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.
Of course, standard costs are not perfect. There is always the chance that a supplier may change the final price after a standard cost has been set. To combat this on accounting sheets, companies can use variances. Variances allow for accountants to still refer to a standard cost, but point out exactly how much the final cost differs from the standard cost.
There are two different types of variances. A favorable variance occurs when the cost is lower than expected. This means that your company will end up making a bigger profit. However, an unfavorable variance occurs when the cost is higher than expected. In this situation, your company will make a smaller profit, or even take a loss. These variances are always listed on the balance sheet directly under the standard cost for a particular transaction, meaning that the numbers make it to the bottom line quickly and that each variance is easily traced back to a supplier and a purchase date.
So let's say that you were producing a good and had set standard costs for labor at $100 per good and the standard cost for materials at $200 per unit. As standard costs, those are the estimates of what you expect to spend. Let's say you produce 1000 units a month. However, your labor costs were actually $10 higher for each unit. $10 times 1000 units creates a $10,000 unfavorable variance for labor, since it costs you more money. Meanwhile, let's say that you got your raw materials at $180 per unit. That means a savings of $20 per unit, or $20,000 total. Thus, you have a $20,000 favorable variance for materials.
In this lesson, we looked at the importance of standard costs for companies. Remember that a standard cost is the amount that you expect to pay for a good or service, especially when it comes to creating something. We compared standard cost to the ability of a household to budget food costs for a month. Through this, we saw how it acts both as a guideline for appropriate spending habits for those who may not purchase routinely, as well as a better way to plan for future spending. To find the standard cost, we add the standard labor cost, the standard materials cost, and the standard overhead cost. Variances from this could be favorable if they resulted in a cheaper final product or unfavorable if they cost the company more.