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What is Standard Costing: Formula, Example, and Implementation

The manufacturing unit of any business model accounts for the major expense of the company. Therefore, estimating the production cost is essential for understanding the company’s annual cost. This estimation is standard costing. Here, the manufacturers predict a product’s average cost. In this article, you will learn to define standard costing and the other things you need to know.

What is the meaning of Understanding Standard Costing?

The actual cost of a product is not up for easy determination. Therefore, coming up with an average cost with the help of a formula is the standard costing definition. You must estimate the labour and material costs to calculate the product price. 

Elements of standard costing

The three elements  units of the standard costingis method are mentioned below:

  • Direct labour: The employee hourly rate multiplied by work hours and the total number of manufacturing units will give the direct labour cost. 
  • Direct Material: The material cost formula to calculate the direct material cost is multiplying the market price of each unit by the number of total units.
  • Overhead costs: The miscellaneous cost that cannot be categorised under either is called overhead cost. To calculate the cost, multiply the variable manufacturing overhead by the total unit. Next, add the result with the fixed overhead. 

Types of Standard Costing

There are three major types of standard costing. These are known as basic, ideal, and current. These three variants usually depend on the accuracy of the estimation. 

  • Ideal Standards: The ideal type of standard costing represents the perfect estimation with no losses. They calculate the minimum cost of a product. And it is possible under favourable conditions. 
  • Attainable Standards: Attainable standard costing is when the predicted cost is attainable under operating conditions which are efficient. 
  • Current Standards: The standard costing used for a short period is called current standard costing. The calculation happens by adhering to contemporary conditions. 

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Advantages of standard costing

This process has helped businesses follow definitive finance guidelines to maximise their profit. It has also helped them in serving their customers more efficiently. Some of the advantages of standard costing are as follows, 

  • Cost control and performance evaluation

As standard costing is a technique of cost accounting of a company, it assists the organisation in controlling expenditures. It is there by fixing the product price with the help of standard costing. Moreover, it makes a company more efficient and competent.

  • Budgeting and planning

Another significance of standard costing is assisting in formulating the company’s budget. The manufacturing unit accounts for the major costs of the organisation. In order to strategize a budget, standard costing is fundamental. 

  • Simplification of costing procedures

This procedure simplifies the costing procedure, such as calculating the inventory value. Manufacturers multiply the actual inventory by each item’s standard cost to obtain the cost estimation. 

Limitations of standard costing

The procedure is mostly efficient and promotes the competence of a business. The reason behind this is to be more competitive in the race. However, here are some of the common drawbacks:

  • Inflexibility in changing conditions

It is not possible for companies to frequently alter their production techniques to calculate a standard costing and maintain it. Since the calculation is based on a particular formula, adjusting the parameters isn’t easy.

  • Difficulty in setting accurate standards 

Apart from the internal factors, many external factors can also affect the standard costing. Therefore, considering environmental factors can alter the accuracy of standard costing. 

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Standard Costing Formula

The following formula calculates the standard costing. 

Standard Costing = direct labour + material cost + manufacturing overhead

Let us see how to determine the value of each element in the standard costing formula. 

1. Direct Materials Cost Variance

This is the difference between the actual and expected costs of the direct material used. The two units here are Material Price Variance (MPV) and Material Quantity Variance (MQV)

  • MPV = Quantity of Materials Used x (budgeted price per unit of materials – actual price per unit of material)
  • MQV = Standard cost per unit x (actual quantity used – standard quantity used)

2. Direct Labour Cost Variance

The difference between standard and actual labour costs for production is the direct labour cost variance. The two units involved are LRV and LEV. 

  • LRV = (Actual hours x actual rate) – (Actual hours x standard rate)
  • LEV = Standard rate per direct labour hour x (standard hours allowed for production – actual hours taken

3. Overhead Cost Variance

The difference between the actual and budgeted amount for overhead cost is the variance. The two units are variable overhead cost variance and fixed overhead cost variance. 

  • Variable overhead cost variance = (Actual cost-standard cost) x actual quantity 
  • Fixed overhead cost variance = Standard overhead cost – actual overhead cost

Standard Costing Example

Details are a must when we are talking about calculating the product details of the company.

