Standard Costing - is it a Waste?
Standard Costing - is it a Waste? Goldratt once called Accounting public enemy number one. Many of you will be familiar with standard costing (and other methods). Is standard costing helpful or not when you are making your decisions?
Accountants are usually very aware of the problems and pitfalls of standard costing, but their colleagues in the other business area place much to high a credence on such numbers. Is this true? What do you think?
Standard costs are developed before a new fiscal year starts. Finance spends considerable effort (possibly together with engineering) to re-estimate the cost of producing a product. They do this for all products - possibly grouping products into product groups to reduce the amount of workload.
Standard cost is based on a lot of assumptions - all of them subject to error, and / or uncertainty. Costs are allocated to products based on:
The sales forecast of the individual product and the total expected sales. Since the standard cost of an article is a single number the accuracy of the forecast is very important. If we sell significantly more or less product, then the standard cost will not reflect reality.
If we sell more then the operating expense part f the cost will be lower than standard and the reverse will be true too. There will be variances during the fiscal year - positive and negative. Usually negative variances are to be avoided sinc e they cause questions (more than positive variances).
While costs vs budgeted cost (on which standard costs are based) may be higher or lower, the more usual variances come from differences in volumes sold and changes in materials prices. To avoid questions from management it is easy to produce more than actual market demand (costs are then absorbed and end up in inventory.
Variances are small or non-existent. BUT inventories can easily become very inflated. Does this kind of variance manipulation make sense? Do you think it does or does not take place?
The only part of costs that can be estimated accurately are materials costs. Only materials price can cause variances here. While management may not like price increases production is not usually blamed for them.
However, there may be a temptation to manipulate profits through material price variances. It can happen (maybe not very often) that a commodity's price declines very significantly. Since materials are (can be) booked to inventory at the standard cost, then such purchase will inflate profits now - the variances go straight to the bottom line.
Production costs continue on as before because the material's cost to produce a product is entered at standard. If market pressures (through knowledge of a commodity's lower prices) cause product prices to fall management may well be confused by the higher than expected fall in product margins.
To arrive at a standard cost accounts must make assumptions about how much effort goes into producing a product. One can be very scientific about this but in the end it is simply a number of assumptions - often not very valid ones.
The only operating expenses that may be more or less accurately allocated might be direct labour. supervision, and other overheads are often simply 'spread' across all products by some simply allocation means - for instance by quantity produced. What the method does is give a false picture of product costs.
This false picture leads to faulty decisions about pricing and whether or not a product should be discontinued. Management may understand the impact of marginal sales (they cost only their added materials) so they may not be fooled by standard costs.
However I suspect that many managers are fooled and do use these standard costs in their decisions. It looks to me that standard costs are a necessary crutch to help justify decisions - often enough wrong decisions.
The waste is in the effort to produce standard costs. The even bigger waste are the erroneous decisions management is 'forced' into making by the information that comes from standard costs.
If standard costs are the cause of some many problems why do we use them? For the company books there is a need to value inventories and there is a need to report according to GAAP or other similar rules.
These statutory reports and the way results must be reported will not be changed. However, nothing prevents us from having a second set of books that we will use to manage our business. This second set must be built in a way that it is useful for all levels of management - which means it should provide managers with the necessary information to be able to make good decisions.
This second set of books must also reconcile to the statutory books - after all the numbers are the same, just placed differently on the page.
What could we replace standard costs with that will provide management with the information they do need for good decisions?