Definition of Standard Costing
Standard costing is a cost accounting system used by some manufacturers to assist in planning and controlling its manufacturing operations. When standard costing is used, the manufacturer’s general ledger accounts for inventories (materials, work-in-process, finished goods) and the cost of goods sold will contain the standard costs. (Think of the standard costs as the “should be” costs which are tied to the amounts in the company’s profit plan.) Any differences between the actual costs and the standard costs will be recorded in cost variance accounts. For external financial reporting, the variances must be allocated to the inventories and the cost of goods sold.
Definition of GAAP
GAAP is the acronym for the phrase generally accepted accounting principles or US GAAP. GAAP is required for a U.S. company’s external financial statements. One of the basic underlying principles in GAAP is the cost principle. This means that the inventories, the cost of goods sold, and the resulting net income must reflect the manufacturer’s actual historical costs.
Example of Standard Costing and GAAP
Assume that a corporation’s profit plan for the year uses $2 as the cost for every pound for its main raw material. Therefore, its standard costing system uses $2 per pound. Due to shortages, the corporation’s actual cost for the 1,000,000 pounds of materials it purchased was $2.60 per pound. This means the general ledger accounts for its inventories and cost of goods sold contain $2 per pound for the materials and its materials purchase price variance account contains an unfavorable variance of $600,000 [1,000,000 X ($2.60 – $2.00)]. To comply with GAAP’s cost principle, the corporation must allocate the $600,000 to the inventories and cost of goods sold when reporting its financial results. (If the corporation turned over its inventory many times during the year, most of the variance will be allocated to the cost of goods sold, since that is where most of the materials are.)
