Part I

Introduction

Definition
Standard costing is most suited for businesses with repetitive operations or processes. It is
preferable compared to historical costing where product cost is determined by data collected in
the past. Past data contains past inefficiencies hence it does not accurately reflect the ideal value
that could have been attained without those inefficiencies, and it does not incorporate the
expected future changes, such as technological advancement, that could help to reach those ideal
standards.

To put it simply, a standard is a predetermined set of measurements or values, which is expected

to be met under normal circumstances by the end of the workflow. Simultaneously, standard
costing, which is essentially the monetary expression of a standard, shows how much the whole
process will cost. It is a method of cost formulation, from management’s standards of efficient
operation, that predetermines the expenses of a production process within a company.

Standard costing is the estimated cost of a workflow process with normal efficiency, calculated
based on past experience whilst excluding past inefficiencies and takes into account changes
expected to occur in the coming budget period. It usually relates to either a product, service or
process and can be expressed in terms of monetary value or other measurable quantities.

Types
When establishing standards, the company should decide on the type of standard to be used that
would be most profitable to the company. The main types of standards are ideal standards, basic
standards, and practical standards.
1. Ideal standards
Also known as perfection standards, are tight standards set at a perfect level of workflow
and are established at maximum efficiency without any disruptions whatsoever.

This type of standard is the most difficult and almost impossible to attain as it represents
a scenario where all the conditions are always perfect at any given time. To reach the
goals, set by ideal standards, work efficiency of workers and machines are always at an
optimum level, the production costs are at an all-time low, and the raw materials are of
the best quality as well as no disturbance during the production process.

Ideal standards will most likely discourage and demotivate employees with its
preposterous level of quality. Additionally, it could also lead to employees abandoning
the product quality to attain this standard. Alternatively, the company could use this
standard as target goals instead of as a measure of efficiency for performance evaluation.
This solution has the potential to improve the company performance level and mayhap it
will also increase the company’s efficiency and productivity.

2. Practical standards
Practical standards are set based on the presumption that the productivity is efficient and
effective under normal circumstances whilst also considering unavoidable recurring
disruptions such as machine breakdowns, wastage of excess & defective materials, rest
periods and so on. These inevitable interruptions are normal and expected, however
allowances are not made for any avoidable interruptions.

Practical standards are usually tough but realistic. The staff will be encouraged to work
hard in order to achieve the standards since it is set at a reasonable level that it is not
impossible to achieve it. This type of standard is most favoured and acceptable among
employees because it gives a definite goal that is both attainable and can propose a
challenge to them.
Essentially, there is no one standard that fits all situations, and there is no standard that will
always be good or one that will always be bad. The decision of which standard type is most
suitable to be used will depend on the current situation within the company and the requirements
needed to provide relevant and reliable information for the company to improve its performance.

Hence, if the company’s management is of the opinion that circumstances are favourable and the
resources available can face a challenge then it may opt for the ideal standards with reasonable
rewards given out if the standard is met. This may help to inspire employees to strive in their
day-to-day activities to reach the target set by the standard.

Approaches to determine standard cost.

There are generally two approaches that are usually utilised by the management accountant when
establishing standard costs which are, historical data analysis and task analysis. However in
certain situations, both approaches are combined in order to determine the standard costs.

1. Historical data analysis is when the standard costs are determined on the basis of the
company’s past records such as the company’s operations, purchases and use of
materials, inventories and labour. This approach is the most commonly used in practice
among businesses.

The main reason for using this method is because it is comparatively cheaper than the
other alternative. This is because this method will analyse the company’s own historical
data to calculate the standard costs whilst including reasonable provisions for future
improvements and uncertainties.

However, the downside of this method is that there is a possibility that past inefficiencies
will be included in the calculation of standard costs. Moreover, if changes are to be made
in the work process, then the historical data will be insignificant to the analysis.
 Likewise, if the company were to introduce a new product, then using this method will be
out of the question.

2. Task analysis, on the other hand, calls for a comprehensive study conducted at each level
of production operation. Hence, the standard cost is computed based on the cost of
activity at every stage of the production process. The studies also require input from the
operating technician or officer so that estimates regarding future activities and
consumption levels can be provided for the analysis.

The advantage of this method is that it is future oriented, and it ensures that past
inefficiencies are not included in standard costs computation. On top of that, this method
helps to provide allowance for expected changes such as redesign of manufactured
products and use of technological advancement during the production process.

