Standard Costing as a Control Mechanism

Standard costing is technique of cost planning and control, based on scientific analysis of elements of cost in terms of standard input / output norms and standard rates / price per unit of input. The following process is involved in setting and practicing  standard  cost.

  • Establish standard cost, component-wise, for each output
  • Measure the actual cost, component-wise, for each output
  • Their comparison with the actual costs and the measurement of variances.
  • The location of responsibility for the variances and the corrective action to be taken.
  • The analysis of variances for ascertaining the reasons for the same.

Establishment of a Standard Costing System

The installation of Standard Costing  System in a manufacturing concern involves the following steps:

  • Standardization of Functions: All activities should be standardized and the technical processes of operations should also be susceptible to planning.
  • Establishment of Cost  Center
  • Classification of Accounts: The different accounts can be codified and different symbol may be used to facilitate speedy collection, analysis and reporting.
  • Setting up of Standards: Standards may be basic (long period) and current (short period).

The standard should be realistic and attainable. Unrealistic standards provoke resentment and depress performance. Loose standard leads the management to indulge in self-congratulation. Normally, a period of one year is more realistic, as it coincides with the budget period and the normal accounting period.

Setting of Standard Costs

Standard Costs should be determined for each element of cost separately and accurately. Like a budget committee in big institutions, there should be a standards committee or Standards Division which will be vested with the work of setting standard costs. The Standards Committee generally consists of all functional heads like program manager, personal manager, etc.

Standard Costs

For any given program or unit the following standards must be determined:

  • Standard material costs
  • Standard labour costs
  • Standard direct costs
  • Standard variable overhead costs
  • Standard fixed overhead costs
  • Standard selling prices and profit

The standard direct material cost is found by multiplying the quantity of materials to be purchased with the rate of a price at which they are available.

Determination of Standard Labour cost involves fixation of

  • Standard  labor  grades
  • Standard  labor  times i.e., standard hours through “Time, Motion and Fatigue Study” with the help of work study engineers and
  • Standard wage rates based on time rate, piece rate and premium plans.

Standard Direct (expenses) cost is any expenditure (other than direct material and direct  labor   which is directly to be incurred on a specific cost unit. It is charged directly to the particular cost standard (account) concerned.

Standard Overhead costs are classified as manufacturing, administration. selling and distribution overheads. They are also classified as fixed, variable and semi-variable so that correct estimate for each class may be prepared for the budget period. Standard overhead rate is determined on the basis of past records and future trend of prices.

Determination of Standard Hour: Time factor is common to all the operations. So if standard costing ‘Standard hour’ is applied to the quantity of work or output which should be performed in one hour. A standard hour may be defined as an hour which measures the amount of work that should be performed in one hour under standard conditions. It has a practical advantage in the measurement of ‘Efficiency Ratio’ and ‘Activity Ratio’.

Efficiency ratio: Efficiency ratio is the number of standard hours equivalent to the work produced, expressed as a percentage of the actual hours spent in producing that work.

Efficiency Ratio = [Standard hours for actual production/Actual hours for action production] x 100

Activity Ratio:  Activity Ratio is the number of standard hours equivalent to the work produced, expressed as a percentage of budgeted standard hours.

Activity Ratio = [Standard hours for actual production/Standard hours for budgeted production] x 100

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