost or consumption.
2. Labor Variance: This looks at how much it would normally cost to employ the kind of workers incurred to employ or produce what you are comparing, looking at differences in wage rates or work output.
3. Overhead Variance: This compares the budgeted and actual overhead costs with the standard overhead cost, with fixed overhead variances and variable overhead further subdivided to identify in detail exactly where in the organization over or underheading has occurred.

Steps Involved in Standard Costing

The process of standard costing includes a few steps that make it important for the business:

1. In the initial stage, the business will fix the standard cost based on the insights from the previous processes and market standards. 
2. After the production process, the business will realize actual costs for different components.
3. After having standard and actual costs, now the business will compare both the costs and determine the variance. 
4. In the last step, the business will analyze the variances for different components and take corrective actions where necessary.

Why Do Companies Use Standard Costing?

There are several strategic motives for which standard costing is used by different companies. They give an outline of the amount that should be spent on a project because the costs involved are already standardized. This method facilitates the identification of cost variances and hence it assists business organizations to identify areas of inefficiency and take necessary action. 

Standard costing also makes it easier in financial planning since it makes the precipitate forecasts correspondingly better, and the allocation of resources. Also, it helps in appraising performance by comparing actual cost with standard cost and hence enables the management to make good policies that will boost the overall profitability.

Conclusion

Standard costing is an estimated cost that works as a benchmark before the actual cost is realized. This method of cost accounting caters to cost components like raw material, labor, fixed cost, variable overheads, etc. This method helps majorly with cost control. Cost controlling helps a business to make insightful decisions, cutting unnecessary costs, etc.