Please note in order to cover this topic in a condensed format requires some order of simplification and therefore limits the complexity and depth that can be contained in this narrative. In addition, to understand how a standard cost system actually works is beyond the scope of this content. However, the underlying premises remain true and the benefits of Standard Costing are very real.
From my experience, combined with the minimal research available on the topic, my estimation is about 75%-80% of manufacturing companies use Standard Cost as the basis for the inventory valuation. The remaining 20%-25% is comprised of, in descending order of use, Actual Cost, FIFO – which is a form of Actual Cost and Weighted Average Costing.
This is somewhat comforting to me, as personally I fundamentally believe Standard Cost is the best approach except for specific industries or situations. For example, Actual Cost would be preferred for suppliers to the US government (e.g., DFAS) where the contract requires Actual Cost be used so government auditors can review the results against the invoices submitted to the government for payment to the supplier.
In fact, the right question to ask is why such a high percentage of manufacturing companies deploy a Standard Cost system if Actual Costing will give me what I want. The answer to that question is along the lines of the old adage “be careful what you wish for, because you might just get it.”
The key to understanding is what lies behind the curtain. In an Actual Cost system, to understand your business results, the company must review all the transactions to understand the underlying details and the actual materials purchased/used for a specific transaction. In addition, the mere requirement of tracking specific purchases throughout the manufacturing process in order to maintain traceability and accuracy of material costs consumed is an overhead burden and a discipline that must be deployed in support of using an Actual Cost system.
It is important to note, the below example is not meant as a complete condemnation of Actual Cost as it does have its place, but rather serves as quick illustration of how Actual Costing can lead one to an incorrect conclusion unless the proper (hint: inefficient) analysis is performed on your results.
By way of example, let’s assume a company manufactured standard catalogue Product A and sold one each at the List Price of $1,000 to Company B and one to Company C. During the procurement process, Purchasing realized they had to expedite material to meet delivery schedules due to an oversight in planning. This material expediting caused the cost for the unit sold to Company C to be $900 as compared to a cost of $600 for the unit manufactured for Company B. As a result the gross margin for the sale to Company C was only $100 ($1,000-$900) while the gross margin for the sales to Company B was $400 ($1,000-$600).
The total revenue for the two sales was $2,000. The total cost equaled $1,500 therefore the total profit margin was $500. Upon reviewing the monthly results, the company executives decided to implement a new higher pricing structure for future sales to Customer C, because of the poor margins for this customer.
The basic premise of a Standard Cost system is manufacturing /operations are measured against an approved standard cost. This enables management to focus and limit reviews of the results to significant variances to the standard established instead of reviewing each and every transaction. By using the same example as above and adding a standard cost of $600 for Product A, the clear difference in management philosophy becomes very apparent.
In this instance, the Standard Margin for each sale would be the same $400, because the revenue for each sales would remain at $1,000 while the cost would be the same $600 standard established for Product A. The company would also record an unfavorable Purchase Price Variance (PPV) as a result of the higher cost of expediting material to meet customer demand.
During the review of the monthly results, the total revenue presented was $2,000 ($1,000 x 2), standard cost of $1,200 ($600 x 2) and an unfavorable PPV of $300 ($900 actual vs the standard of $600). By summing the three elements, the total reported Gross Margin was reported $500 ($2,000-$1,200-$300), which is the same as the results in the Actual Cost example. However, management focused on the real fundamental issue which was the expediting fee as the profitability for sales to Company B and Company C were the same.
To assign the actual cost of the expediting fees to the next sale is completely arbitrary when manufacturing for a standard product offering. In addition, it can easily lead to inappropriate business actions. In essence, as the above examples highlight, Standard Cost enabled management to have a meaningful discussion on the causes of the expediting fees as compared to focusing on the false assumption of having a customer with unacceptable margins.
There are other benefits to the organization other than financial review of results. Two examples are 1) the Purchasing department can be measured against their procurement cost objective quite easily, from a top level perspective, by reviewing the Purchase Price Variance balance and 2) Inventory transactions do not need to be transacted by lot/serial number unless required for government compliance to warranty validation. This saves operations from this overhead burden.
The true elegance and simplicity of Standard Cost becomes even more apparent when manufacturing in large volumes as compared to the simple example discussed above. The basic point to remember is Standard Cost enables management by exception (i.e., variance to standard) as opposed to managing the entirety.