Standard Costing’s Time Has Finally Come…To Its End
For many manufacturing organizations, standard costing has been the default option for the last several decades. As far back in the 1920s, the Ford Motor Company was one of the first mass producers to champion and adopt the practice. Standard costing was praised and adopted as an innovation in production control. Since then, businesses and business schools worldwide have taught it as the preferred system to control production efficiencies and costs.
Standard cost has primarily appealed to companies with large and complex business models for a good reason. It allows the accountants to input prices and quantities captured during the budget cycle and “roll” the estimate upwards to help an organization plan profitability and make decisions. Managers and executives use the standard costing process to steer the company along and ensure that operations are aligned with the company strategy and direction.
However, the time has come to perform a thorough analysis of our inventory costing systems to determine if what we already have is really good enough.
Business leaders must take a pause. Is their standard costing system producing accurate results and delivering what they need when they need, and how they need it?
From my perspective, a combination of perennial pain points and new technologies suggests a, better approach is warranted.
What is Standard Costing?
To cover the basics and serve as a starting point for the discussion, standard costing is an accounting and inventory valuation methodology used to estimate the costs of transforming raw materials into finished goods.
Managers use standard costing to allocate costs, estimate margins, close the books, and prepare annual budgets. Companies use standard costs for budgeting because the actual costs cannot yet be determined. In the manufacturing process, it is not yet possible to predict the demand of a product or all the variables that will affect manufacturing costs.
Here’s how it works:
Standard costing is typically an annual process that involves assigning “set” or predetermined costs to inventory items for valuation.
- Differences between actual costs and standard costs appear as variances, which can be flagged for investigation.
- Determines profit margin based on projected costs until variances are calculated and brought to the income statement.
Standard costs are also known as “pre-set costs,” “predetermined costs,” and “expected costs.” Therefore, standard cost is based on many assumptions - all subject to error and/or uncertainty.
These variances can be drilled down to the cost-drivers and root cause factors in the manufacturing process at the product and business unit level. For instance, labor cost variances and material cost variances can be explored to see where more or less than the expected resource was consumed.
Hence, standard costs allow a manufacturer to practice management by exception. If the actual costs are what they should be, management action is not required. If the actual costs are more than the standard costs, management must act to remedy the situation, or the anticipated profitability will not be achieved.
Variance calculations are based on actual costs and standard costs. Actual costs are the amounts paid or incurred. Standard costs are an estimated or predetermined cost of performing an operation or producing a good or service under normal conditions.
At the end of the year (or accounting period), if the standard costs allocated are compared to the actual expenses, and an adjustment is made to realize the actual costs. If the company’s actual costs were lower (higher), the company would have a credit (debit) adjustment (variance) to the income statement with an offsetting entry to the balance sheet.
There are six variances in the simplest system of standard costing —two for each of the three categories of materials, labor, and overhead:
- Materials price variance and materials quantity variance,
- Labor rate variance and labor efficiency variance, and
- Overhead spending variance and overhead volume variance.
The two main determinants of variance calculations are price and usage.
- As production activities begin, the actual costs of materials, labor, and overhead (indirect manufacturing costs such as maintenance, insurance, and some electricity) aggregate in control accounts, one for each actual cost input category.
- As production continues and the raw inputs are transformed into work in process (WIP) inventory, the ERP system splits and transfers the actual costs from each control account to either the WIP GL’s or variance accounts. The dollars posted to the WIP inventory account are based on standard costs for the actual units produced.
- The process continues as the WIP is transferred to the FG accounts and sellable product is produced.
The variance accounts show the difference between the actual costs and the standard costs for the units produced. Those differences or variances can be favorable or unfavorable.
For large and unusual unfavorable and favorable cost variances, a cost accountant begins an investigation that ranges from:
- A reconciliation exercise in Excel,
- Discussions with the manufacturing team, or
- Stopping by the shop floor to ask other managers and supervisors about possible reasons higher-than-expected costs incurred.
The Typical Standard Cost Process
Standard costs are developed before the new fiscal year starts through a series of steps by the accounting team. Finance spends considerable effort with each business function to re-estimate the cost of producing a product.
These steps typically include:
- Review scrap factors - actual vs. standard. Investigate and understand variances. Work with plant teams to update scrap factors. Input and validate information into Enterprise Resource Planning (ERP).
