Standard Cost System: Introduction
Standard costs are set (target) costs expected to be incurred when a company operates under efficient conditions (Drury, 2008). The main function of standard costing is to eliminate wastage of resources during operation and increasing efficiency during operation. Standard costing is generally best applied to companies whose activities are simple and repetitive (Drury, 2008). In view of this fact, it is thus important to analyze the applicability of standard costing in the modern world that is characterized by globalization, changes in product lifecycles and changes in consumer spending.
Importance of Standard Costing & Reasons for Setting Up
Costing involves the identification and recording the monetary value of all the resources involved in the production process. The first objective of costing is to determine the resources used to produce the final goods and services (Cheatham & Cheatham, 1993). Costing also acts as a management tool as it provides economic feedback while at the same time offers important cost information that is ultimately used to manage cost and the activities within the organization.
The management in a company use costing systems to identify the operation costs and the performance costs. Costing systems mainly provide data for operation costs which offer management a list of all expenditure connected to a given operation within the company. Costing systems also return information about performance costs. Here managers are able to understand the expenditures that affect the company’s profitability (Horngren & Foster, 1991). Activities which do not contribute much to the total profits can be removed and alternative activities implemented.
Standard Costing System
According to CIMA, the standard cost has been defined as a predetermined cost derived from management benchmarks of proficient operations and the expenditures that are necessary and relevant to a given operation. The standards are set from the company’s past experience and the total standard cost comprises those of direct materials and labour in addition to overheads. In order to gauge on the performance of a given operation, the standard cost is compared to the actual cost. The difference between the standard cost and the actual cost is referred to as variance and is useful in the identification of inefficiencies within a given operation (Cheatham & Cheatham, 1996).
In order to effectively analyze the applicability of standard cost, it is important to understand how the standards are set. We first consider setting standards for direct materials. In setting up standards for direct materials, we consider several issues; quality, quantity and price of the material. The quality standards to be maintained for a given product are decided and set. The production department then sets up the quantity standards. Historical records and projection for future market conditions act as a guide for setting the quantity standards. The final aspect involves the determination of the standard price. The material cost is comprised of the cost of purchasing, storage, discount policy and transportation of the materials.
We next consider the setting of direct labour costs. In any organization, the second-largest amount of cost is usually the labour costs (Oliverio & Newman, 2009)). The first step in this process is the identification of the benefits derived from the workers and assigning it to a specific product or process. The time for the production of a given product is established and the labor is appropriately graded. Different labor grades receive different wages and the time taken to produce a given product by the different grades of workers is studied in order to establish the final direct labor cost. The standards for direct labor cost will thus rely upon the standard labor time for production and the hourly labor rates.
The last element is that of overheads. Setting standards for overheads is done mainly to reduce the total cost. The standard overhead rates are derived by dividing the overhead expenses by labor hours or units manufactured. It is important to recognize that overheads are divided into fixed, variable and semi-variable overheads. Fixed overheads remain unchanged irrespective of the production level. Variable overheads change in accordance to the change in production levels i.e. the expenses change in direct relation to the output produced.
Having set the standards for direct materials, direct labor and overhead costs it is the possible to calculate the variances. The variances are the differences that arise between the set standard cost and the actual cost incurred (Harrell, 1992). In standard costing, two variances are mainly considered and they are the price and quantity variances. The price variance is the difference between the actual price of a product and the standard price. The quantity variance is the difference between the standard quantity set to be produced and the actual quantity produced from an operation. When the standard cost exceed the actual cost, the variance is favorable hence objectives have been met but when they are lower than the actual cost then the variance is unfavorable meaning something is wrong with the production process and appropriate actions should be taken to rectify this condition.
Companies That Use Standard Costing in the Modern World
Many years have passed since the introduction of the standard costing technique. In the modern world, companies operate on a global scale. There is increased competition nowadays with the products being demanded not only provided by local suppliers but also by foreign companies. Looking at the American market, the exports in 1983 were $352.5 billion compared to the imports valued at $358.7 billion (Cheatham & Cheatham, 1996).
This was the first time that the U.S. had a negative balance and this has continued to vary since then. The negative balance at the time was blamed at the cheaper goods supplied by the foreign competitors. Some of the factors established for the lower costs were; cheaper labor, better automation systems and less diversity of products. In the modern market, it is thus imperative for companies to use a cost accounting system that enable them operate effectively in the global market.
