How To Develop A Standard Cost System

Developing Standard Cost SystemAlthough standard cost systems were initiated by manufacturing companies, these systems can also be used by service and not-for-profit organizations. In a standard cost system, both standard and actual costs are recorded in the accounting records. This dual recording provides an essential element of cost control: having norms against which actual operations can be compared. Standard cost systems make use of standard costs, which are the budgeted costs to manufacture a single unit of product or perform a single service. Developing a standard cost involves judgment and practicality in identifying the material and labor types, quantities, and prices as well as understanding the kinds and behaviors of organizational overhead. This post provides short and easy reading about how to develop a standard cost system.

A primary objective in manufacturing a product is to minimize unit cost while achieving certain quality specifications. Almost all products can be manufactured with a variety of inputs that would generate the same basic output and output quality. The input choices that are made affect the standards that are set. Some possible input resource combinations are not necessarily practical or efficient.

For instance: a work team might consist only of crafts persons or skilled workers, but such a team might not be cost beneficial if there were a large differential in the wage rates of skilled and unskilled workers. Or, although providing high technology equipment to an unskilled labor population is possible, to do so would not be an efficient use of resources.

The following scenario best indicates such above situations:

A company built a new $250 million computer-integrated, statistical process controlled plant to manufacture a product whose labor cost was less than 5% of total product cost. Unfortunately, 25% of the work force was illiterate and could not handle the machines. The workers had been hired because there were not enough literate workers available to hire. When asked why the plant had been located where it was, the manager explained: “Because it has one of the cheapest labor costs in the country”.

 

Once management has established the desired output quality and determined the input resources needed to achieve that quality at a reasonable cost, quantity and price standards can be developed.

Experts from cost accounting, industrial engineering, personnel, data processing, purchasing, and management are assembled to develop standards. To ensure credibility of the standards and to motivate people to operate as close to the standards as possible, involvement of managers and workers whose performance will be compared to the standards is vital. The discussion of the standard setting process begins with material. Read on…

 

How To Develop Raw Material Standards

The first step in developing material standards is to identify and list the specific direct materials used to manufacture the product. This list is often available on the product specification documents prepared by the engineering department prior to initial production. In the absence of such documentation, material specifications can be determined by observing the production area, querying of production personnel, inspecting material requisitions, and reviewing the cost accounts related to the product. Three things must be known about the material inputs: types of inputs, quantity of inputs used, and quality of inputs used.

In making quality decisions, managers should seek the advice of materials experts, engineers, cost accountants, marketing personnel, and suppliers. In most cases, as the material grade rises, so does cost; decisions about material inputs usually attempt to balance the relationships of cost, quality, and projected selling prices with company objectives. The resulting trade-offs affect material mix, material yield, finished product quality and quantity, overall product cost, and product salability. Thus, quantity and cost estimates become direct functions of quality decisions.

Given the quality selected for each component, physical quantity estimates of weight, size, volume, or some other measure can be made. These estimates can be based on results of engineering tests, opinions of managers and workers using the material, past material requisitions, and review of the cost accounts.

Specifications for materials, including quality and quantity, are compiled on abill of materials (BOM)“. Even companies without formal standard cost systems develop bills of materials for products simply as guides for production activity. When converting quantities on the bill of materials into costs, allowances are often made for normal waste of components.  After the standard quantities are developed, prices for each component must be determined. Prices should reflect desired quality, quantity discounts allowed, and freight and receiving costs. Although not always able to control prices, purchasing agents can influence prices. These individuals are aware of alternative suppliers and attempt to choose suppliers providing the most appropriate material in the most reasonable time at the most reasonable cost. The purchasing agent also is most likely to have expertise about the company’s purchasing habits. Incorporating this information in price standards should allow a more thorough analysis by the purchasing agent at a later time as to the causes of any significant differences between actual and standard prices.

When all quantity and price information is available, component quantities are multiplied by unit prices to obtain the total cost of each component. (Remember, the price paid for the material becomes the cost of the material). These totals are summed to determine the total standard material cost of one unit of product.

 

How To Develop Labor Rate Standards

Development of labor standards requires the same basic procedures as those used for material. Each production operation performed by either workers (such as bending, reaching, lifting, moving material, and packing) or machinery (such as drilling, cooking, and attaching parts) should be identified. In specifying operations and movements, activities such as cleanup, setup, and rework are considered. All unnecessary movements by workers and of material should be disregarded when time standards are set.

To develop usable standards, quantitative information for each production operation must be obtained. Time and motion studies may be performed by the company; alternatively, times developed from industrial engineering studies for various movements can be used. A third way to set a time standard is to use the average time needed to manufacture a product during the past year. Such information can be calculated from employee’s past time sheets. A problem with this method is that historical data may include inefficiencies. To compensate, management and supervisory personnel normally make subjective adjustments to the available data.

After all labor tasks are analyzed, an operations flow document can be prepared that lists all operations necessary to make one unit of product (or perform a specific service). When products are manufactured individually, the operations flow document shows the time necessary to produce one unit. In a flow process that produces goods in batches, individual times cannot be specified accurately.

Labor rate standards should reflect the employee wages and the related employer costs for fringe benefits, Social Security, and unemployment taxes. In the simplest situation, all departmental personnel would be paid the same wage rate as, for example, when wages are job specific or tied to a labor contract. If employees performing the same or similar tasks are paid different wage rates, a weighted average rate (total wage cost per hour divided by the number of workers) must be computed and used as the standard. Differing rates could be caused by employment length or skill level.

 

How To Develop Overhead Standard

Overhead standards are simply the predetermined factory overhead application rates. To provide the most appropriate costing information, overhead should be assigned to separate cost pools based on the cost drivers, and allocations to products should be made using different activity drivers.

 

After the bill of materials, operations flow document, and predetermined overhead rates per activity measure have been developed, a standard cost card is prepared. This document  summarizes the standard quantities and costs needed to complete one product or service unit.

Data from the standard cost card are then used to assign costs to inventory accounts. Both actual and standard costs are recorded in a standard cost system, although it is the standard (rather than actual) costs of production that are debited to Work in Process Inventory. Any difference between an actual and a standard cost is called a variance.

Author: Lie Dharma Putra

Putra is a CPA. His last position, in the corporate world, was a controller for a corporation in Costa Mesa, CA. After spending 15 years as a nine-to-five employee, he decided to serve more companies, families and even individuals, as a trusted business advisor. He blogs about accounting, finance and tax, during his spare time, and helps accounting students (around the globe) to understand the subject matter easier , faster. Follow him on twitter @LieDharmaPutra or add him to your circle at Google Plus Lie+

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