It is not possible to measure output in terms of units produced for a department making several different products or operations.
If a department produces 100 units of X, 200 of Y and 300 if Z, it is not possible to add their production since they aren’t homogeneous.
What would solve this is the use of standard hours that can act as a common denominator for adding together the production of unlike items.
That is, assume that the unit standard times are as follows
X – 5std hours
Y – 2std hours
Z – 3std hours
The production for the department will be calculated in standard hours as follows.
iii. Setting standards for overheads
In setting standard overhead costs we apply what we have learnt in our earlier chapter (in absorption costing). The predetermined overhead absorption rates become the standards for overheads for each cost center using the budgeted standard labor hours as the activity base or planned production volume.
Production volume will depend on two factors:
– production capacity (or volume capacity) measured in standard hours of output which in turn reflects direct production labor hours
Efficiency of costing by labor or machines, allowing for rest times and contingency
allowances
Separate rates for fixed and variable overheads are essential.
>>> An Illustration on standard hours
A department has a workforce of 20 men working a 30-hour week making standard units. Each unit has a standard time of 2 hours to make. The expected efficiency of the workforce is 125%.
a. Budgeted capacity of indirect labor hours = 20*30= 600 production hours per week
b. Budgeted efficiency is 125%, so that the workforce would take only 1 hour of actual production time to produce 1.25 standard hours of output
c. This means that budgeted output is 600*1.25=750 standard hours with each requiring 2 standard hours, the production activity or volume of 375 units per week.
iv. Setting standards for sales price and margin
Setting of product selling price is a top-level decision that is based on factors such as:
• anticipated market demand
• manufacturing costs
• competing products
• inflation estimates.
After much discussions and deliberation, a price for the product is set; this is the standard selling price. The standard sales margin is the difference between the standard cost and the standard selling price.
Recapitulation
A standard cost is a predetermined calculation of how much is expected to be incurred under certain specified working conditions. It is a benchmark for measuring performance. In managerial and cost accounting, standards relate to the quantity and cost of inputs used in manufacturing goods and services. Quantity standards say how much of a specific input should be used in manufacturing a unit of product or in providing a unit of service. Cost standards say what the cost of the input should be.
It is not an average of past costs since these may contain mistakes of past inefficiencies and may not incorporate changes in the business’ operating environment e.g. technological changes.
Standard costs are developed from a scientific study of the various production cost elements involved in producing a certain good or service (These are usually specified in a product’s technical specifications). To develop these costs, one needs to have a good idea or reliable estimate of the materials, labour and other cost levels that will apply during a specified period.
Standard costs give a basis of cost control through variance analysis. It is one of the leases. It is also the basis of budgeting. Standard costs are also applied in setting prices, valuing closing stocks and performance evaluation
A standard costing system is most suited to an organization whose activities consist of repetitive
operations and the requirements per unit can be specified, for instance, in the manufacturing
sector where standardized output is produced. More so, it can be used in the manufacturing industries where the organization produces different goods which undergo a series of common operations. Note that standard costing cannot be applied to activities of a non-repetitive nature.
Types of Standard
The standard cost set could be basic, ideal, attainable or current.
(i) Basic Standards: These are long-term standards that would remain unchanged over the years. Their sole use is to show trends over time for such items as material prices, labour rates, efficiency, e.t.c.. They, therefore, cannot be used to highlight current efficiency or inefficiency; for this reason, basic standards do not normally form part of the reporting system and will, therefore, be used as a background for statistical analysis over time. Their main advantage is that they provide a base for a comparison with actual cost through a period of years with the same standard and establish efficiency trends over time.
(ii) Ideal Standards: These are standards, which can be achieved under the best circumstances. They represent perfect performance. They are, therefore, based on the best possible operating conditions. They allow for no work interruptions and call for a level of effort that can only be attained by the most skilled worker working at 100% efficiency. Normal production problems such as material spoilage, stoppages, idle time, machine breakdowns, shrinkage, e.t.c. are not allowed in ideal standards.
They can be revised periodically to reflect changes in the organization’s operating conditions, e.g. changes in technology. However, since the ideal standards assume perfect operating conditions, they would be unattainable in real life, which has normal operating problems such as idle time and machine breakdown, idle time and employee slowdown due to fatigue.
These standards act as a motivational tool to the workers. Although workers know that they will never stay within the standard set, it acts as a constant reminder that he/she is not efficient enough and needs to improve. However, when these standards are set too high, they tend to discourage even the most productive and diligent worker.
