Dive into this lesson to learn what standard cost is and explore the two categories of standard cost. When you are through, you’ll understand the difference between actual and standard cost and how standard and actual costs are used in accounting and in business.
Standards Are Everywhere
We may not be aware of it, but standards are everywhere! From the time we wake up to the time we sleep at night, standards practically govern our lives, making many aspects of our life easier and more manageable. When you take your shower in the morning, you have a specific set of preferred bath products. Going to school, you are conscious of your travel time, so you basically know what time to leave home in order to arrive on time to class. At university, students need to meet the required GPA and teachers, even with the concept of academic freedom, follow certain standards as to how lessons will be delivered to the learners. When you sleep at night, you have pre-established required sleeping time for yourself to get well-rested and ready for the next day.
Even the manufacturer of your favorite soda drink, as well as your favorite fast food, have certain standards as to the quality and quantity of the ingredients to use for their products. The laundry shop on the corner has standards as to the process time and the quantity of water and detergent to use. In all types of business, as well as in accounting, standards are ever-present. To some extent, any type of organization, whether manufacturing, service, merchandising, and even the not-for-profit, use standards.
Standard and Actual Costs
In the context of a manufacturing firm, a standard cost is a pre-determined or pre-established cost to manufacture one unit of product. A standard cost has the components of the cost of direct materials, direct labor, and overhead to make one unit. Companies have a so-called standard cost card for each product which shows the standard quantities and standard costs of inputs to make a particular unit of product.
In business, there are two categories of standards – the ideal standards and the practical standards. Ideal standards assume perfect operating conditions. Here, normal production inefficiencies are not taken into account. Machine breakdowns, downtime, employee errors, break periods, etc. are not considered. As a result, standard costs under this category are very tight and, most often, are difficult to meet. Practical standards, on the other hand, consider these normal and reasonable production inefficiencies. Hence, the resulting standard costs are quite tight, yet attainable.
The process of establishing standard cost is quite tedious. It requires inputs from people performing various functions in the organization from purchasing, engineering, production, and accounting. Often, the company’s historical records of production inputs and purchase prices are very useful in the standard cost setting process.
Actual cost, as the term implies, is the actual cost of direct materials, direct labor, and overhead to make a unit of product. It is the historical cost of resources given up to make an item.
Standard Versus Actual Cost
The difference between standard and actual cost is called variance. If actual cost is higher than the standard cost, the variance is unfavorable. This means that the company spends more in terms of the actual manufacturing cost components – items like materials, labor, and overhead – than the determined pre-established standard costs for manufacturing that product. Conversely, if actual cost is lower, the variance is favorable. That is, the company is able to make savings on some or all of the components of manufacturing cost.
In accounting, if variances are insignificant or small in amount, these are closed to cost of goods sold (COGS). Favorable variances decrease COGS and, therefore, increase net income. Unfavorable variances increase COGS and decrease net income. If variances are significant, whether favorable or unfavorable, these are allocated between the company’s inventory account and COGS. However, significant unfavorable variance that is due to production mistakes or inefficiencies is never allocated to an asset or inventory account. This will only be closed to COGS and eventually net income.
In operations, variance reports can be used by managers to improve operations. Variances act as red flags, which will help managers direct their attention to areas that need it. In management, this is called management by exception, where managers will only focus their attention on areas that specifically need it, so they will have more time available to pursue other, more important, management functions.
For instance, a significant price variance indicates that the actual prices of items purchased differ significantly compared to the standard prices. This may prompt management to investigate what caused such variance. Further investigation may reveal glitches in the process such as, perhaps, the purchasing department did not do canvassing, or there was a substitution of raw materials or that quantity discounts were not availed of because of a rush order. When the cause is identified, it becomes easier for management to introduce corrective actions to improve operations in the future.
A standard cost is a pre-determined or pre-established cost to make a unit of finished product. Standard costs may be ideal or practical. Ideal standards assume perfect conditions and are very tight and highly unattainable. Practical standards, which consider normal and reasonable product inefficiencies, are tight, yet attainable. Actual cost is the actual cost of direct materials, direct labor, and overhead to make a unit of product.
The difference between actual cost and standard cost is called variance. A variance is unfavorable if actual cost is higher than standard cost. If actual cost is lower, the variance is favorable. In accounting, variances are either closed to COGS and net income or allocated between the inventory account and COGS, depending on whether the variance is significant or not, favorable or unfavorable. Variance reports are used by many managers in improving operations. Managers then use these reports to engage in management by exception, which is when managers only focus their attention on areas that specifically need it.