Standard costing systems - Purpose and principles of standar...

Learning Outcomes

By the end of this article, you will understand the core purpose of standard costing systems. You will be able to explain the main principles behind setting standards, distinguish between types of standard costs, and describe how standard cost cards underpin budgeting and variance analysis. You will be able to identify the role of standard costing in planning and control, and summarise the advantages and limitations of these systems.

ACCA Management Accounting (MA) Syllabus

For ACCA Management Accounting (MA), you are required to understand how standard costing systems support planning, cost control, and performance measurement within organisations. For this topic, your revision should focus on:

• The objectives and rationale for using standard costing systems
• The fundamental principles of setting and maintaining standard costs
• Types of cost standards: ideal, attainable, basic, and current
• The construction and function of a standard cost card
• How standard costs are used in budgeting, variance analysis, and inventory valuation
• Key strengths and potential limitations of standard costing
• The link between standard costing, marginal and absorption costing

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. What is the main purpose of a standard costing system within a manufacturing organisation?
2. Which type of standard is most commonly used to motivate staff performance: ideal, attainable, or current?
3. What main components are shown on a standard cost card for a product?
4. True or false? Standard costs may be used as the basis for both marginal and absorption costing.

Introduction

Standard costing is a management accounting technique that sets predetermined costs for products or services, which act as benchmarks for planning, control, and performance measurement. By comparing actual results with these standards, organisations can analyse variances and make informed decisions.

Key Term: standard cost
The planned, predetermined unit cost of a product or service, established in advance for budgeting, control, and performance evaluation purposes.

The Purpose of Standard Costing

The main goal of standard costing is to improve planning, control, and decision-making. By expressing expected costs for materials, labour, and overheads in advance, managers can:

• Prepare more accurate budgets
• Control actual costs against targets
• Identify problems quickly through variance analysis
• Motivate staff with clear expectations
• Simplify inventory valuation and reporting

Standard costing also allows costs for products or services to be estimated before production begins.

Key Term: variance
The difference between a standard cost and the actual cost incurred, used to analyse performance.

The Principles of Standard Costing

Standard costing is based on the following principles:

1. Pre-determination: Costs are set in advance, using operational data and assumptions about efficiency, resources, and expected wastage.
2. Standardisation: The process of specifying clear methods, material quantities, and time requirements for production or service activities.
3. Continuous comparison: Actual results are compared with standards on a routine basis, with differences (variances) isolated for review.
4. Responsibility: Variances are assigned to individuals or departments accountable for cost control and efficiency.

Types of Standards

Organisations may use different types of standards, each suited to particular objectives:

Attainable standards are most common for motivating employees and supporting practical cost control, as they are challenging but achievable.

Key Term: standard cost card
A document that summarises a product or service’s standard costs for each resource, including materials, labour, and overheads, for one unit.

Worked Example 1.1

A company plans to produce a wooden chair. The standard costing team has determined the following per unit:

• 6 kg of timber at $5 per kg
• 2 hours of direct labour at $12 per hour
• Variable overhead at $3 per labour hour
• Fixed overhead absorbed at $4 per unit

Calculate the standard cost per chair.

Answer:
Direct materials: 6 × $5 = $30
Direct labour: 2 × $12 = $24
Variable overhead: 2 × $3 = $6
Fixed overhead: $4
Total standard cost per chair: $64

The Standard Cost Card

A standard cost card brings together all the standard resource requirements and cost rates for producing one unit. It is used for budgeting and as a basis for cost control.

A typical standard cost card includes:

Key Term: absorption costing
A costing method that includes all production costs (variable and fixed) in the cost per unit.

Key Term: marginal costing
A costing method that includes only variable production costs in the cost per unit; fixed costs are treated as period costs.

Application in Planning, Control, and Decision-Making

1. Planning: Standards help compile budgets by estimating resource and cost requirements for future output levels.
2. Control: Actual costs are compared to standard costs, with variances analysed to monitor efficiency and cost control.
3. Performance Measurement: Variances are allocated to those responsible, to improve accountability and decision-making.
4. Inventory Valuation: Inventory values can be calculated more efficiently using standard costs.

Worked Example 1.2

The following standards apply per product:

• 4 kg of raw material at $2.50 per kg
• 1.5 hours of labour at $8 per hour
• Fixed overhead absorption rate at $3 per unit

If actual costs for a month are higher than standard for materials and lower for labour, what is the likely impact?

Answer:
There will be an adverse material variance (actual > standard) and a favourable labour variance (actual < standard). Management should investigate the causes to determine if action is needed.

Advantages of Standard Costing

• Enables timely identification of cost variances
• Promotes consistent budgeting and forecasting
• Clarifies responsibility for cost control
• Supports benchmarking and trend analysis
• Reduces administrative workload through simplified inventory valuation

Limitations of Standard Costing

• Establishing realistic standards can be complex and resource intensive
• Standards may become quickly outdated in fast-changing environments
• Not always suitable for customised or non-repetitive production
• Excessive reliance on standards may discourage innovation or adaptation
• May cause demotivation if standards are set too high or are perceived as unfair

Exam Warning

When preparing for the ACCA examination, remember that standard cost systems work best where activities are repetitive and resources or outputs are homogenous. Applying standard costing in very dynamic, customised, or service-based environments requires caution.

Standard Costing, Marginal and Absorption Costing

Standard costs may be used within both marginal and absorption costing systems.

• In marginal costing, only variable costs are included in the standard cost per unit.
• In absorption costing, the standard cost per unit includes both variable and fixed production overheads.

The choice of method affects inventory valuation and the analysis of variances.

Worked Example 1.3

Given:

• Standard variable production cost per unit: $25
• Fixed production overhead rate: $5 per unit
• Number of units produced: 1,200
• Number of units sold: 1,000

Calculate total production cost and closing inventory value under absorption costing.

Answer:
Production cost = 1,200 × ($25 + $5) = $36,000
Units in closing inventory = 1,200 − 1,000 = 200
Inventory value = 200 × $30 = $6,000

Summary

Standard costing systems provide a structured framework for setting expected costs, creating budgets, and analysing performance. By identifying and investigating variances, organisations can take timely corrective action. While standard costing brings major benefits in planning and control, it is only as effective as the accuracy and relevance of the standards themselves. Understanding both the advantages and limitations is essential for effective exam preparation and practical application.

Key Point Checklist

This article has covered the following key knowledge points:

• The main purpose of standard costing in planning, control, and decision making
• How standards are set and applied in standard costing systems
• Differences among basic, ideal, attainable, and current standards
• The structure and function of a standard cost card
• Standard costing’s relationship to marginal and absorption costing
• Key benefits and common limitations of standard costing
• Use of standard costing for budgeting, variance analysis, and inventory valuation

Key Terms and Concepts

• standard cost
• variance
• standard cost card
• absorption costing
• marginal costing