Imagine you run a hotel where servicing each room means spending $20 on cleaning supplies, $10 on laundry, and $15 on the housekeeping staff’s pay. The standard cost for turning over a room for the next guest would be $45 — a benchmark that can help you see when your actual costs are higher or lower than they should be.
No matter what industry you’re in, standard costs play a crucial role in your organization’s financial management and decision-making. They can help you spot production inefficiencies, identify issues like waste and rising costs, and decide if how you’re spending your money is helping or hindering your business.
Here’s everything you need to know about how to calculate and implement standard costing to optimize operations.
What is standard costing?
Standard costs typically include three main elements: direct materials (your cleaning supplies), direct labor (your staff’s wages), and service or manufacturing overhead (the energy and water used in the laundry).
Keep in mind that budgeting and standard costing aren’t synonymous. The first involves forecasting and allocating resources throughout the organization, while the second focuses on the typical costs associated with the production of specific goods or services. But standard costing enables more accurate financial planning and resource allocation, which means better budgeting — among many other benefits.
The benefits of standard costing
Let’s take a closer look at some of this cost accounting method’s biggest benefits.
Enhanced budgeting and planning
Your budgets need a foundation built on data so you can forecast expenses and allocate resources with confidence. It’s easier to plan for the future when you know what something should cost, and that’s what standard costing offers — a budget based on real spending.
Improved cost control
Think of standard costs as your early warning system. By comparing your actual costs to the standards you’ve set, you’ll know when something is off. For our hotel owner, that might mean the cost of hot water has suddenly spiked, or the cleaning crew is burning through supplies a lot faster than usual. Standard costing makes it easy to identify and address these issues before they turn into bigger problems.
Simplified decision-making
Whether you’re considering a new supplier, evaluating the size and efficiency of your staff, or deciding whether to invest in new equipment, the standard cost method gives you the insights you need to make data-driven decisions that align with your financial goals.
Increased efficiency
Your team can’t work toward a standard if no one knows what it is. If they know how long a task should take them or how many materials should be used, they can organize their workflows accordingly.
With standard costing, you can set clear expectations for employees and rely on metrics to measure their performance. Having a system for identifying and eliminating any inefficiencies communicates what’s required to meet financial targets, helping everyone use resources more effectively.
Improved performance measurement
Clear benchmarks are the key to clear results. By tracking variances between standard and actual costs, you’ll gain an objective view of how well your business is performing so you can continue doing what’s been proven to work and address areas needing improvement.
The challenges of standard costing
While many different types of businesses will benefit from implementing the standard cost accounting method, it does have drawbacks. Here’s a look at some of the challenges you need to be aware of.
Variance analysis complexity
One of the key disadvantages of standard costing is the complexity involved in variance calculations and analysis — the process of identifying and interpreting differences between your standard and actual costs. Finding the underlying factors that cause cost differences can be time-consuming, and pinpointing the exact sources of inefficiency is especially tricky for businesses with a wide range of products, services, or locations.
Inflexibility
When you set standard costs, you’re making assumptions about what’s “normal.” But things change. Material prices fluctuate, labor costs go up, and production processes evolve — all factors that can quickly make your pre-set standards outdated and irrelevant.
Different types of standard costing like basic, current, or attainable standards offer different degrees of flexibility. But if you don’t adapt your standards to the new normal, you’ll see a lot of variance, and you might not make the right decisions about how to react to it.
Motivational issues
While clear benchmarks typically boost efficiency, your employees might feel you’ve set them up to fail if you pressure them to meet unrealistic standards. Setting your standard costs too low could cause workers to cut corners, and although that might save money in the short term, it’s a great way to let your customers down. And for the employees who stick to the process even though they know that any variances reported might count as a mark against them, their morale — and eventually their productivity — are likely to take a hit.
Overhead allocation
Remember those overhead costs we mentioned — the energy and water used to launder the linens for our hypothetical hotel? Think about how complicated it can be to calculate what percentage of the energy bill you should attribute to washing the towels and sheets from a single room. It’s important to factor overhead into your standard costs, but allocating too much or too little of an indirect cost to one product or service can make it seem more or less profitable than it really is. This might lead to poorly informed decisions that hurt your business in the end.
How to calculate standard costs
After reading through the challenges of standard costing, you can see why coming up with accurate calculations is easier said than done. But it’s more manageable if you break it down into the following steps.
1. Determine your direct material costs
Start by identifying all the materials required to produce your product or deliver your service, like the cleaning supplies used to turn over a hotel room. Next, use historical data, supplier quotes, or industry standards to estimate the cost of each material. You can then calculate the standard direct material cost per unit by multiplying the cost by the quantity you need for one service or unit of production.
2. Estimate your direct labor costs
To figure out your standard labor costs, determine the average wage rate for your employees and the amount of time it takes to complete one unit of production or service. If it takes your housekeeping staff 30 minutes to clean a room, you’d just multiply the average of their hourly rates (the price you pay for an hour of their time) by 0.5 (half an hour).
3. Calculate your overhead costs
To standardize indirect costs like rent, utilities, maintenance, and depreciation, you’ll need to first choose a base, like the number of hotel rooms serviced. If you service 1,000 rooms in a month and the laundry facilities spend $10,000 on energy, water, and cleaning equipment depreciation, you can divide the total overhead ($10,000) by the number of rooms (1,000) to get an overhead rate of $10 per room.
4. Combine the components
Now, add together the standard costs for direct materials, direct labor, and overhead. The total represents the standard cost of producing one unit of your product or delivering one unit of your service. In our hotel example, you’d sum the costs of cleaning supplies, labor, and allocated overhead to get the standard cost of turning over a room, as we did in the introduction to this piece.
5. Regularly review and adjust
Standard costs aren’t set in stone, and treating them as a permanent benchmark will do your business more harm than good. Conduct periodic reviews to make sure you’re adapting to changes in material prices, labor rates, and overhead costs so you can keep your standards up to date.
How to implement standard costing in manufacturing
Standard costing is best suited for industries like manufacturing, where processes are repetitive, outputs are measurable, and cost control is a critical concern. Here’s how to get started:
- Establish standard costs: Set standard costs for materials, labor, and overhead based on historical data, supplier quotes, and industry benchmarks.
- Develop standard cost sheets: Create detailed cost sheets for every product, outlining the standard costs associated with each component of the manufacturing process.
- Implement a monitoring system: Put systems in place to track actual costs in real-time to make comparing them against your established standards easier.
- Train employees: Get your employees up to speed on the standard costing process and how it applies to their roles so they can do their part efficiently.
- Conduct variance analysis: Regularly compare actual costs to standard costs to find and analyze the reasons behind variances so you can make improvements.
- Take corrective actions: Adjust your processes to address variances — for example, renegotiate supplier contracts to bring your actual costs in line with standards.
- Practice continuous improvement: Refine your standard costs and processes based on the insights you glean from variance analysis to ensure efficiency and cost control.
Simplify standard costing with Fishbowl
Streamlining your cost management can drive better financial outcomes for your business, and it’s easier with Fishbowl, the all-in-one inventory management solution that integrates seamlessly with QuickBooks to help you implement standard costing, monitor expenses, and maintain financial accuracy across platforms.
If you don’t use standard costing, don’t worry — Fishbowl supports multiple costing methods, helping you track your inventory value with ease.
Are you ready to take control of your operational and inventory costs and make your company run more efficiently? Schedule a demo of Fishbowl, the intuitive, scalable, and user-friendly inventory management platform.