Standard Costs Are Divided Into Which Of The Following Components

Decoding Standard Costs: A Deep Dive into its Components

Standard costing is a powerful management accounting technique that helps businesses plan, control, and evaluate their costs. It's a crucial tool for budgeting, performance measurement, and pricing strategies. Understanding the components of standard costs is key to effectively using this system. This article will delve deep into the core elements of standard costs, explaining each component in detail and providing practical examples to enhance your understanding. We'll explore how these components interact to provide a comprehensive picture of a product's expected cost, and ultimately, how they contribute to informed business decisions.

Introduction to Standard Costs

Standard costing involves setting predetermined costs for each unit of product or service. These "standards" represent the expected cost under efficient operating conditions. By comparing actual costs to these pre-determined standards, businesses can identify variances—the differences between planned and actual figures. These variances are crucial for understanding cost overruns or undershoots, pinpointing areas for improvement, and ultimately, enhancing profitability. The beauty of standard costing lies in its proactive approach; it allows for timely identification and correction of potential problems before they significantly impact the bottom line. The key to successful standard costing is setting realistic and attainable standards.

The Three Main Components of Standard Costs

Standard costs are typically divided into three primary components:

• Direct Materials: This encompasses the cost of all raw materials directly used in the production process.
• Direct Labor: This includes the wages and associated labor costs directly involved in manufacturing the product.
• Manufacturing Overhead: This comprises all indirect costs associated with production that cannot be directly traced to specific products.

Let's examine each component in detail:

1. Standard Direct Materials Cost

The standard direct materials cost represents the expected cost of raw materials needed to produce one unit of a product. This component has two key elements:

• Standard Quantity (SQ): This is the amount of raw material expected to be used in producing one unit of the finished product. This is determined through engineering studies, considering factors like material wastage, spoilage, and efficient production techniques. For instance, a standard recipe for a loaf of bread might specify a certain weight of flour, water, and yeast. Any deviations from this standard quantity are analyzed to determine potential inefficiencies.

• Standard Price (SP): This is the expected price per unit of raw material. It's determined based on market research, historical data, and anticipated price fluctuations. Factors such as supplier contracts, bulk purchasing discounts, and market trends are all considered when setting the standard price. Fluctuations in the market price versus the standard price will lead to a materials price variance.

Example:

Let's say a company manufactures chairs. The standard quantity of wood required for one chair is 5 board feet, and the standard price per board foot is $5. The standard direct materials cost for one chair is therefore: 5 board feet * $5/board foot = $25.

This means the company anticipates spending $25 on wood for each chair produced. Any variation from this will result in a materials cost variance, which is then investigated to understand the cause (e.g., higher than expected wood prices, increased waste during production).

2. Standard Direct Labor Cost

Standard direct labor cost represents the expected cost of labor directly involved in manufacturing one unit of a product. It also consists of two main elements:

• Standard Hours (SH): This represents the time (usually in hours) expected to be spent by labor on manufacturing one unit of the product. It's determined through time and motion studies, considering factors such as worker skill levels, machine efficiency, and production processes. The standard hours should reflect optimal performance under efficient operating conditions.

• Standard Rate (SR): This is the expected hourly rate of pay for direct labor. This includes wages, fringe benefits, and any other labor-related costs per hour. Factors such as union agreements, prevailing wage rates, and company compensation policies are considered when setting the standard rate.

Example:

Continuing with our chair manufacturing example, let's assume that the standard hours of direct labor required to produce one chair is 2 hours, and the standard rate per hour is $20. The standard direct labor cost for one chair is: 2 hours * $20/hour = $40.

This implies that the company expects to spend $40 on direct labor for every chair produced. Deviations from this standard would result in a labor rate variance or a labor efficiency variance, prompting an investigation into the reasons behind the discrepancy.

