Updated July 10, 2023
Definition of Standard Cost
Standard cost (SC) is the pre-determined cost that will be incurred to purchase goods or conduct operations in a normal environment. Every company requires a budget to estimate the cost involved in a project.
The budget is usually prepared on a (SC), which may vary from the actual cost involved. The deflection of actual cost from the standard cost is termed variance in cost.
Explanation
The decision to accept a project mostly depends on the project’s estimated cost; if the cost is less than the estimated inflow, then the project is accepted. The project cost is calculated per the standard costing method, where a neutral cost is decided for the goods and services needed. The (SC) is generally the prevailing market cost, and informed buyers and sellers are ready to exchange goods and services at that cost.
Formula for Standard Cost
- Standard price = The price of goods or services decided per the market. It includes inflation, the overall price index, etc.
- Standard quantity = The quantity required in a project generally can be fixed using references from past similar projects. The standard quantity helps place an order for raw materials or services.
Example
Company XYZ is planning to prepare a budget for its upcoming project. The company is a manufacturing company and wants to start manufacturing a new clothing line. The details of the (SC) and quantity of the line items are mentioned below:
- Direct Material: Standard Price = $20 per unit and Standard Unit = 5000units
- Direct Labour: Standard Price = $200 per labour and Standard Unit = 2000 labourers
- Fixed Manufacturing Overhead = $50 per unit produced and Standard units to be produced = 3000 units.
- Variable Manufacturing Overhead = $30 per unit produced and Standard units to be produced = 3000 units.
Calculate the budgeted (SC) for this project.
Solution:
It is calculated as
Standard cost = Standard Price * Standard Quantity
The (SC) of Direct Material is calculated as
- (SC) of Direct Material= $20 * 5000 units
- (SC) of Direct Material = $100,000
The standard Cost of Direct Labour is calculated as
- (SC) of Direct Labour = $200 * 2000
- (SC) of Direct Labour = $400,000
Standard Cost for Fixed Manufacturing Overhead is calculated as
- (SC) for Fixed Manufacturing Overhead = $50 * 3000
- (SC) for Fixed Manufacturing Overhead = $150,000
Standard Cost for Variable Manufacturing Overhead is calculated as
- (SC) for Variable Manufacturing Overhead = $30 * 3000
- (SC) for Variable Manufacturing Overhead = $90,000
Total Standard Cost is calculated as
- Total Standard Cost = $100,000 + $400,000 + $150,000 + $90,000
- Total Standard Cost = $740,000
So the total (SC) estimated for the project is $740,000. The standard price and quantity that are taken are as per approximation. The real cost may be more or less than the Standard Cost. If the real cost is less than the standard cost, then management has done a good job and found ways to minimize cost compared to the standard cost. If the actual cost exceeds the standard cost, then the efficiency of the management in case of costing is poor and needs to improve.
Use of Standard Cost
- (SC) is used in manufacturing companies, Service Company, budgeting, etc. The main purpose is to predict the cost incurred in a project accurately.
- Auditors use (SC) to determine the accuracy of the data presented in the financial statements; if too much variation is noticed, then management may be misrepresenting the data.
Advantages
Some of the major advantages are as follows:
- Standard cost gives an approximation of the total cost to be incurred. These approximation helps to raise the actual money required for the project. Without (SC), it would not have been easy to guess the capital needed for a project. So the (SC) helps to estimate the capital requirement.
- As the cost is already known, a bar is set regarding the spending limit. If spending deviates from the (SC), it acts as a trigger to the management, and reasonable restrictions are placed to retain the cost per the estimation.
- Management gets a guideline regarding the cost that is prevailing in the market. So it helps them to bargain for the best price and complete the project at the cheapest rate. A good idea about the cost of input makes management more efficient.
- The (SC) helps in accounting inventories and the cost of goods sold more effectively. Other stakeholders can calculate the actual strength of the inventory for a company with the help of (SC). They would have to rely on management’s provided cost figures without (SC).
- Production cost is limited and reduced due to (SC). Management always tries to keep the the cost per standard, thus minimizing production costs.
Disadvantages
Some of the major disadvantages are as follows:
- Judging the proper standard quantity of inputs to be used in the project is tough. If there is any slight error in the judgment, there will be a shortage or excess of capital for the project. Capital is not free, so if the capital is excess, the company will have to pay interest on surplus capital,, and if the capital is issued less than required, the project may not be completed.
- Too much attention to cost may create unnecessary pressure on laborers, and they might feel exploited. Laborers are not machines, so the productivity of laborers may vary from person to person. Judging the productivity of human resources in terms of (SC) is difficult.
Conclusion
Standard cost is extremely useful in setting a budget for projects. It helps to set a guideline for management, and proper costing knowledge is taught before the start. However, too much dependency on standard costs is also not right. Societal and human factors should be considered while setting the (SC).
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