Standard Costs Explained

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Pop Quiz: Your electricity bill for your home arrives stating that you owe the power company $150 for the past month’s usage. Is this a reasonable bill?

Clearly, the answer is – it depends. You might compare this bill to a previous bill to determine if it is reasonable, or you might just rely on your intuition about whether or not it “feels” right. Worst of all, you may just pay the bill without a second thought.

Many small manufacturers approach inventory and production costs the same way. They look at their monthly income statements to see how much it cost to produce inventory for that month. Maybe the company will compare those costs to a previous period or previous production run to assess whether or not they are reasonable. Maybe they look at the gross margin for the whole company to see if it meets expectations. Maybe they don’t review the costs at all.

Going back to the electricity bill example: $150 might seem reasonable at first glance. But, what if you were on vacation all month with all lights turned off and all electronics unplugged? A reduced quantity of electricity usage should correspond to a reduced cost to you. Or, what if your usage remained consistent between periods, but the $150 bill was twice what you normally pay for monthly electricity? A per-unit price increase of the electricity used would lead to an unfavorable increase in your electricity bill.

This is the essence of standard costing: Establishing reasonable expectations of expected costs to manufacture inventory (e.g. establishing standard costs), comparing those standard costs over a period of time to actual costs incurred to manufacture inventory, investigating variances between standard and actual costs to determine the underlying cause (was it a price issue or a quantity issue?), and taking corrective action.

Improved pricing decisions: Every manufacturer understands the importance of product margins, but often those margins are tracked only on a company-wide or division-wide basis. Establishing standard costs will allow your company to track margins by product line, or by production run. Not only will you know whether or not your company as a whole is profitable, but you will also know which products are more profitable than others. If you could focus your company’s efforts on growing revenue on a product with 30% margins, or a product with 10% margins, which would you choose? Standard costing enables these decisions.

Improved cost controls: Standard costs provide a benchmark against which management can compare actual costs incurred during production. When actual costs vary significantly from standards, management can investigate the differences between standard and actual costs to determine whether they were caused by material, labor, or overhead and also whether the variance was due to unexpected swings in quantity or price of inputs.

Financial reporting: Standard costing systems track both standard and actual costs in a manufacturer’s general ledger. The standard costs are used to track inventory and establish a benchmark to use in making management decisions. The actual costs are used to track actual spending, and periodically adjust the value of inventory from standard cost (which is not GAAP-compliant) to actual cost (which is GAAP-compliant).

Standard costing can be confusing (at first) and time-consuming to implement. However, the information available under a standard costing system will help management of manufacturing companies improve margins, control component costs, and generate more useful information from its financial statements. If your company is interested in implementing a standard costing system, please give us a call! We’ll work with you to meet your goals.