STANDARD COSTING

Standard costs are part of cost accounting system whereby standard cost is incorporated directly and formally into the manufacturing accounts. It is divided into two major parts (1) Historical Costs (2) Pre‐determined Costs. Historical cost means the actual cost or past cost and historical costing is a system in which actual costs incurred in the past are determined.  

Standard costing aims at eliminating waste and increasing efficiency in operation through setting up standards for production costs and production performance. In short, standard costing is a control device and not a separate method of product costing. It can be used with any method of product costing, job costing or process costing.

DEFINITION

Standard cost 'The planned unit cost of the product, component or service produced in a period. The standard cost may be determined on a number of bases. The main use of standard costs is in performance measurement, control, stock valuation and in the establishment of selling prices.’ CIMA Official Terminology, 2005.

A standard costing system is a method of cost accounting in which standard costs are used in recording certain transaction and the actual costs are compared with the standard cost to learn the amount and reason for variations from the standard. ‐  W.B. Lawrence

Standard costing involves the preparation of cost based on pre‐ determined standards and continuous comparison of actual with them for the purpose of guidance and control. ‐  D. Joseph

It is a cost accounting technique for cost control where standard costs are determined and compared with actual costs, to initiate corrective action.

·         It is a control method involving the preparation of detailed cost and sales budgets.

·         A management tool used to facilitate management by exception.

OBJECTIVES OF STANDARD COSTING

The objectives of Standard Costing for which it is implemented are:

1.      It helps to implement budgetary control system in operation.

2.      It helps to ascertain performance evaluation.

3.      It supplies the ways to utilise properly material, labour and also overhead which will be economic in character.

4.      It also helps the management to supply necessary data relating to cost element to submit quotations or to fix up the selling price of a firm.

5.      It also helps the management to take various corrective decisions viz., fixation of price, make-or-buy decisions etc. which will be more beneficial to the firm.

TYPES OF STANDARDS

Basically, there are two types of standard:

A.    Current Standard

B.     Basic Standard

      A.    Current Standard:

It is established for the use over a diminutive period of time and is related to current circumstances. Such a standard remains in operation for a limited period and belongs to the current conditions. These standards are revised at regular intervals. Current standard are of three types like

1.      Ideal standards,

2.      Expected standards, and

         3.      Normal standards. 

      1.  Ideal Standards 

Under these standards, upon perfection, attention is focused. The aim of these standards is on absolutely minimum cost which only in perfect operating conditions can be attained. No scraps, idle time, break down & rest period is provided by these standards. These standards become impossible to be attained in the long run. In practice idle standards are rarely attained & have been referred to as theoretical standards. Unfavorable variances are being revealed by the accounts as regular feature where ideal standards are used. As a result of this among the staff members depressing feeling occurs. Idle standards can be used without change or adjustment for a long time. Unless radical changes are being made in the product or in the manufacturing processes, these standards once set are rarely being changed. These standards can also be used in highly mechanized industry as engineering standards.

2. Expected or practical standards: Such standards are likely to be expected or utilized in the future period. Such standards are based on expected performance after making a reasonable allowance for unavoidable losses and other inevitable lapses from perfect efficiency. So it is most generally used standard and is best suited for cost control. This standard can be anticipated as well as attained in future in sync with the specified budget. 

3. Normal Standards: Upon the past averages which are adjusted to anticipate future changes, these standards are based. For relatively longer period covering a trade cycle, the preparation of these standards is done. For the formation of these standards, allowance is given to normal fatigues & breaks, normal mistakes in production, normal waste & scrap & normal machine breakdown & maintenance. The cost performance is represented by theses standards which should normally be attained. Because of the probable errors in the prediction of the extent & duration of the cyclical effects, these standards are very likely attainable but they are very difficult to compute. A standard should not be very high so that frustration is caused but it should be high enough so that reasonably diligent effort needed for its accomplishment can be expected. For long term planning & decision making purpose, the normal standard may be good but their utility is limited in appraisal of efficiency.

   A.    Basic standards:

      This is a standard which is established for use unaltered for an indefinite time. It is similar to an index number against which all results are measured. Variances from basic standards show trends of deviations of the actual cost. However, basic standards are of no practical utility from the point of view of cost control and cost ascertainment. This standard is set on a long‐term basis and seldom revised. It is an underlying standard from which current standard can be developed. 

ESTABLISHING A SYSTEM OF STANDARD COSTING

Ø  Setting up cost centers

Ø  Classification of accounts

Ø  Determination of size of the standard

·   Current

§     Ideal

§     Expected

§     Normal

·   Basic

Ø  Setting up of standard

Ø  Standard cost card

ADVANTAGES OF STANDARD COSTING

1.   More effective cost control is possible under standard costing if the same is reviewed and analyzed at regular intervals for improvements and immediate action can be taken if deviations from standards are found out which, ultimately, leads to cost reduction.

