The costs of running a manufacturing business are not always completely straightforward. When you factor in material expenses, overhead such as rent and utilities, and employee wages, how do you determine whether you are losing money or making money on each product that you manufacture?
When it comes to managing your manufacturing costs accurately, businesses generally have two costing options:
- Standard Costing to understand price variances and adjust costs periodically or implement Actual Costing (a more challenging methodology) due to managing and tracking costs in a timely fashion and reporting periodically.
- In both approaches, your organization must understand why and where profitability is adversely impacted below benchmarked metrics (fiscal budget) and adjust accordingly to effectively (and continuously), measure the Cost of Goods Sold (COGS) driving manufacturing operational efficiency from shop floor to the top floor.
Standard and Actual Costing Benefits and Limitations
Both standard and actual costing options have benefits and limitations and most often a manufacturer’s preferred costing decision is unique to each business, but the need to follow one method or the other cannot be ignored. The benefits of accurate costing cannot be disputed, including reduced expenses, more effective budgeting, increase in profits, and accurate price setting for forecasted future jobs.
Using the more traditional standard costing method requires you to assign predetermined estimated values to each of your materials, labor, and overhead. Typically, discrete manufacturers with steady pricing scenarios who drive repetitive production in long runs, prefer standard costing. All transactions regardless of what products are being manufactured will use standard costing and any differences from actual cost rendered from receipts and production will be reported as favorable or adverse variances.
The ability to manage variances is the biggest upside to standard costing. Variances can be due to a variety of factors, such as labor requirements and the number of components used in production. It is therefore essential that your manufacturing and cost accounting data is set up accurately in your ERP software. Once established, variances allow you to evaluate the root cause of costing discrepancies allowing you to take corrective action. As a general rule for adoption (subject to industry), standard costing is more common because inventory valuation is simplified and manufacturing and accounting find it easiest to maintain, manage and reconcile.
Actual costing, on the other hand, requires the manufacturer to track and monitor an ever-changing actual cost to each individual component in the manufacturing process (materials, labor, and overhead) to get an accurate final price. Actual costing tends to be preferred by manufacturers with frequently changing costs, such as job shops, make to order/engineered to order manufacturers, compounders, assemblers, and those with volatile raw material pricing. A benefit to actual costing is that inventory can be reported at a true periodic cost for material and production (labor and overhead), allowing your company to report actual prices continuously throughout the fiscal year avoiding periodic variance analysis.
In the end, your decision to deploy either standard costing or actual costing should be based on your specific accounting needs. An impactful ERP software vendor should offer both options today and in the future. DELMIAWorks offers these capabilities today and will continue to do so as the market and customer dynamics change in the future.