Standard costing: objectives, principles, types of standards and setting standards for material, labour and overheads

1. Meaning

A standard cost is a predetermined cost of a unit of product or service, worked out in advance from technical specifications of material, labour and overheads under stated working conditions. CIMA calls it “the planned unit cost of the products, components or services produced in a period.” Standard costing is “a control technique that reports variances by comparing actual costs to pre-set standards so facilitating action through management by exception” (CIMA).

2. Objectives and principles

1. To set yardsticks against which actual performance is measured.
2. To find variances and their causes, element by element.
3. To fix responsibility: price variances to the buyer, usage and efficiency variances to the foreman.
4. To control and reduce cost by acting on the significant variances only (management by exception).
5. To help pricing, quotations and stock valuation on a stable basis.
6. To make employees cost-conscious, and to provide a base for incentive schemes.

The principles: standards must be set scientifically, for each element and each cost centre; actual costs are recorded in the same classification; the comparison is regular and prompt; and variances are analysed by cause and reported to the person responsible.

3. Types of standards

• Ideal standard: attainable only under perfect conditions, no waste, no idle time. Discouraging in practice.
• Basic standard: set once and left unchanged for years, used to show trends.
• Current standard: set for a short period to reflect current conditions.
• Normal standard: the average expected over a trade cycle.
• Expected (attainable) standard: what can be achieved with efficient working, allowing for normal loss and idle time. The usual choice: tight but reachable.

4. Establishing a standard costing system

1. Preliminary study of the product, processes and existing cost records; standardise the products and methods first.
2. Set up cost centres and a standards committee: the works manager, purchase manager, personnel manager, production engineer and cost accountant.
3. Classify the accounts so that actual costs are collected by the same elements and centres as the standards.
4. Decide the type of standard and the standard hours / level of activity (normal capacity) on which overhead rates are based.
5. Set the standards for each element (section 5) and prepare a standard cost card for each product.
6. Decide the accounting method (single plan or partial plan) and the variance accounts.
7. Arrange reporting: which variances, how often, to whom.
8. Review and revise standards when methods, prices or wage rates change permanently.

5. Determining the standards

Direct material: quantity standards from engineering specifications and test runs, with an allowance for normal loss (evaporation, scrap); price standards by the purchase department from current prices, contracts and expected trends, including freight and handling.

Direct labour: time standards from time and motion study of each operation, with allowances for fatigue and normal idle time; rate standards from wage agreements and the grade of worker the job needs. The standard time is the time an average qualified worker should take at normal pace plus these allowances. Idle time is paid time not worked; normal idle time is built into the standard rate, abnormal idle time becomes the idle time variance.

Direct expenses: from contracts (royalty per unit, hire of a special tool per hour).

Overheads: budget overheads at normal capacity, split into fixed and variable. Variable overhead rate = budgeted variable overhead / budgeted hours; fixed overhead rate = budgeted fixed overhead / budgeted hours (or units). Variable overhead is allowed in proportion to output; fixed overhead is a fixed sum for the period, so its rate depends on the activity level assumed.

6. Standard cost card (illustration)

7. Advantages and disadvantages

Advantages: a yardstick for efficiency; management by exception; responsibility fixed; cost control and reduction; simpler stock valuation and bookkeeping; quick pricing; better planning and budgeting; workers made cost-conscious.

Disadvantages: costly to install and run, unsuitable for small firms and for job-order work where every job differs; standards go out of date quickly in inflation; setting them is technical; too-tight standards demoralise workers and too-loose ones hide waste; some variances (fixed overhead volume) are hard to assign to anyone; and variance reports can lead to blaming rather than correcting.

8. Standard costing and budgetary control

They are complementary: budgets are usually built from standard costs, and both compare actual with predetermined figures to control.

How this is examined

The 16-mark question (definition, then the eight steps of establishment) and the 10-mark comparison with budgetary control are the most set. For “techniques of standard costing,” write the setting of standards (section 5), the cost card, and variance analysis in one paragraph. Disadvantages, types of standard, standard time and idle time are 6-mark notes.