A standard cost is a carefully estimated, predetermined cost of producing one unit of output, such as one chair, one liter of paint or one hour of a service. It states what the unit should cost if materials are bought at expected prices, used in expected quantities, and if labor and overhead are used efficiently. Standard costs act as benchmarks: actual costs are compared with them to identify where operations are running better or worse than planned.
Standard costs are a tool of managerial accounting and cost accounting. They are similar to budgets, but a budget usually refers to a total for a department or period, while a standard cost is set per unit. The total budgeted cost of production is effectively the standard cost per unit multiplied by the planned number of units. When a company records inventory and cost of goods sold at standard and analyzes the differences, it is using a standard costing system.
How a standard cost is built
Each element of cost has two parts, a quantity standard and a price standard:
Here the sum runs over each input, is the amount of that input allowed for one unit of output, including normal waste, and is the expected cost of each pound, hour or other measure of input. The three elements are:
- Direct materials: the quantity of each material allowed per unit, times the expected purchase price including freight and less discounts.
- Direct labor: the hours allowed per unit, including normal breaks and setup time, times the expected wage rate including payroll taxes and benefits.
- Manufacturing overhead: the hours of the allocation base allowed per unit, times a predetermined overhead rate calculated from budgeted overhead and budgeted capacity, often split into variable and fixed parts.
Worked example: a standard cost card
A furniture maker sets the following standards for one oak dining chair:
| Element | Standard quantity | Standard price | Standard cost |
|---|---|---|---|
| Oak lumber | 12 board feet | $4.50 per board foot | $54.00 |
| Fabric | 0.75 yards | $16.00 per yard | $12.00 |
| Direct labor | 2.5 hours | $28.00 per hour | $70.00 |
| Variable overhead | 2.5 labor hours | $6.00 per hour | $15.00 |
| Fixed overhead | 2.5 labor hours | $10.00 per hour | $25.00 |
| Total | $176.00 |
If the company plans to make 4,000 chairs next quarter, the standard cost of planned production is $704,000. If actual production costs come in at $731,000 for 4,000 chairs, managers know there is a $27,000 overrun and can analyze whether it came from paying more for oak, using more of it, or spending more labor time than allowed.
Setting standards
Standards may be set as ideal standards, which assume perfect conditions with no waste or downtime, or as practical, also called attainable, standards, which allow for normal spoilage, breaks and machine maintenance. Most companies use practical standards, so that a favorable variance reflects genuinely good performance, and because ideal ones are rarely met and can discourage staff. Standards are developed by engineers, purchasing managers, production supervisors and accountants together, using time and motion studies, supplier quotes and past results. They are usually reviewed at least once a year, or sooner if prices or methods change significantly.
Uses and limitations
Standard costs are used to value inventory and other product costs, set selling prices and quote for jobs, prepare budgets, including the flexible budget, and evaluate performance by managers responsible for purchasing and production. They simplify bookkeeping because every unit of the same product carries the same cost. For external reporting under US GAAP and IFRS, inventory may be carried at standard cost only if the results approximate actual cost, so significant variances must be allocated to inventory and cost of goods sold. Standards can become outdated quickly in environments with volatile prices or frequent product changes, and focusing too narrowly on meeting a standard cost can lead managers to buy cheaper but poorer materials, harming quality.