4 Importance of Standard Costing with detailed explanation

Standard costing is a branch of cost accounting or managerial accounting that is mostly used in a manufacturing concern that involves direct material, direct labor, and overheads.

Standard rates are used while assigning the cost of direct labor, direct material, and overhead costs; the finished goods and cost of goods sold will contain standard rates rather than actual.

It does not mean that the company will not pay for actual they will compare the standard or estimated rates with the actual expense, and the difference will be shown as a variance.

Standard costing is a management tool for evaluating the performance of different departments.

The result of variation may either be favorable or unfavorable. The differences come due to the distraction of actual figures from budgeted figures.

When the actual cost incurred exceeds the estimated cost, the result will be unfavorable.

The unfavorable results notify the management that if everything was constant, the company would earn less profit than planned.

When the actual cost incurred is less than the budgeted or estimated cost, the result is favorable, which means that the company has performed according to or better than the management’s expectations.

Importance of Standard Costing:

1) Increase in Efficiency:

Standard costing is mostly used in companies that involve manufacturing processes and have a high value of direct labor, direct material, and overhead costs.

Using predetermined or standard rates for production and raw material can help management forecast their costs for the future period and compare the standard costs with actual costs after the completion of the job.

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With a standard costing system, the employees are also well aware of the set standards, so they always try to meet the standards. This helps the employees to meet the set standards.

In the course of all these processes, the company’s efficiency will increase automatically.

For example, if the company sets the labor hour needed to complete one unit, the laborers will try to complete their job according to standards. Hence the efficiency of labor will increase automatically.

The same will be the case with direct material also. Management sets a predetermined quantity of raw material required to complete one production unit to decrease wastage and extra usage.

And make sure that every employee follows the standards in the production department. In this way, the wastage of raw materials will decrease, which ultimately results in high profits.

2) Important While Making Budgets:

Standard cost is all about budgets and estimations. The standards are used to forecast any future cost.

These standards are usually the industry’s best practices, so while making budgets and estimates, there is little chance of deviating actual data from budgets.

3) Improved Cost Control:

Standard costing is vital in controlling the cost of materials, labor, and overheads, as the standards are mostly taken from the industry’s best practices.

Improvement in labor efficiency and wastage control will always help the management to control their product cost.

4) Provide Information For Decision Making:

Decision-making is involved in all types of organizations, from small to large.

In small organizations where all the control lies with one person, did not require much information to make decisions.

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But in large organizations where a lot of financial data originates daily, managers require some calculations to decide.

Standard costing gives the managers and directors comparative information about the internal costs of different departments.

Management can easily make their decisions considering the short-term and long-term future planning.

What industries use standard costing the most?

Standard costing is a popular costing methodology used by many industries. 

However, some industries use it more frequently than others. Here are a few industries that tend to use standard costing the most:

  1. Manufacturing: Standard costing is most commonly used in manufacturing industries, where the production of physical goods involves a high cost.
  2. Construction: The construction industry is another sector that uses standard costing to track and manage project costs.
  3. Retail: Retailers often use standard costing to track inventory costs, including the cost of goods sold.
  4. Food and beverage: This industry uses standard costing to track the cost of raw materials, ingredients, and labor, as well as to monitor the profitability of specific products.
  5. Pharmaceuticals: Pharmaceutical companies use standard costing to determine the cost of producing drugs and to ensure that they are priced appropriately.

What is the main problem with standard costing?

While standard costing can be a useful tool for many businesses, some potential problems are associated with its use. Here are a few of the main problems with standard costing:

  1. Limited accuracy: Standard costing relies on predetermined cost estimates for materials, labor, and overhead, which may not reflect actual costs. As a result, standard costing may not accurately reflect the true cost of a product or service.
  2. Inflexibility: Standard costing assumes that production will remain consistent over time, which may not be the case in practice. Changes in demand or production processes can render standard costs irrelevant and can make it difficult to use standard costing to make accurate decisions.
  3. Motivational issues: Employees may be motivated to meet the predetermined standards of management rather than focusing on improving processes or reducing costs. This can lead to a focus on short-term performance rather than long-term improvements.
  4. Time-consuming: Creating and updating standard costs can be time-consuming, requiring significant resources and attention to detail. This can be especially challenging for businesses that operate in rapidly changing environments.
  5. Lack of relevance: In industries where raw materials and labor costs vary widely, standard costing may not effectively track and manage costs. Instead, businesses may need to adopt other costing methods, such as activity-based or job order costing, to understand their costs better.
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Overall, standard costing can be a useful tool for businesses, but it’s important to be aware of its limitations and consider alternative costing methods when necessary.