Standard Costing: How to Set Performance Standards and Measure Efficiency?
Standard Costing: How to Set Performance Standards and Measure Efficiency?
Standard Costing: A practical guide on how to set planned costs and performance standards, use the Standard Cost Card to measure efficiency, analyze variances, and implement continuous improvement—Digital Salla.
- What is Standard Costing and why is it essential for budgeting?
- How to build a Standard Cost Card for a single product unit.
- Setting standards for Direct Materials and Direct Labor (Price vs. Quantity).
- Variance Analysis: Identifying the root cause (Is it the Price or the Efficiency?).
- Management by Exception: Focusing resources on material deviations only.
1) The Concept of Standard Costing
Standard Costing is a control system that uses pre-determined, estimated costs (Standards) as a benchmark to evaluate actual performance. Instead of waiting for the end of the month to see “Total Spending,” managers can identify “Waste” or “Gains” daily by comparing standard consumption with actual consumption.
2) How to Set Performance Standards
Standards are reached through a collaboration between Engineers, Production Managers, and Accountants.
- Ideal Standards: Assume peak efficiency and zero waste (highly motivating but often unrealistic).
- Practical Standards: Allow for normal spoilage, machine downtime, and worker rest (recommended for evaluation).
3) The Standard Cost Card (Unit Blueprint)
The Standard Cost Card shows the “Standard Price” and “Standard Quantity” required for one unit of finished product.
4) Variance Analysis: The Management Core
A variance is the difference between Standard and Actual.
- Favorable (F): Actual Cost < Standard Cost (Helps profit).
- Unfavorable (U): Actual Cost > Standard Cost (Hurts profit).
5) Direct Materials Variances (Price & Quantity)
Total Material Variance is split into two causes to assign responsibility:
Routing & Work Centers Template - Excel Template
5.1 Price Variance (Purchasing Dept)
(Actual Price − Standard Price) × Actual Quantity Purchased
5.2 Quantity Variance (Production Dept)
(Actual Quantity Used − Standard Quantity Allowed) × Standard Price
6) Direct Labor Variances (Rate & Efficiency)
Similarly for labor:
| Variance | Formula | Potential Cause |
|---|---|---|
| Rate Variance | (Actual Rate − Standard Rate) × Act. Hours | Overtime, hiring experienced (expensive) staff. |
| Efficiency Variance | (Actual Hours − Std. Hours Allowed) × Std. Rate | Poor training, machine breakdowns, low-quality materials. |
7) Manufacturing Overhead Variances
Overhead analysis is more complex because it involves fixed and variable components.
- Spending Variance: Did we pay more for supplies than planned?
- Volume Variance: Did we produce enough units to absorb our fixed costs?
8) Operational Controls & Readiness Checklist
To ensure Standard Costing provides accurate evaluations:
Standard Costing Quality Gate
- Are standards based on practical levels rather than impossible ideals?
- Is the Material Price Variance isolated at the time of purchase?
- Are workers’ efficiency reports discussed weekly with floor supervisors?
- Is “Normal Spoilage” clearly defined and built into the standard quantity?
- Are Inventory Valuation methods (FIFO/WAC) consistent with standard cost updates?
9) Common Errors and How to Prevent Them
- Outdated Benchmarks: Using standards from two years ago to evaluate performance today.
- Blaming Only Production: A high material waste might be caused by the Purchasing Dept buying lower-quality, cheaper materials.
- Ignoring Significant Variances: Only investigating unfavorable ones. Large favorable variances often mean the standard was set too low or quality is being sacrificed.
- Mismatched Drivers: Using labor hours as a standard in a factory that is 90% automated.
10) Frequently Asked Questions
What is Standard Costing?
It is a management control system that sets targets for spending and efficiency, then monitors deviations from these targets to improve performance.
What is a Standard Quantity Allowed?
It is the quantity that should have been used to produce the actual units achieved (Actual Units × Unit Standard Quantity).
Why separate Price and Efficiency variances?
Because they are usually controlled by different managers: Purchasing controls the price, while Production controls the efficiency (quantity/hours).
11) Conclusion
Mastering Standard Costing transforms your accounting from a “Reporting Tool” into a “Strategic Shield.” By building precise Standard Cost Cards and performing disciplined Variance Analysis, you gain the power to identify hidden waste, reward efficient departments, and make pricing decisions based on what your costs should be in an optimized environment.
Action Step Now (30 minutes)
- Take your last month’s actual material consumption report.
- Compare it with your Bill of Materials (Standard).
- Calculate the Material Quantity Variance for your top 3 products.