Conversely, this approach is time consuming and quite expensive to engage because it
requires a comprehensive team approach where information from various departments
such as production, human resources, sales and finance are taken into account. Although
this method could enhance the reliability and accuracy of the standard cost estimates as
well as increase commitment and motivation among employees, there is the possibility of
proneness to set easier targets to achieve standard costs since there is no historical data to
be used as a guideline because it is either ignored, irrelevant or non-existent.
Importance of standard costing as a tool for management & cost control
Standard costing is a highly beneficial tool for management and cost accountants for a variety of
reasons and purposes. Among its many uses, the main purpose of standard costing is to provide
the management team with details regarding the day-to-day activities of the operations
department, thus giving management insights to determine cost of product as well as to measure
the efficiency of production or operations to implement suitable corrective actions.

Other than that, there are several more purposes of this system for accountants, which are as
follows: -

i. As a control mechanism for managerial and costing.

ii. For planning and preparation of budgets.
iii. To estimate future costs for decision making purposes.
iv. To facilitates the accumulation of product costs for inventory purposes.
v. For motivating employees to achieve targets set by the standard; and
vi. As a benchmark for employees’ performance evaluation.

In other words, from the functions of standard costing listed above, it can be concluded that this
system is vital to accountants and managers for its importance as a tool for management and cost
control that can assist them in handling their business more efficiently. The importance of
standard costing as a tool for management and cost control can be summarised as follows: -

1. Increase the company’s efficiency.

First and foremost, any standard costing system will provide an estimate of the production costs.
Though accurate reports from actual findings and analysis of the company’s historical data are
preferable to any sorts of estimation, they are not timely enough for the management to use in
order to make vital decisions. Hence a reliable estimation of costs computed through the standard
costing system provided promptly is highly preferable due to its timeliness.
For proper control and performance measurement in an organisation, variances, which can be
obtained by computing the differences between actual costs and standard costs, should be
measured, and analysed. Hence production and reasonable pricing policies can be formulated
with certainty when standard cost systems are in place. This will also help to keep production
costs in check.

This will help businesses to be more efficient with their decision making because in the world of
businesses, time is of the essence, time wasted waiting for the accurate reports can easily lead to
loss of business opportunity and in worse cases loss of money.

2. Allows for cost control.

Moreover, a standard costing system can be used to control costs by setting standards for each
type of cost incurred by the business for production which are mainly costs for material, labour,
and overhead. Standard costs usually serve as an indicator against actual costs which can be
compared. The difference between standard cost and actual cost are called variances.
This method can help to identify and analyse variances and, consequently, allow managers and
accountants to be more aware and effective in controlling the production cost.

In the case of variances, where there are differences between actual costs and standard costs,
managers and accountants can identify and rectify any discrepancies that caused it. This will then
allow them to improve cost control which means they can implement essential corrective actions
needed and in the future, they can be more aware of the company’s spending habits and strive for
little to no variances, if possible.

3. Helps management make important decisions in a timely manner.

Next, such a system can be used to provide useful, reliable, and detailed information for the
management team to plan and make crucial decisions on behalf of the company. Standard
costing can easily affect the way a business operates. Once the management has determined any
variances, this will allow them to act and improve promptly based on the current business
practices and spending.

For instance, the actual cost of raw materials is RM30,000.00 and the standard cost stands at
RM10,000.00, this will cause a variance of RM20,000.

The managers can then begin to investigate and figure out why the scenario occurred in the first
place and how to avoid such things from happening henceforth. The large variance in the
example could be caused by several possible reasons such as inflation or the inefficient use of
materials purchased. If immediate action is taken to remedy problems such as this, the company
may have a good grip on the control over costs. A proper standard costing system assists in
achieving cost control and cost reduction.

4. Budgets prepared are more accurate.

Other than that, this system can also assist accountants when preparing the company’s budget. A
company’s budget is almost always composed of standard costs, because it would be near
impossible to include the exact actual cost in the budget on the day it is finalised.

When managers control costs by using standard costing, the future actual costs, in theory, will be
highly likely close to the standard costs estimated. This outcome is very favourable because it
indirectly means that the profit plan went as projected in the budgets. It will lead to more
accurate budgets in the future.

Also, a fundamental aspect of the budget is to compare its numerical figures to actual results in
the next accounting periods; the standards used within it will continue to appear in financial
reports all throughout the budget period.
 5. Lower production costs

Another point is standard costing is a form of control technique that follows the feedback control
cycle as shown below in Figure 1. The feedback system could help to eliminate unwanted costs
in the future and will inadvertently lead to a potential reduction in overall production costs. The
output would be the production of a product in a sufficient volume. Then, the methods,
operations, and processes of production can be standardised, hence the costs will be controllable
by applying corrective actions.

