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Actual versus Standard Cost - Selecting a Costing Method

Close-up of worker putting a box on conveyor belt for shippingSince the dawn of the industrial age, tracking of production costs has been a challenge for accountants. The concept of inventory was not new when mass production started, but in-process jobs were a new creation. At the start of the industrial revolution inventory accountants tracked historical costs (first in, first out), which was enough for the general store but not the plant floor. In the 1920’s standard costing came into wide use as the solution for allocating indirect costs to production jobs.

Significant labor costs caused early management accountants to design standard costing to focus on labor costs, which, at the time were a large component of production costs. Standard costing to this day is a compromise, where costs are knowingly distorted, based on allocated indirect costs. This compromise was necessary at the time due to the difficulty in tracking actual costs. 

While standard costing is a compromise, that results in cost distortions versus true actual costs, the distortions are small in high volume homogeneous production environments, especially those with significant labor costs.

Everyone who has worked in manufacturing knows that the production processes prevalent in the 1920’s have continually progressed with labor compromising an ever-smaller portion of total costs. This shrinking labor content caused management accountants to question the wisdom of allocating all indirect overhead costs to products based on labor. The result was the birth of Activity Based Costing, ABC.

Introduced in the late 1980’s by Kaplan and Bruns, ABC costing purported to correct for the cost distortions inherent in standard absorption costing by using cost drivers based on activities other than direct labor. ABC costing provided interesting insights into the real drivers of indirect costs but has proved to be impractical to implement as an ongoing real-time costing system.

ABC costing has its own limitations and distortions. Have you ever asked a purchasing manager the cost of a purchase order? They will answer with an astronomically inflated cost derived from the annual cost of the entire purchasing department divided by the number of purchase orders processed that year.

Processing purchase orders is an activity purchasing does, so it makes sense that the number of purchase orders processed would be a driver for overall purchasing department costs. 

Consultants and software vendors often use this oversimplification to sell automated purchasing software that promises to increase the number of purchase orders buyers can process each year. Logically, this attribution of cost makes complete sense, but most often, it presents an overly optimistic cost savings target that will never be achieved.

This is because this methodology fails to distinguish between fixed and variable costs. One can assume that the purchasing manager spearheading this cost savings initiative has no plans to take a salary cut commensurate with the downsizing of his or her department. 

Software vendors play on managers optimism about future growth and ever-increasing workload. The new software will allow the increased volume to be absorbed without adding additional headcount or increasing overtime.

Even if this scenario is realized, the fixed costs of the purchasing department are not reduced and may even increase, due to software cost amortization or annual maintenance fees. If the number of purchase orders processed in a year remains static to the level before the software is implemented this fixed cost will not change or increase slightly on a per purchase order basis. Considering fixed costs can be 50% of total costs, the implied savings from the activity-based cost per purchase order estimate will never be realized.

This is an example of the distortion that can occur when indirect costs are applied using a cost driver. The same distortions are inherent wherever costs are allocated using standard costing. Therefore, variance analysis is very important in standard costing. 

In standard costing, costs are periodically updated. This might occur once or twice a year or even quarterly if input costs are volatile. In between these standard cost rolls, the accuracy of the standard costs are constantly being evaluated by the cost accountant through the analysis of variances, such as purchase price variance, material usage variance and overhead variance.

Modern ERP systems allow standard cost variances to be broken down into price and efficiency variances. Efficiency variances are derived by comparing the standard quantities a process should yield to the actual quantities yielded. Price variances look at the price of the cost component captured at the standards roll versus the actual price of the cost component on the given activity.

Price variance is most often analyzed on purchased components and material and is the difference between the standard cost captured at the cost roll and the actual price paid. Identifying this variance is easy in a standard cost system.

Identifying price variance as a component of material variance resulting from a production process is more complex and depending on ERP system setup is not always available. In the case of labor, price variance is the difference between the cost of labor rolled up at the cost roll and the actual cost of labor reported on a work order operation multiplied by the cost of the labor resource per hour. 

Usually, the cost of the labor resource is a blended standard labor cost and not specific to the actual labor rate of the employee doing the work even though modern ERP systems will capture the actual employee labor rate. 

