We dive into the topic of standard costing for AAT Professional Diploma in Accounting students, and look at using standard costing to create a budget, and monitor it.
Standard costing is used by organisations to calculate the standard cost of products and forms the basis of selling prices and budgets. However, it differs from general budget setting because it concentrates on cost units, in other words the cost of individual products, as opposed to the costs of the business’s sections or departments.
Elements of standard costing are included in all the AAT management accounting units at all levels, although they’re not named as such until professional level, because standard costing is used in all stages of the budgetary process; planning, decision making, monitoring and control.
Standard costing at each AAT level
Let’s think about manufacturing a pair of shoes. At foundation level we would have considered the three elements of cost: materials, labour and overheads, classified them into direct and indirect costs, and categorised them as fixed, variable or semi-variable.
If our shoes require half a metre of leather and two soles per pair, then these are the raw materials and will vary in direct proportion to production. Labour cost can be both direct and indirect, for example, production workers and supervisors. Rent and rates for our premises are examples of fixed costs which are either recovered via an overhead absorption rate if we are using absorption costing or covered by product contribution if we are using marginal costing.
By combining our understanding of cost behaviour, the costs/rates and a detailed understanding of the quantities required for production, we can create a cost card, in this case using marginal costing:
Because all the elements shown are variable costs, the rates are multiplied by the quantities required to calculate the total cost of each element. These are combined to give the total marginal cost of making a pair of shoes.
This is the standard cost of one unit and is the fundamental basis of budgetary planning. For example, if we are planning to manufacture 500 pairs of shoes then it is easy to use the cost card to calculate that the marginal cost will be £9,625 in total (500 x £19.25).
However, in order for a budget to be accurate, the costs and rates must be up to date and the production quantities and times accurate. There will obviously be discrepancies if a machine breaks down and our workers are idle for a period of time or there is a shortage of materials and we have to use lower grade leather that results in higher than normal wastage.
Four standard types for variation
There are four types of standard that allow for some variation, so it’s important to be clear which is being used:
- Ideal – assumes full labour efficiency with no wastage of raw material
- Normal – is the current expected cost of a product and allows for a degree of wastage and inefficiency
- Target – allows for normal working conditions, with allowances made for waste and inefficiency, but is set at a level an organisation wishes to achieve
- Basic – is based on historical information so enables comparisons over time
Let’s say that our standard is ‘normal’ and was used to set a budget for the manufacture of 500 pairs of shoes. This means that in our planning we have allowed for some expected waste and inefficiency:
Monitoring budgets is the next stage and this is done by comparing the budget to the actuals using variance analysis.
If actual production was 600 units, then 100 more pairs of shoes were produced than planned, this will result in higher total variable costs but will not affect any budgeted fixed costs due to the costs’ behaviour.
At advanced level we learned how to flex budgets, in order to remove the effect of changes in production volume so that these predictable variations do not obscure other differences, and to calculate basic variances:
The key objective of monitoring budgets is to understand why the actuals are different to the flexed budget so that decisions can be made to control costs that vary significantly from the standard and bring them back on track.
Understanding the variance
The variance for leather is £200 adverse, meaning that the spend on this material was more than planned. The question though is why. Has more been used, or wasted, than expected, or did it cost more per metre than planned?
Standard costing allows variance analysis to drill down into usage and price variances for materials and efficiency and rate variances for labour and the idle time variance to provide better explanations of the differences. Maybe there was a shortage of materials and we used different leather from planned, which was harder to work with, so took more time and resulted in more rejects. This could also explain the adverse labour variance.
Acting on the variance
Let’s assume this was the case. First, we need to decide if this is a significant variance or is within the ‘normal’ standard’s tolerances. If it’s deemed significant, we then need to know if the situation is temporary or permanent. If the issue is now resolved, no action will be required. However, if it isn’t, we might need to look for a new supplier or new materials.
Maybe production processes will have to be amended so they are more suited to the different grade material and training put in place for production staff.
Finally, we should review the standard. If a permanent change is made to a cost or quantity on a product’s cost card, it should be reflected in the normal standard to ensure it’s relevant and accurate, bearing in mind it is the benchmark to which our actuals are compared.
Gill Myers is a self-employed accounts consultant. She has taught AAT qualifications since 2005 and written numerous articles and e-learning resources.