- Review Bill of Material (BOM) yields - actual vs. standard. Investigate and understand variances. Work with plant teams to update BOM yields. Input and validate information into your ERP system.
- Facilitate the process to obtain purchase prices for all components - complete and share analysis of actual vs. standard. Investigate and understand variances. Work with procurement teams to estimate prices. Input and validate information into your ERP.
- Review all BOMs - Investigate each level of a production BOM to ensure all inputs and calculations are configured and input correctly- Investigate each level of a subcontracting BOMs to ensure all inputs and calculations are configured and input correctly.
- Work with the commercial team to obtain sales estimates. Based on the sales estimate, calculate the number of required direct labor (DL), machine hours (MC), and overhead hours (OH) required. Depending on the company, hours may be broken into fixed and variable calculations. Input information into your ERP and validate the input.
- Prepare Cost Center Budget - Analyze the current year’s actual dollars, hours, and rates. Work with plant and HR teams to prepare a new estimate - Input and validate cost center budget in the system
- Work with business teams to obtain a capital budget. Work with plant teams to bake in cost reductions and efficiency gains into already calculated rates. Input and validate information into ERP.
- Update the system to copy over the costing cycles into the new year. Work with IT to complete and validate.
- Execute the cost run. Executing the cost run triggers the annual replacement of old standards with the new standards for material costs, overhead rates, and line labor/machine hour production rates. (Ben, can you briefly explain the cost run here?)
- Export and analyze the cost run in Excel.
- Manage Excel files so others in finance can update their workstreams with the new information.
- Prepare budget and executive summaries in Excel & PowerPoint.
- Management prepares a top-down budget estimate. If their top-down estimate doesn’t align with the detailed bottom-up budget, they will request that arbitrary cuts be made to prices, line efficiency, or allocation rates until the budget equates to their mental model.
- Repeat and adjust until results fit budget targets. As sales estimates, capital budgets, or procurement prices are updated and changed; the entire process will need to be repeated.
At a previous employer the standards/budget process consumed 80% of available time from July-October. There were hundreds of products across all sorts of segments produced at three different plants, in addition to contract manufacturing. It was a major undertaking by the finance team.
Basic Standard Cost Calculations
To calculate the standard cost of a product, an ERP uses the following formulas:
Standard Cost = Direct Labor + Direct Materials + Manufacturing Overhead
1. Direct Labor Calculation
Direct labor = Hourly Rate x Hours Worked
2. Direct Materials Calculation
Direct Materials = Raw Materials x Market Price
3. Manufacturing Overhead Calculation
Manufacturing Overhead = Fixed Cost + (Machine hours x Machine rate)
Arguments for Why Standard Costing is Used
There are several reasons given for why standard cost systems are used.
Facilitates Budgeting Activities
Budgeting for a company (that manufactures a product) is based on estimates for prices and quantities of all inputs. When a dollar amount, quantity, and thus, the rate is assigned to labor, materials, and manufacturing overhead, the budget can be completed.
Fixed process inputs make it easier to create a budget and model out scenarios, and project future profitability. A budget is always a static estimate, determined at some point in time. Budgeting activities for the upcoming year begin around June/July of the current year and are completed by September/October.
As part of the standard cost process, the inventory value is calculated and fixed for each component and product. To calculate inventory value, multiply the amount of actual inventory by the standard cost of each item.
Calculating inventory using standard costs is a simple approach. Standard costing is beneficial for those who prefer a static figure to remember or reference throughout the year.
However, as prices fluctuate and manufacturing efficiencies vary, the static inventory number represented by the standard cost will be incorrect. Using the standard, for example, to represent the production cost for quoting sale prices will lead to unprofitability.
Discovering this only comes after months of frustration and unexplained misses.
A common retort found in my research is the following:
“One batch of a product may cost more to produce than another batch of the same product. Production delays on the line result in staff overtime to finish that second batch. Imagine these types of problems happening all the time, making it very difficult to keep track of the actuals. Eventually, those extra charges will be accounted for by being added to the variance cost. Going by the standard costing method to keep things simplified.”
The solution here is simple; accountants must upskill and reskill. Using Excel as the primary database, calculation tool, and the summary tool is an outdated and dangerous approach. Widely available and powerful tools like PowerPivot or PowerBI can process massive numbers of records and perform any level of calculation detail, save time, and provide insights.
