Standard cost accounting

Last updated September 20, 2021

Standard cost accounting is a traditional cost accounting method introduced in the 1920s,^[1] as an alternative for the traditional cost accounting method based on historical costs.^[2]^[3]

Overview

Standard cost accounting uses ratios called efficiencies that compare the labor and materials actually used to produce a good with those that the same goods would have required under "standard" conditions. As long as actual and standard conditions are similar, few problems arise. Unfortunately, standard cost accounting methods developed about 100 years ago, when labor comprised the most important cost of manufactured goods. Standard methods continue to emphasize labor efficiency even though that resource now constitutes a (very) small part of the cost in most cases Statler, Elaine; Grabel, Joyce (2016). "2016". The Master Guide to Controllers' Best Practices. 10 Paragon Drive, Suite 1, Montvale, NJ 07645-1760: The Association of Acccountants and Financial Professionals in Business. p. 352. ISBN 978-0-996-72932-1.CS1 maint: location (link)".

Standard cost accounting can hurt managers, workers, and firms in several ways. For example, a policy decision to increase inventory can harm a manufacturing manager's performance evaluation. Increasing inventory requires increased production, which means that processes must operate at higher rates. When something goes wrong, the process takes longer and uses more than the standard labor time. The manager appears responsible for the excess, even though they have no control over the production requirement or the problem.

In adverse economic times, firms use the same efficiencies to downsize, right size, or otherwise reduce their labor force. Workers laid off, under those circumstances, have even less control over excess inventory and cost efficiencies than their managers.

Many financial and cost accountants have agreed on the desirability of replacing standard cost accounting^{[ citation needed ]}. They have not, however, found a successor.

History

One of the first authors to foresee standard costing was the British accountant George P. Norton in his 1889 Textile Manufacturers' Bookkeeping.^[4] John Whitmore, a disciple of Alexander Hamilton Church, is credited for actually presenting "...the first detailed description of a standard cost system..."^[5] in 1906/08. The Anglo-American management consultant G. Charter Harrison is credited for designing one of the earliest known complete standard cost systems in the early 1910s.^[6]

When cost accounting was developed in the 1890s, labor was the largest fraction of product cost and could be considered a variable cost. Workers often did not know how many hours they would work in a week when they reported on Monday morning because time-keeping systems (based in time book) were rudimentary. Cost accountants, therefore, concentrated on how efficiently managers used labor since it was their most important variable resource. Now, however, workers who come to work on Monday morning almost always work 40 hours or more; their cost is fixed rather than variable. However, today, many managers are still evaluated on their labor efficiencies, and many downsizing, rightsizing, and other labor reduction campaigns are based on them.

Traditional standard costing (TSC), used in cost accounting, dates back to the 1920s and is a central method in management accounting practiced today because it is used for financial statement reporting for the valuation of an income statement and balance sheets line items such as the cost of goods sold (COGS) and inventory valuation. Traditional standard costing must comply with generally accepted accounting principles (GAAP) and actually aligns itself more with answering financial accounting requirements rather than providing solutions for management accountants. Traditional approaches limit themselves by defining cost behavior only in terms of production or sales volume.

Standard cost accounting, topics

Historical costs

Historical costs are costs whereby materials and labor may be allocated based on past experience. Historical costs are costs incurred in the past. Predetermined costs are computed in advance on basis of factors affecting cost elements.

In modern cost account of recording historical costs was taken further, by allocating the company's fixed costs over a given period of time to the items produced during that period, and recording the result as the total cost of production. This allowed the full cost of products that were not sold in the period they were produced to be recorded in inventory using a variety of complex accounting methods, which was consistent with the principles of Generally Accepted Accounting Principles (GAAP). It also essentially enabled managers to ignore the fixed costs, and look at the results of each period in relation to the "standard cost" for any given product.

For example: if the railway coach company normally produced 40 coaches per month, and the fixed costs were still $1000/month, then each coach could be said to incur an Operating Cost/overhead of $25 =($1000 / 40). Adding this to the variable costs of $300 per coach produced a full cost of $325 per coach.

This method tended to slightly distort the resulting unit cost, but in mass-production industries that made one product line, and where the fixed costs were relatively low, the distortion was very minor.

For example: if the railway coach company made 100 coaches one month, then the unit cost would become $310 per coach ($300 + ($1000 / 100)). If the next month the company made 50 coaches, then the unit cost = $320 per coach ($300 + ($1000 / 50)), a relatively minor difference.

Variance analysis

An important part of standard cost accounting is a variance analysis, which breaks down the variation between actual cost and standard costs into various components (volume variation, material cost variation, labor cost variation, etc.) so managers can understand why costs were different from what was planned and take appropriate action to correct the situation.

Related Research Articles

Cost accounting procedures to optimize practices in cost efficient ways

Cost accounting is defined as "a systematic set of procedures for recording and reporting measurements of the cost of manufacturing goods and performing services in the aggregate and in detail. It includes methods for recognizing, classifying, allocating, aggregating and reporting such costs and comparing them with standard costs." (IMA) Often considered a subset of managerial accounting, its end goal is to advise the management on how to optimize business practices and processes based on cost efficiency and capability. Cost accounting provides the detailed cost information that management needs to control current operations and plan for the future.

Management accounting Field of business administration, part of the internal accounting system of a company

In management accounting or managerial accounting, managers use accounting information in decision-making and to assist in the management and performance of their control functions.

Inventory or stock refers to the goods and materials that a business holds for the ultimate goal of resale, production or utilisation.

Cost of goods sold (COGS) is the carrying value of goods sold during a particular period.

