# 8.1 The Role of Standard Costs in Management

#### Uses of standard costs

Whenever you have set goals that you have sought to achieve, these goals could have been called standards. Periodically, you might measure your actual performance against these standards and analyze the differences to see how close you are to your goal. Similarly, management sets goals, such as standard costs, and compares actual costs with these goals to identify possible problems.

This section begins with a discussion of the nature of standard costs. Next, we explain how managers use standard costs to establish budgets. Then we describe how management uses the concept of management by exception to investigate variances from standards. We also explain setting standards and how management decides whether to use ideal or practical standards. The section closes with a discussion of the other uses of standard costs.

#### Nature of standard costs

A standard cost is a carefully predetermined measure of what a cost should be under stated conditions. Standard costs are not only estimates of what costs will be but also goals to be achieved. When standards are properly set, their achievement represents a reasonably efficient level of performance.

Usually, effective standards are the result of engineering studies and of time and motion studies undertaken to determine the amounts of materials, labor, and other services required to produce a product. Also considered in setting standards are general economic conditions because these conditions affect the cost of materials and other services that must be purchased by a manufacturing company.

Manufacturing companies determine the standard cost of each unit of product by establishing the standard cost of direct materials, direct labor, and manufacturing overhead necessary to produce that unit. Determining the standard cost of direct materials and direct labor is less complicated than determining the standard cost of manufacturing overhead.

The standard direct materials cost per unit of a product consists of the standard amount of material required to produce the unit multiplied by the standard price of the material. You must distinguish between the terms standard price and standard cost. Standard price usually refers to the price per unit of inputs into the production process, such as the price per pound of raw materials.

Standard cost, however, is the standard quantity of an input required per unit of output times the standard price per unit of that input. For example, if the standard price of cloth is $3 per yard and the standard quantity of material required to produce a dress is 3 yards, the standard direct materials cost of the dress is 3 yards x$ 3 per yard = $9. Similarly, a company computes the standard direct labor cost per unit for a product as the standard number of hours needed to produce one unit multiplied by the standard labor or wage rate per hour. Standard manufacturing overhead cost To find the standard manufacturing overhead cost of a unit, use the following steps. First, determine the expected level of output for the year. This level of output is called the standard level of output. Second, determine the total budgeted manufacturing overhead cost at the standard level of output. The total budgeted overhead cost includes both fixed and variable components. Total fixed cost is the same at every level of output within a relevant range. Total variable overhead varies in direct proportion to the number of units produced. Third, compute the standard manufacturing overhead cost per unit by dividing the total budgeted manufacturing overhead cost at the standard level of output by the standard level of output. The result is standard overhead cost (or rate) per unit of output. The formula to compute the standard overhead cost per unit is: Total Budgeted Manufacturing OH at standard level / standard level of output Sometimes accountants find the standard overhead rate per unit of input, such as direct labor-hour instead of per unit. To find the standard overhead cost per unit, multiply the direct labor-hours per unit times the standard overhead cost per direct labor-hour. For instance, if the standard overhead costs per direct labor-hour is$ 5 and the standard number of direct labor-hours is two hours per unit, the standard overhead cost per unit is $5 x 2 hours =$ 10.

As discussed in the previously, budgets are formal written plans that represent management's planned actions in the future and the impacts of these actions on the business. As a business incurs actual expenses and revenues, management compares them with the budgeted amounts. To control operations, management investigates any differences between the actual and budgeted amounts and takes corrective action.

When management compares actual expenses and revenues with budgeted expenses and revenues, differences—called variances—are likely to occur. The responsibility of management is to investigate significant variances. Obviously, management must determine when a variance is significant. This process of focusing on only the most significant variances is known as management by exception. The process of management by exception enables management to concentrate its efforts on those variances that could have a big effect on the company, ignoring those variances that are not significant.

In developing standards, management must consider the assumed conditions under which these standards can be met. Standards generally fall into two groups—ideal and practical.

A company attains ideal standards under the best circumstances—with no machinery problems or worker problems. The company can attain these unrealistic standards only when it has highly efficient, skilled workers who are working at their best effort throughout the entire period needed to complete the job.

Practical standards are strict but attainable standards that have allowances made for machinery problems and rest periods for workers. Companies can meet these standards if average workers are efficient at their work. These standards are generally used in planning.

Generally, management does not use ideal standards because ideal standards do not allow for normal repairs to machinery or rest periods for workers. A company rarely runs its operations under ideal conditions. Since planning under ideal standards is unrealistic, managers rarely use ideal standards in budgeting. Instead, management uses practical standards in planning because these standards are more realistic, allowing for machinery repairs and rest periods for workers. Any variances that result when practical standards are used indicate abnormal or unusual problems.

In addition to developing budgets, companies use standard costs in evaluating management's performance, evaluating workers' performance, and setting appropriate selling prices.

Firms evaluate management's and workers' performances through the use of a budget. When management compares actual results with budgeted amounts, it can see how well it is performing its own duties and managing its employees. Management also can evaluate workers based on how well they performed relative to the budgeted amounts pertaining to the activities they performed.

Standard costs are useful in setting selling prices. The budget shows the expected expenses incurred by the business. By considering these expenses, management can determine how much to charge for a product so that it can produce the desired net income. As the business actually incurs these expenses, management determines if the selling prices set are still reasonable and, when necessary, considers some price adjustments after taking competition into account.