Management of Accounting Development Standard Costing and the Relationship - Report Example

1. Main principles of Standards costing and variance analysis Standard costing refers to the principles and procedure which involve the use of predetermined standard costs relating to each element of cost, and for each line of product manufactured or service rendered. A standard cost is an estimated cost which suggests what the cost should be under given conditions. The Terminology of Cost Accountancy defines standard costing as “the preparation and use of standards costs, their comparison with actual costs, and analysis of variances to their causes and points of incidence.” The technique of standard costing thus involves: a. The ascertainment of standard costs b. The use of standard costs c. Their comparison with the actual costs and the measurement of variances d. The analysis of variances for ascertaining the reasons for the same and e. The location of responsibility for the variances and the corrective action to be taken. Since the technique is based wholly on the ascertainment of standard costs, it is necessary to know what these standard costs are. Standard costs are pre-determined or forecast estimates of cost to manufacture a single unit, or a number of units of a product, during a specific immediate future period. They are usually the planned costs of the products under current and anticipated conditions, but sometimes they are the costs under normal or ideal conditions of efficiency, based on an assumed given output, and having regard to current conditions. They are revised to conform to super-normal or sub-normal conditions, but ore practically to allow for persisting alterations in the prices of material and labour. Therefore, a standard cost can be defined as “A pre-determined cost calculated with respect to a prescribed set of working conditions, correlating technical specifications and scientific measurements of materials and labour to the price and wage rates expected to apply during the period to which the standard cost is expected to relate, with an addition of an appropriate share of budgeted overhead. Its main objective is to provide bases of control through variance accounting for the valuation of stocks and work-in-progress and in exceptional cases for fixing selling prices.” The use of standards facilitates many business functions. Standards are very useful in the monitoring and controlling of business activities in general. The need for standard costs arises as a result of the benefits it provides for a business, such as Cost control Pricing decisions Performance appraisal Cost awareness Management by objectives Cost Control Cost control does not merely refer to minimization of costs. Cost control means identifying costs with their benefits and ensuring that the costs are justified, given the benefits that are derived. Standard costs provide a very useful framework for cost control. The great value of standards in cost control is that they provide the ability to compare actual costs with desired costs on a timely basis. Timely reporting of difference i.e. monthly, weekly, daily or for each work shift etc, between actual and standard costs allows managers to take appropriate action to correct problems and maintain desired performance. Without standards many cost control problems would go undetected until considerable damage is done. Pricing Decisions A company’s product pricing decisions are greatly influenced by costs. When the cost of a product is used in determining its selling price, standard costs are used more often than actual costs, as standard costs reflect the desired or expected cost of a product, whereas actual costs may include efficiencies or inefficiencies of production that are not expected to prevail and that cannot be anticipated when the pricing decision is made. Performance Appraisal The performance evaluation of employees is an onerous task, involving different variables, some of them being subjective and hence difficult or inappropriate to use in comparing employees. When standards are established for evaluating employee performance, they provide tangible measurement inputs that can be applied uniformly to all employees. Cost Awareness Most employees have little or no awareness of cost associated with business activities. Standard costs and standard cost performance reports often inform employees about the cost implications of their actions. Such cost awareness may result in better employee efforts at cost control. Management by Objectives This is a concept in which managers establish specific objectives for all business activities. When such activities are within the desired performance levels, little or no management action is necessary. However, when performance is at wide variance with desired levels, management takes suitable action. Standards provide the quick, ready reference for identifying and reporting variances from acceptable performance levels. Variance Analysis Standards may be set and variance computed not only for each cost element but also for each of the factors which determines the cost. The variances of particular elements of cost and those relating to quantity and price are known as principle variances. When variances and analyzed, a principal variance may be found to have a number of constituent parts. A cost variance which is only a part of the principal variance is known as a sub-variance. Variances may be expressed either in amounts or in percentages. When it is expressed in amount, the variance is calculated by subtracting actual cost from the standards cost. To express variance as a percentage, the ratio of actual cost to the standard cost is multiplied by 100. Thus, the actual cost is obtained as a percentage of the standards cost. The base for comparison is the standard cost (100). Hence, the actual cost percentage figure should be deducted from the standard cost percentage (100) to derive the cost variance in percentage. 