(iii) Attainable standards: these are practical standards, which are tight but attainable. They can be attained through reasonable, though highly efficient, efforts by an average worker at a task. They allow for normal machine breakdowns, employee rest times, idle time, decline in efficiency and other inefficiencies that may arise in the production process.
They are used for product costing and pricing for stock valuation, for budgeting and for cost control and performance evaluation. But to be meaningful, attainable standards need to be revised regularly so as to affect the conditions expected to prevail during the period in which the standards would be applied. Variances from attainable standards are very useful to management as they represent deviations that fall outside the normal, recurring inefficiencies and signal a need for management’s attention.
Of all the standards, attainable standards are likely to produce the highest level of motivation especially when the employees are adequately involved in setting them. They should provide a challenge to employees by giving them a tough but realistic target, thus it motivates employees and management to achieve high levels of output.
(iv) Current Standards These are standards set for use over a short period of time, related to current. Since basic standards cannot be used for analyzing current efficiency levels, a current period standard can be developed for the basic standards. The current period standard can then be used to analyze the current period performance.
Current standards are useful especially in inflationary conditions where current standards could be set for a three-month period or on a monthly basis to reflect the changes in prices.
Type Impact
Ideal – one school of thought says that they provide employees with incentive to be more efficient even though they are unattainable
– others say that they are demotivation since the variance will always be
adverse and they see it as impossible and decide not to work so hard.
Attainable – they are motivating. Realistic but a challenging target to achieve
Current – they have no effect on motivation
Basic – may have an unfavorable impact on motivation. Over time they become easily achievable; employees become bored and lose interest since they have nothing to aim for
The Relationship Standards and Budgets
Standards and budgets are one and the same thing. The only distinction between the two is that a standard is a unit amount and it applies to particular products, individual processes or single operations while a budget is a total amount, which lays out the cost limits for functions and departments and for the firm as a whole.
>>> Illustration
The standard cost for labour per unit of product is Shs500. If 10,000 units are to be produced during the period then the budgeted cost of materials is Shs.5,000,000 (Shs.500 per unit x 10,000 units).
Importance of standard costing; Why set standards? (Advantages of standards)
Standard costing systems provide cost information for various uses. These include:
(i) Setting of budgets
Standard costing systems assist in setting budgets and evaluating performance of the managers. Standard costs are of particular importance for budgeting as they provide reliable and convenient source of data to be used in the budgeting process. This, thus, reduces the budgetary time because for instance, once the desired output units is known, then the budgeted cost is simply derived by multiplying the budgeted cost per unit and the desired output in units.
(ii) Act as control devices and simplifies performance evaluation
Standard costing systems act as control devices by highlighting those costs or items that do not conform to the budget or plan and thus alerts managers to those situations that need corrective action. It acts as a yardstick against which costs and other items are measured to determine whether the variance is favorable or unfavorable.
Once the budgets are prepared and agreed upon, the employees’ performance can be acceptably measured against the set standards to determine whether the performance is acceptable or not. Appropriate corrective measures can then be taken by the management.
(iii) Profit measurement and inventory valuation
Standard costing makes inventory valuation much easier as it simplifies the task of tracing costs to products for inventory valuation and profit measurement purposes. If the actual number of physical units in inventory is known then the value of inventory is simply obtained by multiplying the standard cost per unit by the physical units. This is because, profit measurement may be time consuming thus making it cumbersome to allocate costs as per the period incurred. Variances are calculated later and written off in the books of account as period costs. This enables the reflection of inventory at actual cost while at the same time determining the correct profit figure.
(iv) Decision making
Standard costing provides a prediction of the future costs that can be used for decision-
making purposes. Standard costs are preferable to estimates based on adjusted past costs because the later may incorporate avoidable inefficiencies.
(v) Management by exception
Standard costing is an example of management exception. By studying the variances, management’s attention is directed towards those items that are not proceeding as per the plan. Most of management’s time is saved and can be directed to other value adding activities. Management only concentrates on the few exceptions reported.
(vi) Motivation
A standard costing system provides a challenging target that individuals are motivated to strive and achieve. Involving the management and employees at all levels of operation in the setting of standards makes them feel as part of the system thus working to meet the standards that they set for themselves.
(vii) Pricing
Standard costs act as a reliable base of calculating total cost of producing a good or service to which a margin can be added to determine the selling price. (Cost plus markup method of price determination)
(viii) Cost reduction
The process of setting, revising and monitoring standards encourages reappraisal of methods materials and techniques thus leading to cost reductions. Analysis of variance (Anova) directs cost analysis to factors that are causing unfavorable variances and thus costs can be controlled, leading to cost reduction.