In our continuing series on standard cost, Society of Cost Management Founder, Mike Fournier discusses how standard cost came about and why it became popular as a costing methodology. Mike is Sr. Cost Accountant at HDT Airborne in Santa Ana, CA., and can be reached at email@example.com.
It is interesting that many of the greatest advancements in costing don’t come from people involved with costing, these advancements usually come from engineers. Alexander Hamilton Church, a pioneer in scientific management, was the first to connect standard work with cost and publish the concept: ‘Production Factors in Cost Accounting and Works Management’ (1910); and, ‘The Proper Distribution of Expense Burden’ (1908). Church was the first to cost the scientific methods that were being developed at the time and recognize that with the available information, not only could the most efficient manufacturing methods be used but the cost of the finished good could be calculated with some accuracy. A recent book that talks about Church’s contribution to costing is ‘Lean Cost Management: Accounting for Lean by Establishing Flow’ by James R. Huntzinger (2007), which is available thru the SCM bookstore.
If you know how long something should take to produce, the standard pay of the people doing the work, the expected (standard) cost of the raw materials, then you should be able to predict with some accuracy, the final cost, and by comparing variances of standard vs. actual, the source of variation can be determined and dealt with or the standard revised.
Standard cost worked fine for many years, and was (and still is) the main source of costing within manufacturing. Many businesses utilizing standard cost applied their manufacturing overhead using one cost pool and the application method was often labor hours or dollars. In the 1970’s, it became obvious that this method of applying overhead was no longer relevant, as labor had become an ever decreasing share of the cost and the cost of technology was increasing, so all costing was declared irrelevant, when really it was only the method of overhead application. (even though full absorption costing is required by GAAP, is allocating cost a good way to look at cost? I think this is a discussion we still need to have)
Activity Based Costing (ABC then came into fashion to solve the manufacturing overhead application problem. Unfortunately, ABC faded quickly as many companies declared its cost to be prohibitive, even though this argument is incorrect, the counter argument being: how much value is it to know your cost structure really well. Many companies that use standard cost today still apply overhead using only one cost pool based on labor dollars or hours.
Standard cost though hangs in there, still the costing method of choice for manufacturing companies, and now other industries as well – healthcare being most noticeable, although they refuse to learn from manufacturing and for the most part, tread this path on their own. (The Society of Cost Management is here to help share information)
Standard cost is not a good cost methodology unless it is maintained, probably 90% of the companies that use it do not maintain it adequately to make it viable as a costing tool. Maintaining it means regular variance review, updating standards, and keeping rates current. Many people do not understand that the purpose is to know what things will cost, not what they cost last year, so rates should not be based on history but be forward looking, projected rates can be made with some degree of accuracy.
Even though standard cost is past its prime, nothing better has come along to displace it. So it continues to be the costing method of choice for many companies, particularly those focused on meeting GAAP requirements and not that interested in their costing structure. What does the future hold? You tell me.