Standard costing means assigning the expected, budgeted costs to the goods manufactured, the goods in inventory, and the goods sold. In other words, the amounts assigned are the costs thatÂ should occurÂ when manufacturing products. The actual costs are then compared to the standard costs and any differences are reported as variances. Since the standard costs are often knotted to the company's annual profit strategy, a variance is also an pointer that the planned amount will be different from the actual profit. Standard costing involves the creation of estimated costs for some or all activities within a company. The cost accountant may perhaps also periodically change the standard costs to bring them into closer alignment with the actual costs.
The core reason for using standard costs is that there are a number of applications where it is too time-consuming to collect actual costs, so standard costs are used as a close approximation to actual costs. Since standard costs are typically somewhat different from actual costs, theÂ accountant intermittently computes variances that interrupt out differences caused by such factors as labor rate changes and the cost of materials.
Disadvantage with Standard Costing
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Despite the advantages just noted for some applications of standard costing, there are substantially more conditions where it is not a viable costing system. Here are some delinquent areas:
Drives inappropriate activities. A quantity of the variances stated under a standard costing system will initiate management to take unfitting actions to create favorable variances. For example, they may buy raw materials in larger quantities in order to improve the purchase price variance, even though this increases the investment in inventory. Correspondingly, management may schedule extended production runs in order to mend the labor efficiency variance, even though it is superior to produce in slighter quantities and accept less labor efficiency in exchange.
Unit-level information. The variance calculations that typically accompany a standard costing report are accumulated in aggregate for a company's entire production department, and so are unable to provide information about discrepancies at a lower level, such as the individual work cell, batch, or unit.
Costly. The management has to maintain separate accounting systems for actual cost and standard cost.
Fast-paced environment. A standard costing system commences that costs do not modify much in the short term, so that you can rely on standards for a number of months or even a year, earlier bring up to day of the week the costs. However, in an surroundings where product lives are short or continuous development is driving down costs, a standard cost may become out-of-date within a month or two.
Slow feedback. A multifaceted system of variance scheming are an fundamental part of a standard costing system, which the accounting staff completes at the end of each reporting period. If the production department is concentrated on immediate feedback of problems for prompt correction, the reporting of these variances is much too late to be useful.
The foregoing list shows that there are a multitude of situations occur where standard costing is not useful, and may even result in incorrect management actions. Nonetheless, as long as you are aware of these issues, it is usually possible to profitably adapt standard costing into some aspects of a company's operations.
Advantages of Standard Costing
Though most companies do not use standard costing in its original application of calculating the cost of ending inventory, it is still useful for a number of other applications. In most cases, users are probably not even aware that they are using standard costing, only that they are using an guesstimate of actual costs. Here are some potential uses:
Inventory costing. It is extremely easy to print a report showing the period-end inventory balances (if you are using aÂ perpetual inventoryÂ system), multiply it by the standard cost of each item, and instantly generate an culmination inventory valuation. The result does not exactly match the actual cost of inventory, but it is close. However, it may be necessary to update standard costs frequently, if actual costs are continually changing. It is easiest to update costs for the highest-dollar mechanisms of inventory on a frequent basis, and leave lower-value items for intermittent cost reviews.
Always on Time
Marked to Standard
Overhead application. If it takes too long to aggregate actual costs into cost pools for allocation to inventory, then you may use a standard overhead application rate instead, and adjust this rate every few months to keep it close to actual costs.
Budgeting. A budget is always composed of standard costs, since it would be impossible to include in it the exact actual cost of an item on the day the budget is finalized. Also, since a key application of the budget is to compare it to actual results in subsequent periods, the standards used within it continue to appear in financial reports through the budget period.
Price formulation. If a company deals with custom products, then it uses standard costs to compile the projected cost of a customer's requirements, after which it adds on a margin. This may be quite a complex system, where the sales department uses a database of component costs that change depending upon the unit quantity that the customer wants to order. This system may also account for changes in the company's
Nearly all companies have budgets and many use standard cost calculations to derive product prices, so it is apparent that standard costing will find some uses for the foreseeable future. In particular, standard costing provides a benchmark against which management can compare actual performance.
Following through all the arithmetic's of variances I have pin pointed reasons for the Material Price Variance, Material Usage Variance, Labour Efficiency Variance, and Labour Rate Variance.
Material Price Variance occurs a failure to purchase the standard quality, thereby resulting in a difference price paid. This will lead into bad purchasing, in which is very discomforting the company's interest such as a rush purchase for an uneconomical markets, and also pushes a purchase of a substitute material on account of non-availability of the material specified by the company. This all are related to the interdependence at variances when it ensues an event has a favorable impact on one variance but an adverse impact on another variance. For example, the purchase of inferior quality materials may account for a favorable price variance but it may also have a negative impact on the material usage & labor efficiency variance due to the quality causing an increase in usage. The adverse may also be affected by inflation and general increase in the market price. In such circumstances the selling price should be altered to refract the current market.
Material Usage Variances may be affected by a whole lot of reasons such as carelessness in the use of material also affect the reason of material usage in resulting excessive consumption. Which brings us to the use of defective or sub-standard material that will cause spoilage to the material. Other reasons such as a change in t plant and machinery who also results to excessive consumption of material. The adverse on the variances is due to excess issues. Managers should check the stock are securely locked away & that only the standard quantity is issued each day. And it's not just that, There are a few more such as :
Faulty material processing
Pilferage of materials
Use of material mixture, rather than standard mixture
Labour Efficiency Variance is affected because of the actual hours used is greater than the standard hours, and it adverse is due to the use of an inappropriate standard that should be changed. Alternatively, there may have been idletime, ten working time should be synchronized. The use of defective or non-standard material which require more or less time than the standard time for processing, insufficient workers, an incompetent supervisors, There is a change in the method of operations, Basically low standard workers are the main reasons for this type of variance.
Labour Rate Variance is the difference between the actual labor rate paid and the standard rate, multiplied by the number of actual hours worked. An unfavorable variance means that the cost of labor was more expensive than anticipated, while a favorable variance indicates that the cost of labor was less expensive than planned. Due to this, some causes/reasons that may affect this variance are Incorrect standards. The labor standard may not reflect recent changes in the rates paid to employees. For example, the standard may not reflect the changes imposed by a new union contract. Pay premiums. The actual amounts paid may include extra payments for shift differentials or overtime. For example, a rush order may require the payment of overtime in order to meet an aggressive delivery date. Component tradeoffs. The engineering staff may have decided to alter the components of a product that requires manual processing, thereby altering the amount of labor needed in the production process. For example, a business may use a subassembly that is provided by a supplier, rather than using in-house labor to assemble several components. Benefits changes. If the cost of labor includes benefits, and the cost of benefits has changed, then this impacts the variance. If a company brings in outside labor, such as temporary workers, this can create a favorable labor rate variance because the company is presumably not paying their benefits.
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There are similar calculations for the direct labor. However, the usage or quantity variance for direct labor is referred to as theÂ direct laborÂ efficiencyÂ variance. If the actual labor hours are more than the standard hours allowed for the good output, an unfavorable efficiency variance is reported. The price variance for direct labor is referred to as theÂ direct laborÂ rateÂ variance. the variance is unfavorable or adverse, if the actual pay rate is greater than the standard hourly pay rate.Â An efficiency variance and a spending (or flexible budget) variance pertain to the variable manufacturing overhead. When actual overhead costs are greater than the standard overhead allowed for the output Manufacturing overhead variances include a volume variance and a budget variance associated with the fixed manufacturing overhead.