What is a Standard Cost?
Standard cost is an estimated cost determined by the company for the production of the goods and services or for performing an operation under normal circumstances and are derived by the company from the historical analysis of the data or from the time and the motion studies. Such costs pre-determined by the company are used as the target costs by the company for comparing it with actual costs, and the difference will the variance.
The variance derived is then used by the management of the company for knowing and correcting the cause, making a further estimation for the coming years, and decision making related to business. It almost always varies from the actual costs because the situation keeps on changing, involving different unpredictable factors. It is also known as the normal cost.
Components
In manufacturing set up, there are three main components which include the following:
- Direct Materials – It is derived by multiplying the quantity of each material with the per-unit material cost.
- Direct Labor – It is derived by multiplying the quantity of each of the labor with the per hour labor cost.
- Overhead – It includes fixed overhead cost and variable overhead, which is calculated by multiplying standard quantity with the standard rate of variable overhead.
Example of Standard Cost
There is a company manufacturing watches. At the beginning of the year, the company calculated the cost of the production of the watches by considering the past trends and the expected future conditions of the market. In the coming year the company will likely produce 5,000 units of watches.
Also, it is expected that the standard direct material cost per unit will be $100, the standard labor cost per hour will be $ 20, the standard variable overhead cost is $15 per hour, and the standard fixed cost is $100,000. The total hours that would be required for producing one unit are 10 hours. Find the standard cost of the company.
Solution
Total will be –
- Total = $450
Total Standard Cost will be
Total Cost will be –
- Total Cost is $ 2,350,000
Advantages
- The management of the company uses these costs for planning the process of future production and ways to increase the company’s efficiencies.
- As the standard cost is calculated using the different statistical measures and the experiences of the management, so with the help of this measure, management can innovate different new ways for producing the products which do not require the same type of procedures and thereby reducing the cost of the company.
- The management uses it to determine the reasonability of the actual costs of the period. The difference between the standard and the actual cost helps the management in knowing how close actual expenses matched with it expected to be and deciding the future course of action. For example, if the actual cost of the material is much higher, then the management may investigate the reason for the excess cost.
Limitations
- The task of setting such cost of the production is difficult one as it requires a high degree of the technical skill of the person responsible for setting the same. Therefore it requires lots of effort and cost. Also, the conditions in any business enterprise keep on charging due to which standards have to be revised only a timely basis; otherwise, it will not be worth any more.
- The situations that would prevail in the future in any company or industry is not certain. Different factors affect the company, which makes it challenging to make the correct estimation of the standard cost of the production of goods or the provision of the services by a company while calculating such costs, past experiences, as well as future expense forecast, is required.
- It is not possible to fix these costs in every type of operation as such a system cannot be used in the industries that have no production of any of the standard products.
Important Points
- It almost always varies from the actual costs because the situation keeps on changing, involving different unpredictable factors. The differences arrived are known as the cost variances.
- In case the actual cost of the company is higher than the standard cost, then the company has an unfavorable variance. In contrast, if the actual cost is less than the standard cost, then the company has a favorable variance. The variances so arrived help the management in evaluating the reason for variances so that appropriate actions could be taken.
Conclusion
It is the cost which is estimated by the company which normally occurs during the production of the goods or services, i.e., the amount company expects to spend on the production. It is used by the management for planning the process of the future output, ways to increase the efficiencies, and to determine the reasonability of the actual costs of the period. However, the task of setting the standard cost of production is difficult one as it requires a high degree of technical skill and the efforts of the person responsible for setting the same.
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