Advantages, Disadvantages and
Limitations of Standard Costing System:
Learning Objective of
the article:
- What are the advantages / benefits and disadvantages /
problems / limitations of standard costing system and variance analysis?
Advantages / Benefits of Standard Costing System:
Standard costing System has the following main
advantages or benefits:
- The use of standard costs is a key element
in a
management by exception approach. If costs remain within the
standards, Managers can focus on other issues. When costs fall
significantly outside the standards, managers are alerted that there may
be problems requiring attention. This approach helps managers focus on
important issues.
- Standards that are viewed as reasonable by
employees can promote economy and efficiency. They provide benchmarks that
individuals can use to judge their own performance.
- Standard costs can greatly simplify
bookkeeping. Instead of recording actual co0sts for each job, the standard
costs for materials, labor, and overhead can be charged to jobs.
- Standard costs fit naturally in an
integrated system of responsibility accounting. The standards establish
what costs should be, who should be responsible for them, and what actual
costs are under control.
Disadvantages / Problems / Limitations of Standard Costing System:
The use of standard costs can present a number
of potential problems or disadvantages. Most of these problems result from
improper use of standard costs and the
management by exception principle or from using standard costs in situations
in which they are not appropriate.
- Standard cost variance reports are usually
prepared on a monthly basis and often are released days or even weeks
after the end of the month. As a consequence, the information in the
reports may be so stale that it is almost useless. Timely, frequent
reports that are approximately correct are better than infrequent reports
that are very precise but out of date by the time they are released. Some
companies are now reporting variances and other key operating data daily
or even more frequently.
- If managers are insensitive and use
variance reports as a club, morale may suffer. Employees should receive
positive reinforcement for work well done. Management by exception, by its
nature, tends to focus on the negative. If variances are used as a club,
subordinates may be tempted to cover up unfavorable variances or take
actions that are not in the best interest of the company to make sure the
variances are favorable. For example, workers may put on a crash effort to
increase output at the end of the month to avoid an unfavorable
labor efficiency variance. In the rush to produce output quality may
suffer.
- Labor quantity standards and efficiency
variances make two important assumptions. First, they assume that the
production process is labor-paced; if labor works faster, output will go
up. However, output in many companies is no longer determined by hw fast
labor works; rather, it is determined by the processing speed of machines.
Second, the computations assume that labor is a variable cost. However,
direct labor may be essentially fixed, then an undue emphasis on labor
efficiency variances creates pressure to build excess
work in process and
finished goods inventories.
- In some cases, a "favorable" variance can
be as bad or worse than an "unfavorable" variance. For example, McDonald's
has a standard for the amount of hamburger meat that should be in a Big
Mac. A "favorable" variance would mean that less meat was used than
standard specifies. The result is a substandard Big Mac and possibly a
dissatisfied customer.
- There may be a tendency with standard cost
reporting systems to emphasize meeting the standards to the
exclusion of other important objectives such as maintaining and improving
quality, on-time delivery, and customer satisfaction. This tendency can be
reduced by using supplemental performance measures that focus on these
other objectives.
- Just meeting standards may not be
sufficient; continual improvement may be necessary to survive in the
current competitive environment. For this reason, some companies focus on
the trends in the standard cost variances - aiming for continual
improvement rather than just meeting the standards. In other companies,
engineered standards are being replaced either by a rolling average of
actual costs, which is expected to decline, or by very challenging target
costs.
In sum, managers should exercise considerable
care in their use of a standard cost system. It is particularly important that
managers go out of their way to focus on the positive, rather than just on the
negative, and to be aware of possible unintended consequences.
Nevertheless standard costs are still found in
the vast majority of manufacturing companies and in many service companies,
although their use is changing. For evaluating performance, standard cost
variances may be supplanted in the future by a particularly interesting
development known as the balanced scorecard.
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