A standard costing system is a system used by mainly manufacturing firms in which the initial journal entries related to work in progress, finished goods, and costs of goods sold of an accounting period are based upon some standard budgeted data decided by the department.
This budgeted data is carefully predetermined by the members of the organization. For instance, the actual amount of output that is produced by that manufacturing firm is multiplied by the budgeted costs of inputs that are necessary to bring that output into finished form. Since these costs are only estimates, these may not be exactly the same as the costs that were actually incurred in that particular period. They are used because they give a clear and close idea of what the accounting system would look like if actual costs were used.
But then again, having accurate costs in the accounting records is absolutely necessary. For this reason, adjusting entries are made at the end of the accounting period every time. These adjusting entries eliminate any difference between the budgeted costs (that were included in the reports) and the actual incurred costs. If this difference is immaterial, it is not particularly shown in the financial statements. However, if the difference is bigger than the materiality amount set by the firm, it would have to be shown in the accounts that it is affecting (Caplan, 2005).
Benefits of Standard Costing System
There are many benefits of using a standard costing system. This is the reason behind its popularity. First and most importantly, using standard costs to develop financial information can help management in planning. Planning is a very important function of a manager. It involves deciding on the goals of an organization and outlining ways to achieve those goals. The standard costing system allows the managers to use the standard costs and estimate what will be a situation in the future. This will allow the managers in deciding what the goals and the strategies should be (Helmkamp, 1990).
The second benefit is that it aids the managers in the decision-making process. The information from the standard costing system is timely, therefore the managers often use it for the decision-making process. The question remains how does the standard costing system help in decision making? The answer is simple. It provides the managers with a large amount of information that is relevant to them before having to wait for the actual performance. This then gives the organization an edge over others in the industry as the organization can decide what it wants to achieve and develop contingency plans accordingly beforehand.
This information then helps the managers take actions to regard pricing strategies, make or buy situations, product profitability analysis, departmental performance evaluation, and efficient utilization of organizational resources (Helmkamp, 1990).
The third benefit of adopting a standard costing system is that it helps in performance evaluation. The standard costs that are set are basically targets and expectations of how the organization should perform in that accounting period. These costs represent what the costs should be, therefore if the actual performance is different from this estimated expected information, it means that the organization is not performing as expected. It means that there is a problem somewhere. If this happens, the organizations can investigate where the difference is arising and take corrective action immediately. However, it is the manager’s duty to compare the standard costs with the actual costs in order to be aware of any significant difference if there are any (Helmkamp, 1990).
The fourth benefit of using a standard costing system is that it makes the employees more cost-conscious. The employees become more aware of the costs that are incurred in the manufacturing process. They fully understand how their actions would affect the total cost schedule and the operation. These standard costs that are set indicate what the costs of the organization should be, therefore the employees have benchmarks set right in front of them, and in order to attain these benchmarks, they become more efficient in terms of cost and time. Since these employees estimate the standard costs themselves, they are motivated to stay within the cost limit that has been allotted to a certain action in the manufacturing process (Helmkamp, 1990).
The last benefit of using a standard costing system is that it helps save costs in recordkeeping. This system of standard costs can be used for inventory valuation. The values assigned to the inventories are determined based on estimates and the detailed accounting information of the inventories is not considered that deeply. Therefore, as the manufacturing costs are predetermined in a standard costing system, the cost of materials, labor, and manufacturing overheads are recorded as the production takes place. The reconciliation of the actual costs with the budgeted costs is done at the end of the accounting period and this is called variance analysis (Helmkamp, 1990).
Limitations of Standard Costing System
Just like every other concept or theory in this world, using standard costs to develop the accounting financial statements also has its limitations. The first limitation is said to be the claim that standard costing is not accurate. As mentioned earlier, the costs are estimated and because of this, people say that these estimates may not be accurate which would make the accounting records that are developed using these estimates to be inaccurate.
The costs that are set are based upon judgment and not facts therefore the results may be biased in any way or can also be subject to human error. If the financial information is not accurate, the organization that uses accounting records to make decisions would definitely end up making misleading and faulty judgments. The comparison that it makes with the estimated and actual data would be meaningless because the estimated data is incorrect. Therefore we can say that using standard costs leads to poor decisions (Maskell, 2008).
The standard costs must be accurately set and it must be kept in mind that the standard costs are not too tight or loose. If the standard costs that are developed are too low and the employees are asked to stick to these costs, they will eventually become frustrated because matching with the tight estimated costs would not be possible for them. This would de-motivate them as they would start thinking that the costs targets are unattainable and the employees would ultimately look for ways to ‘beat the system’. On the other hand, if the costs that are set are too loose, the employees would not have any incentive to become cost-efficient and this would be like encouraging under achievement on the part of the employees (Helmkamp, 1990).
Developing the standard costs in a standard costing system is not a one-time thing. The managers after developing the standard costs must review these costs from time to time. If there is any need, these costs must be revised. Therefore it takes up a large amount of the manager’s valuable time (Helmkamp, 1990).
