In the early 20th century, the volume of transactions became too great for manual accounting systems to cope. Companies introduced the concept of a standard cost, an estimated or budgeted cost that managers could use for planning and control on a daily basis. In standard cost accounting, the accountant periodically compares standard costs with actual costs, recording any differences as variances and adjusting the standard costs accordingly if the variance is significant. Computerised accounting systems have largely made standard costing unnecessary for the original reasons; it is still in use by manufacturing companies in particular, due to its other advantages.
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Standard costs are based on a theoretical best practice, requiring the company to identify the most efficient methods for production to set the standard. Average past performance is also taken into account, with the intention that the standard cost will be a reasonable estimate of the actual costs when the two are compared. Having established costs based on best practice, any variances in actual material or labour costs may indicate inefficiencies in production to be investigated.
It's almost impossible for a company to establish a budget without using some standard costs for projecting future expenses and revenues. Standard costing is used to establish expected costs in many areas of the business, and allows managers to be aware of how actual costs compare with those planned for. Budgeting differs from standard costing in that the budget is a statement of expected costs, while standard costing aims to project what costs will be if certain levels of production are achieved.
Where material costs change rapidly or frequently, calculating the actual value of stock or work in progress at any one time becomes time-consuming and inefficient. Using standard costs for the period enables the cost accountant to produce reports within a reasonable time frame. The impact of changes in inventory valuation on projected gross profit is also minimised when standard costs are used, allowing managers to focus on production performance and efficiency.
By using standard costs for direct production costs and overheads and reporting on variances, the company can define responsibilities by cost centres and set targets for efficiency. Analysis of the differences between actual and standard costs highlights potential areas of concern, assisting managers to take prompt corrective action and providing data to be used to compile future standards.
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