Many companies have adapted their operations to enable them operate in the global market and one notable change is automation. Standard costing puts a major emphasis on direct labor cost but since automation has drastically reduced this value, standard costing cannot accurately help in the control process. In standard costing systems efficiency and labor quantity standards assume the speed of laborers influence the output. This is however no longer the case as machines have replaced people and the output is dependent on their speed. Another assumption is that labor is a variable cost but this may not be the case. In some case direct labor is fixed hence reliance on labor efficiency variances forces managers to build numerous inventories mainly finished goods and work in process inventories.
Another section where standard costing lacks is in quality control. Globalization has resulted in companies putting much importance on the quality of their products. Standard costing mainly centers on price control and efficiency but no emphasis on quality is provided. Companies in the global market cannot effectively use standard cost accounting due to this major drawback (Cheatham &Cheatham, 1996).
Another change that has arisen in the modern world is that products have shorter lifecycles. Due to changes in consumer tastes and new technologies, most products become obsolete after a very short time in the market. Products such as personal computers and mobile phones are a very good example of products that change continuously in the market. Standard costing involves setting up of predetermined cost and thus continually changing products cannot be effectively controlled using this method. With new technologies, new raw materials are continually being integrated into the market (Drury 2008). This proves to be a problem with companies using standard costing as the price standards being used are set from historical records hence cannot account for raw materials that have never been used before.
Due to increase in wealth the consumer habits have changed a lot. In the modern world, consumers buy products that appeal to their taste. Companies are required to produce non-standard products that can cater to the taste of every potential customer. Companies in the modern market have to balance between cost and quality. Diversification of products has become a necessity but producing products that are expensive may adversely affect the company. Production of diverse products means that different expenditures will be encountered thus limiting the use of standard costing.
In order to be more effective, companies operating in the modern market need to focus on the future. There is need for companies to focus on continuous improvement of their products and operations. Although standards are usually revised, they are not done frequent enough to enable continuous improvement (Cheatham & Cheatham, 1996). Standard costing mainly relies on static values hence not suitable for companies that seek to continuously change their tactics of operation.
The 21st century has been characterized by companies engaging in researches to improve their operations. Standard costing system mainly concentrates on the manufacturing phase of a product’s lifecycle. It neglects other cost that occur before and after manufacturing. Cost incurred before manufacturing included those of research and development. These are very crucial especially in the modern world. Costs that are incurred after manufacturing are those for marketing of the product (Kaplan & Bruns, 1987). Using standard costing systems limit the control of these costs hence inappropriate to modern manufacturing companies.
Modern companies mainly pay their workers on a “set-piece” basis instead of hourly rates. Set-piece basis is where workers are paid depending on completion of a given task or product component. Standard costing mainly relies on hourly rates hence this change may prove difficult to integrate into the system (Mclean, 2006). Another issue that may discourage the use of standard costing is where variance reports are use to control worker’s effectiveness. Managers are charged with the duty of punishing workers hence when variance reports are used for this purpose, workers may take actions to hide unfavorable variances for example workers may engage in a crash effort to ensure the outputs are high at the end of the month which may result in low quality products (Horngren & Foster, 1991).
The points discussed above have highlighted the changes in the modern world that challenge the standard costing system. It has however been noted that standard costing is alive and well and is being used in many companies throughout the world. In their Article “Standard Costing is Alive and Well” Johnsen and Sopariwala (2000) discuss the applicability of standard costing in the current fast paced economy.
In order for standard costing to be effective in the modern economy it has to be revised to meet the market demands. One of the important changes that can be applied to traditional standard costing is periodic provision of product cost information (Fleischman & Tyson, 1998). The tradition standard costing system mainly relied on monthly based information but for application in the new economy, changes in the product cost have to be researched and updated regularly.
Another change that may enable usage of the standard costing system is empowerment and training of employees. It is necessary for employees to understand what standard costing is and how they can help the company meet its set standards (Broadbent & Cullen, 2003).
