INSIGHT

Standard cost accounting: What it is and when it makes sense for businesses 

Chris Rosales, Jamie Emerson-Heery • April 24, 2025

Services: Cost Accounting

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Are your profit margins slipping through the cracks?  

Standard cost accounting might be your missing piece. This powerful approach doesn’t just track where your money went—it predicts where it should go, giving you the insight to spot inefficiencies before they drain your profits and the clarity to make decisions with confidence. 

Today, we’ll review what standard costing is and if it’s right for your business.  

What is standard costing? 

Standard costing is a cost accounting method where predetermined estimated costs are used instead of actual costs in the accounting records.  

Rather than tracking every penny as it’s spent, this approach establishes target costs for materials, labor, and overhead before production begins. 

At its core, standard costing creates a financial “blueprint”; a benchmark against which actual performance can be measured. It’s like setting a budget for each unit you produce, then comparing what you actually spent to identify where you’re over or under your targets. 

Basic principles of standard costing 

The fundamental principles of standard costing include: 

• Predetermined cost estimation: Standard costs are educated estimates of what each component of production should cost under normal capacity. 
• Variance analysis: The difference between standard and actual costs (called a variance) is calculated, analyzed, and used to identify inefficiencies and opportunities for improvement. 
• Performance measurement: Standard costs provide a baseline for evaluating operational efficiency and management performance. 
• Cost control: By highlighting deviations from expected costs, standard costing helps managers identify areas that need attention before they significantly impact profitability. 
• Simplified inventory valuation: Standard costs streamline the valuation of raw materials, work-in-progress, and finished goods inventory, offering an alternative to more complex cost layering systems like FIFO and LIFO. 

Standard costs can be established at different levels depending on your business goals. These include basic standards (long-term benchmarks), ideal standards (perfect operating conditions), attainable standards (efficient but realistic conditions), and current standards (based on existing performance levels). 

How does standard cost accounting work? 

At its core, standard cost accounting creates a financial prediction for production costs (materials, labor, and overhead) before manufacturing begins. These costs are used to benchmark performance.   

The process works through four fundamental steps: 

1. Setting standards – Management establishes target costs for each component of production based on historical data, engineering studies, and market conditions. 

2. Recording at standard – As production occurs, inventory and cost of goods sold are recorded using these predetermined standard costs, not actual costs. 

3. Tracking variances – The differences between standard and actual costs (called variances) are calculated and analyzed to identify inefficiencies or cost savings. 

4. Taking action – Management uses variance analysis to make informed decisions about pricing, production methods, and purchasing strategies. 

This system creates a continuous improvement cycle where standards are periodically reviewed and updated based on actual performance, helping businesses progressively optimize their operations and costs. 

Variables (and variances) in standard costing 

Standard cost accounting relies on several key components that work together to create a comprehensive cost management system.  

Direct materials 

Direct materials represent all raw materials that become part of the finished product. For standard costing purposes, two key variables are established: 

• Standard quantity: The predetermined amount of materials needed to produce one unit 
• Standard price: The expected cost per unit of material 

When actual production occurs, two types of variances may arise: 

• Material price variance: Occurs when you pay more or less than the standard price 
• Material usage variance: Happens when you use more or less than the standard quantity 

For example, if a furniture manufacturer sets standards of 10 board feet of oak at $5 per board foot for a chair, but actually uses 11 board feet at $5.20, both price and usage variances would occur. 

Direct labor 

Direct labor includes wages and benefits for workers directly involved in production. Similar to materials, labor standards include: 

• Standard hours: The predetermined time required to complete one unit 
• Standard rate: The expected hourly wage rate 

Labor variances include: 

• Labor rate variance: Difference between standard and actual wage rates 
• Labor efficiency variance: Difference between standard and actual hours worked 

These variances help identify issues with labor scheduling, training needs, or process inefficiencies. 

Say a winery establishes standard costs for labor where each case of wine should require 0.5 hours of direct labor at a standard rate of $20 per hour. During the harvest season, the winery produced 10,000 cases of wine. The actual labor used was 5,200 hours at an average rate of $21 per hour. 

• The standard labor cost should have been: 
  10,000 cases × 0.5 hours × $20 = $100,000 
• The actual labor cost was: 
  5,200 hours × $21 = $109,200 

This creates two variances: 

• Labor rate variance = (Actual rate – Standard rate) × Actual hours 
  = ($21 – $20) × 5,200 = $5,200 unfavorable 
• Labor efficiency variance = (Actual hours – Standard hours) × Standard rate 
  = (5,200 – 5,000) × $20 = $4,000 unfavorable 

For wineries, these variances are particularly important as labor costs significantly impact the final cost per bottle.

Manufacturing overhead 

Manufacturing overhead encompasses all indirect production costs that can’t be directly traced to specific products. Overhead is typically divided into: 

• Variable overhead: Costs that change with production volume (utilities, supplies) 
• Fixed overhead: Costs that remain constant regardless of production level (rent, depreciation) 

Standard overhead costs are typically applied using predetermined rates based on a cost driver like direct labor hours or machine hours. 

