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What is Standard Costing and How Does It Work

Standard Cost Accounting (or Standard Costing) is a form of cost accounting that uses predetermined costs for materials, labor, and overhead to estimate the costs of goods or services. Standard costing is typically used in manufacturing to determine the cost of products based on standard rates for materials, labor, and overhead. Companies use standard costing to set target costs for production and then compare actual production costs to the target costs. This comparison helps companies identify variances they need to address to improve their production processes.

How to calculate Standard Cost

We can calculate the standard cost of a product or service by adding the typical costs of direct materials, direct labor, and overhead. The standard cost of direct materials is the average cost of the raw materials used to produce a product or service. For direct labor, it is the average hourly wage rate for the workers who make a product or service multiplied by the time it takes them. The standard overhead cost is the average indirect cost incurred to produce a product or service.

Adding these three amounts together will get us the total standard cost. We usually calculate this on aggregate for a historical period and then divide the full standard cost over the number of units produced to arrive at an average standard cost per unit.

How to perform Variance Analysis between Standard and Actual cost

Standard Costing

We use variance analysis to compare the standard costs of a product or service to the actual expenses incurred. This comparison aims to identify variances that management needs to address. To perform variance analysis, we calculate the standard cost per unit as outlined above. Next, we calculate the actual cost per unit for the same product or service. Finally, we compare the two sets of numbers to identify variances.

The most common variances we analyze are:

  • The material price variance represents the difference between the standard cost of materials and the actual cost of materials
  • The material quantity variance shows the difference between the standard quantity of materials used and the actual quantity of materials used
  • The labor price variance is the difference between the standard labor rate and the actual labor rate
  • The labor efficiency variance is the difference between the standard hours of labor required to produce a product or service and the actual hours of labor it took

We can also analyze overhead variances, but they are a bit more complex. We typically divide those into two categories:

  • Fixed overhead variances are the differences between the standard fixed overhead costs and the actual fixed overhead costs
  • Variable overhead variances are the differences between the standard variable overhead costs and the actual variable overhead costs.

Variances can also be favorable and adverse (unfavorable). A favorable variance means that the actual incurred costs are less than the standard costs. On the other hand, a negative variance implies that the actual costs exceed standard costs.

Companies need to investigate favorable and adverse variances and determine their cause. Once the cause is determined, management can take corrective actions to address any potential issue.

Learn more about variance analysis in the following series of articles:

Advantages and Disadvantages of using Standard Cost Accounting

Some benefits of using standard cost accounting include:

  • It provides a basis for comparing actual costs to standard costs
  • It helps identify variances that management needs to address to improve the production processes
  • It can help motivate employees to meet or even exceed goals
  • It can help companies set better production targets

Some of the disadvantages include:

  • It can be time-consuming to calculate standard costs
  • Standard costs may not always reflect actual costs
  • Companies may use standard cost accounting to hide inefficiencies and problems
  • Companies may have difficulty setting realistic standard costs

Despite the disadvantages, standard cost accounting is a valuable tool that can help companies improve their operations. When used correctly, it can provide insights into where we need to make improvements. When misused, it can lead to faulty decision-making based on inaccurate information. As with any accounting method, standard cost accounting has pros and cons. The key is understanding these pros and cons and using the method to benefit your company.

When to use Standard Costing in Business Operations

Manufacturing companies are typically the primary users of standard cost accounting. This is because standard costing is well suited for products that are produced in large quantities. Companies with one-of-a-kind products or services, or those that produce small quantities of products, may not find standard costing as beneficial.

In addition, standard costing can be a valuable tool for companies that are trying to improve their production processes. By comparing actual costs to standard costs, companies can identify areas where they need to make changes to reduce costs and optimize the workflow. Businesses can also use standard costing to set target costs for new products or services. Finally, standard costing can help companies evaluate the performance of their employees and suppliers.

Using the Standard Costing Variance Analysis template on Magnimetrics

If you work at a manufacturing company employing or planning to employ Standard Costing of production, we got you covered.

We have prepared a sample variance analysis template on the Magnimetrics platform that you can use and extend to track the production performance of your company.

