Setting Standard Costs - Ideal and Practical Standards:
Learning Objective of
- Who provide the inputs in setting standard costs?
- Define and explain ideal and practical standards.
- What is the difference between
budgets and standards?
- What is the purpose of standard
Setting price and quantity standards requires the combined expertise of all
persons who have responsibility over input prices and over effective use of
inputs. In a manufacturing firm, this might include accountants, purchasing
managers, engineers, production supervisors, line mangers, and production
workers. Past records of purchase prices and input usage can help in setting
standards. However, the standards should be designed to encourage efficient
future operations, not a repetition of past inefficient operations.
Ideal versus Practical Standards:
Should standards be attainable all of the time,
should they be attainable only part of the time, or should they be so tight that
they become, in effect, "the impossible dream"? Opinions among managers vary,
but standards tend to fall into one of two categories. These are
ideal standards and
are those that can be attained only under the best
circumstances. They allow for no machine breakdowns or other work interruptions
and they call for a level of effort that can be attained only by the most
skilled and efficient employees working at peak effort 100% of the time. Some
managers feel that such standards have a motivational value These managers argue
that even though employees know that they will rarely meet the standards, it is
a constant reminder of the need for ever increasing efficiency and effort. Few
firms use ideal standards. Most
managers feel that ideal standards tend to discourage even the most diligent
workers. Moreover, variances from ideal standards are difficult to interpret.
Large variances from the ideal are normal and it is difficult to
Practical standards are those standards
that are tight but attainable. They allow for normal machine downtime and
employee rest period. They can be attained through reasonable, though highly
efficient, efforts by the average worker. Variances from such standards
represent deviations that fall outside of normal operating conditions and signal
a need for management attention. Furthermore, practical standards can serve
multiple purposes. In addition to signaling abnormal conditions, they can also be
used in forecasting cash flows and in planning inventory. By contrast, ideal
standards cannot be used in forecasting and planning; they do not allow for
normal inefficiencies, and therefore they result in unrealistic planning and
Comparison of Budgets and Standards:
The budget is one method of securing reliable and prompt information
regarding the operation and control of an enterprise. When manufacturing budgets
are based on standards for materials, labor, and factory overhead a strong team
for possible control and reduction of costs is created.
Standards are almost indispensable in establishing a budget. Because both
standard and budgets aim at the same objective-managerial control-it is felt
that the two are the same and cannot function independently. This opinion is
supported by the fact that both use predetermined costs for the coming period.
Both budgets and standard costs make it possible to prepare reports which
compare actual costs and predetermined costs for management.
Building budgets without the use of standard cost figures can never lead to a
real budgetary control system. The principle difference between budgets and
standard costs lies in their scope. The budget, as a statement of expected
costs, acts as a guidepost which keeps the business on a charted course.
Standards, on other hand, do not tell what costs are expected to be, but rather
what they will be if certain performances are achieved. A budget emphasizes the
volume of business and the cost level which should be maintained if the firm is
to operate as desired. Standard stress the level to which costs should be
reduced. If costs reach this level, profit will be increased.
Purpose of Standard Costing:
Standard cost systems aid in planning operations and gaining insights into
the probable impact of managerial decisions on cost levels and profits. Standard
costs are used for:
Controlling costs, directing and motivating
employees and measuring efficiencies.
Promoting possible cost reduction.
Simplifying costing procedures and expediting cost reports.
Assigning costs to materials, work in process, and finished goods
Forming the basis for establishing bids and contracts and for setting