Most companies do not have the workforce to maintain the integrity of the inventory transactions, much less analyze them for price differences. The prevailing thought is that this level of analysis is not worth the expenditure of time.

Rather, operation management’s time is best spent ensuring that data is accurately reported on the shop floor and captured as it occurs. This is the best way to maintain the integrity of a perpetual inventory system. 

Problems with bills of material or in reported production will have downstream effects on inventory, such as stock outs or inventory not available in the system when it is physically available for use. These events are the triggers to evaluate bills of materials and routings for accuracy. While this is a fire fighting based approach for maintenance of production data, it is far more effective use of time than analyzing individual employee labor efficiencies.

Focusing on losses, and changes in input costs are key to continuously improving manufacturing efficiency and passing along increased input costs as they happen. This works well with high volume manufacturers producing standard products to stock, but what if you are a job shop that makes everything to order? Is standard costing a practical solution for you?

The answer is no. In environments like machine shops were everything is custom made to order, actual cost is the best solution. Today’s ERP systems are capable of tracking actual specific costs. In the perfect implementation, all purchases are charged directly to the job, including expenses normally considered overhead. In these systems, the actual costs are accumulated on the job until it is complete and shipped. After shipment, the job’s costs and margin are reviewed on a report that shows the actual margin by job. Seeing the actual margin per job is ideal for managers. With new ERP systems capable of tracking actual costs, why wouldn’t everyone use actual costs?

The primary reason a company might opt for standard costing over actual costing is the additional workload to issue materials and purchases to specific jobs. Automatic issues of materials are not unheard of when using actual costing, but this adds a level of complexity not supported by all ERP systems. 

When using standard costing it is common to see back flushing of materials and components used to automatically issue parts upon receipt but in actual costing this is less common. Often, actual time spent working on a job is not captured to save time on reporting it. 

In lot-controlled environments manual issues are the norm for inventory control. These environments are suited for actual costing. Problems can arise in actual costing when the margins on jobs are relied on too heavily. These actual costs are just the costs directly attributed to the job. These costs are never comprehensive of all costs for a business and in the best implementations represent gross margin at best. These systems must account for fixed overhead and normally this is just the standard application of overhead absorption costing—labor hours X work center overhead rate.

Just like in standard costing systems, variable and fixed overhead costs must be allocated to a job using a cost driver, which is normally direct labor, or machine hour based. This is because there are always purchases that are not specific to one job. This either requires receipts to be done to multiple jobs, i.e., allocated by the receiving employee or it needs to be charged to an overhead expense account that will be allocated as an indirect cost. Every business has manufacturing costs related to management and support departments, which must also be allocated using an overhead rate.

In actual cost systems, the best practice is to directly charge all costs which are due to a specific job to that job and charge off all the rest to overhead expenses that will be allocated. Leave the allocations to the accountants.

Actual costs systems do an excellent job of capturing direct costs but are no better at allocating indirect costs. In implementations where these direct costs are volatile, and the company prices its products based on estimates, actual costing makes sense. In high volume production of standard parts, standard costing still rules.

When deciding whether actual costing might be right for you, consider the reporting implications. While seeing actual margin by job seems ideal, analyzing margins over time by part can be daunting, due to the variability in costs by job. The standard reporting provided by these systems, does not make it easy to identify changes in input costs. Looking at trends in costs over time is not as simple as looking at a purchase price variance report. More discipline is required from sales and engineering employees during the estimating process to ensure current increased input costs are passed on to the customer.

The latest ERP systems are more powerful than ever, but the complexity of allocating costs persists. A substantial portion of costs are fixed and not specific to individual jobs, and fixed costs are not fixed in perpetuity. Meaden and Moore Business Solutions can help you analyze these costs in your current systems and develop improved reporting to help you manage your margins efficiently. MMBS can also help you decide on the best method for you to use when upgrading to a new system. Implementation of a new system is an ideal time to consider a change in costing methodology. Contact a Meaden & Moore expert to learn more about the ERP data conversion and migration process.

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Scott Holter is the Director of Meaden & Moore’s Business Solutions Group. He has spent 20 plus years in manufacturing and technology consulting.

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