Define Standard Cost and Standard Costing. How is Standard Costing useful in the effective control over the cost?

Defining Standard Cost and Standard Costing

Standard Cost represents the scientifically determined cost of producing a unit of a product or providing a service. It is built upon a detailed analysis of various cost elements – direct materials, direct labor, and overheads – considering factors like price, quantity, and efficiency. It’s a planned cost, not a historical one.

Standard Costing is a system of cost accounting that uses standard costs for pricing inventory, controlling costs, and evaluating performance. It involves the following key steps:

• Setting Standards: Establishing predetermined costs for materials, labor, and overhead.
• Measuring Actual Costs: Recording the actual costs incurred during production.
• Variance Analysis: Comparing actual costs with standard costs to identify deviations (variances).
• Reporting and Corrective Action: Analyzing variances, reporting them to management, and taking corrective actions.

How Standard Costing Aids in Effective Cost Control

1. Variance Analysis: The Core of Control

Standard costing’s primary strength lies in its variance analysis. Variances highlight discrepancies between standard and actual costs, categorized as:

• Material Variance: (Price Variance & Usage Variance) – Differences in material price and quantity used.
• Labor Variance: (Rate Variance & Efficiency Variance) – Differences in labor rate and hours worked.
• Overhead Variance: (Expenditure Variance & Volume Variance) – Differences in overhead spending and production volume.

By pinpointing these variances, management can focus on areas requiring attention. For example, a significant adverse material price variance might indicate poor purchasing practices or supplier issues.

2. Performance Evaluation and Accountability

Standard costing provides a basis for evaluating the performance of departments and individuals. Managers can be held accountable for variances within their control. This fosters a sense of responsibility and encourages cost consciousness. For instance, a production manager might be evaluated based on labor efficiency variance.

3. Budgeting and Forecasting

Standard costs serve as a foundation for budgeting and forecasting. They provide realistic cost targets, enabling more accurate financial planning. The standards established can be used to create budgets for each cost element, facilitating better resource allocation.

4. Decision Making

Standard costing aids in various managerial decisions, such as:

• Pricing Decisions: Standard costs provide a benchmark for setting selling prices.
• Make-or-Buy Decisions: Comparing standard costs with external supplier quotes.
• Product Mix Decisions: Evaluating the profitability of different products based on their standard costs.

5. Inventory Valuation

Standard costs can be used to value inventory, simplifying the accounting process. This is particularly useful in industries with high production volumes. However, it’s crucial to periodically revise standards to reflect changing economic conditions.

Limitations of Standard Costing

While powerful, standard costing isn’t without limitations. It requires significant initial investment in setting standards, and standards need regular revision. Furthermore, it may not be suitable for industries with highly variable costs or rapidly changing technologies. The focus on variances can sometimes overshadow qualitative factors affecting performance.