Cost is a very important aspect of a business and it is where the profit of a company is based. It is basically a measurement, in monetary terms, of the amount of resources used for the purpose of production of goods or rendering services. For example, in manufacturing a personal computer, the resources needed such as materials and labor as well as resources for transporting and delivering the product to consumers all have cost which will comprise the cost of the PC. Included in the cost is the profit which is the main reason for the existence of the business.
Because of the factors that affect the costing of products, the choice of a costing system is necessary in a company. It serves as a control method for cost awareness and for improving production performance.
The focus then of this paper is about costing system specifically the standard costing system. The paper discusses first the functions of a cost system and why companies need a cost system. Secondly, the paper tackles the standard cost system and its advantages and disadvantages in relation to globalization, shorter product life cycle and the changing consumer behavior. The paper also discusses other costing system that are currently used in the industries to determine where countries or part of the world the standard costing system is more relevant and when it should be used more effectively.
Functions of Costing Systems
According to Drury and Tayles (2003), companies need cost systems to perform a number of different functions which include (1) allocating costs between cost of goods sold and inventories for periodic internal and external profit reporting; (2) providing relevant cost information to manage the cost and mix of activities, products, services, locations and customers; (3) providing economic feedback to managers to manage costs and improve efficiency and effectiveness of existing operations; and (4) providing relevant information to manage the cost and mix of future activities.
Based on its functions, costing system directly influenced the activities of a company especially a manufacturing company. Costing system determines if an activity does not provide profitability to the company or an alternative activity will provide more profit. For example, as stated earlier, the final cost or the price of a product comprises of different costs such as direct material, direct labor, and overhead, when a company analyze and review cost information, the management find out that outsourcing will yield to more profit thus cost system helps in determining which activity or mix of activity will be of greater importance in the part of the company. Cost system helps determine which activity can be eliminated or added for future business, when and how a company can impose cost reduction and how to improve efficiency of existing operations.
The Standard Costing
Most Western and American companies are the ones to use standard cost system at present. Profit motivated companies seek to reduce costs and expenses in the process of manufacturing and marketing of their products or performing their service to the customer (Lewis, 1993). In order to reduce costs and expenses, and control method in costing, there must be a basis for comparison which is referred to as benchmark (F.S.P. et al,, 1983) or standard (Lewis, 1993) that can be used to signal when deviations from predetermined results are incurring, whether it is a performance or requirements. Standard costing is basically the process of setting cost performance goals that benchmark desirable performance and then using these cost goals to evaluate performance (Prentice-Hall, 2000).
Standard costing involves setting expected cost levels for each period by cost category such as the direct material, labor and overhead costs. This means that although the company pays for the actual costs, its inventories and cost of goods sold will depend on the standard cost set by the company. The difference between the actual cost and the standard cost is called the variance (Accounting Coach, 2006). In standard costing the price or rate standards and the quantity or efficiency standards are the two standards that are considered. Price standards like the raw material cost standards are derived from economic forecasts which are based on the average historical costs (DBN, 2006) while the quantity or efficiency standards like the labor efficiency or the number of units that must be produced are based from engineering studies or product design specifications (Irwin, 2003).
Standard costing serves as a valuable management tool. The variance mentioned above is use as a tool in determining if the company will be able to achieve less or more than its planned profit. A variance is unfavorable if the actual cost exceeds the standard cost (Irwin, 2003) but favorable if the actual cost is much lower than the standard cost.
Standard costing has many advantages which includes providing basis for cost comparisons and enabling managers to employ management by exception. Management exception is the process where managers focus their attention on those areas where the most significant variances occur (Prentice-Hall, 2000). Because of the cost standards set, there would be a means of performance evaluation and motivation for employees to achieve standards. It may also result in cost savings in maintaining inventory records (Anonymous, 2006). Cost standards primarily help management in budgeting.
However traditional costing system such as standard costing poses many disadvantages especially today that most industries are driven by technology, globalization and changing consumer behavior.
