How Does Standard Costing Work?

Posted by: Paul Bramall Post Date: 27th January 2016

Because of its impact on companies’ financial performance, anyone working in accounting needs to be familiar with standard costing. Let’s take a look at what it is and how it works.

What is standard costing?

Standard costing is an essential part of costing within manufacturing organisations, used to reach what the company feels is the actual cost of a product. This is based on things like the costs of materials, labour and manufacturing overheads.

How does standard costing work?

However, it will not necessarily be reflective of the real cost, due to the unpredictable nature of many of the factors involved.

How does standard costing work?

Let’s look at an example of standard costing:
Unit A:

  • Requires 3 metres of material at £4 per metre.
  • Requires 2 hours of labour time to assemble. Labour rate is £8 per hour.
  • Manufacturing overhead is £5 per unit.

From the above information, we would come to a standard cost of £12 material, £16 labour and £5 overhead. Therefore, the overall cost would be £33 per unit.

In reality, though, these prices may not reflect what actually happens. For example, when you go to buy the product, the price of the material could fluctuate. This would then create what we call in standard costing a ‘variance’ (see our post on budget variance). This could either be a positive or negative variance; or, in the accounting world, a ‘favourable’ or ‘adverse’ variance.

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Why use standard costing?

By using standard costing, we can keep an eye on the cost of products. Remember, many manufacturing companies reach their selling price based on what they expect the product to cost, meaning it is hugely important to organisational performance.

Standard costing allows any variances to be identified, which can then be investigated, and attempts can be made to come up with a contingency if possible. If a favourable variance is found, a higher profit is likely to be made. In the case of an adverse variance, it is likely that profit will be less than expected, and could even lead to the company making a loss on selling its products.

This is more likely to occur in some industries than in others. A recent example of this is the cost of steel, which saw a huge increase in cost in around 2010, and caused problems worldwide for a number of companies.

Another form of costing often employed by manufacturing companies is marginal costing, where profit can be made from selling products at a lower price during times of high capacity.

Standard costing is covered in detail on our accounting courses.

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