Activity-based costing (ABC) is a costing method that identifies activities in an organization and assigns the cost of each activity to all products and services according to the actual consumption by each. Therefore this model assigns more indirect costs (overhead) into direct costs compared to conventional costing.

In accounting and economics, fixed costs, also known as indirect costs or overhead costs, are business expenses that are not dependent on the level of goods or services produced by the business. They tend to be recurring, such as interest or rents being paid per month. This is in contrast to variable costs, which are volume-related and unknown at the beginning of the accounting year.

Throughput accounting (TA) is a principle-based and simplified management accounting approach that provides managers with decision support information for enterprise profitability improvement. TA is relatively new in management accounting. It is an approach that identifies factors that limit an organization from reaching its goal, and then focuses on simple measures that drive behavior in key areas towards reaching organizational goals. TA was proposed by Eliyahu M. Goldratt as an alternative to traditional cost accounting. As such, Throughput Accounting is neither cost accounting nor costing because it is cash focused and does not allocate all costs to products and services sold or provided by an enterprise. Considering the laws of variation, only costs that vary totally with units of output e.g. raw materials, are allocated to products and services which are deducted from sales to determine Throughput. Throughput Accounting is a management accounting technique used as the performance measure in the Theory of Constraints (TOC). It is the business intelligence used for maximizing profits, however, unlike cost accounting that primarily focuses on 'cutting costs' and reducing expenses to make a profit, Throughput Accounting primarily focuses on generating more throughput. Conceptually, Throughput Accounting seeks to increase the speed or rate at which throughput is generated by products and services with respect to an organization's constraint, whether the constraint is internal or external to the organization. Throughput Accounting is the only management accounting methodology that considers constraints as factors limiting the performance of organizations.

Contribution margin (CM), or dollar contribution per unit, is the selling price per unit minus the variable cost per unit. "Contribution" represents the portion of sales revenue that is not consumed by variable costs and so contributes to the coverage of fixed costs. This concept is one of the key building blocks of break-even analysis.

In accounting and economics, a semi-variable cost is an expense which contains both a fixed-cost component and a variable-cost component. It is often used to project financial performance at different scales of production. It is related to the scale of production within the business where there is a fixed cost which remains constant across all scales of production while the variable cost increases proportionally to production levels.

Alexander Hamilton Church was an English efficiency engineer, accountant and writer on accountancy and management, known for his seminal work of management and cost accounting.

The Accounting Principles Board (APB) is the former authoritative body of the American Institute of Certified Public Accountants (AICPA). It was created by the American Institute of Certified Public Accountants in 1959 and issued pronouncements on accounting principles until 1973, when it was replaced by the Financial Accounting Standards Board (FASB).

Total absorption costing (TAC) is a method of Accounting cost which entails the full cost of manufacturing or providing a service. TAC includes not just the costs of materials and labour, but also of all manufacturing overheads. The cost of each cost center can be direct or indirect. The direct cost can be easily identified with individual cost centers. Whereas indirect cost cannot be easily identified with the cost center. The distribution of overhead among the departments is called apportionment.

Management accounting principles Management accounting case

Management accounting principles (MAP) were developed to serve the core needs of internal management to improve decision support objectives, internal business processes, resource application, customer value, and capacity utilization needed to achieve corporate goals in an optimal manner. Another term often used for management accounting principles for these purposes is managerial costing principles. The two management accounting principles are:

Principle of Causality and,
Principle of Analogy.

Emile Oscar Garcke was a naturalised British electrical engineer, industrial, commercial and political entrepreneur managing director of the British Electric Traction Company (BET), and early author on accounting. who is noted for writing the earliest standard text on cost accounting in 1887.

Joseph Slater Lewis MICE FRSE was a British engineer, inventor, business manager, and early author on management and accounting, known for his pioneering work on cost accounting.

Michael Chatfield (1930s-2004) was an American economist, accounting historian, and Emeritus Professor of Accounting at the Southern Oregon University, known for his work on the history of accounting and accounting thought, and particularly for his History of Accounting: An International Encyclopedia, edited with Richard Vangermeersch.

Jerome Lee Nicholson was an American accountant, industrial consultant, author and educator at the New York University and Columbia University, known as pioneer in cost accounting. He is considered in the United States to be the "father of cost accounting."

George Pepler Norton was a British accountant, known for the publication of his 1889 Textile Manufacturers' Bookkeeping, which contributed to the establishment of modern cost accounting.

John Whitmore was an American accountant, lecturer, and disciple of Alexander Hamilton Church, known for presenting "the first detailed description of a standard cost system."

George Charter Harrison was an Anglo-American management consultant and cost account pioneer, known for designing one of the earliest known complete standard cost systems.

References

↑ Richard Vangermeersch. "Control: Classic model," in: History of Accounting: An International Encyclopedia. Michael Chatfield, Richard Vangermeersch eds. 1996/2014. p. 174-75.
↑ Thomas Downie (1927). The mechanism of standard (or predetermined) cost accounting and efficiency records. p. 7, p. 54
↑ Adolph Matz (1962) Cost accounting. p. 584.
↑ Solomons, David. "Costing Pioneers: Some Links with the Past*." The Accounting Historians Journal 21.2 (1994): 136.
↑ Michael Chatfield. "Whitmore, John," in: History of Accounting: An International Encyclopedia. Michael Chatfield, Richard Vangermeersch eds. 1996/2014. p. 607-8.
↑ Michael Chatfield. "Harrison, G. Charter 1881-," in: Michael Chatfield, Richard Vangermeersch (eds.), The History of Accounting (RLE Accounting): An International Encyclopedia 2014. p. 291.