Iycee Charles de Gaulle Summary Standard Costing Essay

Standard Costing Essay

TERM PAPER STANDARD COSTING MANAGEMENT ACCOUNTING & CONTROL SYSTEM Srinidhi Rangarajan 1PB11MBA34 3rd SEM M. B. A PESIT ABSTRACT In recent years, numerous tools such as activity-based costing, the balanced score card and target costing have gained prominence in the business community. Nonetheless, traditional management accounting continues to be prevalent in practice. One example is standard costing, which has been used on a wide front during the last century.

Standard costing is used by Customers who employ predetermined costs for valuing inventory and for charging material, resource, overhead, period close, and job close and schedule complete transactions. Differences between standard costs and actual costs are recorded as variances. Manufacturing industries typically use standard costing. Costs of items can be shared across organizations using standard costing. A note on the same has been provided in this paper. An attempt has been made to understand the way in which costs are built up for a manufactured item through this paper.

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The objectives of the paper are: * To understand the meaning of standard costing, its meaning and definition  * To learn its advantages and limitations                                                                 * To learn how to set of standards and determinations * To learn how to revise standards KEY WORDS: i. Standard cost ii. Standard time iii. Actual time INTRODUCTION It is a known fact that management accounting is managing a business through accounting information. In this process, management accounting is facilitating managerial control.

It can also be applied to one’s own daily/monthly expenses, if necessary. These measures should be applied correctly so that performance takes place according to plans. Planning is the first tool for making the control effective. The vital aspect of managerial control is cost control. Hence, it is very important to plan and control costs. Standard costing is a technique which helps to control costs and business operations. It aims at eliminating wastes and increasing efficiency in performance through setting up standards or formulating cost plans.

Meaning of Standard                                                    When you want to measure something, you must take some parameter or yardstick for measuring. This can be called as standard. The word standard means a benchmark or yardstick. The standard cost is a predetermined cost which determines in advance what each product or service should cost under given circumstances. Standard Costing and Variance Analysis A standard costing system consists of the following four elements: 1. Setting standards for each operation. 2. Comparing actual with standard performance. . Analysing and reporting variances arising from the difference between actual and standard performance. 4. Investigating significant variances and taking appropriate competitive action. Standard costing application Standard costing This is generally best suited to organisations with repetitive activities. It is probably most relevant to manufacturing organisations with repetitive production processes. Standard costing cannot be applied easily to non-repetitive activities because there is no clear basis for observing and recording operations.

It is difficult to determine a clear standard. Two commonly used approaches are used to set standard costs. 1. Past historical records can be used to estimate labour and material usage. 2. Engineering studies can be used. This may involve a detailed study or observation of operations in terms of material, labour and equipment usage. The most effective control is achieved by identifying standards for quantities of material, labour and services to be used in an operation, rather than an overall total product cost.

Variances from standard on all component parts of cost should be reported to identify the cause – and ultimate responsibility – for the variance from standard. Variance analysis Variance analysis involves breaking down the total variance to explain: 1. How much of it is caused by the usage of resources differing from the standard 2. How much is caused by cost of resources differing from the standard Together, variances can help to reconcile the total cost difference by comparing actual and standard cost. The main purpose of variances is to provide reasons for off-standard performance.

In this way, management can improve operations, correct errors and deploy resources more effectively to reduce costs. Literature Study/ Theoretical Background THE HISTORY OF STANDARD COSTING The typical standard costing system was developed in the early 1900s. According to Drury (1992) it was the scientific management principles recommended by F. W. Taylor and other prominent engineers who provided the basis for the development of a standard costing system. Scientific management engineers developed information about standards in order to establish ‘the best way’ to use labour and material resources within manufacturing.

The standards that the engineers arrived at provided information for planning the flow of work so that the waste of materials and labour was kept to a minimum. One interesting fact is that the engineers did not view standards as a tool to control financial cost at this point in time (Drury, 1992). One of the first thoughts of using standards as a tool to control costs came from G. Charter Harrison, who designed and installed the first complete standard costing system known to exist. Harrison worked at this point for the Boss Manufacturing Company, Illinois, in USA – makers of work gloves.

