Standards refer to the acceptable measures of performance. Actual results are compared to the standards and the deviations are investigated. This enables the management to have better control over its operations, especially in managing costs.
Standard costing is a cost accumulation system that makes use of predetermined costs. These predetermined costs are known as standard costs.
Standard costs are based on past experiences, market rates, industry standards, or other relevant information.
Quantity standards refer to the acceptable units of raw materials (direct materials) and labor hours (direct labor) used to produce a product or provide services. Factory overhead is often measured based on machine hours or direct labor hours.
Cost standards refer to the acceptable price spent for the required quantity of raw materials, labor hours, and machine hours.
The standard cost of direct materials is the total cost of materials required to produce a unit of a product or provide a service. It is computed by multiplying the standard cost of a unit or raw material by the standard quantity required to produce one product.
For example, 5 blue widgets are needed to produce a unit of Product A. Based past experiences, the company has determined a standard cost of $2.50 per blue widget. Hence, the standard cost of direct materials per unit of the product is $12.50 (5 units x $2.50).
The standard cost of direct labor is the total cost of labor required to produce a unit of a product or provide a service. It is computed by multiplying the standard rate of an hour of direct labor by the standard hours required to produce one product.
For example, 1.5 labor hours are needed to produce a unit of Product A. The standard cost per labor hour is $8. Hence, the standard cost of direct labor is $12 (1.5 hours x $8).
Factory overhead may be divided into: variable factory overhead and fixed factory overhead. The standard cost of variable factory overhead uses the same computation as that of direct labor. Variable factory overhead standards are often computed based on direct labor hours or machine hours.
The standard cost of fixed factory overhead is usually expressed in total amount for given level of production.
Actual costs are compared with standard costs. For example, Company A produced 1,000 units of Product A and spent $15,000 for direct materials. If the total standard cost of direct materials is $12,500 (as computed earlier), then there is an unfavorable variance of $2,500. The variance shall be investigated to determine its cause. It might be due to higher purchase price of the raw materials and/or excessive quantity used.
Variance analysis is thoroughly discussed in the other lessons.
Ideal standards, also known as theoretical standards, require perfect performance with no allowance for machine breakdowns, work interruption, wastage, etc.
Practical standards allow for normal downtimes, wastage, breakdowns and rest periods. They are regarded as "hard but attainable" standards. Cost accounting and budgeting normally use practical standards.
In this lesson, you learned the types of standards: quantity standards and costs standards, as well as standard costs set for direct materials, direct labor, and factory overhead. This allows for variance analysis, where actual costs are compared to the standard costs set.