Standard Costs Definition

Standard cost accounting is a goal or budget costs that is associated with variable costs. They are also used to measure the cost that management believes that it will incur over a period.

Standard Costing Explained

In short, standard costing takes the direct labor, direct materials, and manufacturing overhead, and estimates the cost over a quarter, year, or whatever the period may be. This is similar to budget costing, but is different in that budget costs account for a total cost while a standard cost estimate is on a per unit basis. Therefore, if a standard cost estimate turns out to be correct, then the total cost would turn out to be equal to the budget cost. But, this sort of thing never happens.

Standard Cost Formula

The standard cost method can be broken down using the following formula:

Standard Costs = Direct Labor * Direct Materials * Manufacturing Overhead

Where:
Direct Labor = Hours Worked * Hourly Rate

Direct Materials = amount of materials * market price

Manufacturing Overhead = Fixed Salary + (Machine hours * Machine rate)

Note: All but the fixed salary component of overhead must be predicted given the market conditions on demand and cost of the materials. It should also be noted that this is the same formula for the manufacturing costs, but the difference lies in the fact that Standard costs accounting is done on a predictive basis.

Standard Cost Example

For example, Jenny is an accountant. Her boss, Craig the CFO, gave her a task to calculate the standard cost of the company for the upcoming year 2010. She was given the following past information for Wawadoo Co. to try and calculate the standard cost for Wawadoo’s product (widget).

Direct Labor-2009
AVg. Labor Hours= 1,960 hours per employee
Avg. Hourly Wage – \$10
Number of employees = 47
Total Costs= \$92,120

Direct Materials-2009
Material Units=20,000
Avg. Market Price= \$20
Total Cost= \$400,000

Fixed Salary per Manager= \$80,000
Number of Managers= 5
Number of Machine hours= 1,000
Hourly Machine rate= \$2
Total Cost=\$410,000

Jenny’s Boss, Craig, believes that the overall demand for widgets will increase by 5% and the price and number of units needed will increase by the same amount. He also believes that there will be a need for 8 new employees as well as a new manager.

Jenny finds the following:

Direct Labor= 1,960 hrs.* \$10/hr* 55 employees= \$1,078,000
Direct Material = \$21 mkt price* 21,000 units= \$441,000
Overhead= (\$80,000* 6) + (1,000 hrs.* \$2/hr* 6) = \$492,000

Total Standard Cost= \$2,011,000 cost for the year

4

Progress Billing Example

Find a progress billing example below.

Progress Billing Example

UNCONDITIONAL FINAL WAIVER AND RELEASE OF LIENS AND CLAIMS

PROJECT NAME: PRIORITY MANAGEMENT

For and in exchange of the sum of \$, the sufficiency of which is hereby acknowledged, the undersigned Contractor, subcontractor, consultant, materialmen or laborer (hereinafter the “Undersigned”) warrants and represents as follows:

(1) The Undersigned has been employed by Business X, LLC. to furnish labor, materials, or services in connection with the construction of improvements on or to the above referenced project.

(2) The Undersigned has performed all labor, materials, or services required under its Contract, Subcontract or Purchase Order in full compliance with all terms and conditions thereof, and all applicable plans and specifications.

(3) Any and all contractors, subcontractors, laborers, suppliers and materialmen that have provided labor, material, or other services to the Undersigned for use or incorporation into the construction of the improvements to the Project have been paid in full for all amounts due and owing to them on the Project, or shall be promptly paid in full from the proceeds of the payment referenced above and there are no outstanding claims of any character arising out of or related to the Undersigned’s activities on or improvements to the Project. If this Waiver is signed by the Prime Contractor, then attached hereto as Exhibit A is a complete list of all subcontractors and suppliers retained by such party as of the date of this Waiver.

(4) The Undersigned waives and releases any and all liens, lien rights, claims of liens, and any other claims for payment for labor, material or equipment of any type or description that it may have against the Owner, the Owner’s Project Manager, the Owner’s Engineering Consultant, the Architect for the Project, the Prime Contractor (if this Waiver is signed by a subcontractor or supplier) and/or any person with a legal or equitable interest in Project, arising out of or in any fashion related to, any labor, materials or services furnished by, through or under the Undersigned on, or used in connection with, the Project, without exception.

