The Importance of Standard Costing

A valuable management tool, standard costing is part of cost accounting. Rather than using actual costs for direct material, labor and manufacturing overhead, standard costs are used to easily track variances and estimate profit.

Though actual costs are still paid, standard costing is often used for inventories and cost of goods sold. The difference between standard and actual costs are known as variances. These variances are what make standard costing such a valuable practice for management. Management can quickly become aware of changes in budgeted costs by tracking the variances.

When standard costing is used, you will often hear the terms unfavorable or favorable variance. This refers to changes in actual costs in relation to planned or standard costs. A favorable variance takes place when actual costs dip below standard costs. Conversely, if actual costs rise above standards, the variance is unfavorable.

In regards to manufacturing companies, standard costs would first be seen as individual parts or pieces of the finished product. This means that the final standard cost will be the sum of the standard costs of each of the individual pieces of the product.

Just in case you are not quite following, I will give you a quick example. Let's say my company assembles a big wheel type of vehicle for kids. Each piece of the big wheel would be assigned a standard cost and all these would be added together to find the standard cost of the completed big wheel:

PART/LABOR                          STANDARD COST

One large wheel                     $5

Two small rear wheels               $5 x 2 

plastic seat                        $1 

plastic frame                       $5 

handlebars                          $.50 x 2 

pedals                              $1.50 x 2 

pedal mechanism                     $10 

nuts and bolts                      $.10 X 15 

assembly labor                      $12 hr x .5 hr

__________________________________________________ 

TOTAL STANDARD COST                 $42.50

PART/LABOR                          ACTUAL COST 

One large wheel                     $4.50 

Two small rear wheels               $4 x 2 

plastic seat                        $1 

plastic frame                       $5 

handlebars                          $.75 x 2 

pedals                              $1.25 x 2 

pedal mechanism                     $10 

nuts and bolts                      $.06 x 15 

assembly labor                      $12 hr x .5 hr 

__________________________________________________ 

TOTAL ACTUAL COST                   $39.40

The above example shows a favorable variance between standard and actual costs. Although some individual items (the handlebars) have actual costs that are higher than standard cost, the overall actual cost of the big wheel ends up being $2.10 less than what management budgeted.

Now that you understand the basics, I will add another layer of complexity to this. It is important to note that there are usually two variances contributing to costs. Not only do you need to track variances in price between standard and actual cost, but you will also need to be aware of usage and efficiency. This applies to anything to which standard costing is applied.

Relating the second variance to the first example, you can see that the actual cost for assembly labor is $12 an hour and it takes 30 minutes to assembly one big wheel. Because humans are assembling the vehicles, the actual time will vary, causing the actual cost to vary as well. This second level of variance would also account for things like quantity ordered, quality of materials and overhead volume.