Standard Costing: Principles and Practices in Manufacturing

Posted on Dec 15, 2024 in Economy

**Knowledge 1: Standard Cost**

Standard costs are predetermined costs that serve as a scientific basis for measuring actual performance. These standards for manufacturing costs are generally integrated formally into the cost accounts. When this happens, the systems are known as standard cost accounting systems. Standard costs are the opposite of actual costs. Actual costs are historical costs that are incurred in a prior period. The difference between the actual cost and standard cost is called a variance.

The variances indicate the degree to which a certain level of performance established by management has been achieved. Variances can be grouped by department or cost element. Standard costs not only serve as a reference but also as a working guide. In this system, the adjusted method of calculation is based on the principle that the true cost is the standard, and the resulting differences, when compared with the real, are the result of inefficiency or waste, as set forth in the Statement of Results.

Estimated cost is the amount that the company says will actually cost a product or a process operation for a certain period. The cost estimate is based on some average of actual production costs of prior periods, adjusted to reflect changes in economic conditions, efficiency, etc., anticipated for the future. Normal cost is close to the definition of estimated costs. Normal costs are an average of costs actually incurred in previous periods and do not contain, therefore, a sense of the future.

Budgeted costs are considered, in many cases, cost estimates or normal costs. Budgeted cost is the planned cost, which is often based on an average of past costs adjusted for expected changes in the future. A budget like this is not the best expression of a proper budgetary process. An adequate budget process should be based on standards. The standard cost is the amount the company says a product or a process operation should cost for a certain period, based on various economic, efficiency, or other factors.

Types of Norms or Standards

• Rules or Standards or Theoretical Ideal: These are rigid rules that in practice can never be achieved. One advantage of ideal norms is that they can be used for relatively long periods without having to change or adapt.
• Above Average Costs: When rules are based on an average of past performance, they tend to be flexible. Above-average costs can include deficiencies that must be incorporated into the rules. If you follow this procedure, you should gradually replace other standards that represent a more significant level of performance.
• Regular Standards: A regular standard is based on likely costs of future economic conditions and normal operations. They tend to rely on past averages that have been adjusted to take account of future expectations. One advantage is that they require frequent adjustments.
• High Level of Performance Possible: This represents the best criterion for evaluating performance, so its use is widespread. It includes a margin for certain operating deficiencies that are considered inevitable. You may reach or exceed these standards through effective action.

Advantages of Standard Cost

• Management Evaluation: Standard costs can be an important tool for evaluating management. Where standards are realistic, feasible, and properly managed, they can encourage individuals to work more effectively.
• Cost Reduction: Variations in the standards lead management to implement cost reduction programs, focusing on areas that are out of control.
• Planning: They are useful to management for the development of their plans. The process of setting standards requires careful planning in areas such as organizational structure, assignment of responsibilities, and policies relating to performance evaluation.
• Decision-Making: They are useful in decision-making, particularly if the standards of product costs are segregated according to the elements of fixed and variable costs, and if prices of materials and labor rates are based on expected trends during the year.
• Clerical Work Reduction: They can result in a reduction in clerical work.

Disadvantages of Standard Cost

• Rigidity or Flexibility: The degree of rigidity or flexibility of the standards cannot be calculated in a specific way. Often, the rules tend to become rigid, even in relatively short periods. While manufacturing conditions are constantly changing, revisions of the standards can occur at infrequent intervals.
• Inventory Problems: These reviews create special problems associated with inventory.
• Weakened Effectiveness: When the rules are revised frequently, their effectiveness in assessing performance weakens. On the other hand, if the rules are not revised when major manufacturing changes occur, we obtain an inappropriate or unrealistic assessment.
• Inflation: Another limitation is inflation, which requires constantly changing standards.
• Difficulty Isolating Variances: Isolating controllable and non-controllable variances is difficult, at best.
• Sociological Concerns: In recent years, some sociologists have done studies that cast doubt on the value of standards as a basis for performance evaluation. They argue that the rules are oppressive and create attitudes of resistance rather than act as incentives.

