What is Standard Costing & It's Meaning Explained with Examples

A budget significantly influences a business's efficiency, production, and profits. In this regard, standard costing is a valuable accounting method that aids in creating precise budgets for manufacturers. However, since it takes a lot of effort to gather information about actual costs, standard costs are used as the principal justification for standard cost accounting.

To learn more about this costing, keep reading till the end.

Standard Cost Accounting is also known as Standard Costing. It is a type of cost accounting that employs fixed costs for overhead, materials, and labour to calculate the prices of goods and services. The cost of products is often calculated using established rates for materials, labour, and overhead in the manufacturing industry.

Standard costing is a method businesses use to define production target costs and then contrast actual production costs with the targets. Companies might find variations they need to address to improve their production processes by using this comparison to find them.

There are three fundamental aspects of a manufacturing system, which comprise the following:

• Direct Resources: It is calculated by multiplying the amount of each material by the material cost per unit.
• Dedicated Work: It is calculated by multiplying the total number of hours worked by the hourly labour cost.
• Overhead: It contains both variable and fixed overhead costs, which are determined by multiplying the standard amount by the standard variable overhead rate.

You can use the following standard costing formula to determine a product's typical cost:

Standard Cost = Material Cost + Manufacturing Overhead + Direct Labour

Here,

Materials Cost = market price per unit x total number of units

Manufacturing Overhead = Fixed Overhead + (Variable Manufacturing Overhead × Total Number of Units)

Direct Labour = employee hourly rate x no. of hours worked x total number of units

XYZ Production manufactures T-Shirts. The authority meets with the team and plans to produce 300 units of T-Shirts in the upcoming year. The team estimates its costs as follows:

• Direct labour: ₹ 100/ hour
• Raw material: ₹ 500/ unit
• Manufacturing overhead: ₹ 400/ unit
• Time to produce one unit: 2 hours
• Fixed overhead: ₹ 50,000

Then, the process of standard costing calculation include:

Materials Cost = ₹500 (cost per unit) x 300 (total number of units) = ₹ 1,50,000

Manufacturing overhead = ₹ 50,000 (fixed overhead) + [₹ 400 (variable manufacturing overhead) x 300 (total number of units)] = ₹ 1,70,000

Direct labour = ₹100 (employee hourly rate) x 2 (number of hours to produce one unit) x 300 (total number of units) = ₹ 60,000

Therefore standard cost = ₹ 1,50,000 + ₹ 1,70,000 + ₹ 60,000 = ₹  3,80,000

1. Assists in Accurate Budgeting

Manufacturers use standard costing to develop budgets since it is challenging to estimate the actual costs of making an item before the production process is complete.

Budgets for manufacturing are typically a good approximation rather than the final cost. Also, once manufacturing is complete, the differences are determined by comparing the standard and actual costs. The budget for the following year can then be improved using this information.

2. Expedites Inventory Costing

When standard costs are used instead of actual expenses, calculating the necessary inventory is made simpler. The cost of manufacturing typically varies from one batch to another during production. A few causes of this include production snags, changes in the cost of raw materials, and adjustments in employees.

Additionally, when using standard costing, manufacturers can determine the inventory value by multiplying the actual inventory by the standard cost of each item. This aids them in estimating the inventory costs that are probably pretty close to the actual expenses.

3. Makes It Simple to Appropriately Price Things

Even before the production process is finished, standard costing aids manufacturers in setting the prices of the finished goods. Companies may appropriately price their products to generate profits without overpricing them if they accurately view the projected manufacturing costs, including materials, labour, and administrative costs.

Also, manufacturers may easily account for changes in production costs with shifting volumes while maintaining consistent product pricing across batches using standard costing.

4. Provides Fruitful Financial Records Management

Maintaining a company's financial records becomes challenging if it is forced to rely only on actual costs. On the other hand, standard costing makes it easier for businesses to create and manage their financial records.

The business may carry out additional financial actions, such as borrowing and overdrafts, using the information from standard cost calculations because it has an intelligent estimate of projected costs.

5. Helps Production Benchmarking

Manufacturers utilise standard expenses to establish benchmarks to assess if actual costs fall within these limits. Budgeting is successful if actual costs are within the range of expected costs.

However, if the actual costs differ negatively from the standard costs, the company seeks to improve its production efficiency to reduce these costs in the future.

Besides the advantages, a few disadvantages include the:

• Not Fruitful With Cost-Plus Contracts: Clients pay manufacturers according to the actual expenses spent under a cost-plus contract. Hence, manufacturers cannot construct customer contracts based on normal costing in such circumstances.
• Not Preferable for Rapid Environments With Frequent Price Changes: A typical costing approach assumes that prices will stay the same for a few months or a year. However, standard costing quickly becomes outdated and useless in accounting in production contexts with short product lifetimes and frequent price changes.
• Can Produce Incorrect Actions: The management may need to correct corrections if they observe unfavourable differences between the standard and actual expenses. Additionally, to reduce price variations, they might, for instance, buy raw materials in more significant quantities, which could result in inventory backup and additional costs.
• Unable to Offer Unit-Level Information: The production department is included in the usual costing variance estimates. However, standard costing is unable to offer specific details on differences for each specific item, batch, or work cell.
• Can Offer Delayed Feedback: At the conclusion of each production cycle or reporting period, the accounting department typically performs the variance computations. Therefore, standard costing with a sluggish response is useless if the manufacturing department needs quick feedback for immediate remedial action.

Standard costing can be a helpful tool, but it is essential to recognise that it has some restrictions. For example, standard costs could only sometimes represent actual expenses, and businesses might struggle to create reasonable standards. It might also take a lot of time to track. Despite these drawbacks, it can still be helpful for industrial businesses looking to enhance their production methods.