Standard costing and absorption costing are two different techniques that both are widely used in modern businesses. Both costing systems developed for different purposes and both systems have their separate criticisms. Standard costing is a very simple technique that can be easily translated in one's business and from the standards set, one can prepare variances and investigate them using particular techniques. Standard costing and absorption costing have different roles when one is preparing the budgets.
According to Jones (2006) in simple words standard costing is like a "sophisticated form of budgeting". This is because budgeting involves investigating the costs, and since standard costing involves investigating in detail all the different costing elements that make up a product, one can easily see that budgeting and standard costing are very similar. In fact when one is preparing budgets, normally one is setting standards, which is the whole principle of standard costing.
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According to Lucey (2002) standard costing is a technique where one determines estimates (standards) of the costs of the product or service one is going to sell. When setting the standards one should set a standard which is attainable. To determine a standard there is a lot of work involved especially technicalities and sometimes even engineering studies are required. Lastly, according to Lucey (2002), one should eliminate from the standard costs mistakes and inefficiencies, and must also upgrade them when either there are changes in methods, or when there are technology advances, or when the product or service requires different material and labour.
How are standards set?
According to Drury (2008) when one is setting a standard he should consider 3 basic types of standards, these being basic cost standard, ideal standard and attainable standard. All 3 standards can be useful, but not all the 3 can be used as standard for labour.
The basic standard: This is a standard which is rarely changed. This is a standard which is mainly used either to see efficiency trends or to compare it with actual costs throughout the years. Its seldom used because according to Chan (1988) it becomes easily outdated as it does not represent current cost.
The ideal standard: This standard can be described as a standard which can be used in a perfect environment (Drury 2008). This standard assumes 100% efficiency, meaning that there will be no wastage. In reality this is not that possible, and if used it can have negative effects on employee motivation, so one should not use this standard (Chan 1988).
The attainable standard: This standard is a standard of work which is carried out efficiently. This is the most difficult standard to determine out of the 3 mentioned. According to Drury (2008) this standard should be set as neither to high nor too low. It should be a bit higher so that one can encourage a high level of efficiency which can have a positive effect on the business.
The problem with the ideal standard is that with time this standard changes, mainly due to the learning curve of labour. According to Chen (1988) this should be used or else the standard will not represent efficiency in the business. However this also depends on a number of factors such as type of production and employee turnover.
Purpose of standard costing
Standard costing has various advantages:
It can be used as a tool for control. Standard cost will highlight those areas which are not going as planned, and so management can focus more on those items.
The process of standard costs will encourage reviews of methods, materials, and labour efficiencies which will lead to cost reduction in the future.
Standard costs are not based on past costs so inefficiencies are eliminated. They will be a better basis of inventory calculation (Lucey 2002).
It can be used for future decision making, as one will know what his costs will be, and so he will be more competitive in his pricing rather than using historical costing.
Budgets can be set using the standard costs, since they are a reliable source of data.
No matter how accurate one will set the standard, there will always be some difference between the standard cost and actual cost. This difference is called the variance. The term variance is rarely used on its own, as normally it is used with other terms such as labour variance and material cost variance. According to Lucey (2002), variance analysis is an evaluation tool that can be used to enhance management performance.
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Some examples of variances are:
Material variance: Here one will consider the price of the material and the usage of material. Both are important and so there are sub-variances which can further show where was the variance. If actual cost is higher than normal cost some possibilities of that difference can be paying higher prices, losing discounts, buying more quality material and greater yield from material usage.
Labour variance: Cost of labour is determined by wage rate and labour hours. So one must also sub-divide the variance for both these determinants. If actual costs are higher some possibilities are higher wages, unplanned bonuses or overtime, unfavourable conditions and material changes which affected their efficiency.
Overhead variance: This variance also comprises of a rate and direct machine hours. Here the reasons of why there was such a variance is more complex. This variance sometimes provide little control ability (Lucey 2002).
Although these are some variances which are commonly used, there are more variances, and some are even industry-related variances. Each company must use only those variances that are controllable and that provides most useful information.
Purpose of variance analysis
The only reason one use variance analysis is to see more clearly what were the real causes of that difference in costing, which affects mostly profit. By investigating such variances the management can see how to improve performances, increase efficiency, reduce costs and see where there are problems and so management can solve those problems. If variance analysis is done a long-time after the events or no action is taken after the variance analysis is done, the tool is not used as it should be, and so the purpose of such analysis is not being fulfilled. (Lucey 2002). So as said before a company must only choose those variances that will be useful for it, the others should be eliminated as they will be of no use.
When to investigate variances
The answer to this question is mostly judgmental, or sometimes a company just put a figure of percentage to declare when the variance will be investigated. However even putting a percentage can be difficult at times, as according to Horngren (2011), for one company a particular percentage can be good enough, but for others that percentage could make management investigate variances and which has little effect.
According to Drury (2008) one should ask why there was such a variance first before investigating it further. This can prompt up several causes that may give reasons of such a variance while reducing extra costs if these variances were investigated further. Drury (2008) also gives some causes. It may be the case that there was a mistakes in how operations were classified like what are direct or indirect labour. Another cause could be changes in prices especially due to inflation. There could also be faulty machines or human error or inefficient use of materials. It could also be due to some event which no cause can be found. All these causes one can say that these are uncontrollable factors, and so it would not make sense in investigating them further.
If one investigate these factors one will incur costs but no benefit will derive from it. So first one must determine whether the factors of variance was due to controllable or uncontrollable factors. But this is not enough. According to Drury (2008) one must then see whether the benefits at incurring the costs for investigating the controllable factor will be greater. If not one should not investigate it further.
Criticism of standard costing
Standard costing has some criticisms. Sometimes to keep standards up-to-date it may be expensive and time consuming. Also in uncertain conditions, especially in recent times due to the financial crisis, can make the standards quickly out-of-date, and so one will lose focus immediately. Standard costing also focuses only on the financial factor, and others factors are ignored like customer satisfaction, quality, the service and other factors, which are all important in today's world. Modern factories that use Just-In-Time methods will make standard costing ineffective. Lastly, complex variances that are not fully understood by managers, make them ineffective and so uncontrollable. (Lucey 2002)
Limitations of Variances
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According to Anthony (2003) although variances tells were there was a variance, it does not tell the users what is being done about it and why it has occurred, as these will require further investigation. Also variance just tell a number, and it is up to the user to decide whether the variance is significant enough that it requires further investigation. Also to investigate a variance one will require that the benefits will exceed the costs, and the benefits are not always easy to identify. Thirdly 2 variances can off-set each other, giving the impression that there was not significant variance, when in reality there was. For example one department performs well and the other did not, and so the variance will be near to zero since the performances off-set each other. Finally variance analysis only tells the user what has happened and not what can be done in the future to reduce that variance. It is up to the management to decide what should be done.