Standard Costing: Uses, How Standards Are Set and the Types of Standard

A soft drinks plant in Lagos produces millions of identical bottles a month. Each bottle uses the same quantity of syrup, the same bottle, the same minutes of line labour.

When the monthly accounts arrive the finance manager does not want to know the total cost of the month: she wants to know whether the plant used more syrup than it should have, whether it paid more for it than it should have, and whether the line ran as fast as it should.

That calls for a yardstick, set in advance, against which the actual can be compared, and this yardstick is the standard cost.

This topic explains what standard costing is, when it is appropriate, how a standard cost card is built up, who sets each element, the four uses of standard costing, the principle of controllability in reporting variances, the types of standard (ideal, attainable, current and basic) with their behavioural effects, and how often standards should be reviewed.

It builds on the earlier topic on the learning curve in budgeting, which showed one way in which a standard time may change. The next topic covers the basic variances: material, labour and idle time.

Standard costs and standard costing

Standard units and when standard costing is appropriate

Standard costing is most useful when an entity makes homogeneous goods in large numbers and there is a degree of repetition in the process. A standard unit of product (or service) should have exactly the same input resources, at exactly the same prices, as every other, so all units have the same standard cost. It is usually associated with manufacturing, but can be applied to standard services.

In a one-off or highly variable production it is much less useful.

Definitions

A standard cost is an estimated or predetermined cost of performing an operation or producing a good or service under normal conditions. Standard costing is a control technique that reports variances by comparing actual costs with pre-set standards, so facilitating action through management by exception.

A standard cost is a predetermined unit cost built from expected quantities of direct materials and expected direct labour time, priced at predetermined rates per unit of material, per direct labour hour and per hour of overhead. Standard costs of products are normally restricted to production costs; administration and selling overheads are not included. Overhead is normally absorbed into standard production cost at a rate per direct labour hour.

The standard cost card

The standard cost of a unit is recorded on a standard cost card: a document that shows the predetermined standard quantities, prices and rates for materials, labour and overhead needed for one unit. The card links to the budget through activity levels: if 1,200 units are budgeted and a unit needs materials costing ₦5,000, the materials budget is ₦6,000,000.

How the elements are set, and by whom

• Material prices: from past purchase records, adjusted for expected inflation and changes in trade discounts, by managers with purchasing expertise.
• Labour rates: an average rate for each grade, based on current pay or the expected average for the year including an expected pay rise, by managers with expertise in pay, usually human resources.
• Material usage: from past records of use, or from the design specification, by operational or technical managers.
• Labour efficiency (time per unit): from past records, comparison with similar work, or time and motion study, by operational managers.
• Overhead rates: a senior management accountant, using the budgeted overhead and the budgeted activity agreed in the annual budget. The standard fixed overhead cost per unit is the budgeted fixed overhead divided by budgeted activity (in hours or units), multiplied by the hours or units per product.

Standards are normally set by people who understand the process, and are usually reviewed once a year in the budgeting process.

The uses of standard costing

1. A system of cost accounting. Units produced are recorded at standard cost and stock is valued at standard production cost.
2. The basis of the budget. Budgeted costs are standard cost per unit multiplied by planned activity.
3. Performance measurement. The differences between standard and actual costs, the variances, are reported to show good or poor performance.
4. Control reporting. Large variances signal that operations may need attention: adverse variances call for control action; large favourable ones should be investigated, to find out why and whether it will continue.

Standard costing can be used with absorption costing or with marginal costing.

Controllability

Variances should be reported to the manager who is responsible for the area to which they relate and who is able to do something to control them. Reporting a variance to someone who cannot influence it has no purpose, and holding a manager accountable for something outside his control is unfair and demotivating.

Types of standard and reviewing standards

Standards are predetermined unit costs, but how much efficiency should they assume? Should they assume perfect conditions, or allow for waste and idle time? The standard is a performance target. If it seems unattainable, employees may be demotivated; if it is too easy, there is no incentive to improve. Four types are used.

