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Standard Costing Methods - Case Study Example

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The paper 'Standard Costing Methods' presents cost accounting which dates back to the period of the industrial revolution. It was then when owners of large scale business encountered the difficulties of running the manufacturing processes and keeping their profit stable…
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Standard Costing Methods
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Historical use of standard costing Cost accounting as we know it nowadays s back to the period of the industrial revolution. It was then when owners of large scale business encountered the difficulties of running the manufacturing processes and keeping their profit stable. Although the surviving business records of 25 sizeable British firms serve as evidences for the statement that British entrepreneurs used standard costing methods even in pre-industrial period 1760-1850 (Fleischman and Parker, 1991), it is still considered that cost accounting began to attract wide interest of industrialists only after 1880. This point of view is well supported with both early (Solomons, 1952) and contemporary researches (Boyns and Edwards, 1997a). Needless to say, standard costing has come a long way before it became generally accepted. Originally, cost accounting systems were mainly concerned with variable costs, such as labour and raw materials expenditures. This trend reflected the nature of businesses of that time, which had their variable costs dominating over fixed costs. It was found that before the First World War standard costing system largely interacted with organizational structure and strategic decision making (Boyns and Edwards, 1997b). Still, no evidences were found that costing system had been used in eliminating wastes and inefficiencies. Moreover, costing practices at that time were limited only to basic industries, such as coal and iron. Later, in 1900-1950 cost accounting at large, and standard costing in particular expanded further in the UK. Although still being under a strict control at engineering (state policy prohibited profiteering in that sector), it developed into government departments and business generally. Standard costing was promoted with accountants connecting theory with practice and a considerable variation was found in perception of standard costing between different times and places of that period in Britain (Boyns and Edwards, 1997c). Therefore standard costing system was not still implemented widely throughout the industries in Britain. It began to grow in popularity as a rather simple and accurate way of improving internal efficiency of a business. Nevertheless, issues of considering fixed assets, especially, depreciation created ambiguities for users of standard costing. These difficulties were strengthened with the trend of fixed costs (depreciation, maintenance, tooling, production control, purchasing, storage, etc.) increasing in value and variable costs decreasing. Accounting historians indicate that the significant change in management accounting occurred only in the late 1950s. In fact the term ‘management accounting’ itself began to enter the language of British accountancy, stressing the connection between these two fields of operations (Boyns et al., 2002). The shift to wide acceptance of standard costing was stimulated by technological, social changes, and budgetary control. In 1953 IBM introduced the first computer available for businesses, beginning the age of computerised accounting. At the same time stakeholders and newspapers were interested in responsible accounting more than ever before in human history. Principles of standard costing became widely accepted, and not without the help of American consultants, as can be seen from the example of BICC, electric cable manufacturer (Boyns, 2003). What were the results of such changes? General adoption of standard costing principles and budgetary control has made it possible to produce responsible accounting, and to link management to accounting: managers were now able to predict expenses, and not only to consider them as fact, but also make efforts to minimise them. About at the same time well-developed theory of standard costing was criticised with propagandists of alternative solutions: marginal costing, and activity-based costing. They argued that while the importance of fixed costs continued to rise, and depreciation, quality control, plant supervision, engineering, etc. have been taking more and more from companies’ budgets, standard costing system fails to reflect them properly, leading to wrong decisions made by managers (Dugdale and Jones, 2003). Still at that time, critiques of standard costing was not heard by the most of managers in the UK. Standard costing has played a crucial role in the history of accounting, by being the first method able to associate costs to product units. According to Horngren et al. (2002, p.247): “[Standard costing] deducts manufacturing costs from sales to compute a gross margin and deducts non-manufacturing costs to measure profit”. Therefore the system establishes a connection between product units and variable costs of the product. Similar connection with the fixed costs seems to be much weaker, which will be