Control over costs is best affected through action at the point where the costs are incurred. Hence the standards should be set for the quantities of material, labour and services to be consumed in performing an operation, rather than the complete product cost standards. Variances from these standards should be reported to show causes and responsibilities for deviations from standard. Product cost standards are derived by listing and adding the standard costs of operations required to produce a particular product.  Let us now consider how standards are established for each operation for direct materials, direct labour and overheads using the engineering studies approach. Note that the standard cost for each operation is derived from multiplying the quantity of input that should be used per unit of output by the amount that should be paid for each unit of input.

Direct material standards

These are based on product specifications derived from an intensive study of the input quantity necessary for each operation. This study should establish the most suitable materials for each product, based on product design and quality policy, and also the optimal quantity that should be used after taking into account any wastage or loss that is considered inevitable in the production process. Material quantity standards are usually recorded on a bill of materials. This describes and states the required quantity of materials for each operation to complete the product. A separate bill of materials is maintained for each product. The standard material product cost is then found by multiplying the standard quantities by the appropriate standard prices. The standard prices are obtained from the purchasing department. The standard material prices are based on the assumption that the purchasing department has carried out a suitable search of alternative suppliers and has selected suppliers who can provide the required quantity of sound quality materials at the most competitive price. Normally, price standards take into account the advantages to be obtained by determining the most economical order quantity and quantity discounts, best method of delivery and the most favorable credit terms.

Direct labour standards

To set labour standards, activities should be analyzed by the different operations. Each operation is studied and an allowed time computed, usually after carrying out a time and motion study. The normal procedure for such a study is to analyze each operation to eliminate any unnecessary elements and to determine the most efficient production method. The most efficient methods of production, equipment and operating conditions are then standardized. This is followed by time measurements that are made to determine the number of standard hours required by an average worker to complete the job.

Overhead standards

Separate rates for fixed and variable overheads are essential for planning and control. Normally the standard overhead rate will be based on a rate per direct labour hour or machine hour of input. Fixed overheads are largely independent of changes in activity, and remain constant over wide ranges of activity in the short term. It is therefore inappropriate for short-term cost control purposes to unitize fixed overheads to derive a fixed overhead rate per unit of activity. However, in order to meet the external financial reporting stock valuation requirements, fixed manufacturing overheads must be traced to products. It is therefore necessary to unitize fixed overheads for stock valuation purposes.

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