Standard Costs: Definition & Advantages

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  • 0:02 Why Is Cost…
  • 0:39 Standard Costs Defined
  • 2:15 Counting the Cost
  • 3:25 Why Use Standard Costing?
  • 4:49 Lesson Summary
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Lesson Transcript
Instructor: Michael Stephenson

Mike earned an MBA in Accounting, holds a CPA license, and has taught college level accounting and business classes.

In this lesson, we'll explore the concept of standard costing and some of the advantages that this accounting method affords companies that implement it. When you are through, test your understanding with a quick quiz.

Why Is Cost Information Necessary?

The typical business cycle includes making or purchasing a product, selling it, and collecting the proceeds from the sale. The business that can collect more money than it spends has a better chance of survival. For this reason, it is vital that a business knows how to measure and manage its costs. While there are different types of costs incurred by a business, such as production costs, administrative costs, and selling costs, in this lesson we are concerned only with production costs. There are also different approaches to computing these costs, but here we will address only the standard cost method.

Standard Costs Defined

A company may use cost information in a variety of ways, but it is typically used to analyze why profits have changed. For example, ABC Company has introduced a new product, and the selling price was set to match that of its competitors. However, after a few months of offering this new product, ABC Company noticed declining profits. In an effort to identify the source of the issue and correct it, management has turned to its accounting staff for answers.

The accountants knew that any explanation for dwindling profits would require measuring the gross profit on each item. Gross profit is the amount of the sale that is available to cover the operating costs of the company. It is computed by subtracting the cost of production from the selling price. ABC's selling price was readily available, but the cost information was not. Due to the absence of this critical component, the accountants had to determine an appropriate method of computing the cost of each item.

After careful analysis, the accounting team chose a standard cost approach. In order to understand this method, we must first define standard cost. Cost is the monetary measurement of the resources used in the production of an item. Those resources generally include raw materials, labor, and overhead. The estimated or expected value of the resources consumed in the production of an item is known as its standard cost. Deviations from this standard are known as variances, either favorable, such as when actual cost is less than standard cost, or unfavorable, such as when actual cost exceeds the standard.

Counting the Cost

The accountants for ABC discovered the following data for its new product:

  • This product consists of 4 units of raw material A and 3 units of raw material B
  • It requires 5 hours of labor to assemble at an hourly labor rate of $12
  • The cost of the equipment and facility allocated to the manufacture of this product is $2 each
  • The acquisition cost of raw materials A and B is $1 and $2, respectively

Based on this information, the accountants computed the standard cost of the product as follows:

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