One of the disadvantages of standard costing is that shorter product life cycles lead to outdated standards (Anonymous, 2006). Consumers periodically change their demands and preferences brought about by introduction of new technology thus most products have shorter life cycles. Products like personal computers, mobile phones, gadgets, appliances, electronic equipments and other products that have sprung from technologies become obsolete within a few months of their introduction. Setting standards for these products would be difficult for the manufacturers.
Price standards are set based on historical costs but as technology evolves, materials or parts used in making products tend to become lower as new materials are also introduced. For example, the microprocessor used in making PCs become lower as new types of microprocessor are introduced with higher memory capacity. It is hard to set cost standard with this material there are new materials that are introduced, the tendency of a manufacturer would be to also adopt with the changes or else its product would be outdated. Historical cost can not be used when new materials would be used in manufacturing products.
Another disadvantage of standard costing is that its primary focus has traditionally direct labor, which represents a shrinking portion of the total costs (Anonymous, 2006). As also brought about by technology, automation and mass production has been the trend in most manufacturing companies today to be able to deliver products faster to consumers. Variances tend to be small or nonexistent in automated production process (Anonymous, 2006) therefore, when a standard costing is used by companies with automated production process, the information on the cost would not be that reliable.
In standard costing, the practice is “how much does the product cost” where the new product costs will be estimated based on the purchased materials and parts, labor costs, and other manufacturing overhead costs under the current production standards (Lee, 1994). Also, as stated above, standards are based on the specification and design of the product so once the cost is realized to be too high, product must be redesigned or smaller profit margin must be accepted. Once the product is developed and design there is a limit to how much cost cutting companies can do in the manufacturing stage (Lee, 1994).
With the integration of economies and societies in the world which is usually called globalization, companies today are competing in the global market where competition is very tough. While standard costing uses variance analyses that tend to focus primarily on cost minimization (Anonymous, 2006), competition in the global market does not primarily focus on cost but on improving its products that will add value to the products. Also, consumers today are not only cost-oriented but also look for the features and qualities of products especially now that consumers are exposed on the innovations and development that technology can provide.
In US companies where standard costing is the most prevalent costing system, costs of designing, producing, marketing, and delivering products dictate the mode of competition (Lee, 1994). This mode of competition tends to focus on product profitability and not on relative position in the market and product leadership which are both very essential in global competition.
Conclusion
Drury (2004) stated that standard costing is most suited to an organization whose activities consist of a series of common repetitive operation which means that standardization is most applicable to companies whose activities does not vary rapidly and whose materials are not much affected by the external changes like changes in technology and whose products’ costs can be easily determined by its specification. Examples of these products are usually those with longer life cycles such as food, and clothing. Manufacturing companies who also have the potential to be successful by using standard costing are those who have definite market segment. Having a definite market segment will help in setting standards. For example, standard costing can be used by beer manufacturers where its market segment composes mostly of adults.
However there are other factors that affect the costing of a product which are brought about by the changes in the internal and external environment of a company. At present, cost is also dictated or characterized by globalization, technology, production process and life cycle, and consumer buying behavior
Based on this study, industries in a world characterized by globalization and shorter product life cycles can effectively used standard costing which is a cost system that primarily focuses on costs and profitability. Also, as wealth of consumers increase, cost will not be much an important factor in attracting wealthy consumers. Quality and value of products will be their focus.
Therefore, standard costing can only be used in some companies especially on companies which do not rely heavily on technology. But on companies like Sony, Dell Computers, Microsoft, and other companies that are heavily reliant on technology and who have achieved market share due to globalization, standard costing will not be effective.
As this study takes place, most sources and articles suggest that target costing which began with world-class Japanese manufacturers and response to shorter product life cycles as well as to increased global competition (Blunt et al, 2006; Lee, 1994), is the more effective costing system today.
References:
Anonymous , Chapter 10 Standard Costs and the Balanced Scorecard
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