Friday, August 15, 2014

Management Accounting - Standard Costing: Meaning, Advantages and Limitations

Introduction – Standard Costing:
Cost control is a basic objective of cost accountancy. Standard costing is the most powerful system ever invented for cost control. Historical costing or actual costing is nothing but, a record of what happened in the past. It does not provide any ‘Norms’ or ‘Yardsticks’ for cost control. The actual costs lose their relevance after that particular accounting period. But, it is necessary to plan the costs, to determine what should be the cost of a product or service. It the actual costs do not conform to what the costs should be, the reasons for the change should be assessed and appropriate action should be initiated to eliminate the causes.


Standard: According to Prof. Eric L.Kohler, “Standard is a desired attainable objective, a performance, a goal, a model”. Standard may be used to a predetermined rate or a predetermined amount or a predetermined cost.

Standard Cost: Standard cost is predetermined cost or forecast estimate of cost. I.C.M.A. Terminology defines Standard Cost as, “a predetermined cost, which is calculated from management standards of efficient operations and the relevant necessary expenditure. It may be used as a basis for price-fixing and for cost control through variance analysis”. The other names for standard costs are predetermined costs, budgeted costs, projected costs, model costs, measured costs, specifications costs etc. Standard cost is a predetermined estimate of cost to manufacture a single unit or a number of units of a product during a future period. Actual costs are compared with these standard costs.

Standard Costing: Standard Costing is defined by I.C.M.A. Terminology as, “The preparation and use of standard costs, their comparison with actual costs and the analysis of variances to their causes and points of incidence”. Standard costing is a method of ascertaining the costs whereby statistics are prepared to show:
(a)    The standard cost
(b)   The actual cost
(c)    The difference between these costs, which is termed the variance” says Wheldon. Thus the technique of standard cost study comprises of:

Ø  Pre-determination of standard costs;
Ø  Use of standard costs;
Ø  Comparison of actual cost with the standard costs;
Ø  Find out and analyse reasons for variances;
Ø  Reporting to management for proper action to maximize efficiency.

Advantages of standard costing:
a.      Cost control: Standard costing is universally recognised as a powerful cost control system. Controlling and reducing costs becomes a systematic practice under standard costing.

b.      Elimination of wastage and inefficiency: Wastage and inefficiency in all aspects of the manufacturing process are curtailed, reduced and eliminated over a period of time if standard costing is in continuous operation.

c.       Norms: Standard costing provides the norms and yard sticks with which the actual performance can be measured and assessed.

d.      Locates sources of inefficiency: It pin points the areas where operational inefficiency exists. It also measures the extent of the inefficiency.

e.       Fixing responsibility: Variance analysis can determine the persons responsible for each variance. Shifting or evading responsibility is not easy under this system.

f.        Management by exception: The principle of ‘management by exception can be easily followed because problem areas are highlighted by negative variances.

g.      Improvement in methods and operations: Standards are set on the basis of systematic study of the methods and operations. As a consequence, cost reduction is possible through improved methods and operations.

h.      Guidance for production and pricing policies: Standards are valuable guides to the management in the formulation of pricing policies and production decisions.

i.        Planning and Budgeting: Budgetary control is far more effective in conjunction with standard costing. Being predetermined costs on scientific basis, standard costs are also useful in planning the operations.
j.        Inventory valuation: Valuation of stocks becomes a simple process by valuing them at standard cost.

Limitations of Standard Costing:

a.      Variation in price: One of the chief problems faced in the operation of the standard costing system is the precise estimation of likely prices or rate to be paid.

b.      Varying levels of output: If the standard level of output set for pre-determination of standard costs is not achieved, the standard costs are said to be not realised.

c.       Changing standard of technology: In case of industries that have frequent technological changes affecting the conditions of production, standard costing may not be suitable.

d.      Applicability: It cannot be used in those organizations where non-standard products are produced. If the production is undertaken according to the customer specifications, then each job will involve different amount of expenditures.

e.       Difficult to set standard: The process of setting standard is a difficult task, as it requires technical skills. The time and motion study is required to be undertaken for this purpose. These studies require a lot of time and money.

f.        Problem in fixing Responsibility: The fixing of responsibility is not an easy task. The variances are to be classified into controllable and uncontrollable variances. Standard costing is applicable only for controllable variances.


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