The Ledger

Should Standard Costing Be Used for Decision Support?

Most manufacturing organizations use standard costing as the default mechanism to cost their products, inventory and estimate the cost of manufacturing activities at each step of completion.

This isn’t news or a surprise to anyone. Organizations began using standard costing in the 1920s – and not much has changed since then. Because most companies already use standard costing, new competitors must also use it to help analysts make apples-to-apples comparisons.

However, what this means and how this costing method impacts an organization’s overall profitability and optimization should be considered.

Let’s break that down a little further:

1. Using standard costs, the organization spends several months gathering inputs for things like raw material prices, labor rates, machine and labor productivity, department spending, etc.
2. The cost accountants determine how to allocate overhead costs across departments and product groups.
3. At the end of the process, the cost accounting team rolls the cost from raw materials through work in process, and then, finally, through finished goods.

As the final step, business stakeholders receive a summary of the costs per product for the next year when performing calculations in decision-making.

What we need to be aware of is that the moment a standard cost is produced, it is out of date – and understanding the relationships between all of the inputs, processes, and calculations is nearly impossible.

Even more, the standard cost activity and cost rates are all determined using a singular scenario for production and sales volumes. The moment any of the following shifts, the standard cost’s accuracy is in serious trouble:

1. Labor rates
2. Production/sales volumes
3. Production yields
4. Labor/machine efficiency
5. Product mix
6. Product raw material input and skin board packaging prices
7. Shipping costs
8. Contract manufacturing rates

Should standard costing be used for decision support?

So, if these costs are changing, and your standard cost isn’t, should you still use it for decision-making? Can you really wait until the next budget cycle when the standard cost is updated again to get an updated cost of producing and selling your products? And how is this all affected at a time in increasingly competitive and volatile economic conditions?

How should standard costing be used in a business?

The above may not be a true revelation or “ah-ha” moment for product costing teams; “Yeah, we know this stuff already,”…“It’s the only tool we’ve got. What else should we do?”…sound familiar?

There is a two-part answer to solving the standard cost problem for manufacturing organizations:

1. First, a business does need a standard cost; something in place to value inventory movements throughout the production environment. The standard cost can’t be $0 – so, instead, use a relatively simple process to create a standard cost. All inputs can be $1 or $.01, so long as everything has a value in the ERP system.
2. The second part of the solution is that organizations need to recognize the limitations of working through an ERP system that is not purpose-built for a specific organization or industry and takes a long time to produce outputs of little value. Instead of working through the ERP system, organizations should work around the ERP System to get better results.

What should organizations do instead of using standard costs for decision-making?

Let’s talk about how best-in-class organizations are arriving at their true cost to manufacture their product – thus understanding product/customer profitability and optimizing decision-making.

We all know there are many things an ERP system does well: it captures transactions from receiving, consuming, inventorying, and issuing goods for shipment. The ERP captures data from business processes – that is what it should be used for.

The second part of the solution is identifying and implementing a product costing software that integrates with your ERP and other business systems that house crucial data related to product costing and customer profitability.

With specialized product costing software, one advantage is that the same standard costing process can be replicated with even more flexibility; adjustments to actuals are able to be incorprated into the costing model in real-time. Even more, each step of the standard costing process can be seen, understood, and explained – so your team will know where costs and inefficiencies accumulate across the business.

Additionally, with specialized product costing software, you can update all or some of your product cost estimates at any time (And yes, they have write-back capabilities to the ERP). Perhaps the best part of this setup is that an organization can even create multiple product cost estimates for various scenarios.

Leveraging the appropriate tools to calculate the actual, standard, forecasted, and simulated costs of products accounts for the real variables and drivers that exist in an organization. With this improved systems setup in place, your organization can finally get the product costing insights needed for intelligent decision-making and a process to help your organization thrive instead of just trying to survive when seeking to maximize product profitability.

Conclusion

For organizations that wants to leverage their understanding and insights into product profitability as a competitive advantage, there has never been a better time to make a change and adopt the right tools to facilitate this transition. For too long, organizations and product costing teams have had to make do with rusty ERPs and out-of-the-box standard costing processes. However, the technology is finally ready for organizations who understand that product cost clarity is and should be a critical competitive advantage.

Investing in the right tools to fully (and finally) grasp each element of product cost and profitability is a strategic move that pays dividends. Because, remember, your competitors probably haven’t figured out how to solve this problem yet, either. = )