What Is Standard Costing? (With Formula And Example)
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
Budgets play a crucial role in determining the efficiency, productivity and profits of a business. Standard costing is a beneficial accounting tool that helps manufacturers plan accurate budgets. If you are interested in a career in accounting, understanding standard costing can help you create efficient budgets in the workplace. In this article, we explain "What is standard costing?", explore its advantages and drawbacks, discover the role of variances in standard cost accounting and explain how to calculate standard costs using an example.
What is standard costing?
If you are working in accounting, understanding "What is standard costing?" can help you plan business budgets efficiently. Standard costing is the practice of estimating expenses in the production process since manufacturers cannot predict actual costs in advance. Manufacturers use this methodology to plan upcoming costs of various expenses, such as labour, materials, production and overhead. It helps the manufacturing team estimate expected costs so that they can budget and plan accordingly. Other terms for standard cost are estimated cost, predetermined cost, expected cost or budgeted cost.
The primary reason why companies use standard costs for budgeting is that manufacturers cannot predict actual production costs accurately until the manufacturing process is complete. There are several unknown variables, such as changes in the cost of raw materials, production delays and changing labour costs that affect the final costs. Besides budgeting, accountants also use standard costs to fix the prices of produced goods.
Advantages of standard costing
Here are the top benefits of using standard costing:
Helps with accurate budgeting
Manufacturers rely on standard costing for creating budgets, as it is difficult to calculate the actual costs of producing an item before the production is complete. Manufacturing budgets are usually a smart estimate and not the actual price. They compare standard and actual costs once manufacturing is complete to identify the variances. They can then use this information to make the following year's budget more accurate.
Simplifies inventory costing
Calculating the required inventory is easier when using standard costs than actual costs. Generally, during production, the cost of manufacturing varies from one batch to another. This can be due to several factors, such as production delays, variations in raw material pricing and changes in employee salaries. With standard costing, manufacturers can calculate inventory value by multiplying the actual inventory with the standard cost of each item. This helps them estimate the inventory costs that are likely to be very close to the actual costs.
Makes it easy to price products accurately
Standard costing helps manufacturers fix the prices of the end products even before manufacturing is complete. By having a clear picture of the estimated production costs, including materials, labour and overhead costs, companies can accurately price their products to make profits without overpricing them. Using standard costing also makes it easy for manufacturers to account for the changes in production costs with varying volumes while keeping the product price uniform across batches.
Provides efficient financial records management
If a company has to rely solely on actual costs, it becomes difficult to maintain its financial records. On the contrary, standard costing makes it easier for companies to produce and maintain their financial records. Since the company has an intelligent estimate of expected costs, it can conduct other financial activities, such as borrowing and overdrafts, using the numbers from standard cost calculations.
Facilitates production benchmarking
Manufacturers use standard costs to set benchmarks so that they can compare if actual costs meet these benchmarks. If the actual costs meet standard costs, it indicates that the budgeting has been successful. If there is an unfavourable variance with the actual costs exceeding standard costs, then the company works on altering its production efficiency to lower these costs in the future.
Drawbacks of standard costing
While standard costing is an efficient accounting tool, it has certain drawbacks. Some of the disadvantages of standard costing are:
Not applicable with cost-plus contracts: A cost-plus contract is a contract where clients pay manufacturers based on the actual costs incurred. In such scenarios, manufacturers cannot rely on standard costing to draft client contracts.
Can lead to incorrect actions: If the management notices unfavourable variances between standard and actual costs, they can take the wrong steps to correct the variance. For example, they might purchase raw materials in larger volumes to reduce price variances, which can lead to inventory backup and extra expenditure.
Not suitable for fast-paced environments with frequent price changes: A standard costing system assumes that prices remain constant for a few months or a year. In manufacturing environments with short product lives and continuous pricing changes, standard costing becomes outdated within a few months, making it irrelevant in accounting.
Can offer slow feedback: The accounting department does the variance calculations, usually at the end of each production cycle or reporting period. If the production department requires immediate feedback for instant corrective action, then standard costing with slow feedback becomes irrelevant.
Does not offer unit-level information: The variance calculations from standard costing are for the entire production department. Standard costing cannot provide granular information about discrepancies for each individual unit, batch or work cell.
