At the end of the day, as the truck carrying your freshly manufactured goods pulls away from the dock, you wonder what sort of profit your hard work and quality products delivered. Unfortunately, the costs of running a manufacturing business are not 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 options: They can track by standard costs or actual costs to understand why their profits (or lack of profits!) were different than planned and take action to adjust accordingly. To effectively measure the cost of goods sold (COGS), materials, labor and overhead are derived from either your budget (standard cost) or your actual expenses (actual cost).
Standard and Actual Costing Benefits and Limitations
Both standard and actual costing options have benefits and limitations and most often a manufacturers’ preferred costing decision is unique to each business. But the need to follow one method or the other cannot be ignored and the benefits of accurate costing cannot be disputed, including reduced expenses, more effective budgeting, increase in profits and accurate price setting of 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, such as stock widget manufacturers with steady pricing scenarios who produce the same thing over and over in long runs prefer standard costing. All transactions, regardless of what is being made, will use the standard cost and any difference from the actual cost is considered a variance.
The ability to see true variances is the biggest upside to standard costing. Variances can be due to a variety of things, such as labor requirements and number of components used, so it is essential that your data is set up accurately in your ERP software. Once established, variances allow you to evaluate the root cause of a costing discrepancy as soon as possible and implement a solution. In general, standard costing is more common because inventory valuation is simplified and accounting finds it easiest to maintain, manage and reconcile.
Actual costing requires the manufacturer to assign an ever-changing actual cost to each individual component of the manufacturing process (materials, labor and overhead) each time to get an accurate final price. Material costs (amount paid or incurred) are typically acquired from a purchase order or a manufacturing order. This method tends to be more work, but produces more accurate cost reporting.
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. One benefit to actual costing is that inventory can be reported at a weighted average over time, allowing your company to see the median price you paid throughout the year and forecast appropriately.
IQMS understands that every manufacturer is unique, so the latest version of our manufacturing ERP and MES software solution, EnterpriseIQ, offers both costing options above to address your specific needs: Post Inventory Transactions at Standard and Post Inventory Transactions at Actual. While our development plan is traditionally focused on ultimate shop floor control, we understand the benefits a comprehensive software solution offers, so many new enhancements are continually being added to the financial management side of the software based on feedback from our customers and a special internal accounting improvement team to keep our manufacturers competitive.
In the end, your decision to deploy either standard costing or actual costing will be have to be considered based on your specific accounting needs. A good ERP vendor should offer both options in order to not pigeonhole you into a method that may not be best for your business.