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Revisiting Standard Cost Rate Development to Boost Competitive Edge

Published August 17 2022
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With increased global competition and pressures on profitability, proactively managing cost structures has become a must for manufacturers, particularly in the current times of high inflation. Therefore, manufacturers need a solution to help develop useful rates for labor and overhead standards to be used as input into standard product costs and inventory valuation - and be able to do so in rapid response to changing conditions.

However, despite investments in Enterprise Resource Planning (ERP) solutions, it is often an offline Excel-based exercise that is undertaken to update direct labor and overhead rates that feed product standard costs. This process is frequently manual, not auditable, and error prone. Because it is so time consuming, it is often only accomplished annually.

Seven Reasons Why Standard Cost Development Matters

Standard costing was born out of the need to properly manage and value inventory of products inclusive of the major costs of production:  direct labor, direct material, and indirect expenses (commonly referred to as overhead). Here are the top seven reasons why it matters in today’s market.

  1. Decision making and control
    • Labor and Overhead rates have a large financial impact on product costing and profitability measurement. Accurate and timely costs impact decision making.
  2. Variance analysis – Measurement and Accountability
    • Price/Volume/Mix variances between actual and standard are important insights into business performance.
  3. Timely updates of standards to keep close to actual
    • The time required to create standards often does not allow for rates to be adjusted more often than annually.
    • Avoidance of unforeseen P/L impacts can be achieved when variances from actual are mitigated through the ability to quickly update standards.
  4. Flexibility in methods to achieve accuracy
    • Leveraging operational drivers to allocate overhead centers to direct centers is necessary to maximize the accuracy of standards.
  5. Efficiency
    • Prevailing processes to create standards consume resources full-time and are time consuming and inefficient.
  6. Documentation, Visibility and Accuracy
    • How standards are produced often needs to be more widely understood.
    • Understanding the details behind standard rates is important for transparency and control
  7. Downstream Decisions
    • These rates drive the current year cost of production for cost of goods sold and inventory valuation. Enhancements in their development means improved official reported results.

The Layers of Standard Cost

Standard Cost of Product Inventory is composed of four layers: Direct Labor, Direct Overhead, Indirect Overhead, and Material.

  • Direct Labor is the cost of production resources charged at their standard wage rates.layers of standard cost
  • Direct Overhead represents the costs of direct labor resources beyond their direct hourly wage rate. This amount includes payroll taxes, retirement and health care benefits, worker's compensation, life insurance and other fringe benefits.
  • Indirect Overhead refers to a group of costs that are related to the sustainment of the manufacturing process, but that are not directly consumed or incurred with each unit of production.
    • Examples include Material handling, Equipment Set-up, Inspection and Quality Assurance, Production Equipment Maintenance and Repair, Utilities, and/or Factory Management Team.
    • Other fixed and allocated costs that are incurred onsite or from corporate are considered SG&A and are not part of the standard cost.
  • Material is cost of purchased production material from external sources.

Five-step Process to Calculate Standard Cost Rates

In general, the process to calculate labor and overhead cost rates is as follows:

  1. Identify which cost centers/accounts are considered applicable and to which category they belong: Direct Labor, Direct Overhead, Indirect Overhead.
  2. Identify applicable drivers by cost pool for allocating to production work centers: Labor Hours, Machine Hours, Headcount, Square Footage, Counts, Splits, Percentages, etc. Pool the costs based on their drivers.
  3. Allocate the Budgeted pooled costs to Production Work Centers based on budget driver values.
  4. Summarize the allocated costs by categories of Direct, Direct Overhead and Indirect Overhead.
  5. Divide the Direct/Direct Overhead/Indirect Overhead costs by Work Center by Direct Labor Hours or Machine Hours. These are the applicable Cost Rates for upload to the ERP.

The overall flow is as follows:

flow to calculate standard cost rates

A Better Solution: The Alithya Fixed Price PCMCS Solution for Manufacturers

Alithya’s Profitability and Cost Management-Cloud Service (PCMCS) solution for Manufacturers fulfills multiple needs in costing and profitability.

PCMCS provides a unique opportunity for manufacturers to ease, streamline and document the process of generating the cost-per-direct labor hour or cost-per-machine-hour rates that are requisite in standard costing. The solution is a fixed scope, fixed price PCMCS-based starter kit. It enables manufacturers to ease, streamline and document the process of generating the direct labor, direct overhead, and indirect overhead cost-per-direct labor hour or cost-per-machine-hour rates.

The solution enables accuracy by allowing users to quickly select the cost centers and work centers that are applicable as sources and targets of allocation, as well as the drivers to be employed. It improves efficiency and timeliness of the standard rate process for automation, documentation, and control, and automates the rate development process enabling more frequent updates, more accurate standard costs, and reduced variances.

PCMCS also provides standard visualizations for analysis and enables end-users to create/maintain reports for decision support. The Standard Rates are based on budgeted dollars and budgeted direct labor or machine hours and are generated by work center.

Who are the Ideal Manufacturers for PCMCS?

The PCMCS for Manufacturers offering from Alithya is well suited in the following situations:

  • Organizations whose ERPs either do not have or have not been configured to use standard rate creation capability.
  • Where there is a diversity of underlying systems such as multiple ERPs or non-ERPs.
  • Where there are only limited resources to manage this process.
  • Manufacturers with a high ratio of Overhead to Direct Cost.
    • For example, an overhead rate of $100+ per hour where the direct labor rate is $25 per hour suggests a high amount of overhead, and a benefit from using drivers other than volume.
  • Mid-Market Manufacturers

Beyond Standard Costing – Migration to Other Methods such as Activity-based Costing

Whereas Standard Costing has its purpose for financial reporting and inventory valuation, its relevance as an analytical basis can be questionable. Advocates of advanced methods such as Activity Based Costing (ABC) have considered standard costing to be an oversimplification that distorts the truth with inaccurate and hidden costs. However, standard cost loyalists have considered activity-based costing, to be complex, expensive, and impractical.

Yet, standard costing and more advanced methods such as ABC can coexist. Using the Alithya PCMCS-based solution for standard costing, users can initially embark on using PCMCS for the development of standard rates. However, because PCMCS is a flexible and powerful allocation engine, users can evolve toward building costing models for analysis purposes that incorporate more sophisticated allocation methods that better apply what is referred to as the “causality principle” that supports ABC calculations. In other words, standard costing can migrate toward being an ABC-like system through the technology offered by the PCMCS solution.

In summary, the Alithya PCMCS solution for Manufacturers is an offering that can be leveraged to fulfill many costing needs. Two specific ones that can have immediate impact are: 1) Creation of standard cost rates in an automated, transparent and accurate manner, and 2) Serving as a launching point for the use of more advanced and more meaningful costing for improved analysis and decision support.

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