Another method that has been proposed for the improvement of the standard costing system is the updating of the variances used in the system (Drury, 2008). Various new variances have been proposed with the aim of ensuring the standard costing system reflects the new economy. Raw material ordering variance has been proposed to enable managers gauge their suppliers’ effectiveness (Harrell, 1992). In the past, the price variance has been criticized for putting too much emphasis on price while neglecting quality. For this purpose a quality variance has been proposed.
In looking at the production level and quality, production variance which shows the difference between what is produced and the actual sales order has been suggested (Drury, 1999). Apart from this another useful variance is the finished goods and sales variance. This two variances measure the opportunity cost by utilizing the budget contribution margin. The finished goods variance portrays the opportunity cost associated with manufactured goods not shipped (Norton, 1999).
Most companies still using the standard costing system have proposed the addition of the method variance into the system. The method variance looks at the usage of machines and how to effectively maximize the output received from a given automated system.
Another suggestion that has presented is the consideration of continuous improvement in the alteration of standard costing system (Cheatham & Cheatham, 1993). Suggestion include using the result from the prior period as a standard, setting up of benchmarks and periodically modifying them, utilizing moving cost reductions and finally target costing.
In view to these possible changes, it is thus evident that the standard costing system is still applicable and it is upon the management of a company to institute appropriate changes to the system so as it fits with the company’s operation. Many suggestions have been offered on appropriate changes and possible modifications on the traditional standard costing system and thus as the economy changes the system should also change to reflect the new economy.
Standard Costing: Conclusion
Standard costing involves setting up of benchmarks that specify the expected cost of products manufactured by a company. The standard costing system was developed in the early 1900’s and has been used as a means of control by many companies. The system generally works best in companies whose production functions are simple and repetitive e.g. manufacturing companies. The world has undergone tremendous changes since the system was first introduced mainly in the technology sector. Other changes that have occurred in the modern economy are globalization, shorter product lifecycle and a change in consumer behavior. Due to these changes, standard costing is under scrutiny on its applicability in the current economy.
The article has analyzed these market factors and the shortcomings of the standard costing system as a control tool when considering these new changes. However, various methods have been presented on how standard costing system can be modified to meet all requirements of control. One major drawback of standard costing systems was discovered to be that it neglected quality control which has become very important as a result of competing in the global market.
For this reason new variances have been proposed that aim to cover quality control, continuous control and control of automated activities. Apart from this, another proposal is changing the organization culture of a company by educating the laborers on the importance of the system and also ensuring managers collect information more frequently than the one month usually set in the standard costing method.
Looking at the list of problems and the proposed changes one can thus conclude that the standard costing system cannot effective operate in the modern economy as it is but can be modified to portray the actual market factors present in the new economy. Standard economy is neither dead nor obsolete it is just outdated and only requires modification to function effectively.
Personal Reflections on Standard Cost System
Writing this paper presented many challenges despite the numerous materials on the subject. Despite this, I had a lot of fun researching and writing this paper. The subject was a little intimidating hence I had to collect a lot of materials to help me understand the requirements better. This however proved very frustrating as many of the materials present could not really answer the underlying question of applicability into the modern world.
The first problem I tackled was finding a correct definition of standard costing and learning how it was instituted. With this knowledge it was easy to understand the shortcomings of the system especially considering the current economic conditions. Although the economy is just recovering it is very easy to see how using inadequate costing systems can affect a company. A costing system is mainly used for control hence if it does not reflect existing conditions no control can be instituted.
While writing this paper, I have learnt a lot about the standard costing system. The use of variances and setting up of the respective standards were the most challenging but as I progressed with my research I came to understand them better. I also had a chance to figure out more about the economic system with which most manufacturing companies operate and the factors that make or break companies. In choosing the final stance it was very interesting to learn that most objections raised about the system was because it had been used since the 1900’s without being revised. This is ridiculous since it is obvious that we cannot apply an outdated model to a period that has undergone so many changes.
Application of Standard Costing
The application of standard costing is a widely used managerial accounting technique that helps businesses set predetermined cost and performance benchmarks for their products or services. By comparing actual costs to these predetermined standards, organizations can identify areas of inefficiency, improve cost control, and make more informed decisions. Standard costing facilitates variance analysis, allowing managers to pinpoint deviations from expected costs and investigate the underlying causes. This information enables better resource allocation, cost optimization, and the identification of areas for process improvement, ultimately leading to enhanced operational efficiency and profitability for the company.
References
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