examined in the next section of the report. One of the most crucial tools used in the standard costing is the variance analysis, which helps to determine how standard costs vary from actual costs depending on changes in volume variation, material and labour cost variation etc (Drury, 2004). That means, accuracy of predictions made on the basis of standard costing depend on variability of costs e.g. related to raw materials and labour. Modern software helps to resolve these issues. Modern use Modern business environment differs from the one in the beginning of the 20th century significantly. While enterprises of an early post-industrial revolution period were mostly involved into variable costs, manufacturers have their fixed costs dominating over variable ones today. Business philosophy has also evolved from extensive increase of volumes of production to cost cutting and maximum internal efficiency in order to achieve advantage over competitors and strive for greater profit. All these evolutionary changes reflected on the costing system. Since the mid-1980s, norm-based standards have come under fire for not providing appropriate strategic signals to managers (Fleischman and Tyson, 1998). Main disadvantages of the standard costing method are described below. The first reason for abandoning standard costing is rather obvious: while helping much in accounting of variable costs, standard costing simply divides evenly fixed costs among all the products. Meanwhile an even division is not always good, as it may hide that some products consume company resources indirectly more than others (e.g. indirect labour is used for support of the particular product). Due to the fact, that fixed costs now take a significant portion of firms’ budgets, another costing system, such as activity-based, which allocates costs to products through activities required to complete it (Cokins, 1996), will be more beneficial. Another problem follows right from the philosophy of standard costing. It uses norm-based standards for costing, while setting standards for costs is constrained with inevitable issues. One of them is the accuracy of the standards set. For example, if standard were initially set, they have to be regularly updated in order to remain valid in future. Otherwise, a manager will once find himself using a costing system based on the standards set ten years ago. Furthermore, costs set in standards should take into account all the complexities of the real situation. E.g. setting costs for materials required has to consider any possibilities of defects in raw materials supplied, because if not then the actual cost is higher than the one set in standards (Jones, 2006). Finally, standard costing encourages for keeping costs, while most of the modern costing systems seek ways to minimise them. For instance, the theory of constraints, which is becoming more and more popular among manufacturers, suggests that there is always at least one constraint that keeps a business from achieving a greater profit. This theory argues that in order to eliminate wastes an organisation should maximise the throughput of its equipment used in production. Evidences show that indeed, businesses using theory of constraints-based system can improve their performance more accurately, and hence gain a sustainable competitive position in the future (Inman et al., 2005). A costing system based on the theory of constraints is called throughput costing and uses revenue less variable costs in order to determine how effectively current fixed costs are used. The pace of business is very fast nowadays, and here comes one more issue with standard costing: it is slow. Standard costing requires time for calculation and the forecast provided on its basis needs to be remade from scratch in the case if the environment has changes. An increase in in inventory can aborb costs of production, while a decrease in inventory decreases profits under standard costing — such swings make the decision making more obscure. Besides that, under some rapid manufacturing concepts, such as Just-In-Time, where an inventory and storage costs have to be minimised (Horngren et al., 2002), standard costing loses to other methods, such as marginal costing (uses revenue per product less variable costs per product to determine its contribution, and then total contribution minus total fixed costs results in a total profit). Finally, workers now are paid not on salary per unit but on an hourly basis, which makes it difficult to count them as variable costs. In facts, there are almost no costs at current organisations, which are fully variable. Other issues, such as complex nature of variance analysis, investigations made when standard costs are not achieved and not when cost reduction is failed to achieve (Grasso, 2005), or difficulties with allocating costs to a wide range of products, which have processes common for several of them, also serve as arguments against a standard costing system. Despite so many contradictory evidences, standard costing system remains to be the most popular costing system in the world. For example, empirical evidences acquired by Sulaiman et al. (2005) indicate that most of Malaysian companies, both Japanese and local still use standard costing, and are guided by the main principles of this method. Although it should be admitted, that throughput