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2
The Theory and Practice
of Standard Costing

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 The Theory and
Practice of
Standard Costing
2
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LEARNING OUTCOMES
After completing this chapter, you will be able to
䉴 explain why and how standards are set in manufacturing and service industries with
particular reference to the maximisation of efficiency and minimisation of waste;
䉴 calculate and interpret material, labour, variable overhead, fixed overhead and sales vari-
ances;
䉴 prepare and discuss a report which reconciles budget and actual profit using absorption
and/or marginal costing principles.

2.1 Introduction
You should be familiar with the basic principles of standard costing and variance
analysis from your foundation (or equivalent) studies. The initial content of this chapter
amounts to a revision of these basic principles. You are advised to devote adequate
time to this revision. The CIMA examination scheme is cumulative and MAPE exami-
nation questions in this particular area may draw heavily on material from foundation
studies.
Standard costing and variance analysis represent a particular approach to performance
evaluation. The concept that underpins them is that efficiency can be monitored by peri-
odically comparing actual costs incurred with standard costs for output achieved. This con-
cept is not valid under all circumstances. In subsequent chapters, the text goes on to explore
both the practice and the limitations of standard costing.

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45 2007.1
 46 STUDY MATERIAL P1

THE THEORY AND PRACTICE OF STANDARD COSTING

2.2 The theory and practice of standard costing
CIMA’s Terminology defines standard costing as follows:

Standard costing: Control technique that reports variances by comparing actual costs
to pre-set standards so facilitating action through management by exception.

You will see from this definition that there are very close relationships between standard
costing and budgetary control (the practice of making continuous comparison between
budget and actual results). They both compare the actual results with the expected perfor-
mance to identify any variances. The difference is that with standard costing the compari-
son is usually made at a unit level, that is, the actual cost per unit is compared with the
standard cost per unit. The resulting variances may be analysed to show their causes and we
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will see how this is done later in this chapter.
In order to be able to apply standard costing it must be possible to identify a measurable
cost unit. This can be a unit of product or service but it must be capable of standardising: for
example, standardised tasks must be involved in its creation. The cost units themselves do not
necessarily have to be identical: for example, standard costing can be applied in some job cost-
ing situations where every cost unit is unique. However, the jobs must include standardised
tasks for which a standard time and cost can be determined for monitoring purposes.

2.3 What is a standard cost?

A standard cost is a carefully predetermined unit cost which is prepared for each cost unit.
It contains details of the standard amount and price of each resource that will be utilised in
providing the service or manufacturing the product.
The standard cost may be stored on a standard cost card like the one shown below, but
nowadays it is more likely to be stored on a computer, perhaps in a database. Alternatively, it
may be stored as part of a spreadsheet so that it can be used in the calculation of variances.
The standard cost may be prepared using either absorption costing principles or marginal
costing principles. The example which follows is based on absorption costing.

Example: Standard cost card: product 176

£ per unit
Direct materials 40 kg @ £5.30 212.00
Direct wages
Bonding 48 hours @ £2.50 120.00
Finishing 30 hours @ £1.90 057.00
Prime cost 389.00
Variable production overhead
Bonding 48 hours @ £0.75 36.00
Finishing 30 hours @ £0.50 015.00
Variable production cost 440.00
Fixed production overhead 040.00
Total production cost 480.00
Selling and distribution overhead 20.00
Administration overhead 010.00
Total cost 510.00
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2007.1
 MANAGEMENT ACCOUNTING – PERFORMANCE EVALUATION 47

For every variable cost the standard amount of resource to be used is stated, as well

THE THEORY AND PRACTICE OF STANDARD COSTING

as the standard price of the resource. This standard data provides the information for a
detailed variance analysis, as long as the actual data is collected in the same level of
detail.
Standard costs and standard prices provide the basic unit information which is needed
for valuing budgets and for determining total expenditures and revenues.

2.4 Performance levels

2.4.1 A standard
CIMA’s Terminology defines a standard:
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Standard : A benchmark measurement of resource usage, set in defined condi-

tions. The definition goes on to describe a number of bases which can be used
to set the standard, including

● a prior period level of performance by the same organisation;

● the level of performance achieved by comparable organisations;
● the level of performance required to meet organisational objectives.

Use of the first basis indicates that management feels that performance levels in a prior
period have been acceptable. They will then use this performance level as a target and con-
trol level for the forthcoming period.
When using the second basis management is being more outward looking, perhaps
attempting to monitor their organisation’s performance against ‘the best of the rest’.
The third basis sets a performance level which will be sufficient to achieve the objectives
which the organisation has set for itself.

2.4.2 Ideal standard

Standards may be set at ideal levels, which make no allowance for normal losses, waste and
machine downtime. This type of ideal standard can be used if managers wish to highlight
and monitor the full cost of factors such as waste, and so on; however, this type of stan-
dard will almost always result in adverse variances since a certain amount of waste and so
on is usually unavoidable. This can be very demotivating for individuals who feel that an
adverse variance suggests that have performed badly.

2.4.3 Attainable standard

Standards may also be set at attainable levels which assume efficient levels of operation,
but which include allowances for factors such as normal loss, waste and machine down-
time. This type of standard does not have the negative motivational impact that can arise
with an ideal standard because it makes some allowance for unavoidable inefficiencies.
Adverse variances will reveal whether inefficiencies have exceeded this unavoidable
amount.
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2007.1
 Chapter extract

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