3. Standard Manufacturing Overhead Cost

Standard manufacturing overhead cost represents the expected indirect costs associated with production for one unit. Unlike direct materials and direct labor, it’s difficult to directly trace manufacturing overhead to individual units. It’s often allocated based on a predetermined overhead rate. This overhead rate is typically calculated using a cost driver, which is a factor that influences the amount of overhead incurred. Common cost drivers include direct labor hours, machine hours, or direct materials cost. The standard manufacturing overhead cost also has two components:

• Standard Overhead Rate (SOR): This is the predetermined overhead rate per unit of the cost driver. It's calculated by dividing the estimated total manufacturing overhead cost by the estimated total amount of the cost driver.

• Standard Overhead Quantity (SOQ): This is the estimated amount of the cost driver used to produce one unit. This could be the standard labor hours, machine hours, or the standard amount of direct materials consumed, depending on the chosen cost driver.

Example:

Let’s assume the company uses direct labor hours as its cost driver for manufacturing overhead. They estimate total manufacturing overhead costs of $100,000 for the year and estimate 10,000 direct labor hours. The standard overhead rate would be: $100,000 / 10,000 hours = $10 per direct labor hour.

If the standard direct labor hours per chair is 2 hours (as calculated earlier), then the standard manufacturing overhead cost per chair is: 2 hours * $10/hour = $20.

This implies that the company expects to allocate $20 of manufacturing overhead to each chair produced. Variances from this standard could be caused by higher than expected overhead costs or differences in the actual amount of the cost driver used compared to the standard.

Calculating Total Standard Cost

The total standard cost per unit is simply the sum of the standard direct materials cost, standard direct labor cost, and standard manufacturing overhead cost.

In our chair example:

• Standard Direct Materials Cost: $25
• Standard Direct Labor Cost: $40
• Standard Manufacturing Overhead Cost: $20
• Total Standard Cost per Chair: $85

This means the company expects each chair to cost $85 to produce. This figure is crucial for pricing decisions, budgeting, and performance evaluation.

Variance Analysis: The Power of Standard Costing

The real value of standard costing comes from comparing the actual costs to the standard costs. Any difference is a variance, and analyzing these variances is crucial for identifying areas for improvement. For each of the three components (direct materials, direct labor, and manufacturing overhead), variances can be broken down into several sub-variances, such as price variances, quantity variances, rate variances, and efficiency variances. Understanding these variances allows management to make informed decisions about resource allocation, process improvements, and cost control strategies.

Frequently Asked Questions (FAQ)

Q: Why is standard costing important?

A: Standard costing provides a benchmark for measuring actual performance against planned performance. This helps in identifying areas of inefficiency, setting realistic budgets, and making informed pricing decisions.

Q: How often should standards be reviewed and updated?

A: Standards should be reviewed and updated regularly, typically annually or even more frequently, to reflect changes in material costs, labor rates, technology, and production processes. Outdated standards can lead to inaccurate performance assessments.

Q: What are the limitations of standard costing?

A: Standard costing relies on estimations and assumptions, which may not always reflect reality. It can also be inflexible in dynamic environments and may not capture all relevant costs, particularly in complex production processes. Overemphasis on achieving standards can sometimes lead to unintended consequences.

Q: Can standard costing be used for service industries?

A: Yes, although the specific components might differ. For example, instead of direct materials, a service industry might have standard costs for supplies and consumables. Direct labor and overhead costs would still apply, but the allocation methods may vary depending on the nature of the service.

Conclusion: Harnessing the Power of Standard Costs

Standard costing is a valuable tool for any business seeking to control costs, improve efficiency, and enhance profitability. By understanding its three core components – direct materials, direct labor, and manufacturing overhead – and by diligently analyzing variances, businesses can gain valuable insights into their operations. While it's essential to acknowledge the limitations of this system, the benefits of proactive cost management and performance evaluation far outweigh the challenges, making standard costing an indispensable tool for sound financial management. Remember, continuous review and adaptation of standards are crucial for maintaining their relevance and ensuring their effectiveness in the long run. By embracing standard costing as a dynamic management tool rather than a rigid system, businesses can unlock its full potential for strategic decision-making and sustained success.