Budgeting is an enormous challenge for all business owners, but that's especially true for manufacturers who often deal with varying material costs, making it difficult to estimate expenses and profits. Many attempt to resolve this issue using a practice known as standard costing.
Below, we'll discuss what that is, its pros and cons, and how you can use standard costs in your own business.
Overview: What is a standard cost?
Standard costs are estimates of the cost of goods sold — that is, the cost required to produce your products. They usually consist of three parts: direct materials, direct labor, and manufacturing overhead.
Direct materials refers to the materials used to create your product, such as the fabric a clothing company uses to create its garments. Direct labor refers to employees' work to produce the product. Manufacturing overhead includes indirect costs, such as the electricity required to power your facility.
Standard costs approximate actual costs, but they probably won't be exactly the same. The difference between the standard cost and the actual cost is known as a variance. If it costs less to produce a product than the standard cost predicted, that's a favorable variance. But if it costs more than the standard cost, that's an unfavorable variance.
Standard costing often shows where variances come from. For example, if you use more cloth to make your clothing than you'd planned when creating your standard cost, that's a materials quantity variance. If it takes your workers less time to create the clothing than you'd thought, that's a labor rate variance.
Periodically, the business owner or accountant reviews the variances and may update the standard unit cost estimates to better reflect actual expenses.
Standard costs usage is one of the 19 cost accounting standards set by the Cost Accounting Standards Board (CASB), designed to promote uniformity and consistency in cost accounting practices.
How do standard costs differ from creating a budget?
A budget is an estimate of your expenditures over a certain length of time, often tracked using accounting software. But that's not the same as standard costs. You may include standard costs in a budget, but a budget might also include other things that aren't directly related to the production costs of your product.
For example, if you plan to purchase a new piece of equipment to produce your product more efficiently, this might be in your annual budget, but you might not consider the cost of this item when calculating your standard costs. However, it could still affect your standard cost indirectly if it enables you to produce products more quickly, or with less waste.
4 advantages of standard costs
There are several reasons businesses might use standard costs. Here are four.
1. Allows for budgeting
No business can predict every expense it will encounter in a year, particularly manufacturers who purchase materials from vendors who change their prices periodically.
Standard costs roughly show business owners how much they'll spend to produce their products, based on historical data. Unless you change your manufacturing processes significantly, your standard costs should get closer to your actual costs. This will enable you to better predict how much profit you'll earn.
2. Helps with cost control
Standard costing variances help businesses identify areas where they're not being as efficient as they'd expected. For example, if it's taking workers longer than planned to produce a product, that could indicate they need more training, or something else is going on that's slowing up their work. But it could be a sign the standard cost estimate for direct labor was too optimistic.
3. Helps determine inventory costs
In reality, it may cost slightly more to produce one batch of product than another, depending on the material cost and how efficiently the workers produce it. But standard costing can give you a rough estimate of how much your inventory is worth. Simply multiply the standard cost of each item by the number of items you have.
4. Useful for setting prices
Standard costs are a nice jumping-off point for setting your sales price. This ensures you earn enough on each sale to cover your production costs, remain solvent, and still make money. Remember, actual profits might differ from projected profits if standard costs deviate significantly from actual costs.
3 disadvantages of standard costs
While standard costs are a useful tool for manufacturers, they have a few drawbacks you should keep in mind.
1. Slow to provide feedback
Most companies only calculate variances every month or so. While this data could still be useful, some of it may be irrelevant because several weeks have passed since the variance occurred. This can limit a company's ability to step in to minimize variances. Publishing more frequent variance reports could solve this.
2. Difficult to get information on specific units
Standard costs provide a high-level view of a company's production department, but they don't drill down into specifics. They lack the granularity to show how efficiently your company produced a specific batch or unit of product.
3. Can lead to a focus on the negatives
Variance reports quickly highlight unfavorable variances, but favorable variances rarely get the same attention. This results in business leaders focusing on what's going wrong and overlooking what's going right, potentially causing low morale among workers.
How to calculate standard costs
The standard cost formula is fairly straightforward. Follow the steps below for each of your products.
|Quantity or Hours Required||Rate per Hour or per Yard||Standard Cost Estimates|
|Direct Materials||2 yards||$4/yard||$8|
|Direct Labor||1 hour||$13/hour||$13|
|Manufacturing Overhead||0.5 hours||$6/hour||$3|
|Total Standard Costs:||$24|
1. Calculate your direct materials cost
This is the average market price of your materials multiplied by how many materials you need to produce a single unit. If you need 2 yards of fabric to make a single shirt, and you can purchase that fabric for $4 per yard, your direct materials cost would be $8.
2. Calculate your direct labor cost
This is the number of hours of labor required to produce your product times the average hourly rate you pay your workers. If it takes five hours to make a product, and you pay your employees an average of $15 per hour, your direct labor cost would be $75.
3. Calculate your manufacturing overhead
Some of your manufacturing overhead costs may be more or less fixed, such as the property taxes you pay for your warehouses. Others, such as the electricity to power your equipment, will depend on your production level. When you're producing more, you run your machines longer, raising your electricity costs.
Break down all your manufacturing overhead costs and estimate how much each unit you're producing is contributing to this. For example, if an electric machine can produce a product in 15 minutes, you could figure the cost of electricity per unit by dividing the hourly price of electricity by four. Finally, add up all your various manufacturing overhead costs to determine the total.
4. Total everything
Once you've completed the three steps above, the only thing left to do is add up your results from each one. This will give you a standard cost estimate to use as a starting point. Then, as you produce more product, you can update this estimate based on your actual costs to reduce variances.
Build a better budget with standard costs
Standard costs have their flaws, but they're still a useful tool for companies to create an accurate business budget without having to do a ton of complicated math. Coming up with an accurate standard cost does require you to know your product and your team's capabilities, but even if you start with guesses, you'll get closer and closer to your actual costs over time. You may even identify ways to improve your profit margins as well.