Standard costing is a method of cost accounting based on standardizing costs, as opposed to actual or expected costs. This method provides a process of arriving at a standard cost in a simpler format than that of the FIFO or LIFO methods. Standard Costing often deals with a business’s manufacturing overhead, costs of direct material, and direct labor.
There are often variances between the actual costs and standard costs of finished products due to direct labor on a particular product, possible maintenance costs, or manufacturing delays. If the actual cost of a product is higher than the standard cost, the variance is unfavorable, possibly indicative of lower than anticipated profits. If the actual cost of a product is lower than the standard cost, the variance is favorable, indicative of higher than anticipated profits. For any business, it is vital that variances are reported once discovered so that the variance can be accounted for.
Variances in volume can also arise, where the amount of product sold varies from what has been budgeted. Variances among the sale of goods are called sales volume variances. Variances among direct materials are called material yield variances. Variances among direct labor are called labor efficiency variances. Variances among overhead are called overhead efficiency variances.
Using the perpetual inventory system, the standard cost of a product should be the sums of direct material, direct labor, and fixed/variable manufacturing overhead. Direct material will often have variances in pricing and usage. Direct labor will often have variances in rates and efficiency or quantity. Variable manufacturing overhead will often have variances in spending and efficiency. Fixed manufacturing overhead will often have variances in budget and volume.
Note that there are additional variances which might affect a standard cost. Often, when new employees join a business, there is a learning curve when working with new equipment and learning new processes. Efficiency should increase over time, but volume of a product may be lower at the beginning of production. Workers may also earn higher wages, affecting direct labor costs. If new, more efficient equipment is installed, this may affect the costs of direct material and direct labor. Equipment degrades over time and may need to be serviced or replaced, leading to gaps in profits as new equipment is installed.