47 Explain How and Why a Standard Cost Is Developed

Fundamentals of Standard Costs

It is important to establish standards for cost at the beginning of a period to prepare the budget; manage material, labor, and overhead costs; and create a reasonable sales price for a good. A standard cost is an expected cost that a company usually establishes at the beginning of a fiscal year for prices paid and amounts used. The standard cost is an expected amount paid for materials costs or labor rates. The standard quantity is the expected usage amount of materials or labor. A standard cost may be determined by past history or industry norms. The company can then compare the standard costs against its actual results to measure its efficiency. Sometimes when comparing standard costs against actual results, there is a difference.

This difference can be attributed to many reasons. For example, the coffee company mentioned in the opening vignette may expect to pay $0.50 per ounce for coffee grounds. After the company purchased the coffee grounds, it discovered it paid $0.60 per ounce. This variance would need to be accounted for, and possible operational changes would occur as a result. Cost accounting systems become more useful to management when they include budgeted amounts to serve as a point of comparison with actual results.

Many departments help determine standard cost. Product design, in conjunction with production, purchasing, and sales, determines what the product will look like and what materials will be used. Production works with purchasing to determine what material will work best in production and will be the most cost efficient. Sales will also help decide the material in terms of customer demand. Production will work with personnel to determine labor costs for the product, which is based on how long it will take to make the product, which departments will be involved, and what type and number of employees it will take.

Consider how many different materials can go into a product. For example, there are approximately 14,000 parts that comprise the average automobile. The manufacturer will set a standard price and a quantity used per automobile for each part, and it will determine the labor required to install the part. At Fiat Chrysler Automobiles’ Belvidere Assembly Plant, for example, there are approximately 5,000 employees assembling automobiles.¹ In addition to having standard costs associated with each part, each employee has standards for the job he or she performs.

Standard costs are typically established for reasonably attainable levels of efficiency (production). They serve as a target and are useful in motivating standard performance. An ideal standard level is set assuming that everything is perfect, machines do not break down, employees show up on time, there are no defects, there is no scrap, and materials are perfect. This level of standard is not the best motivator, because employees may see this level as unattainable. For example, consider whether you would take a course if the letter grades were as follows: an A is 99–100%, a B is 98–99%, a C is 97–98%, a D is 96–97%, and below 96% is an F. These standards are unreasonable and unrealistic, and they would not motivate students to do well in the course.

At the other end of the spectrum, if the standards are too easy, there is little motivation to do better, and products may not be properly built, may be built with inferior materials, or both. For example, consider how you would handle the following grading scale for your course: an A is 50–100%, a B is 35–50%, a C is 10–35%, a D is 2–10%, and below 2% is an F. Would you learn anything? Would you try very hard? The same considerations come into play for employees with standards that are too easy.

Instead of these two extremes, a company would set an attainable standard, which is one that employees can reach with reasonable effort. The standards are not so high that employees will not try to reach them and not so low that they do not give any incentive for employees to achieve profitability.

In order for a company to establish its attainable standard cost for each product, it must consider the standard costs for materials, labor, and overhead. The material standard cost consists of a standard price per unit of material and a standard amount of material per unit. Returning to the opening vignette, let us say the coffee shop is trying to establish the standard materials cost for one cup of regular coffee. To keep the example simple, we are not incorporating the cost of water or the ceramic cup cost (since they are reused). Two components for the cup of coffee will need to be considered:

1. Price per ounce of coffee grounds
2. Amount of coffee grounds (materials) used per cup of coffee

To determine the standards for labor, the coffee shop would need to consider two additional components:

1. Labor rate per minute
2. Amount of time to make one cup of regular coffee

To determine the standard for overhead, the coffee shop would first need to consider the fact that it has two types of overhead as shown in (Figure). Greater detail about the calculation of the variable and fixed overhead is provided in Compute and Evaluate Overhead Variances.

1. Fixed overhead (does not change in total with production)
2. Variable overhead (does change in total with production)

All of this information is entered on a standard cost card.

Once a company determines a standard cost, they can then evaluate any variances. A variance is the difference between a standard cost and actual performance. There are favorable and unfavorable variances. A favorable variance involves spending less, or using less, than the anticipated or estimated standard. An unfavorable variance involves spending more, or using more, than the anticipated or estimated standard. Before determining whether the variance is favorable or unfavorable, it is often helpful for the company to determine why the variance exists.

Different factors may produce a variance. The company could have paid too much or too little for production. It may have purchased the wrong grade of material or hired employees with more or less experience than required. Sometimes the variances are interrelated. For example, purchasing substandard materials may lead to using more time to make the product and may produce more scrap. The substandard material may have been more difficult to work with or had more defects than the proper grade material. In such a situation, a favorable material price variance could cause an unfavorable labor efficiency variance and an unfavorable material quantity variance. Employees who do not have the expected experience level may save money in the wage rate but may require more hours to be worked and more material to be used because of their inexperience.

Another situation in which a variance may occur is when the cost of labor and/or material changes after the standard was established. Toward the end of the fiscal year, standards often become less reliable because time has passed and the environment has changed. It is not reasonable to expect the price of all materials and labor to remain constant for 12 months. For example, the grade of material used to establish the standard may no longer be available.

Manufacturing Cost Variances

As you’ve learned, the standard price and standard quantity are anticipated amounts. Any change from these budgeted amounts will produce a variance. There can be variances for materials, labor, and overhead. Direct materials may have a variance in price of materials or quantity of materials used. Direct labor may have a variance in the rate paid to workers or the amount of time used to make a product. Overhead may produce a variance in expected fixed or variable costs, leading to possible differences in production capacity and management’s ability to control overhead. More specifics on the formulas, processes, and interpretations of the direct materials, direct labor, and overhead variances are discussed in each of this chapter’s following sections.