Definition: A standard cost is an estimated expense that normally occurs during the production of a product or performance of a service. In other words, this is theoretically the amount of money a company will have to spend to produce a product or perform a service under normal conditions.
What Does Standard Cost Mean?
Standard costs are sometimes referred to as preset costs because they are estimated based on statistics and management’s experience. Basically, management calculates how much each step in the production process should cost based on the market value of goods, median wages paid per employee, and average utility rates. This estimated calculated amount is the standard cost. It’s the amount that the company should have to pay to produce a good.
Example
Management uses these costs in two different ways. First, they use them to plan out future production processes and increase efficiencies. By looking at the preset costs for operations, management can innovate new ways of producing products that don’t require the same procedures–thus, reducing cost.
Second, management uses these expenses to determine how reasonable the actual costs were for the period. Since present costs and actual costs are rarely identical, management can evaluate how close the actual expenses matched what they should have been. This is similar to the budgeting process. If the actual expenses were higher than the preset expenses, the company would have an unfavorable variance. On the other hand, if actual is less than the standard, the difference is said to be a favorable variance. Management can use these variances twofold. It can evaluate the efficiencies or inefficiencies that led to the variances and adjust them. It can also evaluate the expenses for fraud.
For example, if actual material were way above the standard limit, management can investigate why so many raw materials were purchased and whether or not all of the purchases were put into production. This ensures employees aren’t ordering goods and stealing them. Typically, standard costs are divided into three categories: material, labor, and overhead.
