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Standard Cost Creation In order to have a standard costing system that operates properly, a company must first develop

standard costs, which follows these steps: 1. Initial standard setting. The industrial engineering staff is directed to create direct labor standard costs, while the purchasing staff creates standard costs purchased goods, and the cost accountant coordinates the development of a set of standard overhead costs. If there are sub-assemblies created during the production process that may be valued at the end of each accounting period, then the industrial engineering staff calculates these standards. 2. Periodic updates. Cost standards must be periodically reviewed. The timing of reviews depends upon how rapidly actual costs change. If there are minimal changes to a manufacturing process, reviews may be only at long intervals. However, if there is an aggressive continuous improvement process in place, then standard costs must be updated more frequently in order to keep pace with the changes in actual costs. There are a number of assumptions to consider when deriving standard costs, which include:

Equipment configuration. A standard cost is based on the expected production equipment configuration to be used, since this has a considerable impact on overhead costs incurred and the assumed speed with which parts are produced. Production volume. A large assumed production run will spread its setup cost over many units, whereas a short production run will result in higher setup costs on a perunit basis. Equipment condition. A poorly maintained machine will be in operation for fewer hours than would otherwise be the case, resulting in less available capacity. Production system. A manufacturing resources planning system has a different impact on costs than a just-in-time system, since they have a different focus on the flow of materials. Union negotiations. Any upcoming union negotiations may result in a significant change in labor rates. Training and experience. A highly trained work force is very efficient, so if there is an expectation for increased production hiring, assume that efficiency levels will decline until the new people can be properly trained.

A final factor to consider when creating standard costs is the level of attainability of the costs. One option is to devise an attainable standard, which is a cost that does not depart very much from the existing actual cost. This results in reasonable cost targets that employees know they can probably meet. Another alternative is to use historical costs as the basis for a standard cost. This is generally not recommended, for the resulting costs are no different from a companys existing actual cost structure, and so gives employees no incentive to attempt to reduce costs. The diametrically opposite approach is to create a set of theoretical standards, which are based on costs that can only be achieved if the manufacturing process runs absolutely perfectly. Since employees cannot possibly meet these cost goals for anything but very short periods of time, it tends to result in lower employee morale. Thus, of the potential range of standard costs that can be set in a standard costing system, the best approach is to set moderate stretch goals that are achievable.

Reasons for using a Standard Costing System:


There are several reasons for using a standard costing system: Cost Control: The most frequent reason cited by companies for using standard costing systems is cost control. One might initially think that standard costing provides less information than actual costing, because a standard costing system tracks inventory using budgeted amounts that were known before the first day of the period, and fails to incorporate valuable information about how actual costs have differed from budget during the period. However, this reasoning is not correct, because actual costs are tracked by the accounting system in journal entries to accrue liabilities for the purchase of materials and the payment of labor, entries to record accumulated depreciation, and entries to record other costs related to production. Hence, a standard costing system records both budgeted amounts (via debits to work-in-process, finished goods, and cost-of-goods-sold) and actual costs incurred. The difference between these budgeted amounts and actual amounts provides important information about cost control. This information could be available to a company that uses an actual costing system or a normal costing system, but the analysis would not be an integral part of the general ledger system. Rather, it might be done, for example, on a spreadsheet program on a personal computer. The advantage of a standard costing system is that the general ledger system itself tracks the information necessary to provide detailed performance reports showing cost variances. Smooth out short-term fluctuations in direct costs: Similar to the reasons given in the previous chapter for using normal costing to average the overhead rate over time, there are reasons to average direct costs. For example, if an apparel manufacturer purchases denim fabric from different textile mills at slightly different prices, should these differences be tracked through finished goods inventory and into cost-of-goods-sold? In other words, should the accounting system track the fact that jeans production on Tuesday cost a few cents more per unit than production on Wednesday, because the fabric used on Tuesday came from a different mill, and the negotiated fabric price with that mill was slightly higher? Many companies prefer to average out these small differences in direct costs. When actual overhead rates are used, production volume of each product affects the reported costs of all other products: This reason, which was discussed in the previous chapter on normal costing, represents an advantage of standard costing over actual costing, but does not represent an advantage of standard costing over normal costing.

Costing systems that use budgeted data are economical: Accounting systems should satisfy a cost-benefit test: more sophisticated accounting systems are more costly to design, implement and operate. If the alternative to a standard costing system is an actual costing system that tracks actual costs in a more timely (and more expensive) manner, then management should assess whether the improvement in the quality of the decisions that will be made using that information is worth the additional cost. In many cases, standard costing systems provide highly reliable information, and the additional cost of operating an actual costing system is not warranted.