(5) This Final Waiver and Release constitutes a representation by the Person signing this document, for and on behalf of the Undersigned, that the payment referenced above constitutes full and complete payment for all work performed and costs or expense incurred (including, but not limited to, costs for supervision, field office overhead, home office overhead, interest on capital, profit and general conditions cost) by, through or under the Undersigned relative to the work of improvements at the Project, including all retainage. More specifically, the Undersigned hereby waives, quitclaims, and releases any claim of damages due to delay, hindrance, interference, acceleration, inefficiencies or extra work, or any other claims of any kind it may have against the Prime Contractor (if this Waiver is signed by a subcontractor or supplier), the Owner, the Owner’s Project Manager, the Owner’s Engineering Consultant, the Architect for the Project, and/or any other person or entity with legal or equitable interest in the Project.

IN WITNESS WHEROF, the person signing this document, acting for or on behalf of the Undersigned and all of its employees, subcontractors, laborers, suppliers and materialmen, executes this document this _________ day of _____________________ , 20_______ .

By:________________________

Title: _______________________________

This instrument was executed and acknowledged before me on this ____________ day of ___________________, 20___ , by _________________________ , on behalf of said entity.

Notary Public

0

Product Costs vs Period Costs

Product Pricing Strategies

Product Costs vs Period Costs

In accounting, all costs incurred by a company can be categorized as either product costs or period costs. The two types of costs are recorded differently.

Product costs are applied to the products the company produces and sells. Product costs refer to all costs incurred to obtain or produce the end-products. Examples of product costs include the cost of raw materials, direct labor, and overhead. Before the products are sold, these costs are recorded in inventory accounts on the balance sheet. They are treated like assets. Product costs are sometimes referred to as “inventoriable costs.” When the products are sold, these costs are expensed as costs of goods sold on the income statement.

Period costs are the costs that cannot be directly linked to the production of end-products. Essentially, a period cost is any cost that is not a product cost. Examples of period costs include sales costs and administrative costs. Period costs are always expensed on the income statement during the period in which they are incurred.

In sum, product costs are inventoried on the balance sheet before being expensed on the income statement. Period costs are just expensed on the income statement.

1

Overhead rate, defined as an expression of overhead costs which are displayed across periods, is an essential function for a business which must manage cash carefully because of overhead costs. It compares cost to productivity to yield a final rate which can be used to compare efficiency to cost. The objective is to have an rate of overhead which decreases each period, ideally. This rate can be expressed as overhead rate per hour, overhead rate per unit, per month, per period, and more.

Overhead rate means, very specifically, overhead cost divided by the main factor of productivity in work. This factor can be labor hours, labor cost, machine hours, or another measure. All-in-all, overhead rate analysis evaluates whether a company is making value of the overhead costs it incurs or whether productivity must be increased to sustain firm value.

This rate of overhead, to indicate increased efficiency in the production of a company, should decrease. This shows that either overhead cost is decreasing or productivity, keeping a standard overhead, is increasing. Though a firm would prefer to have both at optimal levels it can experience increased value with a positive change in either.

Exceptions to the above paragraph exist. If the rate of overhead is increasing because of a plant expansion it may not be a negative indication. Additionally, if labor hours or cost are increasing while a company experiences a decrease in productivity then the overhead rate variance might appear favorable though it is not. Critical thinking skills are required to make sense of the any of the financial ratios in a company.

The formula is quite simple. For a company to calculate overhead, the most difficult task is to keep pristine records of cost and production. From these, the overhead rate equation is a matter of simple division.

Overhead rate = Overhead cost / productivity (labor hours, labor cost, machine hours, etc.)

Once the proper data is available overhead rate calculations are quite simple.

If:
Labor Cost = 100

Rate of Overhead = \$5,000 / 100 = 50

For example, John is the chief operating officer of a plant which produces chemicals for pharmaceutical companies. John runs a “tight ship” in his plant: he knows what factors are important and sets achievable goals to increase productivity. To balance this, he is a caring manager who motivates the best of those who he works with.

