Why It Matters: Standard Cost Systems

In order to make a profit, businesses keep costs as low as possible and sell the product for as much as possible. While the marketing department tends to focus on sales price, managerial accounting focuses on controlling costs.

Woman shopping for clothesContrary to what some people may think, in most cases, the sales price of a product is not dependent on cost, though there are some business contracts where price is based on cost plus a specified mark-up. When you go shopping, as you look through the items on sale, you rarely, if ever, think of the cost of that item from the manufacturer’s perspective. For the most part, whether you are a consumer in a retail store or a manufacturer buying raw materials, the sales price is determined by what a willing purchaser will pay for the item on the open market.

Therefore, the cost of materials and the cost of labor are both largely a matter of market price. However, there are some aspects of the total cost of goods manufactured that can be controlled. For instance, if a clothing manufacturer is inefficient at cutting out patterns, it may be leaving a lot of fabric on the floor. Using more of the fabric reduces costs, which increases profits. Standard costing attempts to address both of these issues, and cost accountants and production managers focus on two aspects of total cost: cost (sometimes called price) and quantity.

For instance, if a product requires five pounds of raw materials to create, and those materials cost $4 per pound on the open market, you can expect your product to cost you $20 per unit in raw materials.

If costs are higher than expected, then management will try to determine if that cost is controllable or not controllable and come up with some strategy to deal with it. For instance, if labor costs are higher than expected, it may be that the labor market is tight or that benefit costs are increasing. It could also be that workers are goofing off or otherwise less productive than expected.

If costs are lower than expected, that could be a good thing, or it might mean that the company is using sub-standard materials or forcing workers to perform too quickly, and either of those may harm the bottom line in the long run.

Management uses standard costs for:

  • Planning – e.g. budgeting and forecasting
  • Directing – e.g. managing the production process in real time
  • Controlling – e.g. identifying cost overruns or cost savings

In the module on Budgeting, we’ll see how both flexible and static budgets are created from standard costs, but for now, let’s examine the controlling function of management. Here are the budget and actual results from a hypothetical company called Boulevard Blanks.

Boulevard Blanks
Partial Income Statement
For the month ended July 31, 20XX
Actual Budget
Sales revenue $        178,200.00 $        178,200.00
Subcategory, Variable manufacturing costs Single Line Single Line
      Direct materials           38,080.00           38,880.00
      Direct Labor           46,500.00           43,740.00
      Allocated overhead             1,395.00             1,944.00
Subcategory, Fixed manufacturing costs
      Allocated overhead           13,485.00           13,365.00
Cost of Goods Manufactured and sold Single Line          99,460.00 Single Line          97,929.00
Gross Profit Single Line$        78,740.00Double line Single Line$        80,271.00Double line

Boulevard Blanks buys alder wood planks (raw materials) and uses bandsaws and pin routers to form the raw materials into guitar bodies that it then sells to guitar manufacturers who turn those shaped but unfinished guitar bodies into finished electric solid-body guitars. The list price for a body is $110.00 and the company plans to sell 1,620 per month (thus, the budgeted sales revenue of $178,200).

As managers, we can see that the gross profit of $78,740 for the month fell short of the planned gross profit of $80,271 even though sales were exactly as predicted. Obviously, in most businesses, actual sales would not be equal to budgeted sales, but in this module on standard costs, we’ll ignore sales variances in order to concentrate on diving into each category of production costs in detail to determine where we can make changes and see where we may have to adjust our expectations.

In addition to sales budgets, management sets expectations around all kinds of items, including selling, general, and administrative costs, but again, in this module, we’ll be focusing on standard costs with regard to the production process.