To ensure that standards and inventory values are measured appropriately, management accountants must focus on working with the business to ensure that data is input and captured following best practices—good data in, good results out.
Allows for Margin Estimation
Using standard costing and the ERP to determine the cost of goods sold (COGS) is a common approach for businesses.
Margin (profit) $1/unit
However, as raw material prices fluctuate, the risk is of quoting an unprofitable price, or an uncompetitive price is very real.
For example, for businesses with complex manufacturing processes that include multi-level BOMs and a myriad of yields, recalculating a standard cost for a finished product off-hand is a difficult, if not impossible, exercise.
All of the inputs in the system must be re-updated and another cost run performed. Due to the number of steps and resources required, updating all inputs is not practical. Thus, even when a new cost estimate is performed, it is also inaccurate.
Allows Financials to Be Produced Quickly
Standard costing is used to produce the P&L for each period. If everything is completed correctly from a month-end task list perspective, the results will be reasonably correct.
However, as the variances between standard and actual post to the GL, large price fluctuations, accounting blips, or usage fluctuations can turn what should be a profitable month into a big red miss or vice versa.
Instead of speed, the accounting teams must investigate the source of the variances, back out the closing process, fix the source of the error, or journal the variance to the balance sheet, and then redo the closing process.
Over ten years, I have seen many month-ends turn to firefighting exercises high on stress and pressure. The added stress then creates more mistakes and leaves little time for analysis.
The standard costs for a company’s products allow management to set benchmarks so that the actual costs can eventually be compared across segments and to the competition. If the benchmarks are not met, the company can try to determine efficiencies in the production process to lower those costs in the future.
Benchmarking can be a useful exercise. But suppose there are years where unusual activities in either the standard-setting or actual product costs created unrealistically high or low costs. In that case, the wrong outcomes may be decided. As there is no way to “fix” bad standards, most analysis will have to be done in Excel to caveat and exclude miscalculations.
Standard Costing Disadvantages
There are a substantial number of disadvantages to standard costing.
Assumes Prices Will Not Fluctuate
The standard costing method allows only one price per year for a component. Implicitly, this assumes there will be little changes in the budgeted amounts in the foreseeable future. Even though there are methods to input various prices across the year and weigh them, the result is still one cost estimate. This is particularly onerous during inflationary and price volatile times as described in The CFO’s Fight For and Against Inflation
If and when a product’s price fluctuates, new efficiencies or deficiencies appear in the production process, or if new lines start and old ones stop, these activities will individual and collectively result in significant variances from the estimates.
Labor rates also fluctuate as the industry and economic factors change. Variances always contain a degree of error—not because of inefficiencies but because the company updated the standards inconsistently.
A Lack of Information Leads to Assumptions
When setting standards and applying overhead costs such as facility and supervisor costs, the best practice is to do time studies, cost-driver analysis, and engineering reviews.
What actually happens is none of the above.
The accounting team will set the allocation structure based on what has historically been done or what they think makes sense. Because the standard-setting process is such a resource and time-intensive, there is not enough time to do the detailed analysis required.
As deadlines approach and information is still outstanding from the manufacturing, procurement, or sales teams, accountants will plug their own assumptions into the system for a wide range of inputs. In many cases, due to time and resource constraints, allocations are a guess. And not a good one.
Accounting must make assumptions about the effort that goes into a product’s production to arrive at a standard cost. In the end, standard product costs are simply based on several assumptions - often not very valid ones.
The only operating expense that may be accurately allocated is direct labor. Supervision and other overheads are simply ‘spread’ across all products by some simple allocation rule - for instance, by the quantity produced.
Allocation is a dangerous concept. A portion of costs is assigned to various production lines and business units. If not done based on true cost driver behavior, all sorts of bastardizations can happen. With the click of a button, a profitable line will be in the red, and an inefficient line will seem to be the new growth opportunity.
Allocation methods provide a false picture of product cost and a false sense of security to managers that products are being sold at the correct price. The false picture leads to incorrect pricing decisions and whether a product should be discontinued.
Remember that standard Costs are like forecasts; no matter how hard you try, the cost you come up with will be wrong no matter how much effort you put into it. By using standard costing, you know that the company executives are going to be making strategic decisions based on incorrect information.
