Standard costing is one of the recognized methods that entities adopt to implement cost control and cost management. It involves establishing ‘standards’ i.e., benchmarks of standard quantity or cost of inputs applied in the production process or provision of services. Actual quantities utilized or costs incurred are then compared with these standards in a process termed as ‘variance analysis’. The differences noted in the variance analysis are analyzed for their causes and further corrective actions are taken. In order that a meaningful variance analysis is carried out, it is important that standards are set appropriately and meaningfully.
The article “ideal vs practical standards” looks at meaning of and differences between two types of standards that can be set by management – ideal standards and practical standards.
Definitions and meanings
Ideal standards are the standards which are set by assuming best-case working conditions. Ideal standards do not consider any wastage that may occur in the production process due to machinery breakdowns, employee strikes, employee unproductivity, material shortages etc. When ideal standards are set, it is assumed that all systems work at 100% efficiency i.e., machines never malfunction, employees work at highest productivity and material supply disruptions never take place.
Ideal standards can have aspirational value for the management and employees as they serve as a high benchmark to work harder towards to achieve them.
Achieving ideal standards for an entity is considered to be difficult and in fact impractical as it requires a set of perfect employees, perfect machines and perfect supply chain. Further, they may also demotivate employee due to constant comparison of their work with over-optimistic and practically unachievable targets.
When ideal standards are applied in standard costing, the variance analysis is likely to show very high variance figures which can make it difficult to assess the real causes of cost overruns. Thus, ideal standards are not as conducive for ‘management by exception’ and are therefore less frequently used as benchmark by entities.
Practical standards are the standards that are set for normal working conditions. They account for reasonable and unavoidable wastages that are part and parcel of the normal production process.
Practical standards consider the impact that factors such as machine maintenance and upkeep time, normal employee breaks etc. can have on production volume and its cost. Thus, these standards are kept at ambitious yet attainable levels.
Practical standards can be achieved when the business and its employees function efficiently. These standards set an achievable goal towards which employees can work and, thus, they act as a motivation tool for employees.
When practical standards are considered in standard costing, the resulting variance analysis reflects the fair amount of variances to which management attention can be drawn. This makes variance analysis more feasible and meaningful. This also makes the application of practical standards conducive for inventory planning.
Difference between ideal and practical standards:
The eight key points of difference between ideal and practical standards have been detailed below:
- Ideal standards are those benchmarks that are set assuming perfect working conditions and without accounting for any possibility of wastages or inefficiencies.
- Practical standards are those benchmarks that are set assuming normal working conditions after factoring in expected wastages/reasonable working efficiency.
2. Consideration for inefficiencies
- Ideal standards do not factor in even normal wastages/inefficiencies such as normal material wastages, expected machine downtime, reasonable rest or break time for employees etc.
- Practical standards are set after considering normal wastages or inefficiencies that are reasonably expected to occur.
3. Assumptions while setting the standards
- Ideal standards assume 100% efficient and perfect working conditions.
- Practical standards assume reasonably efficient working conditions.
4. Achievement of set standards
- Ideal standards are practically unattainable as they require operation of perfect working conditions which do not tend to exist in real business practices.
- Practical standards are strict yet attainable as they are set considering efficient working conditions. They can thus be achieved when processes and employees function efficiently without abnormal roadblocks.
5. Variance level and decision making
- The variances resulting from application of ideal standards tend to be wide. Identifying variances occurring due to normal and abnormal inefficiencies becomes difficult making ideal standards not conducive to efficient variance analysis.
- Variances resulting from application of practical standards reveal abnormal inefficiencies. These variances can thus be analyzed for causes and can be subject to ‘management by exception’.
- Ideal standards are not commonly used for standard costing and performance evaluation.
- Practical standards are more frequently used by management for cost control and cost management.
- Ideal standards provide a benchmark of ‘ideal performance level’ which has aspirational value for the business and its employees.
- Practical standards serve as a motivation tool for employees. These standards are also suitable for meaningful variance analysis and can effectively lead to corrective measures.
- Ideal standards can be counter productive. They may prove to be demotivating for employees as they tend to be practically unattainable.
- Practical standards may not provide sufficient push to the employees to work harder to achieve better results.
Conclusion – ideal vs practical standards
The primary goal of setting of standards is to facilitate cost management and cost control. The standards set and compared to actual performance levels must thus be appropriate. Inappropriate setting of standards, either too high or too low, can lead to erroneous comparisons diluting the impact of cost control measures.
Practical standards are expected to be a balance of both attainability as well as reasonable rigidity to motivate efficient performance. Furthermore, truly and real adverse variances can be dealt with when practical standards are considered which makes these standards a popular choice for management.
Ideal standards, however, may be used for different purposes. The management may set ideal standards as a high-level benchmark to push employees to work harder to ultimately boost overall efficiency in the entity. The results that are actually achieved can then be compared against practical standards to discover the efficiencies or inefficiencies/shortcomings.