Budgets are formal written plans that represent management’s planned actions in the future and the potential 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 while ignoring those variances that are not significant.

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

Firms evaluate management and worker performances through 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 can also 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 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.

There are five benefits that result from a business using a standard cost system:

• Improved cost control
• More useful information for managerial planning and decision making
• More reasonable and easier inventory measurements
• Cost savings in record keeping
• Possible reductions in production costs

Improved cost control

Companies can gain greater cost control by setting standards for each type of cost incurred and then highlighting exceptions or variances—instances where things did not go as planned. Variances provide a starting point for judging the effectiveness of managers in controlling the costs for which they are held responsible.

Assume, for example, that in a production center, actual direct materials costs of $52,015 exceeded standard costs by $6,015. Knowing that actual direct materials costs exceeded standard costs by $6,015 is more useful than merely knowing the actual direct materials costs amounted to $ 52,015. Now the firm can investigate the cause of the excess of actual costs over standard costs and take action.

Further investigation should reveal whether the exception or variance was caused by the inefficient use of materials or resulted from higher prices due to inflation or inefficient purchasing, or something else. In any case, the standard cost system acts as an early warning by highlighting a potential hazard for management.

More useful information for managerial planning and decision making

When management develops appropriate cost standards and succeeds in controlling production costs, future actual costs should be close to the standard. Management can use standard costs in preparing more accurate budgets and in estimating costs for bidding on jobs. A standard cost system can be valuable for top management in planning and decision making.

More reasonable and easier inventory measurements

A standard cost system provides easier inventory valuation than an actual cost system. Under an actual cost system, unit costs for batches of identical products may differ widely. For example, this variation can occur because of a machine malfunction during the production of a given batch that increases the labor and overhead charged to that batch. Under a standard cost system, the company would not include such unusual costs in inventory. Rather, it would charge these excess costs to variance accounts after comparing actual costs to standard costs.

Thus, in a standard cost system, a company assumes that all units of a given product produced during a particular time period have the same unit cost. Logically, identical physical units produced in a given time period should be recorded at the same cost.

Cost savings in record keeping

Although a standard cost system may seem to require more detailed record keeping during the accounting period than an actual cost system, the reverse is actually true. For example, a system that accumulates only actual costs shows cost flows between inventory accounts and eventually into cost of goods sold. It records these varying amounts of actual unit costs that must be calculated during the period. In a standard cost system, a company shows the cost flows between inventory accounts and into cost of goods sold at consistent standard amounts during the period. It needs no special calculations to determine actual unit costs during the period. Instead, companies may print standard cost sheets in advance showing standard quantities and standard unit costs for the materials, labor, and overhead needed to produce a certain product.

Possible reductions in production costs

A standard cost system may lead to cost savings. The use of standard costs may cause employees to become more cost-conscious and to seek improved methods of completing their tasks. Only when employees are active in reducing costs can companies really become successful in cost control.

Three of the disadvantages that result from a business using standard costs are:

• Controversial materiality limits for variances
• Non-reporting of certain variances
• Low morale for some workers

Controversial materiality limits for variances. Determining the materiality limits of the variances may be controversial. The management of each business has the responsibility for determining what constitutes a material or unusual variance. Because materiality involves individual judgment, many problems or conflicts may arise in setting materiality limits.

Non-reporting of certain variances. Workers do not always report all exceptions or variances. If management only investigates unusual variances, workers may not report negative exceptions to the budget or may try to minimize these exceptions to conceal inefficiency. Workers who succeed in hiding variances diminish the effectiveness of budgeting.

Low morale for some workers. The management-by-exception approach focuses on unusual variances. Management often focuses on unfavorable variances while ignoring favorable variances. Workers might believe that poor performance gets attention while good performance is ignored. As a result, the morale of these workers may suffer.

For a short discussion of standard cost benefits, watch:

You can view the transcript for “Standard Cost Versus Actual Cost: Which is Best?” here (opens in new window).

Now, check your understanding of the benefits of standard costing.