Costing your goods and/or services:

Setting a standard cost

Setting a standard cost for a cost unit follows much the same procedures as preparing a job cost, except that planned figures are used in lieu of actuals.  For any given cost unit the following standards must be set:

Standard direct material costs -

This calls for setting standard material specifications, the standard usage per unit of each kind of material used, the standard price of these materials and the standard material mix ratios and losses expected (standard yield) if process work is involved.  The price standard will be made up of prices obtained, negotiated and agreed with suppliers.  This agreed price may take into account any future short term increase.  If this applies then the final standard will be based upon the mean of a range prices likely to prevail during the time that the standard is operational.  The standard must also make allowances for normal loss, defective material, storage, deterioration, theft and wastage that may occur during the production process.  This amount should be added to the figure for planned usage.  Lastly for many firms operating in fast moving consumer goods market the packaging forms an important part of the promotional mix and this added cost must be taken into consideration when setting the standard cost.

Standard direct wage costs -

This sets standard labour grades (i.e. the grades of labour to be employed on making the units), the standard labour times per unit of each grade of labour employed and the standard wage rates of those grades.  Most companies set their wage costs after negotiations with the relevant trade union.  With the introduction of set period contracts, this part of the standard setting process has become easier because the labour rate is already known.  However the main problem occurs when calculating the time needed to perform a task as this varies according to worker motivation and level of skill together with the type of machinery used.

If a firm is to control its labour costs the time taken to complete a task should be recorded.  An allowance must be built into the labour cost standard to take account of operator’s fatigue, together with a contingency allowance for reading diagrams and cleaning machinery.  If new products are being made the company should also set a reject allowance to take account of problems brought about by the introduction of new manufacturing processes.  When making these allowances care must be taken that they are set at an equitable level or cost overruns will be incurred which could add between 10 and 15 per cent to total labour costs.

Standard direct expenses –

Sets the unit cost of any direct expenses incurred in producing or selling the units.

It is possible to split the conversion overhead into its fixed and variable components although in practice this is rarely done.

Standard factory overhead costs -

Sets pre-determined rates in respect of the variable and fixed overheads and ten using these rates to compute the variable and fixed overhead costs per unit of production.

Standard factory variable overhead costs -

Involves ascertaining how many units of activity the cost unit uses and multiplying this figure by the variable overhead rate per unit of activity (standard variable overhead rate) taken from the flexible budget.

Standard factory fixed overhead cost –

Setting this cost calls for a standard fixed overhead rate, determined by dividing the budgeted units of activity into the budgeted fixed overhead cost found in the flexible budget.

Standard selling and distribution overhead costs – This is set in the same way as the unit standard manufacturing overhead costs.

Standard selling price and standard sales margin – Finally the planned, standard, unit selling price is set and by deducting from this the total unit standard price, the unit standard sales margin is found.  This is either known as standard profit or standard contribution.

All the above data  should be recorded on a standard cost card which forms a complete record of all the costs standards and standard costs relating to that unit.  It is important for valuing work in progress. Once all the information has been collected and staff have been consulted and involved in the  process the firm’s management can compare actual and standard costs.  This is referred to as a variance analysis.

Costs of using standard costing systems:

Standard cost systems are costly to implement and operate.

Standards must be updated frequently.

Standard cost systems also create incentive problems and are not particularly timely.

Standard costing has been criticised for 2 main reasons – Activity based costing has highlighted how costs change with activity and secondly, target costing, sometimes called Kaizen costing has proved to be very effective in controlling costs in new product design and development.  Kaizen costing seeks to reduce actual costs to below their standard costs and is therefore the exact opposite of standard costing which seeks to ensure that actual costs are the same as standard.  There is a danger that standard costing systems fail to reduce costs in the long-term, thereby depriving the firm of a cost competitive advantage in the market place.

Benefits of using standard costing systems:

Control –

the system provides a yardstick against which actual operations and their costs can be measured.

Efficiency and economy –

the process of setting standards involves examining and stetting down the technical standards of the business.  This can mean establishing the best materials and methods which can lead to greater efficiency, the most economic mixture of materials and methods or both.

Cost consciousness –

The standards provide a common language for talking about cost as well as a target of efficiency that everyone can strive after.

Exception -

Management by exception allows managers to concentrate on those few things that need their attention rather than all the things that are happening according to plan. The variances shown up b standard costing provide those exceptions.

Responsibility –

The different kinds of variance point to the areas where responsibility for them lies – material price being the responsibility of Purchasing, material usage that of Manufacturing, and so on.  Further subdivision, to different production cost centres, for instance clearly defines who is responsible for the exceptions from the expected results.

