Standard costing is the practice of
substituting an expected cost for an actual cost in the accounting records, and
then periodically recording variances showing the difference between the
expected and actual costs. This approach represents a simplified alternative to
cost layering systems, such as the FIFO and LIFO methods, where large amounts
of historical cost information must be maintained for items held in stock.
Standard costing involves the creation
of estimated (i.e., standard) costs for some or all activities within a
company. The core reason for using standard costs is that there are a number of
applications where it is too time-consuming to collect actual costs, so
standard costs are used as a close approximation to actual costs.
Standard costing and the related
variances is a valuable management tool. If a variance arises, management
becomes aware that manufacturing costs have differed from the standard
(planned, expected) costs.
- If actual costs are greater than standard costs the variance is unfavorable. An unfavorable variance tells management that if everything else stays constant the company's actual profit will be less than planned.
- If actual costs are less than standard costs the variance is favorable. A favorable variance tells management that if everything else stays constant the actual profit will likely exceed the planned profit.
The sooner that the accounting system
reports a variance, the sooner that management can direct its attention to the
difference from the planned amounts.