• Ideal standards assume perfect operating conditions: no waste, no labour inefficiency, no breakdowns. They are never achieved, so variances are always adverse and staff may be demotivated when their performance is always worse than standard. They are useful as long-term targets and show senior management the potential for savings.
• Attainable standards assume efficient but not perfect conditions, with an allowance for waste and inefficiency, set at a higher level than current performance so that some improvement is needed. They are the most likely to motivate, since they are challenging but achievable. The difficulty is deciding how much improvement to require: 1%, 5% or 10%.
• Current standards are based on present working conditions and what the entity can achieve now. They give a realistic guide for budgeting, but no incentive to improve unless bonuses are paid for favourable variances; and where current performance is inefficient they build the inefficiency in. They may include allowances for expected waste or idle time.
• Basic standards stay unchanged over a long period. Variances show trends (improving or worsening performance) but the standards are out of date, do not motivate and are not useful for budgeting. They are the least common.

Reviewing standards. Standards should be revised regularly so that they are meaningful targets that staff may be motivated to achieve, so that reported variances are realistic and not just reflecting out-of-date standards. In practice they are reviewed annually in the budgeting process, since they are long-term averages and some variation is expected over time.

Layouts for building a standard cost

1. Materials: quantity per unit × standard price, for each material.
2. Labour: hours per unit × standard rate, for each grade.
3. Variable overhead: hours per unit × variable rate per hour.
4. Standard variable (marginal) cost = total of the above.
5. Fixed overhead rate = budgeted fixed overhead ÷ budgeted hours (or units); fixed overhead per unit = hours per unit × rate.
6. Standard full production cost = variable cost + fixed overhead per unit.

Money is in naira and each answer is rounded once, at the end.

Worked examples

1. Materials.
   A 3 × 250 = 750; B 2 × 400 = 800; total ₦1,550.
2. Labour.
   Grade 1 1.5 × 600 = 900; grade 2 1 × 450 = 450; total ₦1,350.
3. Variable overhead.
   2.5 hours × 120 = ₦300.
4. Standard variable cost.
   1,550 + 1,350 + 300 = ₦3,200.
5. Fixed overhead.
   Budgeted hours = 12,000 × 2.5 = 30,000
   rate = 4,500,000 ÷ 30,000 = ₦150 an hour
   per unit 2.5 × 150 = ₦375.
6. Standard full production cost.
   3,200 + 375 = ₦3,575.
   A budget for 1,200 units would show materials ₦1,860,000 (1,200 × 1,550).

1. Ideal.
   Standard hours 5,000 × 2.0 = 10,000; actual 12,500; 2,500 hours adverse × 600 = ₦1,500,000 A.
2. Attainable.
   Standard hours 5,000 × 2.4 = 12,000
   500 hours adverse × 600 = ₦300,000 A.
3. Current.
   Standard hours 5,000 × 2.5 = 12,500; variance nil.
4. Comment. The performance is identical; the variance depends entirely on the standard. The ideal standard gives a large permanent adverse figure that tells the manager nothing new and may discourage; the current standard shows nothing and gives no push to improve; the attainable standard shows a modest adverse figure that points to a possible 500 hours of improvement.

Expect variants: a standard cost card with a normal loss, a standard for a service (hours and rates), a request to say who should set each standard, and a discussion of the behavioural effects of each type.

Common mistakes

• Including selling and administration costs in the standard production cost.
• Dividing fixed overhead by units when the rate is per labour hour, or the reverse.
• Calling an ideal standard attainable.
• Listing the types without their behavioural effects.
• Reporting variances to the wrong person.
• Forgetting to review standards when conditions change.

Quick revision

• Standard cost = predetermined unit cost; standard costing reports variances for management by exception; suits repetitive, homogeneous output.
• Setters: purchasing (prices), HR (rates), operations (usage and efficiency), management accountant (overhead rates).
• Uses: costing system, budget basis, performance measure, control report.
• Types: ideal, attainable, current, basic; attainable motivates most; review at least annually.

How the marks are earned

• Build the card in the correct order.
• Explain who sets what and why.
• Discuss the types with their behavioural effects.

Practice questions

These are original questions, written in the style of the Skills examination. Work each one before you open the answer.

Recall check: multiple choice

Section B style: written questions

Model answers

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