2.   Analysis of variance and its measurement helps to detect inefficiencies and mistakes which enable the management to investigate the reasons.

3.     Since standard costs are predetermined costs they are very useful for planning and budgeting. It also helps to estimate the effect of changes in Cost-Price-Volume relationship which also helps the management for decision-making in future.

4.      Standard Costing serves as a guide to the management in several management functions while formulating prices and production policies etc.

5.   As standard is fixed for each product, its components, materials, process operation etc. it improves the overall production efficiency which also ultimately reduces cost and thereby increases profit.

6.      Once the Standard Costing System is implemented it will lead to saving cost since most of the costing work can be eliminated.

7.      Delegation of authority and responsibility becomes effective by setting up standards for each cost center as the supervisors or executives of each cost center will know the standard which they have to maintain.

DISADVANTAGES OF STANDARD COSTING

1.  Costly System: Because the Standard Costing requires highly skillful and competent personnel, it becomes a costly system too. For the same experts are paid high remuneration.

2.     Difficulties in Fixation of Standard: It is always difficult to determine precise standard costs in a given situation which will coincide with actual cost when operations are over. Standard cost are determined partly by the past experience and partly by the cost projections based on advanced statistical techniques. Thus, uncertainties revolve around standards.

3.  Constraint for Service Industry: Standard costing is applied for planning and controlling manufacturing costs. Thus, it cannot be applied in a service industry.

4.     Consistency of Standard: because the standards of marginal costing fluctuate and vary time to time, it is difficult to always sustain and continue the same standards.  

5.    Unsuitable for Non‐standardized Products: Standard costing is expensive and unsuitable for job manufacturing industries as they manufacture non standardized products such as catering, tailoring, printing, etc.

6.     Relatively Fixed Standards: A business may not be able to keep standards up‐to‐date. In other words, a business may not revise standards to keep pace with the frequent changes in manufacturing conditions. Firms may avoid revising standards as it is a costly affair.

SOLE PROPRIETORSHIP

'Sole' means single and 'proprietorship' means ownership. It means only one person or an individual becomes the owner of the business. Thus, the business organization in which a single person owns, manages and controls all the activities of the business is known as sole proprietorship form of business organization. The individual who owns and runs the sole proprietorship business is called a ‘sole proprietor’ or ‘sole trader’. A sole proprietor pools and organizes the resources in a systematic way and controls the activities with the sole objective of earning profit.

 DEFINITION 

A business enterprise exclusively owned, managed and controlled by a single person with all authority, responsibility and risk.

A sole proprietorship is defined as a business owned by a single person who receives all profits and assumes all risks.

A sole proprietorship is an unincorporated business owned by one individual, making it the simplest form of business to start and operate.

CHARACTERISTICS OF SOLE PROPRIETORSHIP

Sole proprietorship forms of business organizations have the following characteristics.

1.            Single Ownership: A single individual always owns sole proprietorship form of business organization. That individual owns all assets and properties of the business. Consequently, he alone bears all the risk of the business. Thus, the business of the sole proprietor comes to an end at the will of the owner or upon his death.

2.                  No sharing of Profit and Loss: The entire profit arising out of sole proprietor-ship business goes to the sole proprietor. If there is any loss it is also to be borne by the sole proprietor alone. Nobody else shares the profit and loss of the business with the sole proprietor.

3.      One man’s Capital: The capital required by a sole proprietorship form of business organization is totally arranged by the sole proprietor. He provides it either from his personal resources or by borrowing from friends, relatives, banks or other financial institutions.

4.                One-man Control: The controlling power in a sole proprietorship business always remains with the owner. The owner or proprietor alone takes all the decisions to run the business. Of course, he is free to consult anybody as per his liking.

5.            Unlimited Liability: The liability of the sole proprietor is unlimited. This implies that, in case of loss the business assets along with the personal properties of the proprietor shall be used to pay the business liabilities.

6.        Less Legal Formalities: The formation and operation of a sole proprietorship form of business organization requires almost no legal formalities. It also does not require to be registered. However, for the purpose of the business and depending on the nature of the business, the sole proprietorship has to have a seal. He may be required to obtain a license from the local administration or from the health department of the government, whenever necessary.

