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Standard Costing, Cost Control, and Measuring Performance

Standards in management accounting are benchmarks or norms that an organization uses to establish expectations, control costs, and measure performance. Standards are often set for the quantity and cost of inputs, such as material requirements and labor requirements, as well as for overhead. For example, a pizza company could set a standard direct materials cost per unit. These standard variable costs, and the standard variable portion of overhead costs are usually estimated in two ways:

1. The account analysis method: An account manager will look at past expenses and determine what proportion has behaved in a fixed manner and what proportion has behaved in variable manner. For example, if in the past, the pizza company incurred on average $500 of material costs each day to make 100 pizzas, the account analysis will determine a standard material cost of $5 per pizza. Similarly, if the company incurs an average of $50 in electricity costs when they make 100 pizzas, and $70 when they make $200 pizzas, we can identify the difference ($20) as a variable cost for creating 100 pizzas. We can then determine that electricity has a fixed proportion ($30/day) and a variable portion ($0.20/pizza).

2. The engineering method: A specialist with knowledge of the costs and usage of inputs builds a model for how much costs should be. In our pizza example, an expert would look at how much oil, flour, cheese, and other toppings go into each pizza, and add up the costs of these individual ingredients. An expert might arrive at a total of $4.80/pizza for direct material costs. Often, information from both methods is used in setting standard costs in order to increase the accuracy of the standard costs a company uses.

The actual results of a business are then compared with these standards and the variance between standard and actual results are broken down into their component parts. For example, we may decide it is reasonable for the company to use $4.90 of ingredients per pizza, $2.00 of direct labor and to sell 100 pizzas/day at $8.50/each. At the end of the year we look at differences such as quantity variance, materials price variance, materials quantity variance, labor rate variance, labor efficiency variance, variable overhead spending variance, and variable overhead efficiency variance. We ask questions such as: was the actual cost of the pizza close to $4.90? If it cost more, was that because we used more ingredients per pizza, or was that because the cost of our ingredients went up? This type of information is invaluable for managers to make decisions. For example, if the cost of ingredients went up, maybe the company should charge more per pizza to cover these costs. If we used more ingredients per pizza then we should have, maybe employees need to be trained better, or better measuring tools need to be put in place to control costs.

By looking at how our costs deviate from expected costs, we have a better understanding of where cost overruns or savings are found and how well our managers and products have performed. Ultimately, we know that overhead is a major cost in many organizations – and the most important objective of standard costing is to control it. Flexible budgets are used to help measure variable portions of overhead costs and compare them with standards that have been set. If managers decide to use actual costs for jobs or processes for reporting, they often still employ standard cost practices for budgeting and operational planning.

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