Management will determine standard costs and quantities. These will be used when preparing standard cost performance reports. At the end of the reporting period, the actual costs of production will be compared against the standards.
Some reasons for using standard costs are for cost control, decisions about pricing, performance evaluation, cost awareness, and management by objective. Cost control involves the identification of a cost with the related benefits of that cost, and determining if that cost is justified based on the benefits generated. Once a standard cost is determined, it is very easy to compare standard costs with actual costs and identify any problems quickly.
There are three types of standards. They are ideal standards, basic standards, and currently attainable standards. Ideal standards are those which can only be attained in situations of perfect operating conditions. These are also called theoretical or engineering standards. Basic standards are useful for evaluating performance over the long-term, such as over several years. These types of standards are useful in detecting trends in performance, unless the environment is changing quickly.
Currently attainable standards are the type of standard that is most often used. These standards are benchmarks for efficient production under current operating conditions. Normal production problems like equipment downtime and employee errors are taken into consideration for currently attainable standards. These standards are often quite realistic and are normally acceptable to employees.
The standard cost system is made up of three parts. They are the setting of standards, the gathering of actual costs, and the analysis of variances. Standards can be set under a variety of methods. Sometimes a standard-setting committee may do the work. Other times, scientific methods such as time and motion studies, simulation studies, pilot projects, and learning curve analysis are used. Looking back at past experience and gathering input from employees are also used when setting standards.
Actual cost information is gathered and compared with the standards using performance reports. These actual costs may be gathered using either a process cost system or a job order costing system. A variance is the difference between an actual cost and the standard cost. Variances are identified and analyzed, looking at the source of the variance carefully. Individual and total variances are examined. When actual cost is greater than the standard cost, an unfavorable variance exists. If actual cost is less than the standard cost, there is a favorable variance. All variances should be evaluated, and appropriate action should be taken to eliminate unfavorable variances to the extent possible in the future.
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