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How to use Standard Costs in your business

Posted on by oggonzalez@gmail.com

How to Use Standard Costs in Your Business: A Comprehensive Guide

In the highly competitive world of business, effective cost management is crucial for maintaining profitability and ensuring long-term success. One of the most powerful tools available to businesses for managing costs is the concept of standard costs. This blog post will explore what standard costs are, how to implement them, the benefits they offer, and practical examples of using standard costs in various business scenarios.

Understanding Standard Costs

What are standard costs?

Standard costs are predetermined or estimated costs for manufacturing a product or performing a service under normal operating conditions. These costs are based on historical data, industry benchmarks, or expected costs and serve as a benchmark against which actual performance can be measured. Standard costs can be applied to labor, materials, and overhead expenses.

Components of Standard Costs

  1. Direct Materials: The costs associated with raw materials required to produce goods.
  2. Direct Labor: The costs associated with wages paid to workers directly involved in production.
  3. Manufacturing Overhead: The indirect costs of production, including utilities, rent, and depreciation of equipment.

Example of Standard Costs

Suppose a company manufactures bicycles. The standard costs for producing one bike might include:

  • Direct Materials: $100
  • Direct Labor: $50
  • Manufacturing Overhead: $30
  • Total Standard Cost per Bike: $180

These standard costs help ensure that the company can efficiently manage its production expenses and can compare actual costs against these benchmarks.

How to Implement Standard Costs in Your Business

Step 1: Establishing Standard Costs

The first step in implementing standard costs is determining what your standard costs will be. This process involves:

  • Analyzing Historical Data: Review past financial records to identify trends and averages for materials, labor, and overhead.
  • Industry Benchmarks: Research industry standards to ascertain reasonable cost expectations.
  • Input from Employees: Collaborate with production managers, accountants, and team members to gather insight and obtain accurate cost forecasts.

Step 2: Determine Cost Variances

Once the standard costs have been established, it’s essential to regularly evaluate actual costs against standard costs. This is done through variance analysis, which identifies differences between expected and actual costs.

Types of Variances to Monitor:

  • Material Variance: The difference between the actual cost of materials used and the standard cost of those materials.
  • Labor Variance: The difference between the actual labor cost and the standard cost of labor.
  • Overhead Variance: The difference between the actual manufacturing overhead costs and the standard overhead allocated.

Step 3: Analyze Variances

After identifying variances, analyze the reasons for these discrepancies. This step is critical for understanding whether cost overruns are due to price increases, inefficiencies, production delays, or other unforeseen circumstances.

For example, if the material variance for bicycle production is unfavorable, managers should investigate whether the cost of raw materials has risen or if fabrication techniques need improvement.

Step 4: Take Corrective Actions

Once the root causes of cost variances are identified, businesses can implement corrective measures. This may involve:

  • Negotiating Supplier Contracts: Reducing the cost of raw materials through effective negotiation.
  • Adjusting Workforce Training: Providing additional training to employees to improve productivity and efficiency.
  • Revising Standard Costs: If market conditions have drastically changed, it may be necessary to update standard costs to reflect current realities.

Step 5: Reporting and Review

For effective cost management, it’s important to report cost variances regularly to management and stakeholders. This allows businesses to make informed decisions based on current financial data. Schedule regular reviews—monthly, quarterly, or annually—to assess the effectiveness of standard cost implementation and make necessary adjustments.

Benefits of Using Standard Costs

  1. Improved Cost Control: Standard costs provide a clear framework for monitoring expenses and hold managers accountable for performance.
  2. Simplified Budgeting: Standard costs facilitate more accurate budgeting by providing a baseline for expected expenditures.
  3. Performance Evaluation: Variance analysis allows businesses to assess departmental and employee performance, driving efficiency and productivity improvements.
  4. Enhanced Decision-Making: With reliable cost data readily available, managers can make more informed operational and strategic decisions.
  5. Pricing Strategy Development: Knowing standard costs helps businesses determine appropriate pricing strategies to ensure profitability while remaining competitive.

