Step-by-step guide on standard costing
Step 1: Identify Cost
Components
First, you need to identify the
cost components relevant to your business or manufacturing process. Common cost
components include direct materials, direct labor, and manufacturing overhead.
Step 2: Set Standard Costs
Once you've identified the cost
components, set standard costs for each one. Standard costs represent the
expected or budgeted costs for producing one unit of the product. These costs
can be based on historical data, engineering estimates, or industry benchmarks.
Standard Cost for Direct Materials:
This includes the cost of raw materials required to produce one unit of the
product.
Standard Cost for Direct Labor:
This is the cost of labor required to produce one unit of the product, based on
standard time and wage rates.
Standard Cost for Manufacturing
Overhead: This includes the estimated overhead costs (e.g., factory rent,
utilities, equipment depreciation) allocated to one unit of the product.
Step 3: Calculate Standard
Cost per Unit
Next, calculate the total
standard cost per unit by adding the standard costs for direct materials,
direct labor, and manufacturing overhead.
Total Standard Cost per Unit =
Standard Cost of Direct Materials + Standard Cost of Direct Labor + Standard
Cost of Manufacturing Overhead
Step 4: Prepare the Production
Budget
Using the standard cost per unit,
prepare the production budget. This budget will show the number of units to be
produced during a specific period.
Step 5: Record Actual Costs
As the production process takes
place, record the actual costs incurred for direct materials, direct labor, and
manufacturing overhead.
Step 6: Calculate Variances
Compare the actual costs to the
standard costs to calculate the cost variances. There are several types of
variances depending upon nature of organization. Some of the followings are:
1. Material
Price Variance: The difference between the actual cost of materials purchased
and the standard cost of materials used in production.
2. Material
Usage Variance: The difference between the actual quantity of materials used
and the standard quantity of materials required for production.
3. Labor
Rate Variance: The difference between the actual labor rate paid and the
standard labor rate per hour.
4. Labor
Efficiency Variance: The difference between the actual labor hours worked and
the standard labor hours allowed for production.
5. Overhead
Variance: The difference between the actual overhead costs incurred and the
standard overhead costs applied based on production levels.
6. Variable
Overhead Variance: This variance compares the actual variable overhead costs
incurred during production to the standard variable overhead costs expected
based on the level of activity (e.g., machine hours, direct labor hours).
7. Fixed
Overhead Variance: The fixed overhead variance compares the actual fixed
overhead costs incurred to the standard fixed overhead costs expected based on
the level of activity. This variance helps analyze how well the business is
managing its fixed overhead expenses.
8. Sales
Price Variance: In situations where standard costing is also used for pricing
decisions, this variance compares the actual selling price per unit to the
standard selling price per unit.
9. Sales
Volume Variance: This variance analyzes the difference between the actual
number of units sold and the budgeted (standard) number of units expected to be
sold, taking into account the standard contribution margin per unit.
10. Mix
Variance: If a company produces and sells multiple products with different
profit margins, this variance compares the actual sales mix (the proportion of
different products sold) to the standard sales mix.
11. Yield
Variance: Relevant in industries where products might have some inevitable
waste or by-products, the yield variance compares the actual yield (output)
achieved during production to the standard yield expected.
12. Subcontract
Variance: If the company has subcontracted some work, this variance compares
the actual cost of subcontracting to the standard cost expected for that work.
13. Efficiency
Variance: This variance compares the actual quantity of inputs (like raw
materials) used in production to the standard quantity of inputs required for
the actual level of output achieved.
14. Rate
Variance (Overhead): In addition to labor rate variance, this variance applies
to overhead costs and compares the actual overhead rate to the standard
overhead rate.
Step 7: Analyze Variances
Analyze the cost variances to
determine the reasons behind the differences between actual and standard costs.
Variances may result from factors such as price changes, production
inefficiencies, or changes in the business environment.
Step 8: Take Corrective
Actions
Based on the variance analysis,
take appropriate corrective actions to improve future performance. For example,
if material usage variance is unfavorable, it might indicate inefficiencies in
the production process that need to be addressed.
Step 9: Revise Standards (if
necessary)
Regularly review and update the
standard costs to reflect changes in the business environment, cost structures,
or improvements in production processes.
Standard costing provides
valuable insights into a company's performance and can help identify areas for
improvement and cost reduction. By regularly monitoring variances and taking
corrective actions, businesses can enhance their overall cost efficiency and
profitability.