Overhead variances are more complex and may include: 

• Spending variance: Difference between actual and budgeted overhead costs 
• Efficiency variance: Related to how efficiently the cost driver (like labor hours) was used 
• Volume variance: Occurs when actual production differs from the planned level used to set fixed overhead rates 

Understanding variance relationships 

Variances don’t exist in isolation—they often influence each other. For instance, purchasing lower-quality materials (favorable price variance) might lead to more waste (unfavorable usage variance) or more labor hours (unfavorable labor efficiency variance). 

Effective standard costing requires analyzing these relationships to understand the true causes of cost deviations and make informed decisions about process improvements. 

By tracking and analyzing these variables and their variances, businesses gain valuable insights into their operations, enabling more effective cost control and better decision-making. 

Financial statement impacts of standard costing 

Standard costing significantly influences how your financial statements represent business performance. When you implement this system, it affects several key financial elements: 

• Inventory valuation on your balance sheet typically reflects standard costs rather than actual costs incurred. This creates consistency in your inventory reporting but requires decisions about how to handle variances. 
• Cost of goods sold on your income statement incorporates standard costs plus or minus applicable variances. How you allocate these variances can meaningfully impact your reported profitability. 
• Variance accounts in your general ledger track differences between standard and actual costs. These accounts must be analyzed and properly disposed of during each accounting close process. 

While standard costing is an acceptable costing method under Generally Accepted Accounting Principles (GAAP), your implementation should include processes for periodic updates to standards to reasonably approximate actual costs computed under recognized inventory costing methods to maintain compliance. 

Understanding these impacts helps you interpret financial statements more accurately, make informed decisions about inventory and pricing, communicate effectively with stakeholders about cost variances, and maintain compliance with accounting standards. 

7 benefits of standard cost accounting  

Standard cost accounting offers businesses numerous advantages that support financial management and operational efficiency. 

1. Improved cost control stands at the heart of standard costing benefits. By establishing clear benchmarks, companies can quickly identify when actual costs deviate from expectations, allowing for timely corrective actions before small issues become major problems. 

2. Decision-making support becomes more robust as management gains clear visibility into costs. This transparency helps leaders make informed choices about production methods, resource allocation, and business practices based on reliable cost data rather than guesswork. 

3. Performance evaluation becomes more objective when standard costs are in place. Managers can assess how well departments, products, or processes are performing by comparing actual results against predetermined standards, creating accountability throughout the organization. 

4. More accurate budgeting naturally follows from a standard costing system. As managers gain better control over costs and understand cost behaviors, the gap between budgeted and actual costs typically narrows over time. 

5. Simplified inventory valuation represents another significant advantage. Standard costing provides a consistent method for valuing identical products, eliminating the complications that arise when trying to track varying actual costs for identical items. 

6. Standardization of activities helps employees work more efficiently as clear expectations are established for various tasks. This consistency can lead to improved quality and productivity across operations. 

7. Pricing decisions become more strategic with standard costing. With clear insight into production costs, businesses can set appropriate selling prices that balance competitiveness with profitability. 

Does standard costing make sense for your business? 

Standard costing can be a powerful tool for many businesses, but it’s not universally applicable.  

Understanding when and where it’s most effective can help you decide if it’s right for your organization. 

When standard costing makes sense 

Standard costing is typically most beneficial for: 

• Businesses with repetitive manufacturing processes 
• Companies producing homogeneous products in large quantities 
• Organizations with stable production methods and predictable cost structures 
• Industries where direct material and labor costs are significant 

When standard costing doesn’t make sense 

Standard costing may not be suitable for: 

• Businesses operating in volatile environments with frequent fluctuations in material prices, labor rates, or production volumes 
• Companies with long production cycles or slow inventory throughput, as standards can become outdated during extended manufacturing periods 
• Smaller businesses with limited resources, as implementation requires significant skill and ongoing maintenance 

In these situations, alternative costing methods like actual costing might be more appropriate, though transitioning between systems requires careful planning and may necessitate changes to accounting processes and systems.  

Standard cost accounting industry examples 

Here are some ways standard cost accounting can be beneficial across industries.  

Manufacturing: A furniture manufacturer can use standard costing to set expected costs for wood, labor, and overhead for each chair produced. This allows them to quickly identify inefficiencies in production or unexpected price increases in materials. 

Food: A large-scale bakery might implement standard costing for its bread production. By establishing standard costs for flour, yeast, labor, and baking time, they can easily track variances and optimize their processes. 

Wine: Wineries can benefit from standard costing by setting standards for grape costs, bottling materials, labor for harvesting and production, and overhead costs like barrel aging. This helps manage the long production cycles typical in winemaking. 

Build a cost accounting model that works for your business 

Standard cost accounting offers a structured approach to understanding, controlling, and optimizing your business costs. When implemented in the right context, it provides valuable insights that can drive more informed decision-making and improved profitability. 

Remember that standard costing is a tool, not a solution in itself. Its effectiveness depends on how well you implement it, how regularly you update your standards, and how thoughtfully you analyze the resulting variances. 

If you’re considering implementing standard costing or refining your existing cost accounting approach, BPM can help. Our team of accounting professionals can assess your specific situation, recommend the most appropriate costing method, and support you through implementation and beyond. 

Take the first step toward better cost management by contacting BPM today.