John spends 1 day each month looking over the important measurements and research which tell him the productivity of his plant. This gives John a solid understanding of his plant from a perspective which he may not have seen.

Overhead Rate Direct Labor Cost Calculation

John decides to calculate overhead rate direct labor cost to evaluate the plant. He performs this calculation:

If:
Labor Cost = 100

Rate of Overhead = \$5,000 / 100 = 50

John compares this to the overhead rate of 52 from last month. He then digs deeper to find that labor productivity has decreased, showing a false decrease in overhead rate per direct labor cost.

John talks with the employees and finds that many are distressed by a recent injury at the plant. A young lady, new to the plant, has slipped on a spilled liquid and injured herself. This liquid was accidentally spilled by a coworker. John believes this may have caused a decrease in morale which has caused labor efficiency to decline.

Create a Plan

John creates a plan to revamp safety procedures at the plant. He sends the plan off to the CFO of the plant and finds that this will not be excessively expensive to implement. He then gets confirmation from the board of directors to try his plan.

John is not sure if this will increase employee morale. Despite this, John moves forward with the plan. In 2 months time, if labor efficiency has not returned to original levels, then he will attempt to fix the problem another way. With a foundation of research and proper management John, unsure of this plan, is sure that he can achieve his goal.

Strategic CFO Lab Member Extra

Access your Strategic Pricing Model Execution Plan in SCFO Lab. The step-by-step plan to set your prices to maximize profits.

0

A company uses a predetermined overhead rate to allocate overhead costs to the costs of products. Indirect costs are estimated, a cost driver is selected, cost driver activity is estimated, and then indirect costs are applied to production output based on a formula using these data.

For example, imagine a company that makes widgets. In order to make the widgets, the production process requires raw material inputs and direct labor. These two factors comprise part of the cost of producing each widget; however, ignoring overhead costs, such as rent, utilities, and administrative expenses that indirectly contribute to the production process, would result in underestimating the cost of each widget. Therefore overhead costs are allocated to production output via predetermined overhead rates, or rates that determine how much of the overhead costs are applied to each unit of production output.

(NOTE: Want the Pricing for Profit Inspection Guide? It walks you through a step-by-step process to maximizing your profits on each sale. Get it here!)

Traditional costing systems apply indirect costs to products based on a predetermined overhead rate. Unlike ABC, traditional costing systems treat overhead costs as a single pool of indirect costs. Traditional costing is optimal when indirect costs are low compared to direct costs. There are several steps for computing the predetermined overhead rate in the traditional costing process, including the following:

1. Identify indirect costs.
2. Estimate indirect costs for the appropriate period (month, quarter, year).
3. Choose a cost-driver with a causal link to the cost (labor hours, machine hours).
4. Estimate an amount for the cost-driver for the appropriate period (labor hours per quarter, etc.).
5. Compute the predetermined overhead rate (see below).

First, use the following formula to calculate overhead rate.

See the following calculation example:

\$30/labor hr = \$360,000 indirect costs / 12,000 hours of direct labor

If you want to learn how to price for profit, then download our Pricing for Profit Inspection Guide.

Strategic CFO Lab Member Extra

Access your Strategic Pricing Model Execution Plan in SCFO Lab. The step-by-step plan to set your prices to maximize profits.

0

The overhead definition is those ongoing expenses of running a business that do not directly relate to its core operations. It is ever present in the mind of accountants. The overhead definition includes the costs that are necessary for the business to continue operations, but that do not actually generate profits for the business.

Some examples include the following:

• Rent payments
• Utility bills
• Insurance costs
• Interest payments
• Legal fees
• Taxes
• Other expenses

When the actual amount of overhead expenses exceeds the applied amount of overhead expenses, the difference is called underapplied overhead. The predetermined rate underestimated the overhead costs for the period, and the applied overhead expenses were lower than the actual overhead expenses. The predetermined rate did not apply enough overhead expense for the period, so call the difference underapplied overhead.

