Applications of Standard Costing

Standard costing is a useful method of control in a number of ways. First, the process of evaluating performance by determining how efficiently current operations are being carried out may be facilitated by the process of management by exception. Very often the problem facing management is the time lost in sifting large masses of feedback information and in deciding what information is significant and relevant to the control problem. Management by exception overcomes this problem by highlighting only the important control information, that is the variances between the standard set and the actual result. This process allows management to focus attention on important problems so that maximum energy may be devoted to correcting situations which are falling out of control.

Second, a standard costing system may lead to cost reductions. The installation of such a system demands a re-appraisal of current production methods as it necessitates the standardization of practices. This examination often leads to an improvement in the methods employed which is reflected in a reduction of the costs of the product. One example of cost reductions through increased efficiency may be seen in the simplication of the clerical procedures relating to inventory control. All similar items of inventory may be recorded in the accounts at a uniform price; this eliminates the need which arises under historical costing for re-calculating a new unit price whenever a purchase of inventory is made at a different price.

Third, standard costs are used as a basis for determining selling prices. Standard costs represent what the product should cost, and are a much better guide for pricing decisions than historical costs which may contain purchasing and production inefficiencies which cannot be recouped in competitive markets.

Finally, perhaps the most important benefit which may be derived from a standard costing system is the atmosphere of cost consciousness which is fostered among executives and foremen. Each individual is aware that the costs and output for which he is responsible are being measured, and that he will be called on to take whatever action is necessary should large variances occur. As we concluded earlier, if the philosophy of top management is positive and supportive, standard costing may act as an incentive to individuals to act in the best interest of the firm. Moreover, a standard costing system which allows subordinates to participate in setting the standards fosters a knowledge of costing down to shop floor level, and assists in decision making at all levels. Thus, if there should occur spoilt work necessitating a decision from the foreman in charge on whether to scrap or rectify the part involved, a knowledge of costs will enable him to make the best decision.

Setting cost standards

The setting of cost standards is no easy task. If they are set too high, for example, large variances will appear and in the degree that production managers consider them to be unrealistic so they will tend to ignore them. If standards are set too low, however, they will not act as incentives to efficiency and production efficiency may fall. The best standards are those which are set at levels which though high are nevertheless attainable, so that they will encourage efficient performance.

The process of setting cost standards requires the standardization of all the elements affecting a product so that specific standards for these elements may be established prior to its actual production. There are two component parts of this process: the determination of a physical standard and the selection of an appropriate value to be attached to the physical standard. This problem may be examined in the context of establishing standard costs for raw materials and labour, which are the two major direct costs of production.

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Read on: Standard Costs and Variance Analysis

We turn now to a consideration of an important method of establishing standards of performance by the use of standard costs. The difficulty about using data recorded in the financial accounting system for planning purposes is that it relates to the past and although managers are interested in the results of previous decisions, they are primarily concerned with decisions which will affect the future.

For control purposes, historical costs are of little use. Particularly in times of inflation, past experience will not inform management whether an operation, a job or a department costs too... see: Standard Costs and Variance Analysis