Standard costing: predetermined costs and variance analysis
Standard costing is the most widely used cost accounting method in the world, and the one most likely to be quietly resented by the people who use it. The idea is straightforward: decide in advance what a unit of product ought to cost in materials, labour and overhead, treat that figure as the standard, and then explain the difference between the standard and what actually happened. The mechanism that does the explaining, variance analysis, is the method's whole reason for being.
Its reach comes partly from merit and partly from law. Standard costing supports absorption costing, and absorption costing is required for inventory valuation under both IFRS and US GAAP, which means almost every manufacturer of scale runs some version of it whether or not they love it. That dual character, genuinely useful in places and statutorily unavoidable in others, makes standard costing both the backbone of corporate cost reporting and the favourite target of its modern critics.
Standard costing sets predetermined standard costs for materials, labour and overhead before production, then uses variance analysis to explain the gap between standard and actual. Variances decompose into a price or rate variance and a quantity or efficiency variance, with a volume variance for fixed overhead when output differs from the budgeted level. Because it supports absorption costing, which is required for inventory valuation under IFRS (IAS 2) and US GAAP, standard costing is the statutory backbone of cost reporting almost everywhere. Its roots lie in early twentieth-century scientific management, and G. Charter Harrison is credited with one of the earliest complete systems around 1911. Lean and throughput advocates criticise it for rewarding overproduction. ---
Where it came from
Standard costing grew directly out of the scientific management movement of the early twentieth century. The work of Frederick W. Taylor and Harrington Emerson on measuring and standardising tasks created exactly the raw material a standard cost system needs: a defensible view of how long a job should take and how much material it should consume. Once you can say what work ought to cost, you can set a standard and measure the deviation.
G. Charter Harrison (George Charter Harrison, 1881 to 1959) is credited with designing one of the earliest complete standard cost systems, around 1911. He set out his thinking in the article series "Cost Accounting to Aid Production" in Industrial Management (1918 to 1919) and later in the book "Standard Costs: Installation, Operation and Use" (Ronald Press, 1930). Earlier precursors exist, and the method was not the work of any single hand, but Harrison's contribution is the one usually named when a complete, working standard cost system is traced to its origins.
How it works
Standard costing begins before anything is made. For each product, the business sets predetermined standard costs: a standard quantity and standard price for materials, a standard time and standard rate for labour, and a standard rate for overhead. These standards act as benchmarks against which actual performance is measured.
When production happens, actuals rarely match the standard exactly, and variance analysis decomposes the total difference into named parts so that management can see where it came from.
- Price (or rate) variance isolates the effect of paying a different price than planned: (actual price minus standard price) times actual quantity.
- Quantity (or efficiency) variance isolates the effect of using a different amount than planned: (actual quantity minus standard quantity) times standard price.
- Volume variance, for fixed overhead, captures the effect of output differing from the budgeted level on which the fixed-overhead absorption rate was set.
The logic carries straight into financial reporting. Standard costing supports absorption costing, in which products carry a systematic share of both fixed and variable production overhead. That is not optional: under IFRS (IAS 2 Inventories) and US GAAP, inventory must absorb a systematic share of production overhead and be measured at the lower of cost and net realisable value. Standard costing is one of the most common ways of meeting that requirement in practice, which is a large part of why it is everywhere.
A worked example
Take an illustrative company, CaP, and a single material input to one of its products. The figures below are illustrative.
The standard says each unit should use 2 kg of material at EUR 5.00 per kg, a standard material cost of EUR 10.00 per unit. In the period just closed, the unit actually used 2.1 kg at EUR 5.20 per kg.
| Item (illustrative) | Standard | Actual |
|---|---|---|
| Quantity per unit | 2.0 kg | 2.1 kg |
| Price per kg | EUR 5.00 | EUR 5.20 |
| Material cost per unit | EUR 10.00 | EUR 10.92 |
Variance analysis splits the EUR 0.92 overspend into its two causes.
- Price variance = (actual price minus standard price) x actual quantity = (EUR 5.20 minus EUR 5.00) x 2.1 kg = EUR 0.42 adverse.
- Quantity variance = (actual quantity minus standard quantity) x standard price = (2.1 kg minus 2.0 kg) x EUR 5.00 = EUR 0.50 adverse.
The two add back to the EUR 0.92 total. The value is not the arithmetic but the diagnosis: the business can now tell whether the overspend came from the purchasing desk paying more or from the shop floor using more, and act on the right one.
- Simple, well understood and cheap. The concepts are familiar to almost every accountant and operations manager, and the method costs little to run.
- A clear benchmark and exception-based control. Standards give an unambiguous yardstick, and variances let management focus attention only where reality diverged from plan.
- Satisfies statutory inventory valuation. It supports the absorption costing that IFRS and US GAAP require for inventory, so it does real regulatory work, not just managerial work.
- Ubiquitous in ERP. Standard costing is built into mainstream ERP systems, so the plumbing already exists in most organisations.
- Standards go stale. A standard set against last year's prices, methods and product mix can quietly stop describing reality, so the variances measure drift rather than performance.
- Variance analysis can drive the wrong behaviour. Chasing favourable variances can pull managers toward decisions that look good on the report and bad for the business. Johnson and Kaplan, in "Relevance Lost" (1987), argued that management accounting had lost its relevance to the way modern operations actually work.
- It can reward overproduction. Lean and throughput advocates point out that building inventory to absorb fixed overhead posts a favourable volume variance, so the system can reward making things nobody has ordered. Brian Maskell (BMA Inc., lean accounting) argues that traditional standard costing is actively harmful to lean organisations and entrenches mass-production thinking. Eliyahu Goldratt is often quoted as having called cost accounting "the number one enemy of productivity".
Where it fits
Standard costing is dominant in Anglo-Saxon manufacturing multinationals, above all for external reporting and inventory valuation. The reason is structural: because absorption costing is mandated for inventory under IFRS and US GAAP, a method that supports it sits at the centre of the statutory accounts almost by default.
That statutory pull explains its persistence. Even in organisations that have adopted activity-based, time-driven or throughput methods for decision-making, standard costing usually remains the statutory backbone, running alongside the newer methods rather than being replaced by them. For inventory valuation it is hard to dislodge; for management decisions, it increasingly shares the stage.
FAQ
What is standard costing in simple terms?
It is a method that decides in advance what a unit should cost in materials, labour and overhead, calls that the standard, and then explains the difference between the standard and the actual cost through variance analysis.
What is variance analysis?
It is the decomposition of the gap between standard and actual cost into named causes, chiefly a price or rate variance and a quantity or efficiency variance, plus a volume variance for fixed overhead when output differs from the budgeted level.
Is standard costing still required under IFRS and US GAAP?
The standards do not mandate standard costing by name, but they require inventory to be valued on an absorption basis, carrying a systematic share of production overhead at the lower of cost and net realisable value. Standard costing is one of the most common ways of meeting that requirement, which is why it remains near-universal.
Why do lean advocates criticise standard costing?
Because building inventory to absorb fixed overhead generates a favourable volume variance, the system can reward overproduction. Brian Maskell argues it is harmful to lean organisations, and Goldratt is often quoted as calling cost accounting the number one enemy of productivity.
Who invented standard costing?
It grew out of early twentieth-century scientific management, drawing on Frederick W. Taylor and Harrington Emerson. G. Charter Harrison is credited with one of the earliest complete systems, around 1911, set out in his 1930 book "Standard Costs: Installation, Operation and Use".