What Is Standard Overhead Cost?

An in-depth look at the concept of standard overhead cost, its components, historical context, formulas, examples, and significance in business operations.

The term Standard Overhead Cost refers to a pre-determined cost associated with the fixed and/or variable overhead of an operation. This cost is derived from the standard time allocated for performing an operation or producing a product and the standard overhead absorption rate per unit of time.

Historical Context

The concept of standard costing originated in the early 20th century as a part of scientific management techniques pioneered by Frederick Winslow Taylor. It was designed to increase efficiency and improve cost control in manufacturing and production processes.

Types of Overhead Costs

Fixed Overhead Costs

Fixed overhead costs remain constant regardless of the level of production or business activity. Examples include rent, salaries of permanent staff, and depreciation of machinery.

Variable Overhead Costs

Variable overhead costs fluctuate with the level of production or business activity. Examples include indirect materials, utilities, and production supplies.

Key Events

• 1900s: Introduction of standard costing by Frederick Winslow Taylor.
• 1910s: Adoption of standard costing in large manufacturing firms.
• 1950s: Evolution of cost accounting techniques post-WWII.
• 2000s: Integration of standard costing in modern ERP systems.

Detailed Explanations

Standard Overhead Cost Formulation

The standard overhead cost can be formulated as:

$$ \text{Standard Overhead Cost} = \text{Standard Time} \times \text{Standard Overhead Absorption Rate} $$

• Standard Time: The estimated time to complete a production process.
• Standard Overhead Absorption Rate: The predetermined overhead cost allocated per unit of time.

Applicability in Business

Standard overhead costs are crucial for:

• Budgeting: Helps in setting cost targets and budgets.
• Cost Control: Aids in identifying variances between actual and standard costs.
• Pricing: Assists in setting product prices by understanding the cost structure.
• Performance Measurement: Helps in evaluating operational efficiency.

Charts and Diagrams

    graph TD
	A[Overhead Costs]
	A --> B[Fixed Overhead]
	A --> C[Variable Overhead]
	B --> D[Rent]
	B --> E[Salaries]
	B --> F[Depreciation]
	C --> G[Indirect Materials]
	C --> H[Utilities]
	C --> I[Production Supplies]

Importance

• Enhanced Cost Control: By comparing actual costs to standard costs, businesses can identify inefficiencies.
• Accurate Budgeting: Provides a solid foundation for preparing budgets.
• Pricing Decisions: Ensures that all costs are considered in pricing products.

Examples

Example 1: Manufacturing Operation

If the standard time to produce a unit is 2 hours, and the standard overhead absorption rate is $5 per hour:

$$ \text{Standard Overhead Cost} = 2 \, \text{hours} \times \$5/\text{hour} = \$10 $$

Example 2: Service Industry

For a service that takes 3 hours with an overhead absorption rate of $8 per hour:

$$ \text{Standard Overhead Cost} = 3 \, \text{hours} \times \$8/\text{hour} = \$24 $$

Considerations

• Inflation: Adjust standard costs periodically to account for inflation.
• Technological Changes: Update standard times and rates with technological advancements.
• Market Conditions: Be responsive to changes in the market that might affect overhead costs.

Related Terms

• Standard Costing: A cost accounting method that uses standard costs for performance measurement.
• Overhead Absorption Rate: The rate at which overhead costs are allocated to products or services.

Comparisons

Standard Overhead Cost vs. Actual Overhead Cost

• Standard Overhead Cost: Predetermined and used for planning and control.
• Actual Overhead Cost: Incurred during actual production and used for variance analysis.

Interesting Facts

• First Use: The concept was first utilized by large manufacturing companies in the early 1900s.
• Global Adoption: Now a standard practice in accounting systems worldwide.

Inspirational Stories

Companies that effectively use standard overhead cost models, like Toyota and Ford, have achieved substantial cost savings and operational efficiencies.

Famous Quotes

• “Cost accounting is enemy number one of productivity.” – Eliyahu M. Goldratt

Proverbs and Clichés

• “A penny saved is a penny earned.”
• “Failing to plan is planning to fail.”

Expressions, Jargon, and Slang

• Absorption costing: Incorporating all fixed and variable costs in product costing.
• Variance analysis: The process of investigating the difference between standard and actual costs.

FAQs

What is a standard overhead cost?

A predetermined cost associated with the fixed and/or variable overhead of an operation or product.

How is it calculated?

By multiplying the standard time by the standard overhead absorption rate.

Why is it important?

It helps in budgeting, cost control, pricing, and performance measurement.

What are the types of overhead costs?

Fixed overhead costs (e.g., rent, salaries) and variable overhead costs (e.g., indirect materials, utilities).

References

1. Taylor, Frederick W. The Principles of Scientific Management. Harper & Brothers, 1911.
2. Drury, Colin. Management and Cost Accounting. Cengage Learning, 2015.
3. Horngren, Charles T., et al. Cost Accounting: A Managerial Emphasis. Pearson, 2018.

Summary

Standard overhead cost is a fundamental concept in cost accounting, enabling businesses to manage costs effectively and make informed financial decisions. It involves understanding fixed and variable costs, calculating standard rates, and applying these in budgeting and pricing strategies. By leveraging standard overhead costs, companies can achieve greater operational efficiency and financial accuracy.