In the course of our engagements, we often help clients evaluate costing methodologies for manufacturing clients. Whether they are considering a change in methodology for better reporting or are in the implementation stage of an Enterprise Resource Planning (ERP) project, clients need to evaluate the pros and cons of their costing options.
When using a standard costing methodology, planned costs are developed and set as the, “standard,” for some period of time – often a fiscal year. Standards costs are set for procured raw materials, labor usage and rates and overhead rates. Costs are then, “rolled,” for manufactured items accumulating all of the costs that go in to production to establish the standard for the finished good.
Under standard costing, inventory is always valued at the standard cost and any variances to standard are expensed as Purchase Price Variances (PPV) or manufacturing variances.
Under actual costing, the actual costs drive the inventory valuation. Within actual costing there are a number of different methodologies to track actual costs:
- First in – First out (FIFO): Cost layers are established as goods are purchased or produced; when sold or consumed the cost of the oldest layer is used until that layer is consumed.
- Average Costing: Under average costing, each addition to inventory is averaged into the inventory value on a weighted unit basis.
- Last in – First out (LIFO): Cost layers are established as goods are purchased or produced; when sold or consumed the cost of the newest layer is used until that layer is consumed.
Under actual costing, you will still have a, “planned,” cost that rolls up all of the manufacturing costs, but unlike standard costing, this planned cost will not drive the inventory value.
Choosing the right method
Understanding requirements and impact of each method on your organization is key to making an informed decision.
|Issue||Standard costing||Actual costing|
|Setup and maintenance||Standard costs require periodic planning effort to establish a new standard cost each year. Additionally the variances produced by standards must be monitored to evaluate the accuracy of the standards.||Actual costing does not require an annual costing event and changes in costs are captured on an ongoing basis.|
|Stability of raw material costs||If raw material costs fluctuate substantially, standard costing will produce significant PPV variances. If Variances are material they may need to be recapitalized in inventory.||Price variations captured in the inventory costs. Margins will fluctuate based on changing inventory values.|
|Manufacturing data accuracy (BOM, Routings)||Standard costs rely on accurate manufacturing data to produce good costs. Any errors will distort inventory valuation.||Inaccurate data will not impact actual costing|
|Actual data capture accuracy||Poor data capture of actuals will not change the inventory valuation. The errors will be captured as variances.||Poor data capture of actuals will distort cost and the inventory valuations.|
|Visibility||Standards provides better visibility to performance against the standard.
Variances can be useful to identify issues in manufacturing and procurement.
|Actuals can hide issues by capitalizing the cost of them into Inventory.|
In general, standard costing requires more effort to maintain, but can provide better visibility to issues in the business through the variances it produce, but may not be a good option for manufacturing companies that use commodities with significant cost fluctuations. Actual costing is easier to maintain, but additional reporting is required to ensure that issues with costs are identified. To learn more about how RSM can assist you with your other business needs, contact RSM’s management consulting professionals at 800.274.3978 or email us.