Standard Costing and Standard Cost Pricing

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Definition of Standard Costing.

Standard costing (also called "Standard Cost Accounting") is a management accounting system used by many manufacturing companies to identify the differences or variances between the actual costs of the goods produced and the standard costs of the estimated costs of the goods produced. It was introduced around 1920 as an alternative for traditional cost accounting approaches (such as the FIFO and LIFO methods) which was based on historical costs.

A standard cost can be described as a predetermined, expected, estimated, forecasted, future cost.

Applications of Standard Costing. Usage

• Variance analysis: This breaks down the variation between actual cost and standard costs into its various elements (volume variation, material cost variation, labor cost variation, etc.) to help managers understand why costs were different from what was planned and determine appropriate action. When differences between standard and actual costs arise, management becomes alert and investigates the reasons through variance analysis:
  
  • If actual costs are greater than standard costs, the variance is unfavorable. An unfavorable variance tells management that the company's actual profit could be less than planned.
  • If actual costs are less than standard costs, the variance is favorable. A favorable variance tells management that the actual profit will likely exceed the planned profit.
  The sooner that the accounting system reports a variance, the sooner that management can direct its attention to the difference and make appropriate corrections.
• Basis for Standard Cost Pricing (see below).

How to calculate standard costs?

To calculate the standard cost of a product, a company can use the following formula:

Standard Cost = Direct Labor + Direct Materials + Manufacturing Overhead

In this formula,

• Direct Labor (a standard quantity of labor and a standard cost per hour of labor) = Hourly Rate x Hours Worked
• Direct Materials (a standard quantity of each material and a standard cost per unit of material) = Raw Materials x Market Price
• Manufacturing Overhead (a budget for the fixed overhead, the standard variable overhead rate, and the standard quantity for applying a fixed and variable overhead rates) = Fixed Salary + (Machine hours x Machine rate)

Benefits of Standard Costing. Advantages

• BUDGETING. Allows a company to budget: A company cannot prepare its budget without the inputs of standard costs. That means, a budget can be nothing but an estimate, just like standard costs. However, by carefully comparing budget with the actually spent costs that are known later, the next year's budget can become more accurate.
• INVENTORY COSTING. Helps simplify a company's inventory calculation: By multiplying the amount of actual inventory by the standard cost of each item, a company can easily calculate its inventory value if the company has been doing a similar type of production for some time. Typically an inventory valuation will use standard costs rather than actual costs because it can be rather difficult to keep track of the actual numbers, although eventually any difference will be accounted for by being added to the variance cost.
• PRICE FORMULATION. Makes it possible for a company to set a product price: Similar to helping with budget preparation, standard costing provides critical information for setting a product's price, which is calculated based on the product's manufacturing costs (including labor, materials and overhead costs).
• FINANCIAL ACCOUNTING: Allows financial records to be produced easier and faster: Using standard costs to produce the required financial reports for a company's management is easier and faster than using actual costs since the former assumes there are no fluctuations in prices.
• BENCHMARKING: Allows for benchmarking and variance analysis: Management can use standard costs to set benchmarks and implement variance analysis in order to determine efficiencies in the production process and to lower those costs in the future.

Disadvantages of Standard Costing. Drawbacks

• Assumes little change to the estimated costs: The standard costing method assumes little change in budget in the foreseeable future. This can result in significant variances from the estimates in situations of changes, such as a product being unexpectedly discontinued or a new one introduced.
• Doesn't provide enough information to distinguish product units: The analysis of a specific product unit requires using actual costs instead of standard costs in order to determine the unit's value with accuracy.
• Focuses on unfavorable variances: Management attention is usually focused on unfavorable variances and their scrutiny. This can make the related staff feel their performance is being questioned, although the real cause of the variances can have nothing to do with workers' efficiency but simply wrong estimation in the first place.
• Emphasizes labor efficiency even though this often constitutes only a small part of the cost.
• if inventory is increased, this means that production processes must operate at higher rates. In case of a malfunction, fixing it maight take longer and uses more than the standard labor time. The manufacturing manager appears responsible for the excess, even though they have no control over the production requirement or the problem.

What is Standard Cost Pricing?

Standard Cost Pricing is an approach to pricing based on standard cost accounting wherein standard variable cost per unit are calculated by adding the total variable costs of production (materials and labor) to the cost of bought-in components and dividing the sum by the number of units produced. This type of pricing can be frequently found in manufacturing environments.

A benefit of this approach is its simplicity. Also it is fact-based. A disadvantage is the risk of underestimating customer demand and the value as perceived by the customer as important mechanisms. This may result in overpricing and underpricing. Furthermore the role of competitors is ignored. Historical accounting costs are used rather than replacement value.

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Compare with: Cost-plus Pricing  |  Target Pricing  |  Marginal Cost Pricing  |  Penetration Pricing  |  Price Skimming  |  Perceived Value Pricing  |  Psychological Pricing  |  Discount Pricing  |  Promotional Pricing  |  Competitive Pricing

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