8.1 Explain How and Why a Standard Cost Is Developed

Standard costs and budgeting are essential tools for financial planning and control. They help businesses set cost targets, estimate future expenses, and evaluate performance by comparing actual results to predetermined benchmarks.

Managers use standard costs to simplify accounting, facilitate decision-making, and identify areas for improvement. Various departments collaborate to establish these standards, considering factors like material prices, labor rates, and production efficiency to create realistic and achievable cost targets.

Standard Costs and Budgeting

Standard costs in budgeting

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• Predetermined costs expected to incur for producing a unit of product or providing a service
  • Determined before the start of a period used as a benchmark for actual performance
  • Basis for budgeting and cost control
• Benefits of using standard costs:
  • Simplifies cost accounting by providing a single, predetermined cost figure for each product or service
  • Facilitates performance evaluation by comparing actual costs against the standard
  • Enables better cost management by identifying areas where actual costs deviate from the standard
  • Supports decision-making by providing a consistent cost basis for pricing and profitability analysis (break-even analysis)
• Standard costs incorporated into budgets to:
  • Estimate expected costs for a given level of production or service (manufacturing budget)
  • Set targets for cost reduction and efficiency improvements (kaizen costing)
  • Monitor and control costs throughout the budget period (variance analysis)
  • Serve as a tool for performance measurement and continuous improvement

Departmental roles for cost standards

• Collaborative effort involving various departments within the organization
• Purchasing department:
  • Provides information on expected prices for raw materials and components (steel, plastic)
  • Negotiates with suppliers to secure favorable terms and ensure a reliable supply
  • Engages in cost benchmarking to compare prices with industry standards
• Production department:
  • Determines standard quantities of materials, labor, and overhead required to produce one unit of product
  • Considers factors such as production processes, equipment efficiency, and historical data (time studies)
  • Focuses on improving production efficiency to meet or exceed standard costs
• Engineering department:
  • Assists in establishing standard material quantities and specifications (bill of materials)
  • Provides insights on product design, manufacturing techniques, and potential process improvements (value engineering)
• Human Resources department:
  • Helps determine standard labor rates based on job classifications, skills, and prevailing market rates
  • Considers factors such as union contracts, employee benefits, and training costs (labor negotiations)
• Accounting department:
  • Compiles and analyzes data from various departments to calculate the overall standard cost per unit
  • Allocates overhead costs to products based on appropriate drivers such as labor hours or machine hours (activity-based costing)
  • Communicates the standard costs to relevant stakeholders and integrates them into the budgeting process

Cost Estimation and Development

• Utilizes various methods for cost estimation, including historical data analysis, engineering studies, and market research
• Involves cost allocation techniques to accurately distribute overhead costs to products or services
• Considers industry best practices and technological advancements in developing standard costs

Factors of cost variances

• Variances are differences between standard and actual costs incurred during a period
• Material price variance:
  • Occurs when actual price paid for materials differs from standard price
  • Caused by factors such as market fluctuations, supplier pricing changes, or purchasing inefficiencies (bulk discounts)
• Material quantity variance:
  • Arises when actual quantity of materials used differs from standard quantity allowed
  • Caused by factors such as waste, spoilage, or changes in product specifications (defective units)
• Labor rate variance:
  • Occurs when actual labor rate paid differs from standard rate
  • Caused by factors such as wage rate changes, overtime pay, or hiring workers with different skill levels (temporary workers)
• Labor efficiency variance:
  • Arises when actual labor hours used differ from standard hours allowed
  • Caused by factors such as worker productivity, training, or changes in production processes (automation)
• Overhead spending variance:
  • Occurs when actual overhead costs incurred differ from budgeted amount
  • Caused by factors such as changes in utility rates, maintenance costs, or fixed overhead allocation (rent increase)
• Overhead efficiency variance:
  • Arises when actual level of production differs from budgeted level, affecting absorption of fixed overhead costs
  • Caused by factors such as changes in production volume, idle capacity, or production mix (seasonal demand)