Understanding variances in standard costing
Variance is the difference between standard and actual costs. The accounting department calculates the variance at the end of the financial cycle and uses this data to optimise future budgets. Standard costing helps to determine if there is a favourable or unfavourable budget variance.
Unfavourable variance: If actual costs are higher than standard costs, then the company earns a lower profit than initially predicted.
Favourable variance: If the standard costs are higher than actual expenses, it is advantageous as it indicates higher profits.
Variances help identify the manufacturing areas that cause differences between actual costs and standard costing. For example, accountants use variance data to find out if the changes were due to labour cost, material cost or operational delays.
Types of variances in standard costing
Variances in standard costing are of two types. They are:
Also known as a price variance, rate variance is the difference between the actual price and the expected price of raw material, multiplied by the actual quantity purchased. An example of rate variance is labour rate variance. This is the difference between the actual cost of labour and the standard cost of direct labour. When rate variance refers to the purchase price of materials, it is known as material price variance or purchase price variance.
Volume variance refers to the difference between the budgeted volume and the actual quantity sold (or used) multiplied by the standard cost per unit of the product. Volume variance is of the following types:
sales volume variance that refers to the variances in the goods sold
material yield variance that denotes the usage of raw materials
labour efficiency variance that calculates direct labour usage
overhead efficiency variance that relates to material overheads
Formula to calculate standard costs
To calculate the standard cost of a product, you can use the following formula:
Standard cost = direct labour + materials cost + manufacturing overhead
Here is how to calculate each of these elements in the formula:
Direct labour = employee hourly rate x no. of hours worked x total number of units
Materials cost = market price per unit x total number of units
Manufacturing overhead = fixed overhead + (variable manufacturing overhead x total number of units)
Except for the employees' hourly rates, accountants usually make calculated estimates for all other values using available historical data.
Standard costing calculation example
Here is an example showing how a manufacturing company may calculate its standard costing:
Faster Path Production manufactures running shoes. The management conducts a meeting with team leaders and they plan to manufacture 300 units of shoes in the coming year. They estimate the costs as follows:
direct labour: ₹500 per hour
raw material: ₹1000 per unit
manufacturing overhead: ₹800 per unit
time to produce one unit: 5 hours
fixed overhead: ₹1,00,000
Using these values, they can calculate standard costing in two steps:
1. Calculate the cost of direct labour, raw materials and manufacturing overhead
To calculate standard costs, the first step is to calculate each sub-component in the formula. In this example, they are as follows:
materials cost = ₹1000 (cost per unit) x 300 (total number of units) = ₹3,00,000
direct labour = ₹500 (employee hourly rate) x 5 (number of hours to produce one unit) x 300 (total number of units) = ₹7,50,000
manufacturing overhead = ₹1,00,000 (fixed overhead) + ₹800 (variable manufacturing overhead) x 300 (total number of units) = ₹3,40,000
2. Calculate the standard cost
Once you have calculated the cost of direct labour, materials and overhead, you can add them together to find the overall standard cost.
Standard cost = ₹3,00,000 (materials cost) + ₹7,50,000 (direct labour) + ₹3,40,000 (manufacturing overhead) = ₹13,90,000.
The company can estimate the cost of manufacturing one unit of running shoes, by dividing the standard cost by the total number of units, which for this example is ₹4634. Using the standard costing value, the company can plan the manufacturing budget and decide the final selling price of the product.
Explore more articles
- 11 Important Benefits Of Coaching In The Workplace: A Guide
- 8 Steps On How To Build An E-Commerce Website (With Tips)
- What Is A Yield Ratio? (Importance And How To Calculate)
- Essential Pedagogical Skills (With Steps To Improve Them)
- Brand Guidelines: Benefits, Elements And How To Create Them
- What Is A Salesforce Administrator? (Duties And Skills)
- Common Business Acronyms For Professional Environments
- What Is Fund Accounting? (With Importance And How It Works)
- What Is Total Quality Management? (A Complete Guide)
- 10 Useful ALM Tools With Features (Plus Comparison Criteria)
- Automation Of Processes (With Definition And Examples)
- Essential Line Cook Skills (And How To Improve Them)