Page 715 - Encyclopedia of Business and Finance

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Standard Costing

level of discipline expected is seriously undermined. If material, they will consider the wrapping used for the
standards cannot be achieved with reasonable effort, cooked hamburger an indirect material. Such a chain’s
workers may become discouraged and become so indiffer- controller’s office has determined the material costs that
ent that their work quality deteriorates significantly. If cannot be directly tied to each unit and/or those material
standards are too easy to achieve, there may be an unnec- costs which individually are not significant for direct
essary waste of resources. tracing. This collection of material costs is then analyzed
Standard costing has applications to any type of busi- to determine the most appropriate basis for allocating to
ness activity. The process described briefly above can be the goods produced.
applied, for example, for processing documents in an Standards are developed for fixed overhead costs, too.
insurance company or in a financial services business, as Fixed costs are costs incurred in production that are not a
well as in manufacturing firms. function of volume produced. Though in the long run all
costs can vary, fixed costs are costs that do not change as
MONITORING STANDARD COSTS activity levels change.
Standard costs are monitored as a basis for determining
the extent to which expectations are realized. Before the A REVIEW OF ACTUAL RESULTS
widespread use of computer-based systems, typical report- Companies have policies about the level of variance that is
ing was done weekly or monthly. In contemporary com- to be investigated. Some variation from expectations is
panies, it is not uncommon for a company with factories allowed, and if standards are realistic, much of the varia-
or stores to monitor on a daily basis their resource usage, tion is eliminated over the period of a year; insignificant
thereby allowing modifications, if judged necessary, to be favorable variances cancel out insignificant unfavorable
introduced promptly. Computer-integrated production variances. Companies monitor the extent to which stan-
methods, for example, allow for maintaining both the dards appear to be reasonable by assessing the end-of-year
actual cost/usage and the standard cost/usage figures in balances in variance accounts.
the records maintained.
Variances that are determined to be significant are
A commonly used method is to determine the differ- investigated. Careful observation and discussion with
ence between what was allowed by standard costs, which those workers involved in producing the output that led
are the budget allowances, and what was actually spent for to a significant variance will aid in determining an expla-
the output achieved. This difference is called a variance. nation. The explanation is the basis for considering what
For example, assume that the factory producing personal changes need to be made.
computers completed 10,000 computers where the stan- In an objective review of observations and discus-
dard usage of one type of metal, as a direct material, was sions, questions may arise as to the appropriateness of a
2 pounds per computer, or 20,000 pounds. The actual
standard, if the actual result is unreasonably different from
usage of the output achieved, 10,000 units, was 20,430 the standard. There may need to be a reconsideration of
pounds. Since actual usage of the direct material was the earlier analyses that were the basis for the standards
greater than the standard allowed, the excess usage is used in the budget followed by operational personnel.
called an unfavorable variance, or 430 pounds unfavor-
able. The monetary cost of this variance is then deter- For an organization to gain optimum value from
mined: The variance in units is multiplied by standard standard costing, all employees involved must under-
cost per unit for the metal. Therefore, if the standard cost stand the motivation for such costing and also under-
for the metal was $2.95 per pound, the variance would be stand the assessment that will be made. Imposing
reported as $1,268.50 unfavorable (430 pounds ¥ $2.95, standard costs without communicating in an honest,
the standard price). candid manner will undermine much of the perceived
value of such costing.
What has been described for a direct material is the
process that is used for each component of production.
Resources monitored include, in addition to direct mate- CONTEMPORARY DEVELOPMENTS
rial and direct labor, variable factory overhead and fixed An Ernst & Young survey in 2003 found that 76 percent
factory overhead. Both standard usage of resources and of U.S. manufacturing companies reported that they used
standard costs for each are established and monitored. standard costs. Developments in the global business
The process for variable overhead is somewhat more world, however, are influencing many companies to make
complex because the components of variable overhead are changes. For example, in the twelfth edition of a popular
multiple indirect resources that are related to volume of German textbook, Flexible Plankostenrechnung und Deck-
production processed. For example, while a chain of fast ungsbeitragsrechnung (Flexible plan cost accounting and
food restaurants may consider ground beef as a direct contribution margin accounting), a cost system that is

692 ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION