Standard Cost Accounting
In modern cost accounting, the concept of recording historical costs was taken further, by allocating the company’s fixed costs over a given period of time to the items produced during that period, and recording the result as the total cost of production. This allowed the full cost of products that were not sold in the period they were produced to be recorded in inventory using a variety of complex accounting methods, which was consistent with the principles of GAAP. It also essentially enabled managers to ignore the fixed costs, and look at the results of each period in relation to the “standard cost” for any given product.
- For example: if the railway coach company normally produced 40 coaches per month, and the fixed costs were still $1000/month, then each coach could be said to incur an overhead of $25 ($1000/40). Adding this to the variable costs of $300 per coach produced a full cost of $325 per coach.
This method tended to slightly distort the resulting unit cost, but in mass-production industries that made one product line, and where the fixed costs were relatively low, the distortion was very minor.
- For example: if the railway coach company made 100 coaches one month, then the unit cost would become $310 per coach ($300 + ($1000/100)). If the next month the company made 50 coaches, then the unit cost = $320 per coach ($300 + ($1000/50)), a relatively minor difference.
Weaknesses of Standard Cost Accounting
* Modern companies tend to have relatively low truly variable costs (primarily raw material, commissions or casual workers) and very high fixed costs (worker salaries, engineering costs, quality control, etc.).
* Equipment has become more complex and specialized and may be a very significant proportion of total costs.
* Organizations with a wide range of products or services have processes which are common to several finished items, making cost allocation irrelevant or misleading.
* The practice of paying workers on a ‘set-piece’ basis changed in favour of paying on an hourly rate.
* Changes in the level of full cost inventory create swings in profitability that are difficult to explain or understand. An increase in inventory can “absorb” costs of production and increase profits, while a decrease in inventory level will decrease profits.
As a result of the above, using standard cost accounting to analyze management decisions can distort the unit cost figures in ways that can lead managers to make decisions that do not reduce costs or maximize profits. For this reason, managers often use the terms “direct costs” and “indirect costs” to replace the standard costing, to better reflect the way allocation of overhead is actually calculated. Indirect costs (often large) are usually allocated in proportion to either labor cost, other direct costs, or some physical resource utilization.
For example: If the railway coach company now paid its workforce a fixed monthly rate of $8,000 (total) and its other fixed costs had risen to $2,600/month, the total fixed costs would then be $10,600/month. The unit cost to make 40 coaches per month would still be $325 per coach ($60 material + ($10,600/40)), but producing 100 coaches would result in a unit cost of $166 per coach ($60 + ($10, 600/100)), provided the company had the capacity to increase production to that level.
Managers using the standard cost for 40 coaches per month would likely reject an order for 100 coaches (to be produced in one month) if the selling price was only $300 per unit, seeing that it would result in a loss of $25 per unit. If they analyzed the fixed vs. variable cost distinction, they would see clearly that filling this order would result in a contribution to fixed costs of $240 per coach ($300 selling price less $60 materials) and would result in a net profit for the month of $13,400 (($240 x 100) – 10,600).
- More at Basics Standard Costing
Oracle’s Standard Costing
Under standard costing, predetermined costs are used for valuing
inventory and for charging material, resource, overhead, period close,
and job close and schedule complete transactions. Differences between
standard costs and actual costs are recorded as variances.
Use standard costing for performance measurement and cost control.
Manufacturing industries typically use standard costing. Standard
costing enables you to:
â€¢ establish and maintain standard costs
â€¢ define cost elements for product costing
â€¢ value inventory and work in process balances
â€¢ perform extensive cost simulations using unlimited cost types
â€¢ determine profit margin using expected product costs
â€¢ update standard costs from any cost type
â€¢ revalue onâ€“hand inventories, intransit inventory, and discrete
work in process jobs when updating costs
â€¢ record variances against expected product costs
â€¢ measure your organizationâ€™s performance based on predefined
If you use Inventory without Work in Process, you can define your item
costs once for each item (in the cost master organization) and share
those costs with other organizations.
If you share standard costs across multiple organizations, all reports, inquiries, and processes use those costs. You are not required to enter duplicate costs.
The cost master organization can be a manufacturing organization that
uses Work in Process or Bills of Material. No organization sharing
costs with the cost master organization can use Bills of Material.