This was in 1911, but it took him a few years before he published the first set of equations for the analysis of cost variances (Solomons, 1968). Harrison was, however, not alone on the standard costing scene. In a series of articles in 1908 and 1909 Harrington Emerson advocated the development of an information system specifically directed towards the achievement of efficiency objectives. Emerson stressed that information about standards permit managers to differentiate variances that are due to controllable conditions and variances that are caused by conditions beyond management’s control (Solomon’s, 1968).

Today standard costing is widely used by manufacturing companies throughout the world. A survey undertaken by Ask and Ax (1997) reported that 73 percent of the companies in the Swedish manufacturing industry operated a standard costing system. Noteworthy is that 12. 6 percent of the companies investigated stated that it was urgent to abandon standards but at the same time 9. 9 percent stated the urgency of converting to a standard costing system. A STUDY ON STANDARD COSTING SYSTEM

Standard costing is most suitable in operations, where activities consist of a series of common or repetitive operations. In manufacturing organisations the processes often are of a repetitive nature and therefore standard costing is relevant in these kinds of organisations. Standard costing procedures can be applied to non-manufacturing activities where operations are of a repetitive nature. However, it cannot be easily applied to activities of a non-repetitive nature, as there is no basis for observing repetitive operations and therefore standards cannot be set.

In organisations that produce many different products and the production consist of series of common operations it is possible to apply a standard costing system (Drury, 1992). In a standard costing system the standard costs for the actual output for a particular period are traced to the managers of responsibility centres who are responsible for the various operations. When it comes to the actual costs for the same period they are also charged to the responsibility centres. The two costs, the standard and the actual, are then compared and the variance between the two is reported (Drury, 1992).

Managers need help in order to analyse where the variances have arisen. Accountants may assist managers in doing this, but it is important they do this together with the responsible managers in order to undertake an appropriate investigation. By doing this together the reason for the variance will easily be identified. An example of the importance of co-operation in investigation of variances is that the accountant might identify the reason for a direct material variance as being due to excessive usage of a certain material.

On the other hand, the responsibility centre manager must investigate this process and identify the reason for the excessive usage. In the accounting literature there is an argument that there is little point in comparing actual performance with standard performance. The argument is that such comparisons can only be made after an event and the usefulness of the result is questioned. However, Drury (1992) argues that if people know in advance that their performance is going to be measured it is more likely that they will perform better. STANDARD COSTING

In the words of Backer and Jacobsen, “Standard cost is the amount the firm thinks a product or the operation of the process for a period of time should cost, based upon certain assumed conditions of efficiency, economic conditions and other factors. ”  Definition                              The CIMA, London has defined standard cost as “a predetermined cost which is calculated from management standards of efficient operations and the relevant necessary expenditure. ” They are the predetermined costs on technical estimate of material labour and overhead for a selected period of time and for a prescribed set of working conditions.

In other words, a standard cost is a planned cost for a unit of product or service rendered. The technique of using standard costs for the purposes of cost control is known as standard costing. It is a system of cost accounting which is designed to find out how much should be the cost of a product under the existing conditions. The actual cost can be ascertained only when production is undertaken. The predetermined cost is compared to the actual cost and a variance between the two enables the management to take necessary corrective measures. Setting Standards

Normally, setting up standards is based on the past experience. The total standard cost includes direct materials, direct labour and overheads. Normally, all these are fixed to some extent. The standards should be set up in a systematic way so that they are used as a tool for cost control. Various Elements which Influence the Setting of Standards Setting Standards for Direct Materials There are several basic principles which ought to be appreciated in setting standards for direct materials. Generally, when you want to purchase some material what are the factors you consider?