The last organization I worked at had a sister company that shared facilities with another under the same corporate umbrella. They shared a waste processing plant, IT expenses, and some building costs.
However, the leadership teams were not on good terms for years, and analysis and negotiation of the actual usage and split of costs were called out each year. The sister organization grew rapidly and didn’t want to absorb more costs, so they played hardball. The other organization where I worked grew slowly, and each year saw the allocated dollars rise with no recourse.
The managers at headquarters celebrated the ever-increasing profitability of the sister company and invested more money there. One hand subsidized the other.
Supplement your learning on cost allocations with A Three Part Managerial Cost Accounting Lecture
Over-Focus is on Unfavorable Variances
1. Favorable variances are seldom noted, and unfavorable variances are heavily scrutinized.
This behavior leads to discontentment with staff who feel that the standard is incorrect due to the allocation methodology. Staff will feel their performance is being questioned when it’s possible that the estimates may have been too low in the first place and that the line already runs efficiently. Standard-setting may have included top-down cuts to line efficiency that will never be met.
For even small companies, the number of variances can be staggering and can overwhelm your ability to monitor and report on variances. Once there are too many unexplained or unrealistic unfavorable variances, the business stakeholders stop paying attention to these reports.
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.
2. Focus placed on the wrong variances
Organizations will obsess over the largest variances. For example, if a company relies on procuring commodity prices, and the price swings begin to occur in both directions, the business will have very little recourse to mitigate the impact. However, this will stick out in summaries and presentations and will be the main topic of performance conversations.
Savvy plant operations teams will find ways to steer the conversation around any unfavorable variances that they have towards being related to these uncontrollable factors.
3. Time-lagged data.
All analysis and reporting will forever look backward as the ERP system, and month-end generate the file variances. The month-end usually takes five days. After that, reporting starts. Variance reports are developed and investigated weeks after the data is generated, creating a time lag. By the time reporting is issued, the plant team is unable to remember what happened weeks ago. Worse, they are unable to make corrections to the process to improve efficiency.
Instead, more real-time feedback is needed to correct inefficiencies quickly.
Incentivizing Bad Behavior
To avoid questions and unfavorable variances, it is easier for plant teams to produce more than actual market demand (because a portion of fixed cost is then absorbed in inventory).
As a result, inventory value increases, profit is higher than if production was equal to what was sold. Profit variances may be small or even non-existent. BUT inventories can easily become very inflated.
Does this kind of manipulation make sense?
At the end of each fiscal year, the accounting team must perform a comprehensive analysis to compare the actual costs to the standard costs that have been allocated. The accounting team then must process journal entries to allocate the difference (a positive or negative variance) back to the products.
This “surprise” affects profitability and may lead to a nasty or unwelcome surprise for executives.
The Impact of Bad Standards on the Financial Statements
Failing to adjust the standard cost for production variances affects the income statement’s cost of goods sold account. Companies can either overstate or understate the cost of goods sold. For example, when standard costs are higher than actual costs, the cost of goods is higher than normal, and profit is lower than normal. Actual costs lower than standard costs have the opposite effect, understating the cost of goods sold and reporting a higher profit.
Ending inventory contains errors in the standard costing process. Similar to the cost of goods sold, ending inventory reported on the balance sheet can have overstatements or understatements. Standard costs lower than actual costs result in understated ending inventory. Standard costs higher than actual costs result in overstated ending inventory.
If there are unexplained variances, the easiest place for accountants to hide them is out of view in some balance sheet account. Over time, these add up. Then, all at once, the mess explodes, and an entire quarter or year becomes unprofitable!
Corrections are necessary to account for production variances. Accountants compare standard costs to actual costs and the end of a production period—the difference between the two needs adjusting to report ending inventory correctly. Accountants can expense small production differences by posting them into the cost of goods sold. This is the most common adjustment to standard cost accounting processes.
The Verdict on Standard Costing
Standard Costing’s time has come and gone.
The main failure of standard cost is that it does not meet the analytical needs of business leaders.
Standard costing over-focuses on artificial unfavorable variances and not the actual cost of production and profitability. Too often, the wrong assumptions are used, and products, lines, and business units that are assumed to be profitable are not, and those that aren’t, are.
While standard costing may benefit established businesses that make a uniform product in batches with strong processes and stable inventory and production volume levels, few meet this requirement.
