What is Standard Costing in accounting? Variance, Standard cost formula, advantages and disadvantages

Standard cost in accounting can be a very useful tool for management, who are trying to plan a more accurate budget. Accurate budgets could lead to a profitable and efficient business at the end of the day. And this is because a standard costing system provides managers with a projected idea of where to spend the costs. Once these managers can compare the standard costs to actual costs, they will be able to determine if new business practices need to be utilized or not.

What is standard costing?

We can define the term ‘standard cost’ as the expected cost per unit of the products produced during a period, which is based on various elements of cost like direct material, direct labour, overheads, etc.

Standard costing is the activity of estimating the expense of a production process. It’s aimed at measuring the performance, inventory valuation and deciding the selling price of the product especially when quotations are prepared.

The main reason for using the standard costs is that there are a number of applications where it’s very time-consuming to collect the actual costs, so standard costs are used as a close approximation to actual costs. After a critical review of the standard costs, the business will estimate the required cost of manufacturing the product, essentially, the overall operating cost. Manufacturers also are able to compare the standard cost to the actual costs to find out the variance.

What is Variance?

The difference between the standard cost and actual cost is noted as a variance. The presence of variance indicates a difference from what was recorded in the product planning.

If the actual costs are greater than standard costs, management can likely expect a lower profit than predicted on the profit plan. If the actual costs are less than standard costs, management might anticipate a higher profit than they originally planned for.

Standard costing formula

Standard cost can be calculate by addition of direct material cost, direct labour cost and overheads. That means,

Standard cost = Direct material cost + Direct labour cost + Overheads

(Overhead = fixed overhead + variable overhead)

Objectives of standard costing

1. To help in Future cost estimation

Standard Costs are set after considering all the possibilities that can arise in the future. It also helps in determining whether a particular project is to be undertaken or not, by determining its profitability.

2. To check the performance

Standard cost acts as targets to the cost centres which should not be exceeded. In such a situation, these targets are helpful in checking the performance through comparison with the actual results.

3. To prepare the Budget

The standard costs are used to prepare budgets, and evaluate the performance of the executive staff on the basis of these budgets.

Step by step process of Standard Costing

Standard costing process is done by following steps –

Step 1. Establishing Standards

First of all, the standards are to be determined on the basis of management’s estimation, wherein the production engineer anticipates the cost of the production. Generally, while fixing the standard cost, more weight is given to the data from the past, the current plan of production and future trends.

Step 2. Determination of Actual Cost

After standards are determined, the actual cost for each element, that is material, labour and overheads are determined, from the invoices, wage sheets, account books and so on.

Step 3. Comparison of Actual Costs and Standard Cost

During this step of the process, managers compare the standard cost with the actual figures, so as to find out the variance. If the actual costs are greater than standard costs, management can likely expect a lower profit than predicted on the profit plan. If the actual costs are less than standard costs, management might anticipate a higher profit than they originally planned for.

Step 4. Determination of Causes

Once the comparison is done, the next step is to find out the reason for the variances, Then take corrective actions and also evaluate the overall performance of the production.

Step 5. Disposition of Variances

The last step to this standard costing procedure, is the disposition of variances by transferring it to the costing profit and loss account.

Advantages of standard costing

1. Standard costing provides a starting point for your budget; You can start making your budget with the overall estimated cost rather than the actual cost.
2. Standard costing provides information about the efficiency of your performance.
3. This method will help the management team while making important decisions to improve efficiency and cut costs.
4. This method can help you effectively set selling prices for products and figuring a profit margin.
5. Standard costing can make employees more cost-aware, and encourage them to improve their methods of completing tasks, and ultimately making the process more cost-effective.
6. More effective cost control is possible under standard costing if the same is reviewed and examined at regular intervals for improvements and immediate corrective action can be taken if deviations from standards are found out which, in the end, leads to cost reduction.
7. After the Standard Costing System is implemented it will lead to saving cost since most of the cost accounting work can be eliminated.
8. Standard costing also useful for inventory valuation purposes. Stock can be valued at a standard cost which can reduce the fluctuation of profit for different methods of valuation for the same.

Dis-advantages of standard costing

1. Figuring out the standard costs can be time-consuming. It involves examining previous reports, interviewing employees, reviewing and changing certain processes and procedures, and regularly reviewing the variance analysis.
2. To establish a standard costing system a lot of time and skills are needed. The process may be overly costly to implement for small businesses.
3. Standard cost is always changing since the conditions of the business are equally changing. So, standards are to be revised in order to make them comparable with actual results.

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