March 30, 2021

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Standard Costing Meaning and How It Works

Standard Costing Meaning and How It Works

Definition

What is the definition of standard costing? This is an accounting system based on the determination in advance of what the good should cost to produce and revenue per unit. In other words, the standard cost is a cost that is calculated in advance and should ideally be reached under a given set of business conditions.

These costs are used as a benchmark to measure and analyze the factual company’s performance. Standard cost accounting is primarily used to manage costs and promote business efficiency. It is an alternative to inventory costing systems.

Standard Costing Meaning and How It Works

How does standard costing work?

Standard costing involves calculating the amount of resources required to make one unit of goods and the costs associated with those resources. Standard costing compares the standard costs with the results a business was able to accomplish through its operations.

The standard cost is made using standards of quantity and price of labor, materials, and direct (as well as indirect, if applicable) expenses for each item.

It finds the reasons for the variances, which is the variation between the actual and forecasted cost, and provides information about these variances to management for taking steps to improve its business strategy.

Pros

Why is a standard costing system beneficial for a business? We can name a few reasons. First of all, even though based on estimates, standards may be very reliable. They help the company with budget planning because if we know the standard quantity of resources and the costs associated with one unit of product, we can scale that up to forecast the cost and the resources that will be required for our expected levels of production.

Standard Costing Meaning and How It Works

Standard costing also helps the management with control. We know how much things should cost, how much materials, labor, and expenses should be required for a given level of production, so we can compare what actually happens against our expectations (standards). This will help the business identify where the action is required to correct things.

Finally, standard costing is going to help the management make decisions. It can more easily and more quickly identify the likely results of any decisions that we take because we can consider their effects on output levels as well as our standards. Standards provide an incentive for the company to keep costs and performance in line with the predetermined management objectives.

Cons

The main disadvantage of the standard costing method is that it might not provide up-to-date information for management when quick pricing and costing strategy decisions need to be made. In other words, the management would need the accounting department to produce reports on what actually happened and then compare the actual results to what was forecasted.

Obviously, this is going to take time and sometimes is not very possible if financial reports are prepared only at specific time intervals. In this regard, actual costing has an advantage over standard. Standard costing, though, can still be used for inventory even if the company decides to use the actual costing method for its pricing and costing strategy.

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Author: Charles Lutwidge

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