Real-Life Example: Standard Cost Implementation in a Manufacturing Company

Let’s consider a fictional manufacturing company, ‘Ride Right Bikes,’ which produces high-quality bicycles. Here’s how Ride Right Bikes successfully implemented standard costs:

Establishing Standard Costs

Ride Right Bikes researched industry benchmarks and examined historical production data, determining the following standard costs per bicycle:

  • Materials: $100
  • Labor: $50
  • Overhead: $30
  • Total: $180

This allowed them to set a profitable selling price while still being competitive in the market.

Monitoring and Analyzing Variances

As production commenced, Ride Right Bikes tracked actual costs using a robust accounting system integrated with their production processes. Each month, they conducted a variance analysis:

  • Material Variance: In January, they discovered that actual material costs rose to $110 per bike, resulting in a $10 unfavorable variance ($110 actual – $100 standard).
  • Labor Variance: Actual labor costs remained at $50, aligning perfectly with the set standard.
  • Overhead Variance: Manufacturing overhead was calculated at $40 per bike, leading to another $10 unfavorable variance.

Investigating Causes

Upon reviewing these variances, the management team at Ride Right Bikes convened to understand the discrepancies:

  • Material Cost Increase: They determined that the increase in material costs was due to market inflation and a supplier’s price hike.
  • Overhead Increase: A rise in utilities also impacted overall manufacturing overhead, necessitating a review of operational efficiencies.

Implementing Corrective Actions

To address the unfavorable variances, Ride Right Bikes implemented several strategic initiatives:

  1. Supplier Negotiations: They renegotiated contracts based on volume and loyalty, securing a better deal on raw materials moving forward.
  2. Cost-Effective Alternatives: They researched alternative suppliers and materials that met quality standards but offered lower costs, ensuring they could keep production costs in line.
  3. Overhead Review: Initiatives to reduce energy consumption led to the implementation of energy-efficient machinery, which would reduce future overhead costs.

Adjusting Standards and Continuous Improvement

In light of these findings, Ride Right Bikes also decided that quarterly reviews of standard costs would allow them to stay responsive to market changes and competitor pricing. Notably, their commitment to continuously refining these standards allowed them to adapt rather than react, positioning them as a resilient player in their industry.

Challenges of Using Standard Costs

While implementing standard costs has significant advantages, businesses may encounter challenges:

  1. Time-Consuming Setup: Establishing accurate standard costs requires thorough analysis and may take considerable time, especially for new businesses.
  2. Resistance to Change: Employees accustomed to traditional accounting practices may resist adopting a new system of standard costs, necessitating effective change management strategies.
  3. Potential for Inaccuracies: If standard costs are not reviewed and updated regularly, they risk becoming outdated, leading to ineffective decision-making and operational inefficiencies.
  4. Costly Implementation: The initial costs of training staff and integrating new systems may be substantial, but the long-term benefits often outweigh these initial investments.

Conclusion

Using standard costs is a powerful strategy for businesses to control expenses, improve budgeting, and make informed decisions. By establishing robust cost benchmarks and continuously monitoring actual performance against these standards, companies can drive efficiency, enhance profitability, and remain competitive in their markets.

As seen in the example of Ride Right Bikes, the careful implementation of standard costs followed by thorough variance analysis and adjustment leads to not just operational improvements but also strategic positioning. Companies looking to enhance their financial performance should consider adopting standard costs as a vital component of their overall management strategy.

References

  1. Drury, C. (2018).  Management and Cost Accounting. Cengage Learning.
  2. Horngren, C. T., Datar, S. M., & Rajan, M. (2015).  Cost Accounting: A Managerial Emphasis. Pearson.
  3. Investopedia. (2023). Standard Costing. Retrieved from Investopedia
  4. Corporate Finance Institute. (2023). Understanding Standard Costs. Retrieved from CFI

By adopting standard costs and aligning them with business strategies, companies can enhance productivity, control costs, and pave the way for sustainable growth. Implement these practices diligently, and watch your business thrive as a result.