Cost Accounting in Action 139
activity selection while ABC focuses on strategic selection of
products, customers, and/or distribution channels.
Standard Costing
The most traditional cost system in widespread use is standard
costing. Standard costing charges all production costs to cost
objects benchmarked to predetermined costs and quantities.
These standard costs go
into budget templates at
Standard costing A sys-
the start of a year and are tem in which cost compo-
then compared with actual nents are predetermined
costs during the year. The using standard costs, assuming normal
difference between planned operations, instead of using actual
results and actual out- costs.The standard costs are then
comes is either a favorable compared with actual costs and vari-
or unfavorable variance. ances are explained in terms of either
price or quantity.
Variances drive the feed-
back loop used in control-
ling the production processes. Managers then work to conform
the process to the standard costing model. It’s important to
review these standards periodically to keep them up-to-date.
Since compensation and performance standards can
depend on controlling variances, standard costing can be a sim-
ple but powerful motivating tool. Because its main feature rec-
ognizes variations from established norms, it works well with the
concept of management by exception.
Standard costing can be used alone or in conjunction with
job-order, process, activity-based costing, or other systems. The
purpose of standard costing is to have a standard cost per prod-
uct, which can be viewed as a goal with which actual costs can
be compared. Its primary use is to measure the favorable and
unfavorable variances between actual and standard costs.
Standard costing can be used for such components as direct
materials, direct labor, and indirect costs. Standard costing sep-
arates factory inputs, materials, labor, and overhead into two
component standards, factory prices and factory quantities.
140 Accounting for Managers
Setting Standards
Standards come from three main sources: experience, theoreti-
cal constructs, and practical references.
Experience gives the most realistic standard. Based on what
was done in the past, it assumes those circumstances will trans-
late well into the future. Unfortunately, this can lead to a rather
cavalier budgeting exercise along the lines of “Take what we did
last year, add or subtract 10%, and call it done.”
Theoretical constructs are less satisfactory. The ideal stan-
dard usually cannot be met. It leads to unfavorable variances as
it assumes minimum prices for all costs and optimal usage of
all resources at 100% manufacturing capacity.
Practical standards, while often set as an intentional chal-
lenge to line management, can usually be reached. These stan-
dards should consider at least four things:
• Prices for materials are not always going to be the lowest.
• Labor is not 100% efficient.
• Normal spoilage will occur.
• Operations do not run at 100% capacity over time.
Most businesses presently use practical standards.
You should know that a new manufacturing environment is
developing that stresses reaching ideal standards. This empha-
sis comes because there’s too much slack and waste built into
practical standards. Management efforts like Total Quality
Management (TQM) look to cut this waste. Positive results have
convinced some that businesses should now move toward ideal
standards. Still, “stress” seems to be the operative word there
and the jury is still out on how widely its use will spread.
The unit price standard sets the price at which direct materi-
als should be purchased. Each material needs its own standard.
It should be contingent on the sales forecast. Suppliers need to
have an estimate of the total quantity to determine the amount
of any discount. Also, the company needs to give suppliers the
quality and delivery standards before a standard price per unit
can be set.
Cost Accounting in Action 141
Direct labor price standards usually come straight from a
union contract or other negotiations between management and
personnel. Any known pay rate increases during the year must
figure into the computation. Direct labor efficiency standards
can come from union contract work rules or predetermined per-
formance standards for the amount of hours that should go into
the production of one finished unit. Any hiring contemplated
should consider the learning curve effects: learning curve ineffi-
ciency is most noticeable in complex processes that require
dexterity, as opposed to processes that are fully automated.
Setting factory overhead standards usually involves input
from many departments. Standard costing establishes a single
cost per unit, which is applied despite fluctuations in activity.
Because of the amount of information, time, and interdepart-
mental coordination involved, companies that use standard
costing often establish a separate department for this task.
Once the standards are in place, management can budget
for costs and production. After comparing the budgeted stan-
dards with actual performance, management then adjusts oper-
ations to track the budget more closely. Also, as noted earlier,
management should review the standards periodically to keep
them current.
Analyzing Variances
Variance analysis looks at the difference between actual and
standard costs. It can measure performance, correct inefficien-
cies, and deal with any accountability functions.
Variances can be favorable or unfavorable. Favorable vari-
ance happens when the actual amount is less than the standard
amount. Favorable variances are credits; they reduce produc-
tion costs. Unfavorable variance occurs when the actual amount
is greater than the standard amount. Unfavorable variances are
debits; they increase production costs.
Variances come in three main flavors:
• price
• efficiency
• volume
142 Accounting for Managers
Favorable and Factors that can cause
Unfavorable price variance include
Don’t be misled by the changes in market
terms “favorable” and unfavorable.” A prices/rates, differences
favorable variance does not necessari- between standard and
ly mean good, nor does an unfavor- actual input quality (i.e.,
able variance mean bad. Management higher-quality inputs cost
should analyze all variances to deter- more per unit than lower-
mine the cause.This analysis would
quality inputs), changes in
include determining if the standard is
correct. In reviewing standards, as delivery channels for
always, compare costs and benefits. materials input, changes
in the mix of worker skill
levels, outdated standard prices/rates, and random variation in
prices/rates.
Efficiency variances can come from more or less efficient
usage of materials, greater or lesser worker productivity, direct
material quality, difficulty of working with materials, worker pro-
ductivity and efficiency, less skilled workers, lower wage rates,
lower worker productivity and efficiency, inappropriate stan-
dards (e.g., ideal standards or outdated standards), and random
variation in materials usage and/or worker productivity.
Output variances can accompany any of the causes of price
and efficiency variances. In addition, output can be affected
when one unit’s outputs become another unit’s inputs.
Standard Costing Critique
To many managers, standard costing seems out of step with the
philosophy of cost management systems and activity-based
management. They feel that standard costing puts too much
focus on direct labor cost and efficiency, particularly as labor
costs tend to become fixed rather than variable. In turn, auto-
mated manufacturing processes tend to be more consistent in
meeting production specifications.
Individual variances are lumped together in broad cate-
gories. Specific product lines and production batches can be
overlooked or managers find variances too late to be useful.
Flexible budget systems can also be slow. Shorter product life
Cost Accounting in Action 143
cycles mean that standards are relevant only for a short time
and the cost to update standards can grow out of proportion
with the benefits. Standard costing’s tight focus on cost mini-
mization ignores other significant concerns, like improving
product quality or customer service.
Many traditional companies are experimenting with phasing
out aspects of standard costing in favor of other cost accounting
techniques. Many features can fit comfortably with techniques
covered in this chapter and the next. In those companies, stan-
dard costing will probably remain as the primary budget-
planning tool.
Static and Flexible Budgeting
Budgeting sets clear financial goals for the organization.
Budgeting also provides a basis for judging the financial per-
formance of the organization. The types of budgets used by
businesses vary somewhat according to the nature of their
operations. Here are common types of budgets:
• budgets for sales, purchases, operating expenses, and
cost of goods sold
• budgets for cash and capital expenditures
• budgets for production, materials, labor, overhead, and
cost of goods manufactured
Businesses usually budget for their fiscal year. The static
budget often goes no further than this. However, a
Budget Skills Ranked High
In a study of employers, the Institute of Management
Accountants found that employers think knowledge of the
budgeting process is the most important accounting skill for new
hires. Managers spend much of their time preparing, defending, manag-
ing, or supervising budget activities. If you haven’t gotten into budgets
already, you might as well start now.
Budgets drive most activities in organizations of all types—new and
established, big and small, private and public, government and nonprofit.
Whatever their situations, managers need to know budgeting.
