Knowing exactly what the cost of the products or services you are offering is essential to driving your pricing strategy, control your costs and identify operational areas for improvement. One common method widely used is referred to as standard costing.

The standard costing method sets predetermined costs for a particular product or service which includes material, labour and overhead costs. These predetermined costs are best set by considering each product in isolation, its bill of materials, and the amount of processing effort required in transforming that bill of materials into a finished product. You need to take into account the different machines used in the process, the labour required for each process and the overheads for each process, and then translate that into a dollar value to arrive at a standard cost.

While standard costing offers numerous advantages, it also comes with its share of drawbacks. In this article, we will explore the pros and cons of standard costing.

Pros of standard costing:

Cost control. One of the primary advantages of standard costing is its ability to help businesses control costs. Companies are able to compare the actual costs incurred against these predetermined costs and be able to identify any cost variances. This allows for early detection and correction of cost overruns, making it easier to manage budgets and improve profitability.

Performance evaluation. Standard costing provides a benchmark against which actual performance can be compared. This enables companies to evaluate the efficiency and effectiveness of their operations and identify any areas for improvement.

Pricing strategy. Standard costing is useful in setting appropriate selling prices for products or services. Companies can factor in the predetermined costs when determining the pricing strategy to ensure they remain competitive and are not selling products at a loss.

Inventory valuation. Standard costing aids in the valuation of inventory by ensuring the value of any finished goods held are an accurate reflection of the time and costs incurred in producing that product.

Budgeting. Businesses can use standard costing as a basis for budgeting. It simplifies the process of developing cost budgets by providing a framework for setting realistic financial targets and monitoring progress toward those goals.

Cons of standard costing:

Inflexibility. Standard costing assumes that costs remain constant. As businesses are aware, costs can change due to factors such as inflation or market fluctuations. Over time, this can lead to deviations between standard costs and actual costs.

Time-consuming. Establishing and maintaining standard costs can be a time-consuming process. It requires continuous updates and adjustments to ensure the standard cost is representative of its actual costs.

Complexity. Standard costing can be complex, particularly for small businesses or those with limited accounting resources. Setting and maintaining standards requires expertise from all areas of the business. Failing to accurately capture the time and costs required to produce a product or service will result in inaccurate cost information.

Variability. Standard costing may not always account for variability in production processes and material usage or quality.

From a financial reporting perspective, any variances between the standard cost adopted and actual cost incurred will be reported as a production variance cost. Production variance costs should be monitored as this will often provide the first sign that there is a deviation between standard cost and actual cost, or that there is wastage or inefficiencies in the process.

Standard costing offers a structured framework for cost control, performance evaluation and decision-making in businesses. The effectiveness of standard costing will ultimately depend on the time and effort in setting up a method which is tailored to meet your business needs.

Please get in touch with our advisory team at Bellingham Wallace if you would like to know more about standard costing or would like a review of your current costing methodology.