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What is standard costing?

Standard costing is an accounting technique that some manufacturers use to identify the differences or variances between 1) the actual costs of the goods that were produced, and 2) the costs that should have occurred for those goods. The costs that should have occurred for the actual good output are known as standard costs.

Standard costing is likely integrated with a manufacturer's budgets (profit plan, master budget) for an accounting year and involve the product costs: direct materials, direct labor, and manufacturing overhead. With standard costing, the accounts for inventories and the cost of goods sold contain the standard costs of the inputs that should have been used to make the actual good output.

If the company had incurred more than the standard costs for the direct materials, direct labor, and manufacturing overhead, the company will not meet its projected net income. In other words, the variances will direct management's attention to the production inefficiencies or higher input costs. In turn, management can take action to correct the problems or seek higher selling prices.

Since the external financial statements must reflect the historical cost principle, the standard costs in the inventories and the cost of goods sold will need to be adjusted for the variances. Since most of the goods manufactured will have been sold, most of the variances will be reported on the income statement as part of the cost of goods sold.