Policies –

Management policies can be based on standard costs with everyone knowing that the underlying technical standards have been defined objectively.  They can know exactly what has been allowed for and what has not.  This makes decisions based on costs more rational and the costs can be a guide to such actions as price setting.

Simplicity –

Costing procedures can be simpler once price and rate variances have been extracted (and their extraction can be almost automatic).  Stock records do no t involve the same complications that FIFO or Average costs require for calculating issue prices.  When stocks and work in progress have to be valued, standard cost make it simpler.  Monthly accounts can be produced more quickly and even before calculating the variances, knowing the standard profit on actual sales in the period can be a useful guide to performance.

Variance Analysis between budgeted and actual costs:

Variance Analysis

A variance is the difference between planned, budgeted or standard cost and the actual costs or revenues received.  When a variance is worse that the budgeted or standard cost it is said to be adverse and it is an accounting convention that adverse variances are shown in brackets.  If  the costs and revenues are better than the budgeted or standard costs the variance is favourable.

Direct Materials Price Variance

This is defined as the difference between the standard price and the actual purchase price for the actual quantity of the material.  This can be calculated at the time of delivery or at the time of usage.  It is best to calculate whether or not  a variance has occurred when the material is delivered. It is also good accounting practice to write off or add to profit any variance which has occurred at the earliest opportunity.

Formula for Calculating whether or not a variance has occurred

Actual Quantity Purchased x (Standard Price – Actual Price)

Causes of Material Price Variances

In the case of materials, an adverse price variance usually means that a supplier has increased the price of the goods after the standard has been set.  If prices are rising because of inflation there is little the firm can do.  Whenever the purchasing department place a large order with one supplier an attempt should be made to fix a price for the life of the contract.  This may not always be possible due to inability to meet minimum order levels and does not become entitled to discounts.  This type of situation shows standards are predictions and are a measure of forecasting rather than a measure of operating efficiency.

Direct Material usage Variance

This is the difference between the standard quantity specified for the actual production and the actual quantity used, at standard purchase price.  It is calculated using the following formula:

(Standard Quantity specified for actual production – Actual Quantity used) x Standard Price

Causes of Usage Variances

Management should be able to control usage variances because the difference will have taken place within the firm.  Often the variance will  have been brought about by carelessness, e.g. incorrect storage which could lead to spillage o deterioration.  It may also have occurred because of careless usage or the workforce being unskilled or inexperienced in using the material.  Lastly the materials used may have been of poor quality.  This often brings about a high usage variance as many of the units produced will fail to meet the required quality levels and will therefore have to be scrapped.

Direct Labour Variance

This is the difference between the standard direct labour cost and the actual direct labour cost incurred for the production achieved.  By doing this calculation, the hours worked or actually booked to the job can be compared with the actual standard hours produced at the end of the programme of work.  The variance is calculated using the following formula:

(Standard direct labour hours produced x Standard rate per hour)

less

(Actual direct labour hours worked x Actual rate per hour)

Direct Labour Rate Variance

This is defined as the difference between the standard and the actual direct labour rate per hour of the total hours worked/paid.  The variance is calculated by the following formula:

(standard rate per hour – Actual rate per hour) x Actual  hours worked/paid.

Causes of Labour Rate Variances

Labour rate variances need not arise if standards are based on the current union negotiated pay rates.  Sometimes the standards are set before the pay rates have been negotiated and so it is important for management to identify the difference between the standard rate and the agreed settled rate.  If this is not the case other causes must be investigated.  Temporary labour may also have been used and they may have been paid a t a different rate.  Lastly, special allowances may have been paid to staff for overtime etc which will effectively increase the hourly rate.

Direct Labour Efficiency Variance

This is the difference between the standard hours for the actual production achieved and the hours actually worked, valued at the standard labour rate.  It is calculated by the formula:

(Standard hours produced – actual hours worked) x Standard rate per hour.

Causes of Efficiency Variances

Inadequate training may be responsible for the variance.  If the workers are inexperienced they usually take longer to do the job or there may be quality problems resulting in more rejects being produced.  The cause could also be due to poor quality materials being purchased because the usual source is temporarily out of stock.

Overhead Variances

The variable overheads will be activity related whereas the fixed overheads will be time related.  An overhead expenditure variance is defined as the difference between budgeted and actual overhead expenditure.

Fixed overheads are calculated using the following formula:

Fixed overhead budgeted cost – Actual conversion overhead incurred.

Variable overheads are calculated as follows:

(Actual units produced x variable overhead absorption rate per unit) less actual stock.