Standard Costing Simplified: Key Strategies for Financial Success
What is Standard Costing?
In a competitive market, standard costing is a method used to provide a clear, accurate budget, helping manufacturing businesses manage their costs more effectively. It pinpoints where they can cut costs or where they might need to invest more, keeping businesses agile and informed.
A "standard cost" is the expected cost for producing one unit of whatever you're making. It takes into account the anticipated costs for materials, labor, and overhead—everything from buying raw materials to paying for the electricity used. This cost acts like a yardstick, helping businesses measure how well they're doing financially by comparing what they thought they would spend against what they actually spend.
Step by Step Approach to Standard Costing
Step 1. Set standard costs for products and services ahead of time. This step includes identifying how much each product should cost to produce.
Step 2. Identify variances (under- or overspending) comparing actual costs against predefined targets.
Step 3. Analyse the variances between expected standard costs and actual costs and identify the reasons why there are differences. This analysis can reveal inefficiencies or areas where spending is higher than expected.
Step 4. Take action to improve processes and streamline operations to reduce unnecessary costs and increase profitability.
Step 1. Setting Standard Costs
Standard costs are usually determined using past data, industry standards, and forecasts of future costs, considering things like inflation and market trends.
Material costs are the costs of all the raw materials needed for production. We estimate these costs based on past purchases and adjust for any expected changes in prices.
Labor costs include payments for workers who will produce the goods. We calculate this by estimating how long the job should take and the pay rate for the workers involved.
Overhead costs cover everything else that's needed to make the product but isn't directly part of manufacturing, like electricity or equipment depreciation. These costs can be allocated based on how many hours workers spend on the job or how much machine time is used.
Example:
Setting up a standard cost involves a detailed process to determine the expected costs involved in production.
1. Identify Costs of Key Components
Materials costs: Calculate the cost of direct materials by multiplying the cost per unit of material by the quantity required for each product. For instance, if the cost per kilogram of a material is R100 and you need 20 kilograms per unit, the standard cost for materials would be R2000.
Labor costs: Determine the labor cost by multiplying the hourly wage by the standard hours needed to produce one unit. If the wage rate is R150 per hour and it takes 10 hours to make one unit, then the standard labor cost is R1500.
Overhead costs: Calculate overhead by multiplying the overhead rate by the applicable measure, such as the number of labor hours. If overhead costs R100 per hour and it takes 5 hours of labor, the overhead cost would be R500.
2. Total the Standard Cost for product
Sum up the costs calculated for materials, labor, and overhead to find the total standard cost of producing one unit. Using the given example, the total would be R4000, composed of R2000 for materials, R1500 for labor, and R500 for overhead.
Step 2. Identifying Variances
After establishing the standard costs, the next step is production and the tracking of actual costs. Let’s say the actual costs incurred were as follows:
Direct Materials: The actual cost was R2,200 for 20 kilograms (due to a price hike in materials).
Direct Labor: The actual labor cost amounted to R1,650 for 10 hours (due to increased wage rates).
Overhead: The actual overhead cost was R550 for 5 hours of labor (perhaps due to an unexpected increase in utility rates).
Total Actual Cost: Adding up the actual costs gives us R4,400, which is composed of R2,200 for materials, R1,650 for labor, and R550 for overhead.
Step 3. Analysing Variances
Material Variance: R2,200 (actual) - R2,000 (standard) = R200 unfavorable.
Labor Variance: R1,650 (actual) - R1,500 (standard) = R150 unfavorable.
Overhead Variance: R550 (actual) - R500 (standard) = R50 unfavorable.
Total Variance: The total actual cost of R4,400 compared to the standard cost of R4,000 results in a total variance of R400 unfavorable.
Step 4. Taking Action to Manage Costs
Given these variances, the business needs to investigate and manage costs as follows:
Review Supplier Contracts
For material variances, especially if due to price hikes, review contracts and negotiate better terms or look for alternative suppliers offering more competitive rates.
Analyse Labour Efficiency
Investigate the reasons behind the increase in labor costs. If due to increased wage rates, consider whether efficiency improvements can balance the higher costs, or if additional training or technology can enhance productivity.
Monitor and Adjust Overhead Spending
For overhead variances, scrutinise the specific causes of increased rates. If utility rates spiked unexpectedly, consider energy-saving measures or renegotiate terms with utility providers.
Continuous Improvement
Implement a continuous review and adjustment process. Use variance analysis not just for pinpointing issues but also for ongoing improvement of costing accuracy and operational efficiency.
Educate and Train Staff
Ensure that all involved staff understand the importance of cost control and are trained to maintain efficiency in their respective roles.
What Entities Should Use Standard Costing?
Standard costing is most beneficial in the following scenerios:
Manufacturing industries that produce goods in bulk, as it helps to predict and control costs effectively, maintaining competitiveness in pricing.
Operations that repeat the same processes over and over with standard costing establishing accurate cost standards that optimise budgeting and financial management.
Industries where projects are unique or services are highly customised, helping to manage budgets and financial efficiency on a project-by-project basis.
Businesses that are aiming to streamline operations and minimise waste by setting clear cost targets and enhancing overall efficiency.
Role of Accountants in Assisting Clients
Accountants are key in helping their clients manage costs effectively and report finances accurately. They should guide clients in establishing robust costing systems to better predict and control expenses. By regularly reviewing financial results and pinpointing where costs differ from budgeted amounts, accountants can offer practical advice to improve operations and increase profits. Their ongoing support ensures that clients make well-informed decisions, streamline their processes, and successfully meet their financial goals. Through clear and straightforward communication, accountants make complex financial information understandable and useful for their clients.
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