Standard Costing

Standard costing is a system of cost accounting in which products are costed at predetermined standard costs rather than at the actual costs incurred, and the differences between the two, called variances, are measured, recorded and investigated. It combines a set of per-unit standards for materials, labor and overhead with a reporting process that tells managers how much each variance cost the business and who is responsible.

Standard costing developed in the early twentieth century alongside scientific management in American manufacturing, and it remains widespread in industries with repetitive production, such as food processing, chemicals, automotive parts and consumer goods. It is a form of management by exception: managers concentrate on significant variances rather than reviewing every cost.

• Standards are set for the quantity and price of each input per unit of output.
• Inventory accounts, including raw materials, work in process and finished goods, are recorded at standard cost.
• Actual costs are recorded when incurred, and the differences are posted to separate variance accounts.
• Variances are reported to managers, usually monthly, and significant ones are investigated.
• At the period end, variance balances are closed, normally to cost of goods sold, or prorated to inventory and cost of goods sold if they are large.

Each cost element is split into a price effect and a quantity effect. For direct materials:

• $AP$ is the actual price paid per unit of material and $SP$ is the standard price.
• $AQ$ is the actual quantity used, or purchased for the price variance if it is recorded at purchase.
• $SQ$ is the standard quantity allowed for the actual output achieved.

Positive results mean actual cost exceeded standard and the variance is unfavorable; negative results are favorable. Labor uses the same structure as a rate variance and an efficiency variance. Overhead variances are split into spending, efficiency and, for fixed overhead, volume variances.

A paint manufacturer's standard for one can of paint is 2 kilograms of pigment at $3.00 per kilogram. In June it produces 5,000 cans, so the standard quantity allowed is 10,000 kilograms and the standard cost of pigment is $30,000. It actually uses 10,400 kilograms, bought at $2.90 per kilogram, for an actual cost of $30,160.

• Price variance: ($2.90 minus $3.00) times 10,400 is $1,040 favorable.
• Quantity variance: (10,400 minus 10,000) times $3.00 is $1,200 unfavorable.
• Net variance: $160 unfavorable, which equals $30,160 minus $30,000.

The total looks minor, but the breakdown tells a story. Purchasing obtained a lower price, but production used 4 percent more pigment than allowed. Managers might check whether the cheaper pigment was of lower quality, causing extra use. The entry records work in process at the standard $30,000, credits raw materials for the actual cost, and posts the $1,040 favorable variance as a credit and the $1,200 unfavorable variance as a debit to their variance accounts.

Standard costing simplifies bookkeeping, speeds up inventory valuation, supports pricing and budget preparation and links naturally with the flexible budget, which shows what costs should have been at the actual level of output. Variance analysis assigns responsibility clearly: price variances to purchasing, quantity and efficiency variances to production.

Critics argue that standard costing suits stable, labor-intensive mass production better than modern manufacturing. Labor is often a small share of cost today, products change quickly, and focusing on favorable price variances can encourage buying in bulk or buying cheap materials, which conflicts with just-in-time manufacturing and quality goals. Volume variances can encourage overproduction under absorption costing. Many companies have therefore supplemented standard costing with nonfinancial measures, activity-based costing or target costing, while keeping standards for inventory valuation and as part of overall budget variance reporting. For external financial statements, standard costs are acceptable under US GAAP and IFRS only if they approximate actual costs.