Ever wondered how successful businesses manage costs in complex production environments? The answer lies in Standard Costing—an accounting tool that helps keep things on track by creating realistic, sustainable budgets. This method helps set performance goals, allocate costs efficiently, and support strategic pricing and decision-making. In the long run, it makes your business more efficient, productive, and profitable.
But how does it work in practice? Standard costing allows you to predict material, labor, and overhead costs in advance. When actual costs don’t match the standard, it shows where you might be overspending.
Here, we’ll cover the basics of accounting for standard costing, why it’s important, and how it can improve your business’s bottom line.
Standard costing is an accounting method that sets a predetermined cost for producing goods or services based on expected inputs, such as materials, labor, and overhead. Businesses use this 'standard' cost as a benchmark to compare actual costs with expected ones. If actual costs are higher than expected, it signals inefficiency or overspending.
The primary goal of standard costing is to control costs and improve financial performance. It applies to both Cost of Goods Sold (COGS) and inventory valuation, giving businesses a clearer picture of financial health.
But which industries or businesses can benefit most from adopting this method? Let’s explore.
Standard cost accounting is commonly used by businesses with repetitive production or large-scale operations. Here are some industries where it’s most effective:
To better understand how standard costing fits into your overall financial strategy, let's take a moment to compare it with a budget. Here's how they differ.
You might be wondering: Is a standard cost the same as a budget? The short answer is no.
A budget is an estimate of total expenditures for a specific accounting period, such as a quarter or year. It covers all costs, from operating expenses to capital expenditures. In contrast, a standard cost is a specific estimate used for individual line items—particularly manufacturing costs. It helps you set benchmarks for direct materials, labor, and overhead within your broader budget.
Now, let's look at the core components that form these cost benchmarks.
Standard costing relies on three main components to set accurate cost benchmarks. Let’s break them down:
This refers to the raw materials used in production. Businesses set a standard cost for materials based on expected prices and usage. For example, if you manufacture furniture, the standard cost for wood might be SAR 50 per unit, depending on supplier contracts and quality specifications.
By comparing actual material costs with the standard, you can identify if you’re overpaying or using more materials than planned.
Labor costs include wages paid to employees directly involved in production. The standard cost for labor is calculated based on the time required to produce a product and the wage rate.
For instance, if it takes 2 hours to make a product at a rate of SAR 25 per hour, the labor standard is SAR 50. Any difference between actual labor costs and the standard indicates efficiency or inefficiency.
Overhead includes indirect costs like utilities, rent, and maintenance. These are divided into:
Standard overhead costs are set by estimating these expenses and dividing them by expected production levels. Variances occur when actual overhead costs differ from the standard.
Now that you've learned what goes into standard costing, let’s see how they come together to calculate standard costs.
Calculating standard costs is straightforward once you understand the components. Here’s how you can do it:
Once you have these numbers, you can calculate the total standard cost per unit:
Standard Cost = Direct Labor + Material Cost + Manufacturing Overhead
Let’s see how these standard costs apply in a real-world example to understand better.
Here’s an example of how to calculate the standard cost for manufacturing a custom metal chair:
Metal Sheets: 20 kg per chair at 2,700 SAR/ton (approx. 54 SAR).
Wood (for armrests): 2 kg at 500 SAR/ton (approx. 1 SAR).
Nails/Screws: Estimated at 5 SAR per chair.
Total direct materials = 60 SAR
Each chair takes 1.5 hours to produce.
Labor cost = 30 SAR/hour
Total labor cost = 45 SAR
Factory rent, utilities, equipment depreciation, and other costs average 30 SAR per unit.
Total overhead = 30 SAR.
Using the formula, Standard Cost = Direct Materials + Direct Labor + Manufacturing Overhead
Standard Cost per Chair = 60 + 45 + 30 = 135 SAR
Now, let’s explore how variance analysis helps you identify inefficiencies by comparing actual costs with expected ones. This is where you really get to see the impact of your cost management efforts.
Variances represent the difference between your planned (standard) costs and actual costs. Tracking these variances helps identify areas where you’re either overspending or underspending.
Variances can be categorized into different types:
Standard costing helps determine whether a variance is favorable or unfavorable:
Having established how variance analysis works, let’s now explore the broader benefits of adopting standard costing in your business.
Adopting standard cost accounting can yield significant benefits for your business. Here’s how it can enhance your financial strategies:
Despite its advantages, businesses can face several challenges when implementing standard costing. Let’s look at some of the common obstacles.
Here are some common challenges associated with standard costing:
Now, let’s move on to the steps to implement standard costing in your business.
Here’s a simple approach to successfully implementing standard costing in your business:
Start by setting cost standards for materials, labor, and overhead. In Saudi Arabia, be sure to consider local factors such as labor rates, supply costs, and regional economic conditions. You can use historical data from your business or local market benchmarks to set realistic standards that reflect what you expect to spend.
Once you have your standards, track actual costs as they occur. Many businesses in Saudi Arabia use ERP systems like HAL or local solutions that integrate with Saudi tax authorities (ZATCA). These tools can help you track expenses in real time, making it easy to compare them to your standard costs.
The next step is comparing your actual costs with the standard costs. For example, if your standard labor cost is SAR 50 per hour, but you paid SAR 55, you’ll see a variance. The same applies to materials and overhead costs. Regularly tracking these variances will help you stay on top of your expenses.
Once you spot variances, investigate why they happened. For example, if labor costs are higher than expected, it could be due to overtime or inefficient processes. If material costs rise, it could be due to supply chain disruptions or price hikes. Keep an eye on local factors like changes in oil prices or new regulations, as these can affect your costs.
After analyzing the variances, take action. If material costs are rising, consider renegotiating with suppliers or finding cheaper alternatives. If labor costs are high, look for ways to improve efficiency, like investing in training or new tools. In Saudi Arabia, adopting technology to streamline processes can help reduce costs in the long term.
Standard costing isn’t a one-time task. You need to review and adjust your standards regularly to account for changes in market conditions, government policies, or your own business operations. This will help keep your cost tracking accurate and ensure better financial control.
Implementing standard costing can be challenging without the right tools. Luckily, there are software options that make it easier to track and manage costs in real-time. Let’s look at the popular ones.
For businesses in Saudi Arabia, ERP systems are a popular choice for managing finances and costs effectively. Here are some tools that can help you manage standard costing:
As we’ve explored, accounting for standard costing is a vital tool for controlling and managing your business expenses. By setting clear cost standards and comparing them with actual costs, you can quickly identify areas of overspending and take corrective actions. This method helps you stay on budget and make better financial decisions.
In Saudi Arabia, where costs can fluctuate due to various factors, standard costing becomes even more valuable. Using tools like HAL ERP can help automate the process, making it easier to track costs, manage variances, and maintain control over your finances.
HAL ERP offers helpful features to manage your finances:
Start managing your finances smarter with HAL. Request a demo or visit our homepage to see how we can help you simplify your financial processes.
