Standard costing offers considerable appeal for manufacturers. With standard costing, specific values are assigned to each finished product for each component of material, labor, direct overhead and indirect overhead.
Collectively, those standard costs comprise the cost of goods sold for each finished product. Using standard costing, the gross profit margin for each finished good is easily determined by subtracting the standard cost from the product’s selling price.
For a company that manufactures small aluminum plates, for example, the cost of goods sold for each plate would account for the aluminum’s cost as well as the direct labor involved in producing each plate.
Direct overhead items, such as depreciation and repairs on production equipment, would be factored into each plate’s cost, as would indirect overhead items, such as the manufacturer’s general administrative costs and other costs not directly associated with plate production. Some overhead expenses, such as rent or financing on the manufacturing facility, may be fixed, while monthly utility expenses would vary according to usage.
Utilizing standard costing techniques enables managers to more efficiently measure costs of goods sold and allows for more effective budgeting and price setting on future jobs. Standard costs, though, need to be periodically compared to actual costs. Such comparisons should be undertaken whenever a company prepares interim financial reports. At a minimum, such comparisons should be made every quarter. Ideally, those comparisons should be made each month.
Those comparisons identify variances, instances where standard costs are higher or lower than actual costs. A favorable variance indicates that standard costs exceed actual costs, while an unfavorable variance means that actual costs are higher than standard costs.
Differing factors may account for variances. Improved levels of production volume may affect standard costs for labor and direct overhead. Wages might increase or decrease during the year, as may other expenses.
The most significant variance factor, though, would likely be actual inventory price changes. The aluminum plate manufacturer faces changes in aluminum costs throughout the year. Manufacturers that rely upon other metals face similar fluctuations in raw material costs. Companies that manufacture petroleum-based products face substantial fluctuations in actual costs that rise and fall based on international oil prices.
While standard costing can be an effective management tool, inventory valuation issues must still be considered. Standard costing is utilized as a means of determining manufacturing cost and may not represent the actual value of inventory using an acceptable inventory valuation technique such as first in, first out (FIFO) or last in first out (LIFO). Therefore, standard costs must be adjusted to accurately reflect actual costs for financial reporting purposes.
When variances are regularly evaluated, standard costing functions as an effective management tool. Increased production, for example, should enable a company to benefit from economies of scale. That increased production volume, though, may lead to unfavorable variances that highlight inefficiencies not previously acknowledged.
Conversely, a favorable variance may indicate that efficiencies attained were greater than anticipated. Given the financial importance of inventory, regular evaluations of standard costing may also illustrate instances where profitability is not possible with current actual inventory costs. Management can then evaluate the appropriateness of raising prices or seeking other ways to lower costs or improve production efficiency.
With regular analysis of variances, standard costing enables managers to compare expectations to actual costs and profit margins. Underlying causes of those variances can then be addressed. By then recalibrating costs and prices, manufacturers can sustain themselves amidst uncertainties.
Shawn M. Parker, CPA is the partner-in-charge of Dallas assurance services for Weaver, the largest independent certified public accounting firm in the Southwest with offices throughout Texas. He can be reached at 972.448.6935 or at email@example.com.