Home Accounting

# Standard Costs

Budgets deal with total expected costs. But, as you saw for Mooster's Dairy, these overall estimates are based upon fundamental assumptions about standard quantity and cost of inputs required in producing a single unit of output. Recall for Mooster: "...direct materials are variable and anticipated to be \$1 per gallon (\$100,000 in total), direct labor is variable and anticipated to be \$.50 per gallon (\$50,000 in total), and variable factory overhead is expected to be \$1.50 per gallon (\$150,000 in total)." Standards are the predetermined expectation of the inputs necessary to achieve a unit of output. Standard costs provide an assessment of what those inputs should cost.

Standards are important ingredients in planning and controlling a business. You have just seen how they influence the budget preparation process. They are also integral to the assumptions needed for proper cost-volume-profit analysis discussed in an earlier chapter. Standards can also be used in pricing goods and services. Perhaps you have had your car repaired; the bill is likely based on an hourly rate applied to a standard number of hours for the job (your specific repair might have actually taken more or less time).

This chapter will look at how standards are used for performance evaluation via measures of efficiency and cost incurrence. You have perhaps worked in a restaurant. Each cashier may have a standard for how much business they must "ring." Managers have standards for how many tables must be "turned." The bus staff is allowed only so much "breakage." Virtually every business has a similar set of standards. In a traditional manufacturing environment, a unit of finished goods is decomposed into its components to determine how much raw material, labor, and overhead is necessary to produce the item. These component quantities are then considered in terms of what they should cost.

## Setting Standards

The decision about the quantity and cost of productive components is more complex than it may seem. If you were building a new home, how much sheetrock (wall board) would you need for the job? In calculating the quantity you would begin with the overall wall dimensions and back out the area for windows and doors. But, you would also realize that some of the cutouts for windows would result in useless scrap material. In addition, it is inevitable that some material will be damaged or cut in error. In estimating the quantity of material, you will want to provide for such elements, but you also realize that excess material may not be easily returned without cost. Determining the right quantity of sheetrock is much like setting standards in a business environment.

Standard setters need to understand waste, spoilage, evaporation, and other characteristics that consume raw materials. Standard setters need to be mindful of how much time it takes to perform certain tasks, remembering that humans will make mistakes and need time to correct them. Humans must also have periods of rest. Standards are applicable to manufacturing and nonmanufacturing tasks. Even the accountants who are seen as the monitors of standards are themselves subject to standards. An auditor may be allowed a certain number of hours to audit payroll, verify a bank reconciliation, and so forth. Without standards, the tasks may expand in scope and time, beyond what is prudent or necessary.

Although performance reports may be prepared by managerial accountants, the standards themselves should originate with personnel who best understand the productive process. These personnel should develop standards that are based on realistic information derived from careful study of business processes. For example, an industrial engineer may engage in time and motion studies to determine the appropriate amount of time to complete a given task. Past data may be used to provide realistic measures of the raw material quantity that is needed to complete a finished unit. Some standards are based on averages; total estimated costs are divided by total estimated output or activity. For example, standard variable overhead can be determined by dividing estimated variable overhead by the estimated activity level for the upcoming period. Likewise, fixed standard per-unit overhead would be determined by dividing estimated fixed overhead by the estimated activity level.

## Philosophy of Standards

It has probably already occurred to you that standards can be set very tight, allowing almost no room for waste or rest. Or, management may adopt a more realistic set of standards that are within reach. After all, standards are somewhat like goals. In playing a round of golf, most players will see "par" as a benchmark against which to compare a score; realistically, few players expect to achieve "par" on a consistent basis. Nevertheless, it constitutes a standard. At other times, golfers will calculate their "handicap" to determine a target score they plan to shoot on a given round of golf. This is also a standard, but one that is expected to be achieved. In setting standards within a business environment, management needs to consciously consider the level of standards to adopt:

• Achievable standards are realistically within reach. Such standards take into account normal spoilage and inefficiency. Such standards are intended to allow workers to reach the established benchmarks. This level of standard provides a clear set of metrics against which job performance can be gleaned. The interpretation is generally unambiguous; when goals are not met, improvement is needed. It is also thought to reduce the opportunity for frustration and discouragement that can be associated with less attainable goals.

• Ideal standards may never be reached. They represent what will result in a state of perfection - no spoiled goods, no worker fatigue, no errors, etc. The idea behind such standards is that employees will never rest on their laurels. Instead, they will achieve their full potential by striving to hit the lofty goal. Many businesses avoid ideal standards because they fear that employees will see ideal standards as meaningless since they cannot hope to achieve them. In other words, the employees cease to strive for a goal they cannot hope to reach. Further, such goals may not help in performance evaluations; what is the feedback value of telling employees they failed to meet such standards (after all, isn't that what was expected)?

## The Downside of the Standards

A manager also needs to consider the downside of standards and develop compensating balances. For instance, if employees are encouraged to work fast, quality can suffer. Standards need to be in place to make sure that quality of output is not adversely affected. On the other hand, some seasoned employees may have become so skilled that they can easily meet their output goals and find themselves able to coast through the work day. Usually skilled workers receive a higher pay scale; it is not unfair to expect them to produce more output. Therefore, one standard may not fit all. A good manager is particularly adept at helping to establish fair standards, and use them to plan and control the operations within their area of responsibility.

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