Comprehensive Financial Planning: Standard Costing

Standard Costing Managers also use budgets to control costs so that established goals can be achieved. Cost control has two aspects: (1) control of prices paid and (2) control of quantities used. Control is achieved by a process termed standard costing that allows management to evaluate the production process by comparing actual results with predetermined standards of costs and quantities. Standard costing is useful in (1) analyzing the day-to-day activities of organizational components, (2) budgeting future activities, and (3) motivating employees. A standard cost is an expected level of performance under certain specified conditions; it is a target cost. Standards and budgets are essentially the same. The difference is that budgets relate to total amounts but standards relate to unit amounts. Standards involve the cost and the quantity of the inputs into a manufacturing process. Cost standards indicate the expected cost of a unit of input, whereas quantity standards indicate how much input of a unit should be used. For ex-ample, if the manufacture of a product is expected to require 2 pounds of direct material costing $5 per pound, the quantity standard is 2 pounds, and the cost standard is $5. When the cost or quantity of a process differs from the standard, managers must focus on the reason for this difference. Investigating deviations from standards is termed management by exception. The method of setting standards depends on the philosophical approach taken by management. There are three general types of performance standards: ideal, normal, and currently attainable performance. An ideal standard sets the unit cost and quantity targets at what should occur under perfect conditions. Ideal standards do not allow for waste, machine breakdowns, or even rest periods for the workers. The management setting standards at the ideal level knows that performance will never achieve the standard but wishes to make comparisons with the maximum possible level of efficiency. On the other hand the motivational impact of standard setting on the work force will be lessened if an ideal standard is used. The workers will soon realize that attaining the standard is impossible and become frustrated. The result of this frustration is likely to be a curtailment of effort. Normal standards set the unit cost and quantity targets at an attainable level that can be reached under efficient conditions. This type of standard allows for such factors as normal waste, an average amount of machine downtime, and worker fatigue. The management that adopts this philosophy of standard setting wishes to compare actual performance to highly efficient performance. If standards are set at a normal level, the workers should frequently attain the standard. Its motivational impact will therefore be greater than that of a standard set at the ideal level. Currently attainable performance standards set the unit cost and quantity targets at a level that can and should be reached during the current period. This standard in essence is not a standard at all but an expectation of results. The management that sets the standard at this level allows for almost all expected factors that will reduce performance. Setting standards at the current performance level can result in inefficient operations and diminished levels of performance among the work force if care is not taken in setting the standard. If the standard is based on past inefficient performance, workers will have no motivation to perform efficiently.