The Standard Cost System
Production managers and schedulers from all manufacturing firms face a series of questions that must be answered correctly if their companies are going to be successful. They must decide what products to schedule and what batch size to run. Controllers must decide things like the sales price of products and whether or not to purchase a new piece of equipment. When these type of decisions must be made, managers typically follow the guidelines of the Standard Cost System (SCS).
For at least the last fifty years, the SCS has been the driving force for these and other decisions because it provided the “rules” under which successful managers were promoted. Because it has worked for them in the past, most managers feel very comfortable using the SCS. The problem is, today’s manufacturing environment is much more competitive and complex. Because of today’s competitive and complex environment, there is a growing awareness that the SCS has a number of flaws that stand in the manager’s way in terms of making correct decisions. According to Srikanth and Umble , the standard cost approach is based on detailed procedures for calculating the cost impact of any proposed action. The authors tell us that there are two major problems with the standard cost approach as follows:
- The SCS is based on assumptions that are invalid in today’s environment.
- The SCS strives for local optimization. That is, it is local in scope and strives to reduce the cost of each process and each product in isolation. In attempting to achieve these local optimums, the cost approach actually encourages a system that suffers from sub-optimization at the global business level.
With these two problems in mind, let’s dive deeper into the Standard Cost System to better understand why these problems exist.
The Basics of the Standard Cost System
minimize the cost at each of the individual operations that they are responsible for. Because of this, the general approach to cost-based systems is to assign to each operation a cost or some sort of financial measure of its impact on the total system. According to Srikanth and Umble , there are four Standard Cost Principles associated with the Standard Cost System as follows:
- Standard Cost Principle 1: Total cost of the system = Sum of cost at each operation.
To fully understand the shortcomings of the traditional cost approach, one must first realize how costs are assigned to each operation, which is to allocate all of the overhead expenses to the mix of manufactured products. Most allocation procedures estimate the total dollars of overhead cost, divided by the estimated direct labor cost, and allocate overhead burden to the product’s cost as a percentage of direct labor dollars.
- Standard Cost Principle 2: The total cost at each operation is proportional to the cost of direct labor for that operation.
- Standard Cost Principle 3: The total cost for the system (excluding material cost) is proportional to the sum of the direct labor costs.
The point to be emphasized here with Principles 2 and 3 is set up to satisfy the basic accounting requirements expressed by Standard Cost Principle 1. Because of this, an overhead proportionality factor reflecting the historical overhead burden rate is then determined. Only then can a cost for each product, be assigned for each operation. But, this standard cost scheme is useless as a decision-making tool unless we make an additional assumption which is Standard Cost Principle 4.
- Standard Cost Principle 4: The standard cost procedure, which utilizes the calculated overhead/direct labor ratio, can be reversed to estimate the impact of any action on the total cost of the system.
The consequences of applying the assumption in Standard Cost Principle 4 are extremely serious. The entire structure of managing manufacturing operations by traditional cost systems hinges on this assumption. It suggests that if the direct labor cost of a given operation can be reduced, then the total cost allocated to that operation will be reduced by a proportionally larger amount. It also implies that the total cost for the whole system can be reduced by a similar amount.
If you accept this assumption, it suggests that the standard cost calculation can be used to accurately determine the financial impact of any “local action” on the entire system. Because of this, our attention becomes focused on the management of costs at each individual operation, within each separate department or functional are. In other words, each manager’s responsibilities now center around controlling and reducing the costs of the operations he/she is responsible for.
This same “freedom” also impacts engineering as they can now focus their attention on specific processes or products and use the standard cost calculations to construct their cost/benefit analyses. In the case of marketing and sales, they can focus on selling products with high margins and stay away from lower margin products. Everything seems to have fallen nicely into place for everyone. In fact, the new motto seems to be that the key to achieving global optimum is by achieving a series of local optimums. But is this really the case?
In my next post, we will demonstrate the limitations of the Standard Cost System and why it is not the best method to use. In addition, we will illustrate the problems the problems of the standard cost approach by way of a real example. As always, if you have any questions or comments about any of my posts, leave me a message and I will respond.
Until next time.
 L. Srikanth and Michael Umble,Synchronous Management – Profit-Based Manufacturing for the 21st Century, Volume One – 1997, The Spectrum Publishing Company, Wallingford, CT
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