Prep Step: Get Your Free Magnimetrics Account

To use the Standard Costing Variance Analysis template (and others we are constantly adding), you need a Magnimetrics account. You can register for free (no credit card required).

So why wait? Get started today and see how Magnimetrics can help you translate your financial data into meaningful insights.

Step 1: Import the Standard Costing Variance Analysis Template to your Projects

You can find the Standard Costing Variance Analysis template in the Start With a Template section on your Dashboard.

Variance Analysis Template on Magnimetrics

You can also create a New Project and select the template from the drop-down menu.

Variance Analysis Template on Magnimetrics

Either way, please select the option to Copy Over Sample Data so that all necessary data points are available in your project.

Variance Analysis Template on Magnimetrics

Step 2: Adjust the inputs on the Assumptions tab

After the app imports the Standard Costing Variance Analysis template, it will take you to the Project Dashboard.

Don’t worry if some of those don’t make sense. Once we run the report, you will have detailed explanations of what each means.

Go to the Assumptions tab and change the following values with your company’s standards:

  • STANDARD_PRODUCTION_HOURS
  • STANDARD_MATERIAL_USAGE
  • STANDARD_LABOR_RATE
  • STANDARD_LABOR_HOURS
  • BUDGETED_PRODUCTION_HOURS
  • BUDGETED_FIXED_OVERHEAD
  • STANDARD_PURCHASE_PRICE_PER_UNIT
  • FIXED_OVERHEAD_ABSORPTION_RATE
  • STANDARD_VARIABLE_OVERHEAD_ABSORPTION_RATE
Variance Analysis Template on Magnimetrics

Step 3: Import your Historical Data

(You can skip this step if you want to stick to the dummy data and see how the template works)

Head to the Data Imports tab and open the Variance Analysis: Actuals Import data import template.

Variance Analysis Template on Magnimetrics

This import template lists all the line items we need to perform the variance analysis. There are a few ways to import your data.

  1. You can use the Export File button to get a template where you can input your values. You can then use the Import File button to upload your data and replace the dummy values.
  2. Another option is to edit the values directly by clicking on them within the import template.
Variance Analysis Template on Magnimetrics

Step 4: Run the Standard Costing Variance Analysis report

After importing or adjusting all the necessary data, head to the Reports tab and Launch the Variance Analysis report.

Variance Analysis Template on Magnimetrics

The app will show the executed report:

  • An explanation of what the different variances show
  • Calculation of each variance and the underlying assumptions/actuals

If you are interested in how everything works, go to Edit Report to look under the hood, get more familiar with how we display the tables or adjust the report to your liking. You can also go to the Formulas tab to see how the template calculates all the variances.

Variance Analysis Template on Magnimetrics

Conclusion

While standard costing can be a helpful tool, it is essential to keep in mind that it has its limitations. Standard costs may not always reflect actual costs, and companies may have difficulty setting realistic standards. In addition, standard costing can be time-consuming to track. Despite its limitations, it can be a helpful tool for manufacturing companies trying to improve their production processes.

Suppose you’re thinking of implementing standard cost accounting in your business operations. Set realistic standards! Otherwise, you might end up with some unwanted variances.

Magnimetrics’ Standard Costing Variance Analysis template is a great tool to help you track performance against your company’s pre-set standards. This will help you identify the areas that need further analysis and potential issues in the production process.

Have you ever used standard cost accounting in your business? What was your experience? Let us know in the comments below! So why wait? Get started today for free and see how Magnimetrics can help you translate your financial data into meaningful insights.

Dobromir Dikov

FCCA, FMVA

Hi! I am a finance professional with 10+ years of experience in audit, controlling, reporting, financial analysis and modeling. I am excited to delve deep into specifics of various industries, where I can identify the best solutions for clients I work with.

In my spare time, I am into skiing, hiking and running. I am also active on Instagram and YouTube, where I try different ways to express my creative side.

The information and views set out in this publication are those of the author(s) and do not necessarily reflect the official opinion of Magnimetrics. Neither Magnimetrics nor any person acting on their behalf may be held responsible for the use which may be made of the information contained herein. The information in this article is for educational purposes only and should not be treated as professional advice. Magnimetrics and the author of this publication accept no responsibility for any damages or losses sustained in the result of using the information presented in the publication.

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