Plant Capacity

Plant capacity refers to the production capacity that a plant can reach according to the combination of certain variables. This combination can be classified into:

• Maximum Theoretical or Ideal: The volume of production a plant could reach without regard to any restrictions.
• Maximum Practical Capacity: The maximum normal practice or ability is represented by a standard that is reached when subtracted from the natural theoretical maximum, downtime caused by repairs, preventive maintenance, rest periods for workers, and so on. It is not a state of excess but the higher threshold that can work a manufacturing center without putting excessive strain on workers and equipment.
• Normal Activity Level or Long-Term: Considers that you can take advantage of a reasonably high percentage of practical capacity. This level of activity involves not absorbing a portion of fixed costs that need to be considered as negative for the period.
• Level of Activities Planned or Short-Term: It is a capacity utilization of something less than the normal or long-term and is meant to help meet the demand of the fiscal year budget. It absorbs a larger share of fixed costs than the previous level.
• Actual and Consequential Activity Level: It corresponds to what is actually executed in the exercise, which may be equal to, greater than, or less than the level of activity anticipated.

Lazy Capacity: Excess capacity is often called the unused production capacity, or that portion of unused fixed factors in production. It is also commonly defined as the difference between practical capacity and production actually made. Slack is the difference between the level of production that could have been achieved and the level of real output.

**Engineering Method**

The standards obtained by this procedure are based on an analysis of specifications and technical characteristics of the product. To achieve these standards, data from previous activities are used, conveniently compiled by technicians and plant engineers, and research data to that effect. These investigations tend to be, for example, time and motion studies, performance materials, and so on.

The next step is to convert the data collected into standard costs.

**Method of Historical Experience**

This method, an alternative to the engineering method, usually operates with a low administrative outlay and is preferred when the standard cost is determined for the first time, with a view to its experimental introduction.

To do this, we proceed to analyze the costs based on reliable records from before. This procedure is technically less reliable than engineering, but it saves time and money both in the calculation and in the implementation. Its implementation involves certain logical mismatches arising from its experimental nature.

**Budget Method**

In this method, the standards are obtained by analyzing the relationships between the departments involved in the production function of the formal organization:

• Product Engineering Department: Is in charge of designing the product or service, assuming responsibility for determining the technical specifications of materials, processes, operations, and human resources.
• Purchasing Department: Manages the procurement of goods and services from third parties required to manufacture a product or service.
• Process Engineering Department: Performs production scheduling and the standardization of time, movement, and performance of machines, equipment, facilities, and human resources.
• Industrial Relations and Personnel Department: Determines the selection of personnel of the company and sets the level of wages according to budget guidelines emanating from top management.
• Cost Accounting Department: Makes the accumulation of data, both standard and actual. One of its main tasks is the preparation of the budgets of factory loads.

**Securing Physical and Monetary Standards**

To perform this task, a standard cost card is usually prepared for each item to be produced. This document discriminates both the raw materials to be incorporated in various stages of production comprising the sequence of the article and the cost of them.

Then, the technique is common in the traditional methodology for setting standards for the three elements of cost. It is presented by Neuner in his work, which we refer to those who wish to further analysis.

Standard Amount of Raw Materials

To set the standard amount, we must consider:

• Basic Specifications: Amount of raw materials required to produce one unit of product. This means that the specifications have to necessarily look at the wastage, waste, and evaporation inevitable and normal in the manufacturing process. For this purpose, a stable and controllable percentage of waste, shortages, etc., is usually established, and any surplus with respect to these shares is a variation in the amount or use of raw materials that should be considered inefficient.
• Other Minor Components: Number of other minor components that are direct, quantifiable, and measurable, such as the main materials (additives, dies, molds).
• Packaging Materials: Packaging materials (boxes, labels, bands, etc.) that are directly identified with the good that is traded.

If more than one material is used, a standard list of materials must be made, which reports on the mixture of raw materials used.

Standard Price of Raw Materials

According to Neuner, standards of material prices are set by the purchasing department. These standards can be established by:

• Calculating a weighted average of the previous orders.
• Calculating the average of recent orders.
• Anticipating likely changes, based on statistical methods or the opinion of a purchasing committee.

**Labor Standards**

Like materials, the standards of direct labor are of two types: quantity and price or fee.