Standard costing provides the illusion of control while requiring resources, time, and energy than alternative costing methods to implement and manage. A process built on untimely and static estimates of input prices/quantities and allocations greatly exacerbate the problem.
Standard costing is backward-looking, inaccurate, and resource-intensive. As organizations strive to be agile and flexible, they must have a system that conforms to them instead of being beholden to the system.
The Future of Product Costing
The future of product costing is Average Costing paired with data modeling.
- Is a simple system to implement, and outputs are unambiguous.
- Provides clear views of actual costs throughout the manufacturing process. Actuals are compared against historical costs for performance management.
- Is a low-maintenance inventory accounting system that requires fewer people and resources to maintain.
- Determines profit margin based on actual costs.
- Benefits newer businesses without historical data in a relevant range and stable inventory and production volume levels.
- Overhead is allocated based on actuals over the volume.
The main benefit is that average costing focuses the business’s attention on what the product costs to produce.
Using Excel data modeling, we can adopt average cost AND build an internal standard cost system in Excel. This highly flexible and dynamic approach allows us to define what variances matter and set internal targets for material prices, volumes, product cost, etc.
Pairing average costing and data modeling techniques through PowerPivot, the finance team can create a robust and adaptive reporting framework that compares actual costs against BOTH historical costs and internal targets for cost and efficiency. As targets are met, the finance team works with the business stakeholders to set new, challenging, attainable targets that keep the organizations motivated and driven.
When standard costing was first introduced, we lacked the computing power to perform the calculations and store the data required. The system once served a valuable purpose, and the cost for providing reasonable cost and profitability estimates were decent in a world of limited alternatives.
However, that time has come and gone. And so should standard costing.
Manufacturers must upgrade to an accounting system that reflects true performance and profitability.
Key Factors & Questions
If you’re still unsure which inventory system best suits your company and industry, review the following considerations.
1. What level of resources can you dedicate to managing accounting processes?
If you have a few people responsible for many things, then Average costing is easier to manage.
If you have established baselines and sufficient resources to manage your system, Standard Cost may provide visibility into where and how you can optimize your spending.
2. Do you have enough historical information on your inventory costs and quantities to determine a solid baseline for what is normal?
Without a good baseline of volume, or price history, variances will cause accounting chaos.
Without historical information to identify Standard Costs, you should select Average Costing.
3. What output do you need from your data?
Do you want inventory valuations to fluctuate with the cost of components, labor, etc.? Or do you want to standardize your valuation and be able to analyze variances as costs fluctuate with shifts, such as market changes?
Why Haven’t We Abandoned Standard Costing Yet?
Standard costing is a known system for many executives and accountants. While it is not perfect, it is a system that still works. Although it takes a lot of time and energy to maintain, people feel more comfortable maintaining the status quo.
Developing a data model and continuously working with the business to discuss performance and set internal targets for performance metrics requires a new set of skills and new energy.
Many accountants lack the data modeling and critical-thinking skills required to drive and lead the change. Standard costing fits accountants well because it is a box-checking exercise. There is a clear start and stop. By my estimate, 80-95% of accountants have yet to use the free and advanced data tools that have been widely available for years.
Business schools have been promoting standard cost as the best way to control manufacturing inputs and costs since the time of Henry Ford and Taylorism. As a result, many top financial executives are influenced by these authority figures and firmly believe standard costing is a necessary, critical control system. Many professors lack the practical experience to understand what is possible and practical for manufacturers in a modern environment. Instead, they parrot what they read from textbooks back to students.
Wall Street: There is constant pressure to benchmark for organizations, especially if the company is public and information is available for and by competitors. Wall Street analysts want to see information in an apple-to-apple comparison against competitors, whether it makes sense from an operational and cost perspective or not.
Consultants love to implement and sell standard costing systems because it keeps their billable hours rolling. Configuring a system for the first time is a process that takes months and is a sure payday. Afterward, issues and errors will frequently pop up, which require their help in resolving. As it’s software they’re selling, they can also count on an annual renewal cost for support and integrating analytics plug-ins. They will tell you everything under the sun at $150-$200 an hour to stop you from pulling the plug.
For more on the ills of standard costing read The Long Arc Bends Toward Justice
For a comparison of Standard Costing vs. Average Costing see Standard Costing vs. Average Costing - Which To Use
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