A standard costing system is a common way to budget for planned projects, managing costs in a production run and evaluating those costs after the production has finished. This system has the benefit of giving a business hard numbers to use when creating estimates for customers. However, there are problems associated with standard costing, especially when a business is new and has no history from which to base its estimates or when a company is beginning a new production process.
Before an accounting period has started, estimate the costs of a planned production process. Determine the amount of materials required and their cost as well as the amount of labor required and that cost. This can be broken down into three costs:
- Standard direct materials costs multiplied by standard quantity of those materials
- Standard direct labor costs multiplied by standard hours worked
- Standard overhead costs, including fixed costs and labor
To estimate standard costs before a production begins, you can use the past costs of similar production runs, engineering estimates, employee input and motion studies.
Suppose you run a T-shirt printing business and a client asks for 1,000 shirts of a specific quantity to be printed with three colors. You could develop a standard cost based on the costs of the shirts and ink, the cost of labor and the amount of time required to process and print the shirts. If this is your first production run for a new company, you would have to contact wholesalers to get estimates for the material costs. To estimate labor costs, you would have to rely on your own experience and the experience of your employees. To calculate overhead costs, like the cost of your equipment lease, building lease and other monthly expenses, you could divide those costs to get the daily rate and then multiply that daily rate by the number of days you estimate the project to take.
The chief advantage of using a standard costing system is that it gives you a starting point for estimating costs even when you have no past experience to give you those numbers. Once production begins, these standard costs become the benchmark for controlling your costs and making management decisions about the production process. For example, if you underestimated material costs, you may need to restrict your workers from working overtime in order to keep the overall costs down.
The primary disadvantage of standard costing is that it can be time consuming to calculate and update over the course of a production cycle. The more time consuming it is, the more expensive it is.
The standard costing system is only as precise as the estimates you use to determine them. This is why it's important to review your costing system regularly. The more experience you have with similar projects, the more precise your standard costs will be. Estimating the costs of producing 1,000 T-shirts, for example, will be much easier if you had completed a similar production of 500 T-shirts last year and even more precise if you did the exact same order using the same materials for another customer only a month ago.
Even the components of your standard costs will become more precise over time. Once a new business has calculated its monthly overhead costs, calculating the costs for future projects will simply be a matter of plugging those numbers into the cost estimates. Developing relationships with suppliers and your employees and understanding how efficiently your employees work will also make estimating costs faster and more efficient.
Of course, if there is any change in your production process, like purchasing materials from a different supplier or training new employees, you should make adjustments to your standard costing model.