How Companies Set Standard Costs

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  • 0:00 What Are Standard Costs?
  • 0:55 Why Use Standard Costs?
  • 1:47 How to Set Standard Costs
  • 2:37 Variances
  • 3:29 Example
  • 4:12 Lesson Summary
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Lesson Transcript
Instructor: Kevin Newton

Kevin has edited encyclopedias, taught history, and has an MA in Islamic law/finance. He has since founded his own financial advice firm, Newton Analytical.

Managing a company's expenses means managing a lot of changing amounts. Sometimes it's easier to just have a standard cost. But what is a standard cost? This lesson explains the importance of them.

What Are Standard Costs?

Have you ever made a budget? Unless you are much better at remembering exact costs than most people, you likely put down some estimates for things like transportation and food. After all, you probably don't drive exactly the same number of miles every day in the same conditions, nor do you eat the exact thing every day that never fluctuates in price. In short, you probably put some estimates down.

If you stuck with your budget, over time you'd likely try to get a more precise idea of how much you spend on each category. In short, you'd be trying to establish a standard cost for something. A standard cost is the amount that you expect to spend on a given good or service. In this lesson, we're going to look at why this is such an important concept for businesses, as well as how to set standard costs and how to deal with variations when they emerge.

Why Use Standard Costs?

Planning on how much to spend at the grocery store is actually a great example of why companies seek to establish standard costs. Let's say that your family of four tries to spend no more than $700 a month at the grocery store. If everyone who buys food in your house is aware of that being the budget, then the chances of someone coming home with lobster and steaks three nights a week is reduced. By using standard costs, companies also seek to educate their employees on how much is a reasonable amount to spend. Standard costs can act as guidelines for how much should be spent on hotel rooms, copy paper, and any other number of supplies.

Additionally, by agreeing to spend $700 a month at the grocery store, your family was then able to budget accordingly. After all, food expenses shouldn't exceed that $700. Likewise, companies are able to plan their own expenses better if they have a solid idea of how much they should be spending.

How to Set Standard Costs

However, how does a company set standard costs? That $700 per month figure for food costs comes from the USDA's website. However, companies have to try a little bit harder to understand their costs. Standard costs have three major components, all of which are added together to find the final standard cost.

Standard direct labor costs are the costs associated with producing a product. For this, you multiply the standard rate of pay by the number of hours needed for a project. Second, we have standard materials cost. Multiply the cost of each unit of materials by the number of units of materials needed. Finally, there is the overhead standard cost. Multiply the overhead cost per unit by the number of units and then add any fixed overhead costs. Add all three of these together to get the final standard cost.

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