Companies calculate product costs to determine ending inventory values, to estimate selling prices and to determine cost of goods sold. Many companies use a standard costing system for calculating the cost of their products. A standard costing system uses budgeted costs to estimate a standard cost for each product. This cost remains in effect for the entire year. Standard costing systems bring several advantages and disadvantages to these companies.
One advantage of a standard costing system considers its ability to provide a benchmark where the company can evaluate its performance. Variance analysis allows companies to recognise significant changes in the expected cost of each product. The company compares the actual cost to produce each product to the standard cost for each product. The difference between these costs represents the variance. A high variance signifies that the company performed very different than expected and requires additional investigation to find the cause of the variance. High unexplained variances identify performance issues.
Another advantage of a standard cost system involves its consistency with product costs. After calculating the standard costs, the company uses these costs throughout the year. Each month, the company uses the same standard unit cost, which creates a consistent basis for measuring the inventory.
A disadvantage of using standard costing systems involves their lack of flexibility. Companies determine their standard costs at the time they create their annual operating budget. These budgets form the basis for creating the standard costs. Once the year begins, a company can experience a variety of changes that influence product costing. For example, increasing fuel prices raise the cost of all the materials used to manufacture inventory items due to the higher freight costs. The standard cost disregards the impact of rising fuel prices.
Another disadvantage of standard costing systems considers the impact on profitability. A company that uses a standard costing system calculates profitability by subtracting the standard cost of an item from the selling price. When actual costs vary from the standard costs, the calculated profit presents an inaccurate picture of the company's performance. This same effect occurs when the company analyses various pricing scenarios.