When the applied amount of overhead expenses exceeds the actual amount of overhead expenses, call the difference overapplied overhead. The predetermined rate overestimated the overhead costs for the period, and the applied overhead expenses were higher than the actual overhead expenses. The predetermined rate applied too much overhead expense for the period, so call the difference between the two amounts overapplied overhead.

There is not set overhead formula due to the vast differences in overhead amounts based on business models. The overhead calculation is subject to many different approaches based on industry, the differences of overhead expenses, and more. This makes accounting for overhead costs more complicated than it may appear initially.

One of the issues regarding overhead expenses is how to report them in the financial statements. They are not directly related to the core operations, however, ignoring overhead costs when determining the costs of production would not accurately reflect the full cost of production. Therefore, assign at least some portion of overhead costs to production activities and units of output.

Fixed overhead refers to the overhead not related to or applied to production. These costs do not fluctuate with production activity and are reported as period costs. Variable overhead refers to the overhead that is applied to production. These costs fluctuate with production activity. In addition, report them as product costs. Apply overhead to production activities. Also apply units of output using a cost driver and an overhead rate.

The cost driver is an activity that can be used to quantify and apply variable costs. For example, a certain amount of variable overhead expenses may be applied to production based on the number of direct labor hours involved in production, or based on the quantity of direct material used in production. The overhead rate is the rate at which you apply variable overhead to production and units of output based on the cost driver activity.

At the end of the fiscal period, the company must account for the amount of overhead variance. There are two ways to do this. First, transfer the overhead variance to the Cost of Goods sold account. Do this when the overhead variance is comparatively insignificant. The second alternative is to prorate the overhead variance to an inventory account, such as Work in Progress, Finished Goods, or Cost of Goods Sold. In this case, the apply overhead variance evenly across the units of inventory in the relevant account. Prorate overhead variance when the amount is comparatively substantial.

Strategic CFO Lab Member Extra

Access your Projections Execution Plan in SCFO Lab. The step-by-step plan to get ahead of your cash flow.

0

Marginal Costs

Marginal cost refers to the cost of producing another unit of output as production volume changes. As production volume changes the price of producing each additional unit of output changes. Marginal cost measures that change. It is also called differential cost or incremental cost.

Marginal Cost Example

Production costs consist of fixed costs and variable costs. Variable cost refers to the costs required for each unit of output. Fixed costs refer to overhead costs that are spread out across units of output.

For example, let’s say you make shoes. Each shoe produced requires seventy-five cents of rubber and fabric. Your shoe factory incurs \$100 dollars of fixed costs per month. If you make 50 shoes per month, then each shoe incurs \$2 of fixed costs. In this simple example, the total cost per shoe, including the rubber and fabric, would be \$2.75 (\$2.75 = \$0.75 + (\$100/50)).

But if you cranked up production volume and produced 100 shoes per month, then each shoe would incur \$1 dollar of fixed costs, because fixed costs are spread out across units of output. The total cost per shoe would then drop to \$1.75 (\$1.75 = \$0.75 + (\$100/100)). In this situation, increasing production volume causes marginal costs to go down.

Marginal Cost Graph

The marginal cost graph is the shape of a U. As production volume increases the cost per unit declines. This is called economies of scale. When the combination of production volume and unit cost reaches the bottom of the U in the graph, the production process has reached its optimal volume. That point represents the most efficient and cost effective production volume level.

Beyond the point of optimal production level, increasing production volume causes the marginal cost to go up. Each unit of production becomes more expensive than the last. This is called diseconomies of scale. The production process has gone beyond its most efficient and cost effective production level and production is growing more and more costly. Beyond the optimal point at the bottom of the U in the graph, increasing production volume is making each unit more expensive.

Managers use marginal cost analysis to determine the optimal level of production volume in a production process.

To learn how to price for profit, download our Pricing for Profit Inspection Guide.

Strategic CFO Lab Member Extra

Access your Strategic Pricing Model Execution Plan in SCFO Lab. The step-by-step plan to set your prices to maximize profits.