Standard Setting

Standard costs are predetermined unit costs, which companies use as measures of performance.

Standards may be set by engineers, production managers, purchasing managers, and personnel administrators.

Depending on the nature of the cost item, computerized models can be used to corroborate what the standard costs Opens in new window should be.

Standards may be established through test runs or mathematical and technological analysis.

Standards are based on the particular situation being appraised. Some examples are as follows:

Cost reductionTight
Pricing policyRealistic
High-quality goodsPerfection

Capacity may be expressed in units, weight, size, dollars, selling price, and direct labor hours. It may be expressed in different time periods (e.g., weekly, monthly, yearly).

Types of Standards

Basic Standards

Basic standards are not changed from period to period and are used in the same way as an index number. They form the basis to which later period performance is compared. What is unrealistic about basic standards is that no consideration is given to a change in the environment.

Maximum Efficiency

These are perfect standards assuming ideal, optimal conditions, allowing for no losses of any kind, even those considered unavoidable. They will always result in unfavorable variances.

Realistically, certain inefficiencies will occur, such as materials will not always arrive at workstations on time and tools will break. Ideal standards cannot be used in forecasting and planning because they do not provide for normal inefficiencies.

Currently attainable (practical)

These refer to the volume of output possible if a facility operated continuously, but after allowing for normal and unavoidable losses such as vacations, holidays, and repairs.

Currently attainable standards are based on efficient activity. They are possible but difficult to achieve. Considered are normal occurrences such as anticipated machinery failure and normal materials shortage.

Practical standards should be set high enough to motivate employees and low enough to permit normal interruptions. Besides pointing to abnormal deviations in costs, practical standards may be used in forecasting cash flows and in planning inventory. Attainable standards typically are used in practice.

Expected Standards

These are expected figures based on foreseeable operating conditions and costs. They come very close to actual figures.

Standards should be set at a realistic level. Those affected by the standards should participate in formalizing them so there will be internalization of goals.

When reasonable standards exist, employees typically becomes cost conscious and try to accomplish the best results at the least cost.

Standards that are too tight will discourage employee performance. Standards that are too loose will result in inefficient operations. If employees receive bonuses for exceeding normal standards, the standards may be even more effective as motivation tools.

A standard is not an absolute and precise figure. Realistically, a standard constitutes a range of possible acceptable results. Thus, variances can and do occur within a normal upper-lower limit.

In determining tolerance limits, relative magnitudes are more important than absolute values. For instance, if the standard cost for an activity is $100,000, a plus or minus range of $4,000 may be tolerable.

Variance analysis usually is complicated by the problem of computing the number of equivalent units of production.

Variances may be controllable, partly controllable, or uncontrollable. It is not always easy to assign responsibility, even in the case of controllable variances.

The extent to which a variance is controllable depends on the nature of the standard, the cost involved, and the particular factors causing the variance.

Advantages of Standards and Variances

  • Aid in inventory costing
  • Assist in decision making
  • Sell price formulation based on what costs should be
  • Aid in coordinating by having all departments focus on common goals
  • Set and evaluate divisional objectives
  • Allow cost control and performance evaluation by comparing actual to budgeted figures. The objective of cost control is to produce an item at the lowest possible cost according to predetermined quality standards.
  • Highlight problem areas through the “management by exception” principle
  • Pinpoint responsibility for undesirable performance so that corrective action may be taken. Variances in product activity (cost, quality, quantity) are typically the production manager’s responsibility. Variances in sales orders and market share are often the responsibility of the marketing manager. Variances in prices and methods of deliveries are the responsibility of purchasing personnel. Variances in profit usually relate to overall operations. Variances in return on investment relate to asset utilization.
  • Motivate employees to accomplish predetermined goals
  • Facilitate communication within the organization, such as between top management and supervisors
  • Assist in planning by forecasting needs (e.g., cash requirements)
  • Establish bid prices on contracts

Standard costing is not without some drawbacks, such as the possible biases in deriving standards and the dysfunctional effects of establishing improper norms and standards.

When a variance has multiple causes, each cause should be cited.

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    Research data for this work have been adapted from the manual:
  1. Budgeting Basics and Beyond By Jae K. Shim, Joel G. Siegel.