Setting Standard Costs - Ideal and Practical Standards:

Learning Objective of the Article:

1. Who provide the inputs in setting standard costs?
2. Define and explain ideal and practical standards.
3. What is the difference between budgets and standards?
4. What is the purpose of standard costing?

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 Practical standards.

Ideal Standards - Definition and Explanation:

Ideal standards 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 manage by exceptions.

Practical Standards - Definition and Explanation:

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 forecasting figures.

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:

1. Establishing budgets.

2. Controlling costs, directing and motivating employees and measuring efficiencies.

3. Promoting possible cost reduction.

4. Simplifying costing procedures and expediting cost reports.

5. Assigning costs to materials, work in process, and finished goods inventories.

6. Forming the basis for establishing bids and contracts and for setting sales prices

 

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