If material is used for a product, it is known as direct material. On the other hand, if the material cost cannot be assigned to the manufacturing of the product, it will be called indirect material. Therefore, it involves two things: ? Quality of material ?         Price of the material                                                                          When you want to purchase material, the quality and size should be determined. The standard quality to be maintained should be decided. The quantity is determined by the production department.

This department makes use of historical records, and an allowance for changing conditions will also be given for setting standards. A number of test runs may be undertaken on different days and under different situations, and an average of these results should be used for setting material quantity standards. The second step in determining direct material cost will be a decision about the standard price. Material’s cost will be decided in consultation with the purchase department. The cost of purchasing and store keeping of materials should also be taken into consideration.

The procedure for purchase of materials, minimum and maximum levels for various materials, discount policy and means of transport are the other factors which have bearing on the materials cost price. It includes the following: ? Cost of materials ?         Ordering cost ?         Carrying cost                                                                                        The purpose should be to increase efficiency in procuring and store keeping of materials. The type of standard used– ideal standard or expected standard– also affects the choice of standard price. Setting Direct Labour Cost

If you want to engage a labour force for manufacturing a product or a service for which you need to pay some amount, this is called wages. If the labour is engaged directly to produce the product, this is known as direct labour. The second largest amount of cost is of labour. The benefit derived from the workers can be assigned to a particular product or a process. If the wages paid to workers cannot be directly assigned to a particular product, these will be known as indirect wages. The time required for producing a product would be ascertained and labour should be properly graded.

Different grades of workers will be paid different rates of wages. The times spent by different grades of workers for manufacturing a product should also be studied for deciding upon direct labour cost. The setting of standard for direct labour will be done basically on the following: ? Standard labour time for producing ?         Labour rate per hour Standard labour time indicates the time taken by different categories of labour force which are as under:                                                                                                                         * Skilled labour Semi-skilled labour                                                                                                 * Unskilled labour                                                                                                             For setting a standard time for labour force, we normally take into account previous experience, past performance records, test run result, work-study etc. The labour rate standard refers to the expected wage rates to be paid for different categories of workers. Past wage rates and demand and supply principle may not be a safe guide for determining standard labour rates.

The anticipation of expected changes in labour rates will be an essential factor. In case there is an agreement with workers for payment of wages in the coming period, these rates should be used. If a premium or bonus scheme is in operation, then anticipated extra payments should also be included. Where a piece rate system is used, standard cost will be fixed per piece. The object of fixed standard labour time and labour rate is to device maximum efficiency in the use of labour. Setting Standards of Overheads The next important element comes under overheads.

The very purpose of setting standard for overheads is to minimize the total cost. Standard overhead rates are computed by dividing overhead expenses by direct labour hours or units produced. The standard overhead cost is obtained by multiplying standard overhead rate by the labour hours spent or number of units produced. The determination of overhead rate involves three things: * Determination of overheads * Determination of labour hours or units manufactured * Calculating overheads rate by dividing A by B The overheads are classified into fixed overheads, variable overheads and semi-variable overheads.

The fixed overheads remain the same irrespective of level of production, while variable overheads change in the proportion of production. The expenses increase or decrease with the increase or decrease in output. Semi-variable overheads are neither fixed nor variable. These overheads increase with the increase in production but the rate of increase will be less than the rate of increase in production. The division of overheads into fixed, variable and semi-variable categories will help in determining overheads. Determination of Standard Costs 1.

Determination of Cost Centre According to J. Betty, “A cost centre is a department or part of a department or an item of equipment or machinery or a person or a group of persons in respect of which costs are accumulated, and one where control can be exercised. ” Cost centres are necessary for determining the costs. If the whole factory is engaged in manufacturing a product, the factory will be a cost centre. In fact, a cost centre describes the product while cost is accumulated. Cost centres enable the determination of costs and fixation of responsibility.

