Standard Costing – Meaning | Types | Variance Analysis

Standard Costing is a cost control technique in which predetermined costs, known as standard costs, are established for materials, labour and overheads, and then compared with actual costs incurred to identify variances. It helps management analyse deviations, improve efficiency, control costs and take corrective action through the principle of management by exception.

1. Important Definitions
2. Other Important Concepts
3. Types of Standards
4. Standard Costing and Budgetary Control

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1. Important Definitions

Standard Cost – CIMA Official Terminology defines standard cost as planned unit cost of a product, component or service.

Standard Costing – CIMA Official Terminology standard costing is a control technique that reports variances by comparing actual costs to pre-set standards so facilitating action through management by exception.

Management by Exception – CIMA Official Terminology1 defines management by exception as ‘the practice of concentrating on activities that require attention and ignoring those which appear to be conforming to expectations. Typically, standard cost variances or variances from budget are used to identify those activities that require attention.’

Variance – CIMA Official Terminology defines Variance as the difference between a planned, budgeted, or standard cost and the actual cost incurred. The same comparisons may be made for revenues.

Variances are, as such, are either:

• Favourable – A favourable variance is achieved when the actual performance is better than the expected results.
• Adverse – An adverse variance is achieved when the actual performance is worse than the expected results.

Variance Analysis – CIMA Official Terminology defines Variance analysis as the evaluation of performance by means of variances, whose timely reporting should maximise the opportunity for managerial action.

2. Other Important Concepts

2.1 The Advantages of Standard Costing

1. Carefully planned standards aids the budgeting process.
2. Standard costs provide a yardstick against which actual costs can be measured.
3. The setting of standards involves determining the best materials and methods which may lead to cost economies.
4. A target of efficiency is set for employees to reach and cost consciousness is stimulated.
5. Variances can be calculated which enable the principle of ‘management by exception’ to be operated.
6. Only the variances which exceed acceptable tolerance limits need to be investigated by management with a view to control action.
7. Standard costs simplify the process of bookkeeping in cost accounting, because they are easier to use than LIFO, FIFO and weighted average costs.
8. Standard times simplify the process of production scheduling.
9. Standard performance levels might provide an incentive for individuals to achieve targets for themselves at work.

3. Types of Standards

3.1 Ideal Standard

Some companies set their standards at the maximum degree of efficiency. Using such an ideal standard, they determine costs by considering estimated materials, labour, and overhead costs; the condition of the factory and machinery; and time for rest periods, holidays, and vacations—but make no allowances for inefficient conditions such as lost time, waste, or spoilage. This ideal standard can be achieved only under the most efficient operating conditions; therefore, it is practically unattainable, generally giving rise to unfavourable variances.

3.2 Attainable Standards

From the potential problems of the ideal standard as discussed in the previous paragraph most companies set attainable standards that include such factors as lost time and normal waste and spoilage. These companies realise that some inefficiencies cannot be completely eliminated, so they design standards that can be met or even bettered in efficient production situations.

Criticisms of Standard Costing

1. The use of standard costing relies on the existence of repetitive operations and relatively homogeneous output. Nowadays many organisations are forced continually to respond to customers’ changing requirements, with the result that output and operations are not so repetitive.
2. Standard costing systems were developed when the business environment was more stable and less prone to change. The current business environment is more dynamic and it is not possible to assume stable conditions.
3. Standard costing systems assume that performance to standard is acceptable. Today’s business environment is more focused on continuous improvement.
4. Standard costing was developed in an environment of predominantly mass production and repetitive assembly work. It is not particularly useful in today’s growing service sector of the economy.

Use of Standard Costing

1. Even when output is not standardised, it may be possible to identify a number of standard components and activities whose costs may be controlled effectively by the setting of standard costs and identification of variances.
2. The use of computer power enables standards to be updated rapidly and more frequently, so that they remain useful for the purposes of control by comparison.
3. The use of ideal standards and more demanding performance levels can combine the benefits of continuous improvement and standard costing control.
4. Standard costing can be applied in service industries, where a measurable cost unit can be established.

4. Standard Costing and Budgetary Control

Budgetary control and standard costing have the common objective of cost
control by establishing predetermined targets. These two techniques are similar in certain respects but differ in respect of other points.

Budgetary Control is a system of planning and controlling costs. It involves the establishment of budgets, measurement of actual performance, comparison of actual performance with budgeted performance to develop the deviations and the analysis of the causes of variations for taking appropriate remedial steps.

4.1 Points of Similarity Between Standard Costing and Budgetary Control

1. The establishment of predetermined targets of performance.
2. The measurement of actual performance.
3. The comparison of actual performance with the predetermined targets to find out variations, if any.
4. Analysis of variations between actual and predetermined performance.
5. To take remedial action, where necessary.

4.2 Conceptual Difference Between Standard Costing and Budgetary Control

1. Budgetary control deals with the operation of a department or business as a whole while standard costing mainly applies to manufacturing of a product or providing a service. As such budgetary control system is more extensive as it relates to the operations of the business as a whole and covers capital, sales and financial expenses in addition to production. But standard costing is more intensive and is concerned with controlling amount involved in various elements of cost.
2. Standard costing can be adopted in a business without any particular policy. Sole object of standard costing is to maximise efficiency in operation by determining standard costs before the start of operations. But in case of budgetary control, it is necessary to lay down the objective or the policy of the firm for the period for which budgets are being laid down.
3. Budgetary control is exercised by putting the budgets and actuals side by side. Variances are not revealed through the accounts. Under the Standard Costing system, actuals are recorded in accounts and the variances are revealed through different accounts.
4. Budgetary control system can be employed in parts such as budget for cash, selling and distribution expenses, research and development expenses, but partial application of standard costing system is not possible.