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Standard cost are predetermined cost that are usually expressed on a per unit basis, they constitute a carefully formulated estimate of what future costs should be, based on a desired level of productivity and process efficiency and a set of assumption about the operating environment. (Oliver L 2000)
Why use standard cost?
Standard costs are mostly used in manufacturing companies mainly as a management control system whereby they help managers and the people involved in the decision making process to make sound decision especially with regards to cost. Management control is the process by which managers influence other members of the organisation in implementing the organisational strategy.
The objectives of any business process in the information age is to survive on the market increase their profit margin and increase the business market share it follows that for businesses to attain these objectives the business must try and keep costs as low as they possibly can and generate as much revenue as the business can, if the revenue is greater than the cost of producing the goods sold the business will make a profit therefore fulfilling their objective.
Standard cost as a cost control mechanism
Standard cost system provides managers with a mechanism to control costs in a process known as management by exception, management by exception is the process by which managers carefully estimate the quantity of materials and the prices of the factors of production required to produce each unit of output and then set a standard or benchmark are rigor but attainable and leave the production to run on its own and only intervene when the process is not going according to plan. (Wood F 2007)
Figure 1.1 shows the standard costs and quantities of each factor input required to produce deluxe virtual yogurt. The weekly capacity is 1000 units hence the standard weekly cost for direct materials is £1600, £800 for labour and £260 for total overhead. These standards are communicated to the production staffs, the purchase department, human resource management department and every other affiliated department of the business as such each department has a target to which it must strive to satisfy the performance of each department will be judged based on how well the standards are observed favourable discrepancies indicate excellent management therefore there will be no need for the managers intervention other than to encourage the good work.
Instead managers can redirect their effort and time perusing strategies that have a significant effect on the business future growth such as developing a balanced scorecard to assist them to align the business daily activities to the overall corporate strategy so that they can give the business a competitive advantage on the market by pursuing those factors that are considered vital for the company's future sustenance.
Adverse discrepancies will however merit the manager's intervention, for instance if the employees resulted into negative behaviour such as late coming, absenteeism, accidents or increased labour turnover because of low levels of motivation the business labour cost will shoot up and result into adverse variances the management will conduct an investigation to track down the root cause of the labour variance, for example low motivation of line workers and corrective measures will be put in place for instance the human resource department can rotate the workers to give them a variety of work Rather than doing the same old boring repetitive job it could be the standards set are too hard to attain in which case the managers will be required to revise the standards, psychology studies has shown that employees will be motivated to exert their effort when the targets are somewhat in between that means the targets should not be too easy to attain and should be extremely difficult to attain.
Motivation can be intrinsic or extrinsic, intrinsic in the sense that it comes out of the individual it is not influenced by material or economic rewards, extrinsic in the sense that it is caused by materialistic rewards such as money. (Armstrong, M. 2006) The management will find out what type of motivation is low and reward the employee accordingly, for example the employee can be paid based on the number of output produced given a limited number of materials, in other words the management can revise and set new standards and reward employees who meet these standards. This will motivate the workers to exert their effort to meet this standard consequently improve labour productivity and lower the unit cost of production. Once that is achieved the managers can leave the production to run on it's and concentrate on other perspectives of the business.
Variances can be caused by materials as well if the purchase department decided to purchase from another supplier at a lower cost it might turn out that the materials are of substandard quality and therefore workers on the production line may be required to use up more than the set quantity standard to produce each unit of output. Again, managers will trace the root of this variance and might decide to build up alliances with suppliers and adopt systems such as just in time stock control system where the suppliers will be required to deliver the materials just as they are needed by the production department as opposed to traditional stock control systems. Figure 1.2 shows a comparison between just in time stock control system and traditional stock control system, by adopting just in time sock control the business can achieve quite a considerable reduction in cost of production for instance the business can save on storage cost and deteriorated stock, the business cash flow can improve in that less money will be tired up in raw materials. (Muller M 2003)
Compared to other cost methods, stand cost is by far the most economical system as it delivers comparative results at lower cost than would actual cost system. Standard costing system is also easy to implement in the organisation easy to understand and usually meets consensus at every level of the organisation it can be used together with other production methods to reduce costs of production. (Wood F 2007)
"David Lyall and Carol Graham stated that more than 90% of 231 companies surveyed in the U.K. apply standard costing for cost control purposes. Furthermore, they found that 63% of the managers using this technique reported being pleased in terms of its decision-making support
Many business still use standard cost system in order to control costs and to help the make cost decision and because it does not demand too much of the managements time, the managers can concentrate on strategies that help the business generate revenue and gives the business a competitive advantage in the information age.