Company background and product information

Suppose we are calculating the standard costing of a company. The required information needed will be, 

  • Direct labour – ₹ 500 per hour 
  • Raw material – ₹ 5000 per unit
  • Total number of units – 500
  • Manufacturing Overhead – ₹ 500 per unit 
  • Time to produce one unit – 5 hours
  • Fixed overhead – ₹ 5,00,000

Establishing standard costs

Material cost – ₹5000 x 500 = ₹2,500,000

Direct labour = 500 x 5 x 500 = ₹1, 250, 000

Manufacturing overhead = ₹ 5,00,000 + ₹ 500 x 500 = ₹ 7,50,000

Therefore, 

Standard costing = ₹ 2,500,000 + ₹ 1, 250,000 + ₹ 7,50,000 = ₹ 4, 500, 000

Variance Analysis

Basically, variance is the difference between the projected and the actual cost of a product. This analysis is the study and reasoning behind the difference. For instance, when a company’s material or overhead cost does not equate with the projected cost, the reason will be looked for. 

This analysis helps organisations to realise the actual issue of the disparity. With that, they may improve their production operations accordingly. 

  • Direct Materials Cost Variance – The material cost variance is the difference between the actual and the projected material cost 
  • Direct Labour Cost Variance – The difference between the actual and projected labour cost is called the direct labour cost variance. 
  • Overhead Cost Variance – When there is a difference between the actual and protected overhead cost it is called the overhead cost variance. 

Interpretation Of Results

The main objectives of standard costing are to calculate a company’s budget, management planning, etc. Together, these help an organisation control its expenditures and maximise its profit. There are two types of parameters in this case,

  • It is an unfavourable variance if the actual cost is higher than the predicted cost. This means the company’s profit is less than the prediction. 
  • If the projected cost exceeds the actual cost, it is the favourable variance. It is because the company maximises its profits.

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Implementing Standard Costing

There are five major ways to apply the standard costing to your company. They are as follows:

  • Building Cost Center

Cost centres are departments in the company that help in determining the organisation’s production cost. They measure all conditions and calculate a certain cost for a product. Trying to achieve favourable variance improves the company’s competence and performance. 

  • Setting The Standard Cost 

You must choose from three major standard costing according to the company’s convenience. If you are an evolving company, selecting current standard costing is your best bet. 

  • Material and Labor and Overhead Standards

This cost differs with the kind of product. Therefore, after researching the product’s market price, fix the costs. 

  • Recording costs and analysis

Thirdly, the data on the actual cost will be subject for recording to calculate the variance. Additionally, analyse the reason for the hike or the decrease. This information will help you detect the sections that need improvement. 

  • Investigation and rectifying variances

Lastly, from the insights gained from the data, try to strategize your costs again to remodel the production cost. This will elevate the company’s competence and market presence in its domain. 

Integration With Other Costing Systems

Standard costing is functional in combination with other costing systems. As standard costing in cost accounting is quite a common costing method, it can be its use can be integrated with systems like: 

  • Absorption Costing – This is also known as full costing. It includes the entire manufacturing cost (variable and fixed). The formula to integrate both of them is 

Absorption cost = (Direct Labor Cost + Variable manufacturing overhead cost + Direct Material Cost) / number of units produced 

  • Marginal costing – This gives the required cost for manufacturing one additional product. Here, the variable cost charges to the units of cost, and the fixed cost is eliminated. The formula to integrate standard costing with this system is 

Marginal Cost = Change in Total Cost/Change in Quantity

Continuous improvement and updating standards

Standard costing is an ongoing process that helps a company to continuously improve its standards. It also helps them to become more competitive. It provides the benchmark for controlling the company’s cost. Additionally, it helps evaluate the performance of the company. 

The more favourable variance they achieve, the more the company standards will elevate gradually. Moreover, pre-determining the cost helps organisations identify the scope for improvement. This approach also helps companies to maximise their profit. 

Real-World Applications

There are various practical applications of standard costing, especially in manufacturing and service industries, NGOs, etc. This system helps industries step closer to achieving product cost, making them more competitive. These industries use them in the following manner, 

  • Evaluate the inventory and production cost 
  • Budgeting and forming relevant predictions for company operations
  • Ensure the efficiency of labour
  • Monitor the use of materials
  • Controlling the cost of the company 

Conclusion

Organisations seeking to draw an effective budget plan must opt for standard costing. These help them to be more efficient in their operations. Therefore, it provides a cost-effective product to the users. This system will benefit the company in multiple ways throughout. Implementing this cost accounting system will aid in establishing a better and stronger presence in the business world. 

FAQs On Standard Costing 

Q1: What is the formula of standard costing?

Ans: Standard costing = Direct labour cost + direct material cost + manufacturing overhead cost 

Q2: Why is standard costing required?

Ans: It is important to fix the price of the product and help in curating a proper budget plan

Q3: Are there any limitations in standard costing?

Ans: Yes, there are a few limitations, like a lack of flexibility with changing conditions, negatively impacting employee morale, etc. 

Q4: What are the types of standard costing?

Ans: There are three types: ideal, current, and attainable. 

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