Standard costing is the practice of substituting an expected cost for an actual cost in the accounting records. Subsequently, variances are recorded to show the difference between the expected and actual costs.

For example, if the direct materials price is $10 and the standard quantity is 20 pounds per unit, you would multiply $10 by 20 to get $200. This would be the standard cost for the direct materials only.

Advantages of Standard Costing:

• 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.
• Inventory costing – It is extremely easy to print a report showing the period-end inventory balances, multiply it by the standard cost of each item, and instantly generate an ending inventory valuation.
• 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.
• 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 a margin.

Problems with Standard Costing:

• Cost-plus contracts – If you have a contract with a customer under which the customer pays you for your costs incurred, plus a profit, then you must use actual costs, as per the terms of the contract. Standard costing is not allowed.

• Drives inappropriate activities – A number of the variances reported under a standard costing system will drive management to take incorrect actions to create favorable variances.
• Fast-paced environment – A standard costing system assumes that costs do not change much in the near term, so that you can rely on standards for a number of months or even a year, before updating the costs.
• Slow feedback – A complex system of variance calculations is an integral part of a standard costing system, which the accounting staff completes at the end of each reporting period.
• Unit-level information – The variance calculations that typically accompany a standard costing report are accumulated in aggregate for a company’s entire production department.

Standard Cost Variances:

A variance is the difference between the actual cost incurred and the standard cost against which it is measured. A variance can also be used to measure the difference between actual and expected sales. Thus, variance analysis can be used to review the performance of both revenue and expenses.

There are two basic types of variances from a standard that can arise, which are the rate variance and the volume variance. Here is more information about both types of variances:

Rate Variance: A rate variance (which is also known as a price variance) is the difference between the actual price paid for something and the expected price, multiplied by the actual quantity purchased. The “rate” variance designation is most commonly applied to the labor rate which involves the actual cost of direct labor in comparison to the standard cost of direct labor.

Volume Variance: A volume variance is the difference between the actual quantity sold or consumed and the budgeted amount, multiplied by the standard price or cost per unit. If the variance relates to the sale of goods, it is called the sales volume variance. If it relates to the use of direct materials it is called the material yield variance.

How to Create Standard Costs:

• Equipment age – If a machine is nearing the end of its productive life, it may produce a higher proportion of scrap than was previously the case.
• Equipment setup speeds – If it takes a long time to setup equipment for a production run, the cost of the setup, as spread over the units in the production run, is expensive. If a setup reduction plan is contemplated, this can yield significantly lower overhead costs.
• Labor efficiency changes – If there are production process changes, such as the installation of new, automated equipment, then this impacts the amount of labor required to manufacture a product.
• Labor rate changes – If you know that employees are about to receive pay raises, either through a scheduled raise or as mandated by a labor union contract, then incorporate it into the new standard. This may mean setting an effective date for the new standard that matches the date when the cost increase is supposed to go into effect.
• Learning curve – As the production staff creates an increasing volume of a product, it becomes more efficient at doing so. Thus, the standard labor cost should decrease (though at a declining rate) as production volumes increase.