Standard Costing in Accounting: Definition, Formula, Method, Example, Advantages and Disadvantages

Companies use various costing techniques to derive the cost of their products. Once they do so, they can apply a markup or margin to that cost to determine the sale price for a specific item. However, companies may also work with fixed prices in the market to stay competitive. It is crucial to keep costs in check at the time they occur. For that purpose, companies may use standard costing.

What is Standard Costing?

Standard costing is a costing technique used to establish benchmarks for the costs incurred during production. Essentially, it involves planning for several types of expenses before they occur. Companies set a standard unit and expected cost for each area during this process. Once they have information regarding the actual expenses incurred during production, they compare it to the standard costs.

Standard costing is more prominent in industries where labour work is the primary component of production. It may not be as prevalent now since companies have machines to replace manual work. Nonetheless, standard costing can help set a target for various processes. It also provides the base for standard cost accounting and assists with variance analysis.

How does Standard Costing work?

Standard costing starts from identifying items that require expenditure. Usually, these include material and labour. Once established, companies use efficiencies to determine how much of these items are required to produce a single unit of product. In some cases, companies may also obtain this information from industry benchmarks or competitors.

At that stage, standard costing only sets a plan or target for the production process. Primarily, it acts as a budget. Managers responsible for those costs ensure they meet standards in their respective departments. Once companies have actual information regarding the costs incurred, they can compare it with the standards. Then, they can use variance analysis to identify any inefficiencies in various processes.

How to calculate Standard Costs?

Companies use different methods to establish standard costs. However, these techniques use the same principles. Primarily, companies calculate standard costs using the following steps.

  1. Establish all the direct costs that go into manufacturing a product.
  2. Calculate the standard units for those areas based on actual output.
  3. Divide those areas into their relative heads and establish whether they are variable or fixed.
  4. These areas should establish the standard costs for the manufacturing process.

As stated above, some companies may also get their information from other sources. Nonetheless, the process of standard costing remains similar.

What are the advantages and disadvantages of Standard Costing?

Standard costing helps companies budget for the manufacturing process. On top of that, it also provides a base to set product prices. Standard costing also promotes accountability within the production process. Similarly, it also helps maximize outputs and minimize wastage. Overall, standard costing works as a cost control tool within companies.

However, standard costing comes with some issues. Initially, it applied to labour-intensive companies to control their costs. With time, machines have taken over and made processes more efficient. Therefore, standard costing has limited use in the modern world. On top of that, setting a standard is not straightforward and requires significant consideration.

Conclusion

Standard costing is a technique within cost accounting that helps establish a benchmark for various costs. However, it has become obsolete as its primary focus was companies with significant labour hours. Despite that, standard costing is relevant to some industries. Companies can set a standard cost for different areas in a few steps, though it requires substantial expertise.

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