2. Activity-based costing and Target costing Activity-based costing - Applying overhead costs to each product or service based on the extent to which that product or service causes overhead cost to be incurred is the primary objective of accounting for overhead costs. In many production processes overhead is applied to products using a single predetermined overhead rate based on a single activity measure. With Activity-Based Costing (ABC), multiple activities are identified in the production processes that are associated with costs. The events within these activities that cause work (costs) are called cost drivers. The cost drivers are used to apply overheads to products and services when using ABC. ABC is valuable for planning, because the establishment of an ABC system requires a careful study of the total manufacturing or service process of an organization. ABC highlights the causes of costs. An analysis of these causes can identify activities that do not add to the value of the product. These activities include moving materials and accounting for transactions. Although these activities cannot be completely eliminated, they may be reduced. Recognition of how various activities affect costs can lead to modifications in the planning of factory layouts and increased efforts in the design process stage to reduce future manufacturing costs. An analysis of activities can also lead to better performance measurement. Workers on the line often understand activities better than costs and can be evaluated accordingly. At higher management levels, the activities can be aggregated to coincide with responsibility centres. Managers would be responsible for the costs of the activities associated with their responsibility. Target Costing – Target costing has recently received considerable attention. Target cost can be defined as “a market-based cost that is calculated using a sales price necessary to capture a predetermined market share.” In competitive industries a unit sales price would be established independent of the initial product cost. If the target cost is below the initial forecast of product cost, the company drives the unit cost down over a designed period to compete. Japanese cost management is known to be guided by the concept of target cost. Management decides, before the product is designed, what a product should cost, based on marketing factors. The target costing philosophy leads to a market-driven approach to accounting. While introducing a new product, a company might test the market to determine the price it can charge in order to be competitive with products already on the market of similar function and quality. A target cost is the maximum manufactured cost for a product. It is arrived at by subtracting from its expected market price the required margin on sales. Target costing is a market-driven design methodology. It estimates the cost for a product and then designs the product to meet that cost. It is used to encourage the various departments involved in design and production to find less expensive ways of achieving similar or better product features and quality. It is a cost management tool which reduces a product’s costs over its entire life cycle. 3. Standard Costing versus ABC & Target Costing The primary variation between the standard costing and ABC analysis is that the later is more logical in segregating and restricting cost centred spending in work activities. The former does a similar job but the segregation is based on departments, which does not seem to be as beneficial when compared to the later. In ABC analysis, the so segregated spending pools are matched with the various work activities (Cokins). This way the actual and true picture of the consumption rate of that particular pool can be figured out. Another difference between the standard costing and ABC analysis is that the later can be frequently updated and refreshed whereas the former has not got such possibility. ABC analysis is often updated on a monthly, quarterly or weekly basis but standard costing is updated only on an annual basis. Standard costing would apply the overhead costs based on a single measure of activity. With ABC, activities are chosen and the overhead costs are distributed to cost pools within these activities through resource drivers. The costs of activities are then applied to products through activity drivers. Standard costing versus Target costing Target costs are conceptually different from standard costs. Standard costs are predetermined costs built up from an internal analysis by industrial engineers. Target costs are based on external analysis of markets and competitors. Standard costing is used mainly in mass production as a tool for control. Costs for standard parts are established by work study or experience, actual costs then being checked against the standard costs (Money Glossary.com). Target costing is a reversed cost accounting technique. Instead of calculating costs first and then setting the price based on these calculated costs, target costing does it the other way around. Target costing is convenient for firms operating in perfect competition. The standard costing approach is to develop a product and then approach the market with a price that was based on a cost-plus calculation. But according to Target costing the process starts at the market price of the product and subtracting a target profit from its price to arrive at a target cost. The product is then developed in such an environment where the market price and the permissible cost components for a product are known. Another major difference between these two methods of costing is that standard costing tends to accept existing structures and only leads to incremental cost reduction. When it comes to Target costing it is more radical and it also provides the opportunity for completely new and innovative approaches of costing (Hergeth). Target costing reduces the development cycle of a product. Costs can be targeted at the same time the product is being designed, bringing in the resources of the manufacturing and finance departments to ensure that all avenues of cost reduction are being explored and that the product is designed for manufacturability at an early stage of development. Standard costing lacks in this combination of activities. Target costing is also used to forecast future costs and to provide motivation to meet future cost goals whereas standard cost is a predetermined cost arrived at by internal analysis. Target costing is very attractive because it is used to control costs before the company even incurs any production costs, which save a great deal of time and money. Bibliography Cokins, Gary. Activity Based Cost Management. John Wiley and Sons, 2001. Hergeth, Helmut. "Target Costing in the Textile Complex." Journal of Textile and Apparal (2002): 1-5. Money Glossary.com. Standard Costing. 23 march 2007. 9 May 2008 . The ICFAI University Press. Introduction to Management Accounting. Hyderabad: The ICFAI University Press, 2004. Read More