ADVANTAGES OF SOLE PROPRIETORSHIP

1.      Ownership

The sole owner of a sole proprietorship possesses all of the authority to make decisions on behalf of the company. Full ownership and management control is another advantage of owning a sole proprietorship. Owners are not required to attend formal meetings required of owners and members of other business structures. With a sole proprietorship, the owner can decide to sale or transfer the company to another individual and make important business decisions at his discretion.

2.      Taxation

Another advantage of forming a sole proprietorship is the taxation rules established by the Internal Revenue Service. Sole proprietors are not required to file separate tax returns for their business. Income made from the business is counted as personal income and owners pay taxes according to their individual tax rates. Sole proprietors must pay Social Security and Medicare taxes as well. The tax rules regarding sole proprietorship's allow owners to avoid the double taxation of corporations.

3.      Changing Business Structures

If your business grows to a place that the business structure of a sole proprietorship no longer works to your advantage, you can easily change your business structure to a more complex model. The only requirement for going from a sole proprietorship to another business structure is filling out the paperwork for your new business structure. You are not required to fill out paperwork with a regulatory body because sole proprietorship's are not governed by regulatory bodies.

4.      Distribution of Profits

Sole proprietors are the sole owners of their businesses and do not split profits with other owners. One hundred percent profit retention allows sole proprietors to use the money at their discretion. You can choose to reinvest the money back into the business to expand the company, start another business or use it for personal reasons.

5        Employment: Sole proprietorship's can hire employees. This can lead to many of the benefits associated with job creation, such as tax breaks. Also, spouses of the business owner can be employed without having to be formally declared as an employee. Married couples can also start a sole proprietorship, though liability can only assumed by one individual.

DISADVANTAGES OF SOLE PROPRIETORSHIP

1.                  Limited Capital: In sole proprietorship business, it is the owner who arranges the required capital of the business. It is often difficult for a single individual to raise a huge amount of capital. The owner’s own funds as well as borrowed funds sometimes become insufficient to meet the requirement of the business for its growth and expansion.

2.           Unlimited Liability: In case the sole proprietor fails to pay the business obligations and debts arising out of business activities, his personal properties may have to be used to meet those liabilities. This restricts the sole proprietor from taking risks and he thinks cautiously while deciding to start or expand the business activities.

3.                Lack of Continuity: The existence of sole proprietorship business is linked to the life of the proprietor. Illness, death or insolvency of the owner brings an end to the business. The continuity of business operation is therefore uncertain.

4.             Limited Size: In sole proprietorship form of business organization there is a limit beyond which it becomes difficult to expand its activities. It is not always possible for a single person to supervise and manage the affairs of the business if it grows beyond a certain limit.

5.           Lack of Managerial Expertise: A sole proprietor may not be an expert in every aspect of management. He/she may be an expert in administration, planning, etc., but may be poor in marketing. Again, because of limited financial resources it is also not possible to employ a professional manager. Thus, the business lacks benefits of professional management.

PARTNERSHIP

A partnership is a form of business organization in which owners have unlimited personal liability for the actions of the business, though this problem can be mitigated through the use of a limited liability partnership. The owners of a partnership have invested their own funds and time in the business, and share proportionally in any profits earned by it. There may also be limited partners in the business, who contribute funds but do not take part in day-to-day operations. A limited partner is only liable for the amount of funds he or she invested in the business; once those funds are paid out, the limited partner has no additional liability in relation to the activities of the partnership.

DEFINITION:

 A legal form of business operation between two or more individuals who share management and profits. The federal government recognizes several types of partnerships. The two most common are general and limited partnerships. 

A partnership is a form of business where two or more people share ownership, as well as the responsibility for managing the company and the income or losses the business generates.

A business owned by two or more people who agree on the method of distribution of profits and/or losses and on the extent to which each will be liable for the debts of one another.

FEATURES OF PARTNERSHIP

1.      Existence of business:

The objective of partnership must be to do some type of business. Business here means any activity leading to earn profit persons joining together and agreed to do charitable work or for formation of any club for entertainment would not be treated as partnership due to absence of the business. Even agreement of taking up any business activity in future shall not be treated as partnership fill the formation of business.

2.      Numbers of persons:

There must be at least two or more persons to form a partnership firm. As per Indian partnership Act, the minimum number of person required is to buy it does not prescribe the maximum limit for the purpose.

3.      Contractual relationship:

There should be a contractual relationship between the persons forming partnership. Persons competent to contract can be partners. They have to mutually agree and jointly decide to go for any business activity as per agreed terms and conditions. This may be either written or oral form among the partners.

4.      Sharing of Profits:

Business is carried on to share profit and not to incur losses. The profits generated by the firm are to share among the partners on an agreeable proportion. Loss it any has also to be borne by them on that ratio.

