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Standard Cost: Benefits and Disadvantages

What is Standard Cost?

Is your manufacturing operation using Standard Cost or Actual Cost to value production costs? Are you wondering what the benefits would be if you switched to a Standard Cost valuation of the production of your products? In this blog post, I’ve listed the advantages and disadvantages of using Standard Cost to help with your analysis.

Many manufacturing entities utilize the Standard Cost system instead of the Actual Cost system to reduce the tracking requirements for purchases, labor, and overhead.

A Standard Cost system is a common way to budget for planned projects, managing costs in a production run, and evaluating those costs after the production has finished. This system has the benefit of giving a business hard numbers to use when creating estimates for customers.  The basic point to remember is Standard Cost enables management by exception (i.e., variance to standard) as opposed to managing the entirety.

Standard Cost is budgeting the cost to produce one unit of an item. You establish and assign a set of costs for each production segment of the item—direct material, direct labor, indirect labor, and machine hours. These costs are used to record cost of production for all like items. At the end of the period, a variance report is run to show actual production costs versus the Standard Costs that were used. The variance report allows the user to compare the Standard Cost of each product or service with the actual cost to determine the efficiency of operation so that remedial action may be taken immediately. For example, the Purchasing Department can be measured against their procurement cost objective quite easily by reviewing the Purchase Price Variance.

Advantages of Standard Cost System:

  1. The use of standard costs is a key element in a management by exception approach. If costs remain within the standards, managers can focus on other issues. When costs fall significantly outside the standards, managers are alerted that there may be problems requiring attention. This approach helps managers focus on important issues.
  2. Standards that are viewed as reasonable by employees can promote economy and efficiency. They provide benchmarks that individuals can use to judge their own performance.
  3. Standard cost systems establish cost centers and responsibility is assigned to the department leaders and their teams.
  4. Standard costs can greatly simplify bookkeeping. Instead of recording actual costs for each job, the standard costs for materials, labor, and overhead can be charged to jobs.
  5. Standard costs fit naturally in an integrated system of responsibility accounting. The standards establish what costs should be, who should be responsible for them, and what actual costs are under control.

Disadvantages of Standard Cost System:

  1. Standard cost variance reports are usually prepared on a monthly basis and often are released days or even weeks after the end of the month. As a result, the information in the reports may be so stale that it is almost useless. Timely, frequent reports that are approximately correct are better than infrequent reports that are very precise but out of date by the time they are released. Some ERP systems, such as Plex Manufacturing Cloud, let you see this data on a daily basis avoiding this disadvantage.
  2. In some cases, a “favorable” variance can be as bad or worse than an “unfavorable” variance. For example, Bridgestone has a standard for the amount of air that should be in their tires. A “favorable” variance would mean that less air was used than standard specifies. The result is a substandard tire and possibly a dissatisfied customer.
  3. Just meeting standards may not be sufficient; continual improvement may be necessary to survive in the current competitive environment. For this reason, some companies focus on the trends in the standard cost variances – aiming for continual improvement rather than just meeting the standards. In other companies, engineered standards are being replaced either by a rolling average of actual costs, which is expected to decline, or by very challenging target costs.

In summary, managers should exercise considerable care in their use of a standard cost system. It is particularly important that managers go out of their way to focus on the positive, rather than just on the negative, and to be aware of possible unintended consequences.

If you would like to find out why Revolution Group has been a trusted Plex ERP consulting partner for more than 20 years, call us at 614-212-1111 or reach us at [email protected]. We would love to discuss the benefits of Standard Cost within your company.