A cost centre relating to a person is called personnel cost centre, and a cost centre relating to products and equipments is called impersonal cost centre. 2. Current Standards A current standard is a standard which is established for use over a short period of time and is related to current condition. It reflects the performance that should be attained during the current period. The period for current standard is normally one year. It is presumed that conditions of production will remain unchanged. In case there is any change in price or manufacturing condition, the standards are also revised.

Current standard may be ideal standard and expected standard. 3. Ideal Standard This is the standard which represents a high level of efficiency. Ideal standard is fixed on the assumption that favourable conditions will prevail and management will be at its best. The price paid for materials will be lowest and wastes etc. will be minimum possible. The labour time for making the production will be minimum and rates of wages will also be low. The overheads expenses are also set with maximum efficiency in mind. All the conditions, both internal and external, should be favourable and only then ideal standard will be achieved.

Ideal standard is fixed on the assumption of those conditions which may rarely exist. This standard is not practicable and may not be achieved. Though this standard may not be achieved, even then an effort is made. The deviation between targets and actual performance is ignorable. In practice, ideal standard has an adverse effect on the employees. They do not try to reach the standard because the standards are not considered realistic. 4. Basic Standards A basic standard may be defined as a standard which is established for use for an indefinite period which may a long period.

Basic standard is established for a long period and is not adjusted to the preset conations. The same standard remains in force for a long period. These standards are revised only on the changes in specification of material and technology productions. It is indeed just like a number against which subsequent process changes can be measured. Basic standard enables the measurement of changes in costs. For example, if the basic cost for material is Rs. 20 per unit and the current price is Rs. 25 per unit, it will show an increase of 25% in the cost of materials.

The changes in manufacturing costs can be measured by taking basic standard, as a base standard cannot serve as a tool for cost control purpose because the standard is not revised for a long time. The deviation between standard cost and actual cost cannot be used as a yardstick for measuring efficiency. 5. Normal Standards As per terminology, normal standard has been defined as a standard which, it is anticipated, can be attained over a future period of time, preferably long enough to cover one trade cycle. This standard is based on the conditions which will cover a future period of five years, concerning one trade cycle.

If a normal cycle of ups and downs in sales and production is 10 years, then standard will be set on average sales and production which will cover all the years. The standard attempts to cover variance in the production from one time to another time. An average is taken from the periods of recession and depression. The normal standard concept is theoretical and cannot be used for cost control purpose. Normal standard can be properly applied for absorption of overhead cost over a long period of time. 6. Organization for Standard Costing The success of standard costing system will depend upon the setting up of proper standards.

For the purpose of setting standards, a person or a committee should be given this job. In a big concern, a standard costing committee is formed for this purpose. The committee includes production manager, purchase manager, sales manager, personnel manager, chief engineer and cost accountant. The cost accountant acts as a co-coordinator of this committee. 7. Accounting System Classification of accounts is necessary to meet the required purpose, i. e. function, asset or revenue item. Codes can be used to have a speedy collection of accounts. A standard is a pre-determined measure of material, labour and overheads.

It may be expressed in quality and its monetary measurements in standard costs. Revision of Standards For effective use of this technique, sometimes we need to revise the standards which follow for better control. Even standards are also subjected to change like the production method, environment, raw material, and technology. Standards may need to be changed to accommodate changes in the organization or its environment. When there is a sudden change in economic circumstances, technology or production methods, the standard cost will no longer be accurate.

Standards that are out of date will not act as effective feed forward or feedback control tools. They will not help us to predict the inputs required nor help us to evaluate the efficiency of a particular department. If standards are continually not being achieved and large deviations or variances from the standard are reported, they should be carefully reviewed. Also, changes in the physical productive capacity of the organization or in material prices and wage rates may indicate that standards need to be revised. In practice, changing standards frequently is an expensive operation and can cause confusion.

