When to update standard costs
/In a standard costing system, most companies go through a cost updating process once a year, in order to bring standard costs more closely in alignment with actual costs. However, there are cases where actual costs fluctuate considerably over time, resulting in large positive or negative variances. In these cases, you can either update costs on a more frequent schedule or in response to a triggering event. The options are noted below:
Increased frequency option. From a procedural perspective, it is easy enough to simply schedule a complete review of all costs semi-annually or once a quarter. However, this can result in a great deal of additional staff review time. A best practice for reducing the associated work is to conduct this periodic review only when there has been a cost variance that exceeds a certain threshold, such as a 5% jump in cost since the most recent regularly-scheduled review.
Selective increased frequency option. Select certain types of commodities for an increased review schedule, and leave the majority of items on the usual annual review cycle. If you use the Pareto principle and only update costs for the 20% of the items that make up 80% of total costs, this will keep cost variances down.
Review when trigger activated option. The most granular alternative is to trigger a cost review whenever a specific item experiences a cost variance of at least 5% (or some other figure). However, since short-term events can cause variances of this size, it may be better to only require a cost review when the cost variance continues for several months. If an item does not exceed its variance trigger all year, then review the cost under the normal review procedure at the end of the year.
Of these approaches, a general increase in review frequency is the most expensive, and is similar to applying a shotgun to a task that really requires a laser to engage in very selective cost reviews. Consequently, the second and third options are both more cost effective and more efficient in targeting only those items experiencing significant cost variances.
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Example of When to Update Standard Costs
A manufacturing company produces electronic devices and sets standard costs for materials, labor, and overhead at the beginning of the year. The following events occur during the year:
Material costs change. The price of a key component (e.g., a semiconductor) increases by 20% due to global supply chain disruptions. The current standard material cost no longer reflects the actual cost.
Labor costs change. A new union agreement increases the hourly wage rate for assembly line workers by 15%. This results in higher labor costs compared to the previously established standard.
Production process improvement. The company invests in automation, reducing the time required to assemble each product, which lowers direct labor costs and alters overhead allocation.
When the company should update these standard costs:
Update the standard costs after the semiconductor price increase becomes evident and is likely to persist for the foreseeable future.
Update labor costs as soon as the new wage rate takes effect, to ensure accurate budgeting and analysis.
Update standard costs following the implementation of the automation process to reflect the reduced labor hours and revised overhead distribution.