costing is slowly becoming a new standard for manufacturers. Apparently, a few decades will pass before the standard costing will be rendered obsolete by most of the businesses. Conclusions and recommendations Standard costing has played a great role in the accounting history by becoming the first system of allocation costs to products. It was born in the needs of industrial revolution, grown as the mass production developed, and became the first bridge between cost accounting and managerial decisions. However, the world of fast-paced commerce with global competition, elimination of wastes, and perpetual cost reduction has preceded the demise of standard costing. While still being widely used, standard costing is slowly giving up to more suitable costing methods in the contemporary environment. The main weakness of standard costing is that it is directed towards standardising costs instead of reducing them. Lean manufacturing, total quality management, Just-In-Time development, activity based management — modern business concepts require costing systems adequate to their philosophies. Throughput costing, based on the theory of constraints and headed towards the maximization of throughput of manufacturing inventory may become a new standard for manufacturers. Companies involved in activity based management naturally adopt activity-based costing, in order to eliminate wasteful activities, while concentrating on the most contributing ones. Marginal costing system helps to see, which items are the most beneficiary among produced. These and other techniques of cost accounting present a solid substitute for standard costing with answers ready for every sophisticated need. As for recommendations to Salamander Potteries, the use of reports generated with the help of standard costing system will not be effective enough to support the decision-making under modern manufacturing techniques. Therefore, I would recommend the shift to throughput accounting, which will help the company to determine how effectively its production capacity is used. Of course, standard costing system still may serve well when determining the variable raw material costs for production. However, the mix of several costing techniques may create additional difficulties for management, e.g. if they produce contrary results. In order to eliminate these difficulties, I would recommend giving preference to throughput costing system. References Boyns, T. (2003). “BICC – structural change and the development of management accounting, c.1945-c.1960”. Proceeding paper at the “Le gouvernement dentreprise: perspectives historiques” Conference March 21-23, Université Paris-Dauphine. Retrieved November 28, 2006 from http://www.crefige.dauphine.fr/recherche/histo_compta/boyns2.pdf Boyns, T. and Edwards, J.R. (1997a) "The Construction of Costing Systems in Britain to 1900. The Case of the Coal, Iron and Steel Industries," Business History, Vol. 39, Iss. 3, pp. 1-29. Boyns, T. and Edwards, J.R. (1997b). “Cost and Management Accounting in Early-Victorian Britain: A Chandleresque Analysis?” Management Accounting Research, Vol. 8, Iss. 1, pp.19-46. Boyns T. and Edwards, J.R. (1997c) “British Cost and Management Accounting Theory and Practice, c.1850-c.1950; Resolved and Unresolved Issues.” Business and Economic History, Vol. 26, Iss. 2, pp. 452-462. Boyns T., Edwards J.R., Matthews M. (2002). “Standard costing and budgetary control in the British iron and steel industry: A study of accounting change.” Accounting, Auditing & Accountability Journal, Vol. 15, Iss. 1, pp. 12-45. Cokins, G. (1996). Activity-Based Cost Management Making It Work: A Managers Guide to Implementing and Sustaining an Effective ABC System. McGraw-Hill. Drury, C. (2004). Cost and Management Accounting, 6th ed. Chapters 18-19, London, Thomson. Dugdale, D. and Jones, T.C. (2003). “Battles in the costing war: UK debates, 1950-75”, Accounting, Business and Financial History, Vol. 13, Iss. 3, pp. 305-338. Fleischman, R.K., Parker, L.D. (1991). “British Entrepreneurs and Pre-Industrial Revolution Evidence of Cost Management”. Accounting Review, Vol. 66, No. 2, pp. 361-375. Fleischman, R.K., Tyson, T.N. (1998). “The Evolution of Standard Costing in the U.K. and U.S.: From Decision Making to Control”, Abacus, Vol. 34, Iss. 1, pp. 92-119. Grasso, L.P. (2005). “Are ABC and RCA Accounting Systems Compatible with Lean Management?” Management Accounting Quarterly, Vol. 7, Iss. 1, pp.12-27. Horngren, C.T., Foster, G., Datar, S.M. (2002). Cost Accounting — A Managerial Emphasis. Prentice Hall. Horngren, C. T., Sundem, G. L., Stratton, W. O. (2002). Introduction to Management Accounting, Chapters 1-19 (12 ed.): Prentice-Hall International. Inman, A., Mehra, S.R., Tuite,G. (2005). “A simulation-based comparison of TOC and traditional accounting performance measures in a process industry”, Journal of Manufacturing Technology Management, Vol. 16, Iss. 3, pp. 328-342. Jones, M. (2006). Accounting, 2nd ed. Chapters 16,18. Wiley. Solomons, D. (1952). “The Historical Development of Costing” in Solomons, D. (ed.) Studies in Costing, Sweet & Maxwell, London, pp. 1-52. Sulaiman, M., Nazli, N., Ahmad, N. Alwi, N.M. (2005). “Is standard costing obsolete? Empirical evidence from Malaysia”. Managerial Auditing Journal, Vol. 20 Iss. 2 pp. 109-124. 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