2. Setting cost standards

To establish cost standards, companies make certain assumptions about their production as well as input prices and quantities, identify standard levels, and collect information about operating costs.

Companies make assumptions concerning the factors listed below:

1. Production volume (e.g., 100,000 units per month).
2. Production efficiency (e.g., 95 % efficiency, 5% defected items and waste).
3. Input standards: prices and quantities (e.g., $1 per gallon of milk and 1 gallon of milk per ice cream bucket).

In addition to making assumptions, management has to identify standard levels:

Ideal standards can be achieved only with the highest efficiency and performance (usually under perfect conditions).

Attainable standards are attainable under current conditions that have an element of inefficiency. Usually it is better to use currently attainable standards than ideal standards because attainable standards may discourage employees less and motivate them to perform better.

Companies usually determine attainable standards for the following costs:

1. Direct materials:
   1. Materials price standard is the price a company expects to pay per unit of direct materials (e.g., $ 4 per 1 yard of atlas fabric, $1 per gallon of milk). It is a standard for the direct materials input. Materials price standard is based on expected costs of direct materials. It is usually set by a purchasing agent. However, the purchasing agent might be tempted to overestimate the materials price standard in order to look good by purchasing direct materials at a lower price.
   2. Materials usage standard is the quantity of direct materials needed to produce one finished item (e.g., 1 gallon of milk per ice cream bucket, 3 yards of atlas fabric per dress). It is a standard for the direct materials input. Materials usage standard is set by using engineering estimates and historical data.
   3. Direct materials standard is an expected direct materials cost per unit of output (e.g., $12 of direct materials cost per dress).
2. Direct labor:
   1. Labor rate standard is an expected cost ("price") per one hour of direct labor (e.g., $10 per hour). Labor rate standard is often equal to the average wage rate paid to workers with various skills levels.
   2. Labor efficiency (usage) standard is the number (quantity) of direct labor hours needed to produce one finished item (e.g., 2 direct labor hours per dress, 1 machine hour per aluminum pipe). Labor efficiency standard is a difficult standard to set because it depends on individual workers as well as on the type of work performed. Also, when setting this standard under management's supervision, workers may work slower in order to decrease the labor efficiency standard. Thus, it is better to use engineering estimates and adjust the standard periodically.
   3. Direct labor standard is an expected direct labor cost per unit of output (e.g., $20 of direct labor costs per dress).
3. Variable factory overhead:
   1. Variable overhead rate standard is an estimated variable overhead cost per direct labor hour (e.g., $5 per direct labor hour). It is determined by dividing expected total variable overhead costs by the total budgeted application base.
   2. Variable overhead application base standard is expected total direct labor hours for a period (e.g., 200,000 direct labor hours per year).
   3. Budgeted variable overhead cost (BVOC) is an estimated total variable overhead cost for a period (e.g., $1,000,000 per year).
4. Fixed factory overhead:
   1. Fixed overhead rate standard is an estimated fixed overhead cost per unit of output (e.g., $2 per dress). It is determined by dividing expected total fixed overhead costs by the total budgeted production (e.g., $300,000 ÷ 100,000 dresses = $3 per dress).
   2. Fixed overhead application base standard is a standard volume of allocation base (e.g., 100,000 dresses per year)
   3. Budgeted fixed overhead cost (BFOC) is an estimated total fixed overhead cost for a period (e.g. $300,000 per year).

Standards for manufacturing costs are summarized in the table below:

Illustration 2: Standard cost components

To illustrate an example, see the table below:

Companies periodically review standards due to the following reasons:

• Cost reduction goals
• Quality improvements goals
• Unattainable standards
• Large variances from standards

As mentioned above, one of the incentives for a company to review its standards is caused by the standard cost variances, which can be identified through variance analysis. Let's look at the major steps and goals of variance analysis.

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