Standard costing and activity-based costing (ABC) are two widely used cost accounting methods in business organisations. While both methods are designed to help businesses determine their costs of products and services, they differ in their approaches to cost measurement and allocation. This article will briefly explore the differences between standard costing and ABC, including their strengths and weaknesses, and provide a comparison of the two methods.
Standard Costing
Standard costing is a cost accounting method that uses predetermined, standard costs to calculate the cost of goods sold (COGS). The predetermined standard costs are based on the cost of materials, labour, and overheads required to manufacture a unit of a product. The standard costs are normally set based on historical data but can also take into account forecasted/budgeted data and are updated periodically to reflect changes in the cost of inputs or production processes.
The use of standard costs allows businesses to compare actual costs to expected costs, identify variances, and take corrective action. By comparing actual costs to standard costs, managers can identify the causes of cost variances, such as inefficiencies in production processes or changes in the cost of inputs. They can then take corrective action to improve efficiency, reduce waste, lower costs, and alter production and sales volume and mix.
Strengths of Standard Costing:
- Standard costing is simple to implement and easy to understand, making it a popular choice for small and medium-sized businesses.
- It provides a clear benchmark for measuring performance and identifying cost variances.
- It enables businesses to make accurate cost estimates, which helps with pricing decisions and budgeting.
Weaknesses of Standard Costing:
- Standard costing assumes that production costs are constant over a range of production volumes, which may not always be the case.
- Standard costing relies largely on historical data, which may not reflect current market conditions or changes in production processes.
- It may encourage managers to focus solely on cost reduction, rather than on improving the quality or value of products and services.
Activity-Based Costing (ABC):
Activity-based costing (ABC) is a cost accounting method that allocates costs to products or services based on the activities required to produce them. Unlike standard costing, which uses a single predetermined cost for each product, ABC considers the costs of all the activities required to manufacture a product or provide a service.
ABC identifies the activities required to produce a product or provide a service, assigns a cost to each activity, and then allocates those costs to the products or services based on their consumption of the activities. For example, the cost of setting up a production line is allocated to each product based on the number of times the production line is set up to produce that product.
Strengths of ABC:
- ABC provides a more accurate picture of the cost of each product or service, as it considers all the activities required to produce them.
- It enables businesses to identify the cost drivers that are responsible for most of the costs and to focus on reducing those costs.
- It helps businesses to make more informed decisions about pricing, product mix, and outsourcing.
Weaknesses of ABC:
- ABC can be complex and time-consuming to implement, and as such might require some investment of resources.
- It requires detailed information about the activities required to produce each product or service, which may not always be available.
- ABC may not be suitable for businesses that produce a large number of products or services with similar production processes and cost structures.
Comparison of Standard Costing and ABC:
Standard costing and ABC are both useful cost accounting methods, but they differ in their approach to cost measurement and allocation. Standard costing uses a predetermined cost per unit of a product, while ABC considers the costs of all the activities required to produce that product. The main differences between the two methods are summarised below:
- Cost allocation: Standard costing allocates costs to products based on a single predetermined cost per unit, while ABC allocates costs based on the consumption of the activities required to produce the product.
- Cost accuracy: ABC provides a more accurate picture of the cost of each product or service, as it takes into account all the activities required to produce them, while standard costing may not always reflect the full actual cost of production.
- Focus: Standard costing focuses on cost reduction, while ABC focuses on identifying and reducing the cost drivers that are responsible for the majority of the costs.
- Complexity: Standard costing is simpler to implement and easier to understand than ABC, which can be complex and time-consuming to implement.
In conclusion, both standard costing and ABC are valuable cost accounting methods that can help businesses understand their costs and make informed decisions. Which method a business should choose depends on its size, complexity, and goals. Small and medium-sized businesses may find standard costing to be sufficient, while larger and more complex businesses may benefit from the detailed analysis provided by ABC. Ultimately, the choice between the two methods should be based on the needs and objectives of the business at hand.
Using standard costing as a base for P&L analytics, managers can compare actual costs to standard costs and identify areas where cost variances are occurring. This information can help managers to make adjustments to their production processes, pricing strategies, and cost control measures to improve profitability. For example, if actual costs are consistently higher than standard costs, managers may need to review their production processes to identify inefficiencies.
Similarly, ABC can be used as a base for P&L analytics to provide a more detailed picture of the costs associated with producing goods and services. By identifying the cost drivers for each product or service, managers can allocate costs more accurately and make better decisions about pricing, production volumes, and product mix. For example, if the cost of a particular activity is driving up the cost of producing a product, managers can consider reducing the activity or finding a more cost-effective way to perform it.
Using standard costing and ABC as a base for P&L analytics can provide significant insights into a company’s costs and profitability. By knowing the true cost of producing goods and services, managers can make knowledgeable decisions and alter strategies about pricing, production, cost control and to drive growth.
We hope you enjoyed this brief article.
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“We hope you enjoyed this brief article.
Head over to the Service offerings of VERANCE to see how we can assist your business on this topic and lots more”
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