Please note that when identifying
cost components in Step 1 of standard costing, it's essential to consider
various factors that can affect the accuracy and relevance of the standard
costs. Here are some key factors to be careful about:
1. Direct
vs. Indirect Costs: Distinguish between direct costs and indirect costs. Direct
costs can be directly traced to a specific product or cost object, while
indirect costs are incurred to support multiple products or operations. Ensure
that you appropriately allocate direct and indirect costs to the relevant cost
components.
2. Material
Specifications: Specify the quality and quantity of materials required for each
unit of the product. Accurate material specifications are essential for setting
appropriate standard costs and ensuring product quality.
3. Labor
Time and Skill Levels: Determine the standard time required to produce one unit
of the product. Consider the skill levels and efficiency of the labor force
when setting the standard labor cost per unit.
4. Production
Process Complexity: The complexity of the production process can influence the
cost components. Complex manufacturing processes may involve more cost
components that need to be carefully identified and managed.
5. Overhead
Allocation: Allocate overhead costs to the relevant cost components using an
appropriate allocation basis. Common allocation bases include direct labor
hours, machine hours, or activity-based costing techniques.
6. Volume
and Economies of Scale: Consider the impact of production volume on the cost
components. Economies of scale may result in reduced costs per unit at higher
production volumes, affecting the standard costs.
7. Seasonality
and External Factors: Take into account any seasonality or external factors
that may affect the availability and cost of materials, labor, or overhead.
8. Cost
Behavior: Understand the behavior of costs (e.g., fixed, variable,
semi-variable) and incorporate this knowledge into setting standard costs.
9. Historical
Data and Benchmarking: Utilize historical cost data and benchmarking against
industry standards to set realistic and competitive standard costs.
10. Cost
Changes and Updates: Regularly review and update standard costs to reflect
changes in the business environment, supplier prices, labor rates, or
technological advancements.
11. Management
Objectives: Align the standard costs with management's objectives, whether they
aim for cost leadership or focus on premium quality products.
12. Legal
and Regulatory Considerations: Ensure compliance with relevant laws and
regulations that may impact cost components, such as labor laws, environmental
regulations, and safety standards.
13. Currency
Fluctuations (for International Operations): For companies operating across
different countries, consider currency fluctuations that may impact the costs
of imported materials or exported products.
By carefully considering these
factors, companies can develop more accurate and meaningful standard costs,
providing a solid foundation for effective cost control and decision-making
within the organization. Regular review and refinement of the standard costs
help businesses maintain relevance and improve cost management over time.
Let’s take an example
For a chair manufacturing company
in India, the cost components may include:
1. Direct
Materials:
Wood: The main material used to
construct the chair frame and legs. Standard Cost: ₹150 per chair
Upholstery Fabric: Used for the
chair seat and back cushion. Standard Cost: ₹100 per chair
Nails, Screws, and Glue:
Fasteners and adhesives used in assembling the chair. Standard Cost: ₹30 per
chair
2. Direct
Labor:
Carpenter's Labor: The labor cost
of skilled carpenters who construct the chair frame and legs. Standard Cost:
₹200 per chair
Upholsterer's Labor: The labor
cost of skilled upholsterers who assemble the chair's cushion and fabric.
Standard Cost: ₹120 per chair
3. Manufacturing
Overhead:
a)
Factory Rent: The portion of the rent expense
allocated to each chair produced. Standard Cost: ₹50 per chair
b)
Factory Utilities: The cost of electricity,
water, and heating used during production. Standard Cost: ₹40 per chair
c)
Depreciation of Machinery: The depreciation
expense of machinery used in the production process. Standard Cost: ₹80 per
chair
The total standard cost per chair
in INR would be the sum of the standard costs for direct materials, direct
labor, and manufacturing overhead:
Total Standard Cost per Chair =
(Standard Cost of Wood + Standard Cost of Upholstery Fabric + Standard Cost of
Nails, Screws, and Glue) + (Standard Cost of Carpenter's Labor + Standard Cost
of Upholsterer's Labor) + (Standard Cost of Factory Rent + Standard Cost of
Factory Utilities + Standard Cost of Depreciation of Machinery)
Total Standard Cost per Chair =
(₹150 + ₹100 + ₹30) + (₹200 + ₹120) + (₹50 + ₹40 + ₹80) = ₹870 per chair
The total standard cost per chair
is ₹870, and this serves as a benchmark for cost control and performance
evaluation during the manufacturing process in the Indian context. The company
will compare actual costs in INR to these standard costs to identify cost
variances and take appropriate actions to manage costs effectively.
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