For this reason, standard cost revisions are usually made only once a year. At times of rapid price inflation, many managers have felt that the high level of inflation forced them to change price and wage rate standards continually. This, however, leads to reduction in value of the standard as a yardstick. At the other extreme is the adoption of basic standard which will remain unchanged for many years. They provide a constant base for comparison, but this is hardly satisfactory when there is technological change in working procedures. Advantages

Standard costing is a management control technique for every activity. It is not only useful for cost control purposes but is also helpful in production planning and policy formulation. It allows management by exception. In the light of various objectives of this system, some of the advantages of this tool are given below: i. Efficiency measurement The comparison of actual costs with standard costs enables the management to evaluate performance of various cost centres. In the absence of standard costing system, actual costs of different period may be compared to measure efficiency.

It is not proper to compare costs of different period because circumstance of both the periods may be different. Still, a decision about base period can be made with which actual performance can be compared. ii. Finding of variance The performance variances are determined by comparing actual costs with standard costs. Management is able to spot out the place of inefficiencies. It can fix responsibility for deviation in performance. It is possible to take corrective measures at the earliest. A regular check on various expenditures is also ensured by standard cost system. ii. Management by exception The targets of different individuals are fixed if the performance is according to predetermined standards. In this case, there is nothing to worry. The attention of the management is drawn only when actual performance is less than the budgeted performance. Management by exception means that everybody is given a target to be achieved and management need not supervise each and everything. The responsibilities are fixed and everybody tries to achieve his/her target. iv. Cost control Costing system aims at cost control and cost reduction.

The standards are being constantly analyzed and an effort is made to improve efficiency. Whenever a variance occurs, the reasons are studied and immediate corrective measures are undertaken. The action taken in spotting weak points enables cost control system v. Right decision It enables and provides useful information to the management in taking important decisions. For example, the problem created by inflating, rising prices. It can also be used to provide incentive plans for employees etc. vi. Eliminating inefficiencies The setting of standards for different elements of cost requires a detailed study of different aspects.

The standards are set differently for manufacturing, administrative and selling expenses. Improved methods are used for setting these standards. The determination of manufacturing expenses will require time and motion study for labour and effective material control devices for materials. Similar studies will be needed for finding other expenses. All these studies will make it possible to eliminate inefficiencies at different steps. LIMITATIONS                                                                                     * It cannot be used in those organizations where non-standard products are produced.

If the production is undertaken according to the customer specifications, then each job will involve different amount of expenditures. * The process of setting standard is a difficult task, as it requires technical skills. The time and motion study is required to be undertaken for this purpose. These studies require a lot of time and money. * There are no inset circumstances to be considered for fixing standards. The conditions under which standards are fixed do not remain static. With the change in circumstances, if the standards are not revised the same become impracticable. The fixing of responsibility is not an easy task. The variances are to be classified into controllable and uncontrollable variances. Standard costing is applicable only for controllable variances. For instance, if the industry changed the technology then the system will not be suitable. In that case, we will have to change or revise the standards. A frequent revision of standards will become costly. Brief summary Standard Costing: Standard costs are realistic estimates of costs based on analysis of both past and projected operating costs and conditions. Standard costing is a budgetary control technique.

Standard costing has three components: 1. A standard. (A predetermined performance level) 2. Actual performance 3. A variance (comparing actual to standard) Computing Standard Costs: A standard costing system uses all elements of product cost, that is, Direct Materials, Direct Labour, and Manufacturing Overhead Calculating Direct Materials Costs Standards: Steps: 1. Calculate the Direct Material Price Standard. Direct Material Price Standard is an estimate of the cost of materials needed in the next accounting period. Typically the purchasing the Department is responsible for developing this number. . Calculate the Direct Material Quantity Standard. Direct Material Quantity Standard is an estimate of all the materials needed to manufacture the budged number units. The production manager or accountants are responsible. Example: Standard Direct Material Cost = Direct Material Price Standard x Direct Material Quantity Standard Materials Price = $2. 75, Standard Material Quantity = 8 $2. 75 x 8 = $22 = Standard Direct Material Cost Calculating Direct Labour Costs Standards: Steps: 1. Calculate the Direct Labour Rate Standard. Direct Labour Rate Standard is