• Standards of Total Labor: The determination of labor time per unit can result from:
  • Providing engineering calculations based on time and motion studies of the operator, crew, or equipment.
  • Calculation by conducting pilot tests.
  • Calculating the average cost of previous leaves.
• Standard Price (Rate) of Workforce: According to Neuner, for fixing the cost of labor, the method used for payment of wages must be taken into account. The following can be used:
  • Systems per Hour or per Piece: The piece rate or the uniform payment for each completed unit represents the simplest situation for setting the standard.
  • Incentive Systems: The use of incentive systems or commodities such as Gantt or Halsey raises the issue of whether the premium should be considered a cost of direct labor.

The hourly rate raises the same problems as the cost of materials. It can be based on a study of past experience, or weighted averages, medians, or other representative data can be used.

**Standards of Manufacturing Overhead**

The standards of this third element of cost are much more difficult to fix than materials and workmanship. This is due to the heterogeneity and indirect components of this third element. Overall, production costs do not vary in a definite way.

Some costs can be considered variables since they tend to accompany increases or decreases in production. Other costs are considered fixed, as during a given period, they tend to fluctuate with the increase or decrease in production levels. The different behavior of costs with respect to changes in the level of production results in fluctuating unit costs at different production levels. There are other items of cost that can be categorized as mixed, as they have a fixed portion and a variable portion. In this type of cost, it is necessary to break up those costs that vary with the production level from those that do not. They can be divided into two traditional groups. Within the classification of joint costs, we can distinguish:

• Semi-fixed Costs: These are costs, part of which is preferentially mixed fixed, so they tend to vary in steps but slowly. Examples: the costs of supervision, control of absenteeism, and internal transport from the factory.
• Semi-variable Costs: These costs are also mixed with a fixed component, but the preferred component is variable and prone to accompany linearly increased or decreased production levels. Examples: light, gas, and phone. Their fixed part is given by the amount paid at the zero level of activity.

This complexity in the composition of the indirect costs of manufacturing makes the task of setting standards difficult. Therefore, they are not charged directly to the respective order or process, but they are concentrated in departments that originate and then load them through quotas.

**Standard Rate Allocation CIF**

(Odds Indirect Cost Manufacturing)

We have seen that to apply charges to the cost of manufacturing products, we use quotas. The division into fixed and variable fees is essential in the time of the analysis of variations to determine the effects of which have been applied and the costs which the absorbed.

The two most widely used methods for calculating the variations arising in the indirect manufacturing costs refer to:

Method of Two Variations

The net change in the indirect manufacturing costs, i.e., the difference between the CIF and CIF production actually incurred, can be analyzed considering two variations: a) budget and b) volume. The change in budget or expense may be partially due to the fixed costs of the budget being set aside, due, for example, to higher rates of pay for supervisors than budgeted, more real depreciation, or insurance or taxes in excess of the budgeted. The change in volume or capacity indicates the extent to which the fixed CIF has been absorbed into production.

Evaluation of the Method of Two Variations

Under the method of the two variations, changes in the budget, which is considered largely controlled by the department supervisors, include any increase or decrease in CIF variables that resulted from the shortcomings of the workforce. This occurs because the actual CIF is compared with a budget allocation based on standard hours.

Method of Three Variations

In this analysis, the CIF applies to the production in the same way: the standard rate of VAT multiplied by the standard number of hours. Therefore, the net change in the CIF (between allocated and actually incurred) remains the same. Under this procedure, the CIF is supposed to vary (or are assigned to the factory) according to the basis of actual hours rather than the standard hours. In this method, there are three variations:

• Changes in Budget or Spending: Represents the difference between the actual CIF budget incurred and the actual level in hours instead of actual hours standard.
• Variation of Efficiency: Corresponds to the difference between actual hours and standard hours worked, i.e., the efficiency of labor hours multiplied by the standard rate of VAT. It is based on the assumption that the cost of the deficiency of labor includes the CIF and labor.
• Variation of Volume or Capacity: Represents the difference between the actual budget level, expressed in actual hours, and the CIF that would have applied to the production if the deficiency had occurred at work, that is, actual hours multiplied by the standard indirect cost rate.

Assessment of the Three Variations Method

The main value of this method for the analysis of the CIF is originated by isolating the variation of efficiency and budget allocation based on actual times rather than the standard hours.