A standard cost system establishes a predetermined figure that companies expect will represent actual production costs. The two most common standard costs are raw materials and labor. Standard costing comes from historical information based on previous production periods. Variance analysis is also possible when managerial accountants review standard costs to actual production costs. Besides its simplicity, other advantages exist with this system.
Identify Operating Standards
Companies can break down standard costing techniques into one of three groups: ideal, practical or lax. Ideal standards occur when no material waste or equipment inefficiencies occur and managers maximize labor output. Practical standards include a reasonable effort by all employees to produce goods to the best of their ability. Lax standards achieve minimum production output with the least effort. While these standards will typically not bring the most benefit to the company, they do for some production.
Identify Unfavorable Variances
Standard costing techniques help a company measure material and labor variances. For example, the company may expect to produce 1,000 units with standard material costs of $5 and standard labor costs of $9 per unit. Actual production costs, however, are $5.75 for materials and $9.50 for labor costs, resulting in unfavorable variances of 75 cents and 50 cents, respectively. The variances help companies focus on specific areas for implementing corrective measures to improve operating costs.
A common purpose of standard costing techniques is to help a company plan its annual budget. Companies will plan their output for the upcoming year, estimate or calculate the standard costs for materials and labor and present this information to upper-level management or production managers. This provides a roadmap for future production expenditures. This production budget can include more than one set of standards, allowing owners and manager to have planned budgets for ideal, practical and lax standards.
Variances from standard costing techniques are not always unfavorable. For example, an increase in produced units can result in higher individual costs for materials and labor. This results in the economic concept of marginal costs. For each additional unit produced, the company’s costs will go up. However, marginal revenue will also rise, as the company has more units to sell, increasing its marginal revenue. The goal should be achieving production levels where marginal costs equal marginal revenue, resulting in the highest profit.