Advantages / Benefits of Standard Costing System:

Standard costing System has the following main advantages or benefits:

1. The use of standard costs is a key element in a management by exception

2. 3. 4. 5. 6. 7. 8. 9. 10.

approach. If costs remain within the standards, Managers can focus on other issues. When costs fall significantly outside the standards, managers are alerted that there may be problems requiring attention. This approach helps managers focus on important issues. Standards that are viewed as reasonable by employees can promote economy and efficiency. They provide benchmarks that individuals can use to judge their own performance. Standard costs can greatly simplify bookkeeping. Instead of recording actual co0sts for each job, the standard costs for materials, labor, and overhead can be charged to jobs. Standard costs fit naturally in an integrated system of responsibility accounting. The standards establish what costs should be, who should be responsible for them, and what actual costs are under control. Effective cost controlHelps in planningFacilitates coordinationEliminates wastesFixing price and formulating policiesMotivates managers-

Disadvantages / Problems / Limitations of Standard Costing System:


1. Standard cost variance reports are usually prepared on a monthly basis and
often are released days or even weeks after the end of the month. As a consequence, the information in the reports may be so stale that it is almost useless. Timely, frequent reports that are approximately correct are better than infrequent reports that are very precise but out of date by the time they are released. Some companies are now reporting variances and other key operating data daily or even more frequently. 2. If managers are insensitive and use variance reports as a club, morale may suffer. Employees should receive positive reinforcement for work well done. Management by exception, by its nature, tends to focus on the negative. If variances are used as a club, subordinates may be tempted to cover up unfavorable variances or take actions that are not in the best interest of the company to make sure the variances are favorable. For example, workers may put on a crash effort to increase output at the end of the month to avoid an unfavorable labor efficiency variance. In the rush to produce output quality may suffer. 3. Labor quantity standards and efficiency variances make two important assumptions. First, they assume that the production process is labor-paced; if labor works faster, output will go up. However, output in many companies is no longer determined by hw fast labor works; rather, it is determined by the processing speed of machines. Second, the computations assume that labor is a variable cost. However, direct labor may be essentially fixed, then an undue emphasis on labor efficiency variances creates pressure to build excess work in process and finished goods inventories. 4. In some cases, a "favorable" variance can be as bad or worse than an "unfavorable" variance. For example, McDonald's has a standard for the amount of hamburger meat that should be in a Big Mac. A "favorable" variance would mean that less meat was used than standard specifies. The result is a substandard Big Mac and possibly a dissatisfied customer.

5. There may be a tendency with standard cost reporting systems to emphasize

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meeting the standards to the exclusion of other important objectives such as maintaining and improving quality, on-time delivery, and customer satisfaction. This tendency can be reduced by using supplemental performance measures that focus on these other objectives. Just meeting standards may not be sufficient; continual improvement may be necessary to survive in the current competitive environment. For this reason, some companies focus on the trends in the standard cost variances - aiming for continual improvement rather than just meeting the standards. In other companies, engineered standards are being replaced either by a rolling average of actual costs, which is expected to decline, or by very challenging target costs.

Standard Cost Variances A variance can be either a price variance or a quantity variance. A price variance arises when the cost to purchase an item differs from its standard price. A quantity variance occurs when the number of units actually required to build a product varies from the amount specified in the standard costing system. More specifically, here are the variances that you can calculate from a standard costing system (they are linked to more complete descriptions, as well as examples):

Purchase price variance. The actual price paid for materials used in the production process, minus the standard cost, multiplied by the number of units used Labor rate variance. The actual price paid for the direct labor used in the production process, minus its standard cost, multiplied by the number of units used. Variable overhead spending variance. Subtract the standard variable overhead cost per unit from the actual cost incurred and multiply the remainder by the total unit quantity of output. Fixed overhead spending variance. The total amount by which fixed overhead costs exceed their total standard cost for the reporting period. Selling price variance. The actual selling price, minus the standard selling price, multiplied by the number of units sold. Sales volume variance. The actual unit quantity sold, minus the budgeted quantity to be sold, multipled by the standard selling price. Material yield variance. Subtract the total standard quantity of materials that are supposed to be used from the actual level of use and multiply the remainder by the standard price per unit. Labor efficiency variance. Subtract the standard quantity of labor consumed from the actual amount and multiply the remainder by the standard labor rate per hour. Variable overhead efficiency variance. Subtract the budgeted units of activity on which the variable overhead is charged from the actual units of activity, multiplied by the standard variable overhead cost per unit.