The last limitation of the standard costing system is that this system may frustrate the managers. They would start to feel that a larger amount of attention and time is spent on evaluating the problems of the businesses and the success of the business is ignored. This may lead to the low morale of the managers and distrust for the use of standard costs (Helmkamp, 1990).
Who should participate in the Standard Cost-Setting Process?
Very few people within the organization can understand standard costing accurately and would be able to use it for the best. These people usually include people who have been with the organization for a while and this experience allows them to precisely assume and estimate the standard costs.
The most important members of the organization that must participate in setting standards are of course managers. The managers must coordinate and take help from other people within the organization who may have knowledge about the information they are looking for and develop the standard costs. This function is very serious for a manufacturing firm as this data will be used to record the accounting records, planning, and other aspects of the management process.
There are different managers at different levels of hierarchy. Each manager must be involved in this process. The line managers who are the closest to the production process have the technical knowledge that is needed to estimate the costs therefore their involvement is very important in the cost setting process.
The department heads must also be involved in the standard cost-setting process. For example, the accounting department head must participate fully in the estimation and development of the standard costs. These managers have knowledge of the procedures that are involved in the estimation process.
Lastly, the most important members of the organization that must participate in the estimation of the standard costs are the highest level of management. These include the CEO and vice presidents. All the standard costs that are developed by the lower levels of management must ultimately come to the management at the highest level. These people must either accept or reject the estimates that are developed according to what they think is right.
How is Standard Costing System Cost-effective?
There are many characteristics of the Standard Costing System that make it cost-effective. First of all, as mentioned above, the standard costs that are set are like targets that are set by the management. The employees of the organization are fully aware of these targets therefore they strive to achieve them. They are aware of what the management expects from them and in order to avoid disappointment, they try and become effective in terms of costs.
They know what action that they take will affect the production process and the costs involved in what ways. When they know this, they can avoid any action that increases the costs more than they should increase. They are also more motivated to achieve the targets and stay within the costs set by the management because the estimated costs are right in front of them. However, the costs must be set very carefully which will ensure that maximum efficiency can be achieved.
Besides this, the standard costing system also helps in saving the recordkeeping costs. The standard costs have to be set one and the other expenses just have to be multiplied with these costs. There is no need to keep track of the actual costs and record them until the end of the accounting period when the actual results have to be reconciled with the estimated information. Therefore, accounting recordkeeping becomes a much simpler process decreasing the costs involved.
Consequences if the Consultancy Firm sets the Standards
There would be a lot of consequences if the consultancy firm is selected by the CEO of MWL to set the standard costs. These include both negative and positive consequences. Before moving on to the negative consequences, I will discuss the possible positive consequences.
The first, only and most important positive consequence of consulting a consultancy firm is that the help that the consultancy firm will give will of course be very expert because consultancy firms deal with such situations from time to time. This firm probably has the knowledge of how to carry out the standard costing system most efficiently and will outline the most effective way of applying this procedure in MWL’s business. In addition to this, MWL is in a very critical position at the moment.
It has carried out expansion strategies and the outcomes of this expansion were not as good as they had expected. The consultancy firm will assist in a way that would ensure that the expansion strategy is successful and the outcomes are better than expected. However, this may not be as simple as it may be thought. There are several negative consequences that are involved in this whole process.
The negative effects of consulting a specialized firm for setting the standards are more than the positive consequences. Most importantly, hiring a consultancy firm to develop the standards will decrease the morale of many other senior positions within the organization. As mentioned in the case study, the purchasing manager, processing manager, production engineer, and the vice president of sales all presented their views regarding implementing the standard costing system.
They all believe that implementing this strategy will not be as easy as it is thought therefore it should not be implemented at the moment. Hiring a consultancy firm would mean that the CEO is rejecting all these opinions. This will cause the morale of the very important employees to go down. They will feel that they are not trusted enough and might not even cooperate with the consultancy firm in the implementation of the standard costing system.
Besides this, the consultancy firm will always remain external and will never be able to understand the true goals and values of the organization. For this reason, the consultancy firm’s implementation would not be as effective and situation-specific as required by the CEO. The implementation strategy would be developed without considering the core values that are shared by only the members of the organization.
In conclusion, I would say that the MWL is in a very critical position. Any misjudgments or bad decision-making can affect its growth forever. Therefore the CEO must ensure that all steps are taken before any strategy is implemented. The CEO must consider both sides of the standard costing system before a decision is made. The benefits include that it helps in evaluating performance, planning, cost savings, decision making, and increased awareness of the costs.
On the other hand, there is always a possibility of human error, the standards may be set too tight or too loose, revision of standard costs is required and this system may end up frustrating the managers. After considering all this, the CEO must involve all those who should participate in the system. This includes all levels of management and then must come to a final conclusion of whether or not the system should be implemented and if it should be implemented, whether or not a consultancy firm must be hired to set the standards.
Caplan, D. (2005) Management Accounting: Concepts and Techniques. Oregon State Univeristy. Web.
Helmkamp, J. G. (1990) Managerial Accounting. Second Edition. John Wiley & Sons.
Maskell, B. H. (2008) Standard Costing Can Lead to Poor Decisions. Lean Institute. Web.