Standard costing

Standard Costing

Standard costing is a key element of performance management with a particular emphasis on budgeting and variance analysis.

The uses of standard costs

The main purposes of standard costs are:

  • control: the standard cost can be compared to the actual costs and any differences investigated.
  • performance measurement: any differences between the standard and the actual cost can be used as a basis for assessing the performance of cost centre managers.
  • variances: as well as being the basis for preparing budgets, standard costs are also essential for calculating and analysing variances. Variances provide 'feedback' to management indicating how well, or otherwise, the company is doing.
  • to value inventories: an alternative to methods such as LIFO and FIFO.
  • to simplify accounting: there is only one cost, the standard.

Types of standard

There are four main types of standard:

Attainable standards

  • They are based upon efficient (but not perfect) operating conditions.
  • The standard will include allowances for normal material losses, realistic allowances for fatigue, machine breakdowns, etc.
  • These are the most frequently encountered type of standard.
  • These standards may motivate employees to work harder since they provide a realistic but challenging target.

Basic standards

  • These are long-term standards which remain unchanged over a period of years.
  • Their sole use is to show trends over time for such items as material prices, labour rates and efficiency and the effect of changing methods.
  • They cannot be used to highlight current efficiency.
  • These standards may demotivate employees if, over time, they become too easy to achieve and, as a result, employees may feel bored and unchallenged.

Current standards

  • These are standards based on current working conditions.
  • They are useful when current conditions are abnormal and any other standard would provide meaningless information.
  • The disadvantage is that they do not attempt to motivate employees to improve upon current working conditions and, as a result, employees may feel unchallenged.

Ideal standards

  • These are based upon perfect operating conditions.
  • This means that there is no wastage or scrap, no breakdowns, no stoppages or idle time; in short, no inefficiencies.
  • In their search for perfect quality, Japanese companies use ideal standards for pinpointing areas where close examination may result in large cost savings.
  • Ideal standards may have an adverse motivational impact since employees may feel that the standard is impossible to achieve.

Management control, variance analysis and 'management by exception'

A key principle of management control is that of 'management by exception'. This involves the following steps:

  1. Set the standard cost for the period.
  2. Record actual results.
  3. Compare the actual cost with what should have happened. The difference is called a "variance".
  4. Investigate significant variances - this allows management to focus only on those areas where the business is not performing according to the plan, thus making management effort more efficient.

Revising standards to calculate planning and operating variances

Some businesses revise standards and calculate what are known as "planning and operating" variances.

There must be a good reason for deciding that the original standard cost is unrealistic. Deciding in retrospect that expected costs should be different from the standard should not be an arbitrary decision, aimed perhaps at shifting the blame for bad results due to poor operational management or poor cost estimation.

A good reason for a change in the standard might be:

  • a change in one of the main materials used to make a product or provide a service
  • an unexpected increase in the price of materials due to a rapid increase in world market prices (e.g. the price of oil or other commodities)
  • a change in working methods and procedures that alters the expected direct labour time for a product or service
  • an unexpected change in the rate of pay to the workforce.

These types of situations do not occur frequently. The need to report planning and operational variances should therefore be an occasional, rather than a regular, event.

If the budget is revised on a regular basis, the reasons for this should be investigated. It may be due to management attempting to shift the blame for poor results or due to a poor planning process.


A company is operating in a fast changing environment and is considering whether analysing existing variances into a planning and operational element would help to improve performance. Discuss the advantages and disadvantages of the approach.


Advantages may include:

  • Variances are more relevant, especially in a turbulent environment.
  • The operational variances give a 'fair' reflection of the actual results achieved in the actual conditions that existed.
  • Managers are, theoretically, more likely to accept and be motivated by the variances reported which provide a better measure of their performance.
  • The analysis helps in the standard-setting learning process , which will hopefully result in more useful standards in the future.


  • The establishment of ex-post budgets is very difficult. Managers whose performance is reported to be poor using such a budget are unlikely to accept them as performance measures because of the subjectivity in setting such budgets.
  • There is a considerable amount of administrative work involved first to analyse the traditional variances and then to decide on which are controllable and which are uncontrollable.
  • The analysis tends to exaggerate the interrelationship of variances, providing managers with a 'pre-packed' list of excuses for below standard performance. Poor performance is often excused as being the fault of a badly set budget.
  • Frequent demands for budget revisions may result in bias.

