Imagine you are managing a factory and need to know how much it will cost to produce a new product. Depending on actual costs, you might wait until the end of the month for a detailed report, but in the business world, where decisions must be made quickly and with precise information, waiting that long is not viable. This raises the question: how can you plan, quote, and make strategic decisions without waiting until the end of the period to know the actual costs?
Actual costs, as the name implies, are the costs that were indeed incurred in the production of a good or service. These costs reflect reality to the last cent. If this is the case, why do many companies prefer to use standard costs instead of actual costs? Well, there are several reasons, but the main one is that calculating actual costs is always “post mortem”; in other words, you have to wait for the cycle, month, or period to close to know the actual costs. In many cases, such as when making a quotation, it is simply not practical to wait until the end of the period to know the costs. A realistic value is needed for negotiating and planning for the future. This is where standard costs come into play.
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Standard costs are the costs that a company should incur to carry out an operation or task and are usually expressed on a per-unit basis. The standard cost assumes certain specific conditions in terms of the use of raw materials, machinery, time, and staff experience, as well as the behavior of indirect manufacturing expenses. Given these conditions, a cost per unit produced is established; for example, $5.00 per unit, while an actual cost could give different values in each period such as $4.86, $4.94, $5.06, $4.49, etc.
Having a standard cost facilitates future planning and quotations.
There are two types of standard costs that can be identified:
- Ideal Standard: This calculation assumes an ideal situation where there is no waste of material, inputs, or time, the staff is fully trained in their tasks, and the machinery is constantly working at its maximum capacity. Being ideal, it helps set a target to aim for; however, it is almost unattainable in practice. Even so, it helps to calculate the achievable standard.
- Achievable Standard: Here, there is some flexibility in the calculation, assuming that some waste of material, reprocessing, machine maintenance stops, and human errors are normal.
Which of the two standards to use? The one that best helps you achieve your strategic goals.
What Should Be Considered When Calculating Standard Costs?
Several aspects must be considered, such as:
- Analyzing Cost History: The most practical way to determine the standard cost is to evaluate how the cost has behaved over past years, study deviations, and determine which moments resulted in costs under optimal conditions. It should be noted that a standard based on historical data may present deviations, not account for current technological improvements, and perpetuate inefficiencies that have been dragging on over time.
- Activity Analysis: Here, an identification and measurement of all the activities involved in manufacturing an item or providing a service are carried out. It includes labor, materials, and machinery costs, among others, always seeking that cost with minimal waste and reprocessing. In practice, if done in detail, it is costly to perform, which is why not all companies do it.
- Benchmarking: It is normal to adopt best practices from other companies, even if they belong to another industry, as long as we are talking about similar operations, such as handling delinquent portfolios, human resources management, etc. These best practices also help establish standard costs, noting that they do not always apply 100% from one company to another.
- Target Pricing: In this case, according to market studies, a price at which the product or service should be offered is established. From this price, the profit margin is determined, and finally, the cost at which it should be produced is determined. For example, if the target price is $150 and the profit is set at $20 per unit, the standard cost would be $130. From here, the detailed standards for manufacturing the product or providing the service are established.
Let's start with the calculation of direct material costs. For this, the production, development, marketing, financial, and administrative departments need to participate. Together, they must determine these three variables: quality, quantity, and price, which are directly related and will depend greatly on the organization's objectives with the specific product.
What quality of materials to use? In what combination? In what quantity? And at what price to sell? These are some of the questions to be answered before determining a standard cost for direct materials.
The second step is calculating direct labor costs. Here, the production and personnel departments participate, determining the standard wage rate according to the required personnel profile. The nature of the process, available equipment, training and experience level of the staff, and the complexity of the product are also considered.
The use of a standard cost sheet is very common, whether the classic paper version or a digital version embedded in software. As an example, we present the following standard cost sheet for manufacturing plastic chairs.
Well, What About Variances?
When using a standard cost, it is normal to find various types of variances in the period when comparing this cost to the actual cost, which we will know once the period has ended.
In the analysis, we can identify the following common variances, though they are not the only ones:
Price Variance:
This is the difference between the budgeted price and the actual price multiplied by the actual quantity purchased. Example: If the standard cost of a kilo of plastic is $3, but the factory pays $4, there is a price variance of $1 per kilo.
Quantity Variance:
This is the difference between the budgeted quantity and the actual quantity used multiplied by the budgeted price. Example: If 10 kilos of plastic are expected to be used for a product but 12 kilos are used, there is a quantity variance of 2 kilos.
Labor Rate Variance:
This is the difference between the budgeted rate and the actual rate multiplied by the actual hours worked. Example: If the standard hourly rate is $15 and the actual rate is $16, there is a rate variance of $1 per hour.
Labor Efficiency Variance:
This is the difference between the budgeted hours and the actual hours worked multiplied by the standard rate.
Overhead Budget Variance:
This is the difference between the budgeted standard cost and the actual cost incurred.
Overhead Efficiency Variance:
This is the difference between the standard usage and the actual usage multiplied by the standard cost per resource unit. Example: If 500 machine hours are expected for the entire batch but 550 are used, there is an efficiency variance of 50 machine hours.
These are some of the variances that can be found when comparing actual and standard costs. They can help fine-tune the standard cost with parameters more aligned to the company's reality.
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Using standard costs offers multiple advantages that facilitate the management and control of production costs. One of them is financial predictability. By establishing standard costs for materials, labor, and overhead, it is possible to plan and budget more accurately, which facilitates strategic decision-making. This also helps to identify significant deviations in actual costs, allowing for quick reactions and adjustments to production processes to maintain efficiency and profitability.
Another important advantage of standard costs is the improvement in performance evaluation and productivity. By regularly comparing actual costs to standard costs, areas where resources are not being used optimally can be identified, and inefficiencies or problems in the supply chain can be detected. This analysis allows for corrective measures to be implemented and production processes to be optimized, contributing to a more efficient operation.