Standard costing is a particular managerial accounting process for calculating product costs. In many cases, it focuses solely on manufacturing overhead. Companies will review budgets to determine the expected costs needed to produce goods. Variances occur when standard and actual costs do not match. Left unchecked, standard costing can distort the income statement and balance sheet.
Accountants will review their company’s past historical performance for producing goods. Costs associated with direct materials, direct labor and manufacturing overhead will lay the foundation for the production budget. Average costs for each of these items are the total expected costs for an upcoming period. Accountants divide this figure by expected production to determine the standard production cost. The general ledger retains the standard cost as total production costs.
Failing to adjust the standard cost for production variances affects the income statement’s cost of goods sold account. Companies can either overstate or understate cost of goods sold. For example, when standard costs are higher than actual costs, cost of goods is higher than normal and profit is lower than normal. Actual costs that are lower than standard costs have the opposite effect, understating cost of goods sold and reporting higher profit.
Ending inventory directly relates to errors in the standard costing process. Similar to cost of goods sold, ending inventory reported on the balance sheet can have overstatements or understatements. Standard costs lower than actual costs result in understated ending inventory. Standard costs higher than actual costs result in overstated ending inventory.
Corrections are necessary to account for production variances. Accountants compare standard costs to actual costs and the end of a production period. The difference between the two needs adjusting to correctly report ending inventory. Accountants can expense small production difference by posting them into cost of goods sold. This is the most common adjustment to standard cost accounting processes.