The suitability of standard costing in different organisations

Standard costing is most suited to organisations with:

  • mass production of homogenous products
  • repetitive assembly work

The large scale repetition of production allows the average usage of resources to be determined.

Standard costing is less suited to organisations that produce non-homogenous products or where the level of human intervention is high.

  Example: McDonalds

Restaurants traditionally found it difficult to apply standard costing because each dish is slightly different to the last and there is a high level of human intervention.
McDonalds attempted to overcome these problems by:

  • Making each type of product produced identical. For example, each Big Mac contains a pre-measured amount of sauce and two gherkins. This is the standard in all restaurants.
  • Reducing the amount of human intervention. For example, staff do not pour the drinks themselves but use machines which dispense the same volume of drink each time.

Standard costing and variance analysis in the modern manufacturing environment

Variance analysis may not be appropriate because:

Non-standard products

Standard product costs apply to manufacturing environments in which quantities of an identical product are output from the production process. They are not suitable for manufacturing environments where products are non-standard or are customised to customer specifications.

Standard costs become outdated quickly

Shorter product life cycles in the modern business environment mean that standard costs will need to be reviewed and updated frequently.This will increase the cost of operating a standard cost system but, if the standards are not updated regularly, they will be of limited use for planning and control purposes. The extra work involved in maintaining up-to-date standards might limit the usefulness and relevance of a standard costing system.

Production is highly automated

It is doubtful whether standard costing is of much value for performance setting and control in automated manufacturing environments.There is an underlying assumption in standard costing that control can be exercised by concentrating on the efficiency of the workforce. Direct labour efficiency standards are seen as a key to management control.However, in practice, where manufacturing systems are highly automated,the rates of production output and materials consumption, are controlled by the machinery rather than the workforce.

Ideal standard used

Variances are the difference between actual performance and standard, measured in cost terms. The significance of variances for management control purposes depends on the type of standard cost used.JIT and TQM businesses often implement an ideal standard due to the emphasis on continuous improvement and high quality. Therefore, adverse variances with an ideal standard have a different meaning from adverse variances calculated with a current standard.

Emphasis on continuous improvement

Standard costing and adherence to a preset standard is inconsistent with the concept of continuous improvement, which is applied within TQM and JIT environments.

Detailed information is required

Variance analysis is often carried out on an aggregate basis (total material usage variance, total labour efficiency variance and so on) but in a complex and constantly changing business environment more detailed information is required for effective management control.

Monitoring performance is important

Variance analysis control reports tend to be made available to managers at the end of a reporting period. In the modern business environment managers need more 'real time' information about events as they occur.

Standard costs and behavioural issues

Standard costs are set with a view to measuring actual performance against the standard, and reporting variances to the managers responsible. The aims of setting standards include:

  • setting a target for performance
  • motivating the managers responsible to achieve those targets
  • holding these managers accountable for actual performance
  • perhaps rewarding managers for good performance and criticising them for poor performance.

Managers and employees might respond in different ways to standard setting.

Factors to consider include:

The type of standard set

Individuals might respond to standards in different ways, according to the difficulty of achieving the standard level of performance.

  • Ideal standard: When a standard level of performance is high, e.g. an ideal standard, employees and their managers will recognise that they cannot achieve it. Since the target is not achievable, they might not even try to get near it.
  • Current standard: When the standard of performance is not challenging (e.g. a current standard), employees and their managers might be content simply to achieve the standard without trying to improve their performance.
  • Attainable standard: An attainable standard might be set which challenges employees and their managers to improve their performance. If this attainable standard is realistic, it might provide a target that they try to achieve. Some employees will be motivated by this challenge and will work harder to achieve it. However, some employees may prefer standards to be set at a low level of performance, in order to avoid the need to work harder.
  • Basic standard: This type of standard may motivate employees since it gives them a long-term target to aim for. However, the standard may become out of date quickly and, as result, may actually demotivate employees.

The level of participation in standard setting

The use of pay as a motivator

If standards are used as a way of encouraging employees to improve their performance, motivation could be provided in the form of higher pay if targets are reached or exceeded.

However, if employees are offered a bonus for achieving standard costs, this could increase their incentive to set low standards of performance, i.e. include 'slack' in the standard cost. Lower standards will increase the probability that the standards will be achieved and a bonus will be earned.

Created at 5/30/2012 4:07 PM  by System Account  (GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London
Last modified at 11/1/2016 12:08 PM  by System Account  (GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London

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