Since spending less on production costs can now be a possibility when implementing a standard
cost system, then it would highly likely that the company has gained an advantage over some of
its competitors. This is because standard costing provides a visualisation of spending habits, thus
employees can be more cost-conscious and efficient. In time, their work performance will
unequivocally improve. In the end, the company can have lower overall costs.

Figure 1: Feedback Control Cycle

Note. The figure represents the feedback control cycle. From The Standard Costing System At
SKF: A Case Study of A Swedish Manufacturing Company, by Beata Morelli & Carl-Joachim
Wiberg, 2002, School of Economics and Commercial Law Goteborg University.
Implications of standard costing in evaluating performance

Budgeting
Standard costing is dubbed as a management accounting control technique that concerns itself
mostly with the budget systems. This technique assumes that planned operations are performed
using established standards. As stated above, said techniques are commonly used to prepare
budgets. These budgeted standards can be concluded as a future action plan designed by
company’s management to assist in achieving the company’s goals.

Standard costs help to determine the limits that must be placed on the execution of the business
to increase profitability. However, these limits are only guidelines. A standard can't be
implemented directly on its own, the company will implement it through the budget because it is
the basic information used in the budget preparation process. Both of these facilities can help in
product pricing and resource management.

The budget is usually planned in lieu of the vision, mission, goals, and objectives of the business
for a certain period and ensures that the plans and controls put forth in the work process will
ensure that the targets are met. In this process, control is a process where standards such as
standard cost are set to obtain those targets, hence this proves that budgets can be used to guide
the business operations.

Sales
Standard costing has a significant positive effect on the total sales of manufacturing companies
that have it in practice. The implication is that standard costing works effectively as a cost
control technique and that elements of manufacturing costs, i.e., materials, labour and overhead,
can be strategically controlled using standard costing to achieve higher sales, which in turn will
increase profitability, through reducing production costs and minimising wastages and losses.

For instance, General Motors has standards for each item on a vehicle. They can determine the
cost of a power antenna and its selling price by determining its standard cost of materials and the
labour cost of installing the antenna to the vehicle. General Motors can also consider the standard
times to determine whether too much or too little labour was used during production. This can
help them reduce the production cost, which consequently will increase the gross profit gained
from this product.

Product pricing
As mentioned above, price formulation is one of standard costing implications as a performance
evaluation tool. If a company sells custom-made products, then it could use standard costs to
compile the projected cost of a customer’s orders, margin included. This can be done by having
the sales department use a database of material costs that change depending on the quantity that
the customer's ordering. Some of the respondents believe that it is near impossible not to use
standard cost as a base when it comes to pricing.

Behaviour of employees
Standard costing is a double-edged sword that can affect the behaviour of employees in both,
positive and negative, ways. On the negative side, using standard costing could lower
employee’s morale and cause a backlash because some managers are more prone to spend more
time rectifying any and all variances than congratulating an employee for a job well done. Also,
knowing the results of poor past reports, the employees will be led to hide any unflattering
reports and could also lead them to take actions, such as sacrificing product quality for cheaper
materials, that would adversely affect the business to avoid any consequences. Moreover, this
also could cause employees to work overtime at every month’s end to meet the targets and it may
have a demotivational effect because everyone needs encouragement and acknowledgement here
and then to keep our morale high, and so that they will feel they are an integral part of the
business.

On the other hand, standard costing can also help encourage employees to be more efficient and
work harder to achieve the standards. Once the targets set by the standards are met, the
employees’ morale is boosted, and they will be more eager and keener to continue to work
harder in the future. Hence, to function effectively, standards should allow employees provisions
against failure to meet the standards without fear of recrimination. The practical difficulty with
such an approach lies in balancing necessary management freedom against slack performance.

Summary
In short, standard costing is an optimal cost estimate under normal working conditions with
normal efficiencies and is determined through either historical data analysis or task analysis.
There are a few types of standard costing, two of them being ideal standards, whereby it is set
under perfect workflow with maximum efficiency and almost impossible to achieve, and
practical standards, which is set under realistic condition and the output is attainable. Standard
costing is a beneficial system as a management tool for companies because it helps to control
costs, formulate product pricing, as well as helps in making decisions among other crucial things
within the company. Therefore, there are many sound implications that can be derived from
implementing standard costing in performance evaluation, mainly in terms of budgeting, sales,
product pricing and employees’ behaviour.
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Table of Figures

Figure 1: Feedback Control Cycle