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The Theory and Practiceof Standard Costing

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The Theory and

Practice ofStandard Costing

2007.145

2LEARNING OUTCOMES

After completing this chapter, you will be able to

explain why and how standards are set in manufacturing and service industries withparticular reference to the maximisation of efficiency and minimisation of waste;

calculate and interpret material, labour, variable overhead, fixed overhead and sales vari-ances;

prepare and discuss a report which reconciles budget and actual profit using absorption

and/or marginal costing principles.

2.1 Introduction

You should be familiar with the basic principles of standard costing and variance

analysis from your foundation (or equivalent) studies. The initial content of this chapter

amounts to a revision of these basic principles. You are advised to devote adequate

time to this revision. The CIMA examination scheme is cumulative and MAPE exami-

nation questions in this particular area may draw heavily on material from foundation

studies.Standard costing and variance analysis represent a particular approach to performance

evaluation. The concept that underpins them is that efficiency can be monitored by peri-

odically comparing actual costs incurred with standard costs for output achieved. This con-

cept is not valid under all circumstances. In subsequent chapters, the text goes on to explore

both the practice and the limitations of standard costing.



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2.2 The theory and practice of standard costing

CIMAs Terminologydefines standard costing as follows:

Standard costing: Control technique that reports variances by comparing actual costs

to pre-set standards so facilitating action through management by exception.

You will see from this definition that there are very close relationships between standard

costing and budgetary control (the practice of making continuous comparison between

budget and actual results). They both compare the actual results with the expected perfor-

mance to identify any variances. The difference is that with standard costing the compari-

son is usually made at a unit level, that is, the actual cost per unit is compared with the

standard cost per unit. The resulting variances may be analysed to show their causes and we

will see how this is done later in this chapter.In order to be able to apply standard costing it must be possible to identify a measurable

cost unit. This can be a unit of product or service but it must be capable of standardising: for

example, standardised tasks must be involved in its creation. The cost units themselves do not

necessarily have to be identical: for example, standard costing can be applied in some job cost-

ing situations where every cost unit is unique. However, the jobs must include standardised

tasks for which a standard time and cost can be determined for monitoring purposes.

2.3 What is a standard cost?

A standard cost is a carefully predetermined unit cost which is prepared for each cost unit.It contains details of the standard amount and price of each resource that will be utilised in

providing the service or manufacturing the product.

The standard cost may be stored on a standard cost card like the one shown below, but

nowadays it is more likely to be stored on a computer, perhaps in a database. Alternatively, it

may be stored as part of a spreadsheet so that it can be used in the calculation of variances.

The standard cost may be prepared using either absorption costing principles or marginal

costing principles. The example which follows is based on absorption costing.

Example: Standard cost card: product 176

per unitDirect materials 40 kg @ 5.30 212.00Direct wages

Bonding 48 hours @ 2.50 120.00Finishing 30 hours @ 1.90 057.00

Prime cost 389.00Variable production overhead

Bonding 48 hours @ 0.75 36.00Finishing 30 hours @ 0.50 015.00

Variable production cost 440.00Fixed production overhead 040.00

Total production cost 480.00Selling and distribution overhead 20.00

Administration overhead 010.00Total cost 510.00

STUDY MATERIAL P146

THETHEORYANDPRACTICEOFSTANDAR

DCOSTING

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For every variable cost the standard amount of resource to be used is stated, as well

as the standard price of the resource. This standard data provides the information for a

detailed variance analysis, as long as the actual data is collected in the same level of

detail.Standard costs and standard prices provide the basic unit information which is needed

for valuing budgets and for determining total expenditures and revenues.

2.4 Performance levels

2.4.1 A standard

CIMAs Terminologydefines a standard:

Standard: A benchmark measurement of resource usage, set in defined condi-tions. The definition goes on to describe a number of bases which can be used

to set the standard, including

a prior period level of performance by the same organisation;

the level of performance achieved by comparable organisations;

the level of performance required to meet organisational objectives.

Use of the first basis indicates that management feels that performance levels in a prior

period have been acceptable. They will then use this performance level as a target and con-

trol level for the forthcoming period. When using the second basis management is being more outward looking, perhaps

attempting to monitor their organisations performance against the best of the rest.

The third basis sets a performance level which will be sufficient to achieve the objectives

which the organisation has set for itself.

2.4.2 Ideal standard

Standards may be set at ideal levels, which make no allowance for normal losses, waste and

machine downtime. This type of ideal standard can be used if managers wish to highlight

and monitor the full cost of factors such as waste, and so on; however, this type of stan-dard will almost always result in adverse variances since a certain amount of waste and so

on is usually unavoidable. This can be very demotivating for individuals who feel that an

adverse variance suggests that have performed badly.

2.4.3 Attainable standard

Standards may also be set at attainable levels which assume efficient levels of operation,

but which include allowances for factors such as normal loss, waste and machine down-

time. This type of standard does not have the negative motivational impact that can arise

with an ideal standard because it makes some allowance for unavoidable inefficiencies.

Adverse variances will reveal whether inefficiencies have exceeded this unavoidable

amount.

47MANAGEMENT ACCOUNTING PERFORMANCE EVALUATION

THETHEORYANDPRACTICEOFSTANDARDCOSTING

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Standard Costing ACCA t4 t7 f5

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