STANDARD COSTING  and VARIANCES for businesses

Pricing techniques - there are several in practice that are used in business today and these are explained below:

FIFO -(First in, first out)

Using this system, we assume that components are used in the order which they are received from the suppliers.  The components issued to production are deemed to have formed part of the oldest consignment still unused and are costed accordingly.

LIFO -(Last in, first out)

This involves the opposite assumption, that components issued to production originally formed part of the most recent delivery, while older consignments lie in the bin undisturbed.

Average Cost –

As purchase prices change with each new consignment, the average price of components in the bin is constantly changing.  Each component in the bin at any moment is assumed to have been purchased at the average price of all the components in the bin at that moment.

Replacement Cost -

The arbitrary assumption is made that the cost at which the stock unit was purchased is the amount it would cost to replace it.  This is often the unit cost of stocks purchased in the next consignment following the issue of the component to production.  For this reason a method which produces similar results to replacement costs is called NIFO – “next in first out”.

Standard Cost –

A pre-determined standard cost is applied to all stock item.  If this standard price differs from the price actually paid during the period it will be necessary to write off the difference as a variance in the profit and loss account.

The one being detailed in this instance is  Standard Cost:

Standard costs

A standard cost is a cost plan relating to a single cost unit.  It covers all aspects of the cost plan including the planned sales margin and selling price.  Standard costs estimate the costs of production and then are compared to the actual costs. They are used for planning decisions such as pricing and outsourcing as it represents the expected future cost of a product, service, process or subcomponent and serve as a benchmark.  The difference between the actual and standard cost is called a variance. Standard costs are used for control as a form of contract among managers, as once these variances are detected they allow the managers to take corrective action.

Standard costing systems, therefore support the budgetary control process, but unlike budgets, comparisons can be made with standard costs as the firm is producing the goods.  If standards are set for a firm’s direct and indirect costs comparisons can be made with actual and planned results.  Standards can be set for direct  materials, both price and usage, for direct labour and for indirect fixed or variable overheads.  The difference between the goal set and the results achieved can then be analysed and the reason communicated to the relevant departments.  A standard costing system will only be effective in controlling costs if management analyse the reason for the variance.  In itself the variance just shows that a difference has occurred.  It is the analysis of the variance which will reveal the reason for the difference and it is only then that management are able to decide what action to take.  The variance may be adverse, meaning the costs or usage are more than the standard envisaged or less in which case they are referred to as favourable.

Benefits of a Standard Costing System

It is expensive and time consuming to install a system of standard costing and if the costs involved are to be justified the firm must gain the following benefits:

Unit costs should be reduced because of improvements made in controlling costs.

Stock control procedures should be simplified because stock and work in progress can be valued at its standard cost.  This makes stock control easier because stock need not be valued on a LIFO or FIFO basis or any other method such as average cost (these methods were explained earlier).

Price setting should be improved because the firm has accurate details about its costs.

The system highlights variances from standards and so management are able to concentrate on that analysis.  There is therefore no need to spend time analysing costs which are performing to standard and so the system is often said to allow management by exception.

The business can benefit from establishing new working practices by reconsidering working practices before the standards are set.

Setting the standards:

The Chartered Institute of Management Accountants defines four different types of standard.  They are the basic standard, ideal standard, normal standard and the current standard.  It is the management who must decide which is the most appropriate for the business.

Basic Standard

This is defined as a standard established fur use over a long period from which a current standard can be developed.  Such a standard could remain unchanged for a long time but if this is the case, it will be useless as an effective short-term attention directing control tool.  Inflation, competition and new technology have meant that management must adapt to a changing business environment if their company is to survive today’s competitive pressures.  While a basic standard may be of interest to see what extent prices of commodities, goods or services have changed over a period of time, it is ineffective as a meaningful control tool unless coupled to a costly and complicated two-tier standard costing system.  Some company’s set a base standard for long-term comparisons, while at the same time using a current standard for current operational control.

Ideal standard

A standard which can be attained under the most favourable conditions.  Some managers believe that if a standard is set, assuming that all waste and inefficiency have been eliminated from the system, that the actual costs should be the same as the  standard cost.  No allowance is made for human error, machine breakdowns or wastage.  Advocates of such a system believe that the resulting unfavourable variances will remind management of the on-going continual need for improvement in all phases of operations and that there can be no room for complacency within the organisation.

This approach contradicts many behavioural scientists’ views that the setting of such variances is self destructive and dysfunctional since they actually remove motivation, for workers believe that the targets are unrealistic and unachievable.

The use of ideal standards may however be appropriate in new hi-tech factories where highly automated production processes controlled by computers can virtually guarantee continuous high quality output.  In such cases adverse variances are likely to be reduced to levels which are almost immaterial and may be so small as not to need investigating.

Normal Standard

A standard which can be attained if a standard unit of work is carried out efficiently, a machine properly operated or material properly used.  Such a standard makes allowances for normal wastage, machine breakdown or operator failure.  This standard represents future performance and objectives which are reasonably attainable and is sometimes called the attainable standard.  It has the added benefit in that it can be used for other purposes such as budgeting and inventory control.  This is possible because the standard is attainable under normal circumstances and can be legitimately used for other purposes.

The current standard

This is defined as a standard established for the use over a short period of time, related to current conditions.  Many business people use the term current standards for the standard currently set by the firm but this is incorrect.  The current operations standards which are used during the accounting or budgeting period will be the attainable or normal standards; while the current standard is the one used in abnormal operating conditions, as it recognises current problems an works within the present conditions.

Before a standard costing system can be installed it is necessary to build up the costs for each individual component or product.

Cost standards

Every cost consists of a usage component and a price component.  Consequently when planning a cost it is necessary to plan both the usage and the price.  Often it is necessary to plan other factors such as the specification of material, or grade of the labour, or  loss in process.  Such a planned figure is called a “cost standard” which can therefore be defined as a usage, price or other standard upon which a standard cost is based.  It will be against these standards that actual costs are compared.  Each standard must provide a target for achievement, provide a yardstick which can be used to evaluate performance and lastly to highlight the aspects of the business not going to plan.

The diagram shows that the  cost accountant must gather a great deal of detailed information from various sources before the standards can be set.  Once this has been done further information will be required because the standards will have to be reviewed to take account of the firm’s product mix, changes in material and labour costs and productivity improvements.  Setting standards is an on-going process because the standards must reflect the current costs and operating efficiencies.

When setting standards there are three elements and these are materials, labour and overheads and these can be further split:

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