5.      Agency:

Partnership contract is based on principle of agency. Each partner is an agent of other partners. The business is carried on by all or any one of them acting on behalf of all other partners.

6.      Utmost good faith:

The partners should have utmost good faith in each other. They should be just and honest. They should present true accounts and must disclose true information to one another.

7.      Unlimited liability:

Like sole proprietorship, every partner has an unlimited liability in respect of debts of the firm. If the property or the assets of the firm are insufficient to meet the claims of the creditors, the private property of the partners can be attached to meet the claims of the creditors.

8.      Restriction on transfer of ownership:

A partner cannot transfer his share in business to an outsider without the consent of all other partners. This is because the partnership agreement is based on contract among individuals.

9.      Capital contribution:

Each partner contributes his share in the capital of the partnership firm. The capital contribution need not be equal or in any particular proportion. It must be as per the agreement each partner is behind to contribute that amount. A partner may be admitted to partnership without any capital contribution.

10.  Duration of the partnership:

The existence of the partnership firm continues at the pleasure of the partners. Legally of partnership comes to an end, if any partner dies or becomes insolvent or retries. The remaining partners may agree to continue the business under the original firm’s name after settling the claims of the outgoing partner.

TYPES OF PARTNERSHIP

There are three relatively common types of partnership which are general partnership (GP), limited partnership (LP) and limited liability partnership (LLP). 

GENERAL PARTNERSHIP

A general partnership is a partnership with only general partners. Each general partner takes part in the management of the business and also takes responsibility for the liabilities of the business. If one partner is sued, all partners are held liable. General partnerships are the least desirable for this reason.

LIMITED PARTNERSHIPS (LP)

In a limited partnership, a general partner may collaborate with a limited partner. A limited partner has no managerial authority, nor in most situations would they earn equal returns. However, the limited partner is protected by limited liability in legal situations regarding debt or other costs that may impact the general partner's personal assets. Along similar lines, limited partners are not considered agents of the organization from a legal perspective. It is also important to understand that this is not the same as a limited liability partnership (LLP), in which all partners have limited liability.

LIMITED LIABILITY PARTNERSHIP (LLP)

The limited liability company has supplanted the general partnership and the limited partnership, because of the limits of liability. But there are still cases in professional practices in which some partners want to be limited in scope of duties and they just want to invest, having the liability protection.

ADVANTAGES OF PARTNERSHIP

Partnership form of business organisation has certain advantages, which are as follows –

1.      Easy to form:

Like sole proprietorship, the partnership business can be formed easily without any legal formalities. It is not necessary to get the firm registered. A simple agreement, either oral or in writing, is sufficient to create a partnership firm.

2.    Availability of large resources - Since two or more partners join hand to start partnership business it may be possible to pool more resources as compared to sole proprietorship. The partners can contribute more capital, more effort and also more time for the business.

3.    Better decisions - The partners are the owners of the business. Each of them has equal right to participate in the management of the business. In case of any conflict they can sit together to solve the problems. Since all partners participate in decision-making, there is less scope for reckless and hasty decisions.

4.     Flexibility in operations - The partnership firm is a flexible organisation. At any time the partners can decide to change the size or nature of business or area of its operation. There is no need to follow any legal procedure. Only the consent of all the partners is required.

5.   Protection of interest of each partner - In a partnership firm every partner has an equal say in decision making. If any decision goes against the interest of any partner he can prevent the decision from being taken. In extreme cases a dissenting partner may withdraw himself from the business and can dissolve it.

DISADVANTAGES OF PARTNERSHIP

Inspite of all these advantages, the following are certain limitations.  

1.      Unlimited Liability:

All the partners are jointly as well as separately liable for the debt of the firm to an unlimited extent. Thus, they can share the liability among themselves or any one can be asked to pay all the debts even from his personal properties.

2.     Uncertain Life: The partnership firm has no legal entity separate from its partners. It comes to an end with the death, insolvency, incapacity or the retirement of any partner. Further, any dissenting member can also give notice at any time for dissolution of partnership.

3.  Lack of Harmony: You know that in partnership firm every partner has an equal right to participate in the management. Also every partner can place his or her opinion or viewpoint before the management regarding any matter at any time. Because of this sometimes there is a possibility of friction and quarrel among the partners. Difference of opinion may lead to closure of the business on many occasions.

4.      Limited Capital: Since the total number of partners cannot exceed 20, the capital to be raised is always limited. It may not be possible to start a very large business in partnership form.

5.    No transferability of share: If you are a partner in any firm you cannot transfer your share of interest to outsiders without the consent of other partners. This creates inconvenience for the partner who wants to leave the firm or sell part of his share to others.