Standard Cost: Definition, Calculation, and Importance- A Detailed Guide

Introduction

Businesses have to think about a lot of things beyond just the reality of their own finances, as well. They need to know what income is projected, what expenses can be accounted for and planned for going forward, and how to best use the employees that they have available to them. Cost calculations are one of the crucial elements in being able to do this properly. With this article, you’ll see how calculating a standard cost is an indispensable tool for making sure your business is not only running smoothly but that it’s also staying profitable even on dates without customers.

Standard Cost Definition – what is standard cost?

Standard cost is simply the average cost of producing one unit of a product. To calculate it, you simply take the total cost of all the materials and labor needed to make the product and divide it by the number of units produced.

Second, the standard cost can be used as a tool for pricing products. If you know how much it costs you to produce something, then you can price your product accordingly. This ensures that you’re not losing money on each sale, and it also helps you

Standard cost is an important business calculation that determines the cost of goods or services. It’s used to set prices and compare businesses. Standard costs can also help businesses manage inventory and budget for future needs.

advantages of standard cost

In any business, it’s important to have a clear understanding of your costs. This is especially true when it comes to manufacturing. After all, if you don’t know how much it costs to produce your product, how can you price it properly? This is where the standard cost comes in.

So why is the standard cost so important? There are a few reasons. First, it provides a benchmark that you can use to compare your actual costs too. If your actual costs are higher than your standard costs, then you know you need to find ways to reduce them. Conversely, if your actual costs are lower than your standard costs, then you’re doing something right and you can use that information to help drive down costs even further.

Additionally, these are the benefits of managing and recording standard costs

1. Cost Control: Standard cost helps in estimating a benchmark cost on which all the other benchmark costs are calculated. Thus it forms the very base of all forms of cost control
2. Elimination of Pilferage and Inefficiencies: By analyzing standard cost variances we can pinpoint the wastages and inefficiencies of the system and on which actions can be taken
3. Norms: Establishing cost norms are important. Standard Cost estimates also help in setting up standards by which costs are reported
4. Fixing Responsibility: In a forensic investigation where management is estimating high variances, standard cost helps in fixing responsibilities to a person or a process that is causing such high variances
5. Exceptions Management: In a year where inflation is very high or there is a critical shortage of raw material, standard cost estimates can help in substantiating such high costs so that such causes exceptions can be built up
6. Process Improvement: One of the major outputs of a standard cost estimate is to improve processes. One or a few such processes which contribute to high costs can be found and can be improved subsequently
7. Planning and Budgeting: Say you are coming up with a new product, and it’s important to know how the product will fare against the competition. Standard cost estimation helps in the process as it gives a very strong indicator of the pricing. Also, approximation of volumes can be made on the same on which budgets in the forms of capital and revenue expenses can be estimated
8. Inventory Valuation: One of the major drawbacks of the valuation of inventory at actual costs is that it overvalues inventory. Valuing stock with standard costs reduces the bias or errors and gives us a near-perfect estimate of the inventory in hand and not due to sales loss

Difference Between Actual Costs and Standard Cost:

The variances generally emerge from two factors:

Rate Variance:

A rate variance is a difference between the actual price and the expected price of raw materials, multiplied by the actual amount bought. This difference is also called a price variance. One kind of rate difference is the difference in the cost of labor. This is the difference between how much labor actually costs and how much direct labor usually costs. When it comes to the price of buying materials, rate variance is called material price variance or purchase price variance.

Volume Variance:

Volume variance is the difference between how much was planned to be sold or used and how much was actually sold or used. This difference is multiplied by the product’s standard cost per unit. There are three kinds of volume changes:

• Differences between the goods sold.
• Material yield variation that shows how raw materials are used
• Labor productivity difference that figures out how much direct labor was used
• Overhead efficiency difference that has to do with material costs

Process of Deriving Standard Cost

We follow a five-step process of standard cost estimation and the necessary course corrections that need to be done post those estimates:

Establishing the Standard: This is the most crucial step. Understanding benchmarks and gathering the right inputs are necessary to estimate the standard cost

Determinants of Actual Cost: There could of many determinants. Generally, they are categorized as :

1. Direct material Cost
2. Indirect Costs
3. Overheads

Comparisons of Standard and Actual Cost: The variations between both of them can originate because of the following factors:

1. Deviation from a prescribed process
2. A longer lead time is required in the actual process
3. Increase or decrease of direct material cost due to inflation or resourcing of sources
4. People’s Expenses are often miscalculated as the cost is not broken down to the smallest possible unit
5. Other areas of variation may include deviations due to over or undercalculation

Determination of Causes: As discussed earlier, the probable causes are determined and responsibilities are assigned for improvement

Course Correction: In an ideal setup, the standard costs must be equal to actual costs. Until they are equal, the management can strive for improvements and course corrections. These analyses of variances help in creating benchmark indices for the future or new product introductions

In order to calculate the standard cost, you will need to determine the following:

1. The number of direct materials needed for one unit of production

2. The amount of direct labor required for one unit of production

3. The number of overhead costs associated with one unit of production

Once you have determined all three of these factors, you can then calculate the total standard cost for producing one unit of your product. To do this, simply multiply each factor by its respective cost per unit. For example, if the cost of direct materials is $10 per unit and the cost of direct labor is $20 per unit, then the total standard cost would be $30 per unit.

How to Calculate Standard Cost

With this example we will try to decipher standard cost accounting and understand standard cost calculation

Let’s assume an example you run a beautiful coffee shop in the middle of Downtown Manhattan. The Café runs for approximately 30 days a month. You serve only one type of coffee. Nearly 300 customer visit and buy your store every day. You end up making 300 Cups of Coffee every day. You need to find the cost at which you need to sell the coffee.

In this problem statement, we need to find out a standard cost for making a cup of coffee first.

For doing this we need to assume the following:

1. There is two staff working in the café. The salary of Each staff is 2000 USD per month. You need to increase
2. The rent of the place is 4000 USD per month
3. Electricity, water, and overheads amount to 500 USD per month
4. Utility expenses per month amount to 500 USD per month
5. For making 1000 cups of coffee you need 2 kgs of Coffee every day. The cost of a kg of coffee is 1000 USD
6. There are two barista machines which cost you approximately 5 dollars of cost every day (Asset amortization)

Samrat Saha

Samrat is a Delhi-based MBA from the Indian Institute of Management. He is a Strategy, AI, and Marketing Enthusiast and passionately writes about core and emerging topics in Management studies. Reach out to his LinkedIn for a discussion or follow his Quora Page