Companies want to know whether their manufacturing processes are as efficient as possible and whether each item or service they produce is of the highest possible quality. Business leaders use benchmarking to study these issues systematically. Benchmarking means measuring the quality of a company's products, performance, or processes against specific standards. It is an essential process for companies that want to improve their products and services.
A benchmark is a standard of performance that companies or managers can measure against. Businesses use many benchmarks, which may come from the company's past performance, a rival's performance, industry standards, and/or government regulations. A benchmark may be a specific line item cost or a cost for an entire process. For example, a furniture manufacturer might have cost standards for the price of a foot of wood or for the total cost of production for one chair.
Businesses establish standard costs as a part of the process in computing variances. A variance is a difference between an expected or predicted cost or output and the actual cost or output. Standards help managers evaluate quantity and price so they can make specific changes that may affect benchmarks. Using quantity standards to benchmark a process is useful for analyzing the price of inputs that organizations need to determine price points of goods and services. If a furniture manufacturer estimated buying wood at $1.25 per foot but the actual cost was $1.20 per foot, then the difference of the two would give a favorable $0.05-per-foot variance.
Using standard costing helps businesses pinpoint how performance deviates from the standard. For manufacturing businesses, accountants often break down the standard costs into one of three categories.
- Direct materials: These are raw goods that can be traced directly to, or easily identified with, a product. For instance, fabric and wood are direct material costs in furniture. Direct materials are a major expense for most businesses, which means that many businesses examine them closely.
- Direct labor is the hours spent producing a product or providing a service that can easily be traced to the product or service. Assembly-line workers in a factory are an example of direct labor. This is often the largest line item in a company's budget.
- Variable manufacturing overhead describes costs related to making goods. These costs rise or fall depending on how many items the business produces. These costs cannot be directly linked to one product. Instead, they will change based on the number of products made. For instance, a purchasing manager might spend two hours buying wood for a furniture manufacturer during a slow time and ten hours during a busy time. These hours cannot be directly linked to the number of chairs, sofas, and tables made, but they do fluctuate depending on the amount of furniture manufactured.
Variable manufacturing overhead is not exactly the same as variable overhead, which means indirect costs that result from manufacturing a product. These costs rise or fall depending on how much or how little a business produces. For example, shipping costs are an example of a variable overhead cost, but they are not an example of variable manufacturing overhead because they are not directly related to making goods.
Companies figure out standard costs for direct materials, direct labor, and variable manufacturing overhead. Then they calculate the variances against actual costs, and after that they examine how the differences affect inventory levels and prices.
Explanation of Sources of Standard Costs
Benchmarking is fundamentally a comparison between actual measures and some established guideline of what the measure should be. For this reason, getting the correct standard measure for comparison is crucial. Benchmarking can be used to compare costs, but it is also used to compare performance, such as lag time to manufacture a product.
Generally, managers will have two possible benchmark numbers that they may use exclusively or together: the budgeted or predicted amount and the industry standards.
As part of the master budgeting process, a business will establish predicted standard costs. This data may come from past performance information or from comparisons with industry standards. The master budgeting process takes multiple steps, starting with preparing the sales budget. This budget will ultimately give the sales goals for the upcoming year and the costs to meet those goals.
Once managers know the sales goals, they will create an inventory budget, which will help them determine the actual costs for making the items that will be sold. Managers or accountants develop this budget in pieces based on the materials, labor, and overhead budgets. There are other subbudgets that they use in the master budget, but accountants rarely use those for standard cost analysis. Instead, the total costs and the specific line item costs come from the materials, labor, and overhead budgets.Fixed overhead costs are expenses that stay constant no matter how much or how little a business produces. Examples of fixed overhead costs include rent and insurance.
Sample Materials Budget
As a group, these businesses and the businesses that depend on them make up an industry. It is from the collective data for an industry that accountants figure out industry-standard costs.
To see how industry-standard costs work in the real world, it makes sense to look at standards in a particular industry. The furniture manufacturing industry has both national and local associations. At the national level, the American Home Furnishing Alliance offers cost standards gathered from their members. Stakeholders also publish cost standards. Since furniture makers use wood, they use cost reports from the U.S. Department of Agriculture to help them generate cost amounts.
Most industries have government regulations that set standards for labor practices, safety issues, and pollution control. One regulation for the furniture industry comes from the U.S. Environmental Protection Agency, which limits the pollutants that manufacturers can use. These rules affect the costs that each furniture manufacturer has.