When the actual cost is more than standard cost then it is what variance?

What Is Inventory Costing?

Inventory costing also called inventory cost accounting, is when companies assign costs to products. These costs also include incidental fees such as storage, administration, and market fluctuation. Generally accepted accounting principles (GAAP) use standardized accounting rules to ensure companies do not overstate these costs.

Inventory costing is a part of the inventory control technique. Proper inventory control within a supply chain helps reduce the total inventory costs and determine how much product a company should carry. This information helps companies decide the needed margins for each product or type.

What is Actual Cost?

As the name itself suggests, actual cost is the cost that is actually incurred or paid. Actual cost is realized and does not depend on an estimate. The management prepares budgets for a period of time to achieve the budget during the financial year. However, variations are bound to occur due to unforeseen circumstances, making the actual results often different from the budgeted. A company having relatively stable production volumes from month to month will have few problems with actual costing.

What Does GAAP Say about Standard and Actual Costs?

While it's commonplace for manufacturing and distribution companies to use standard cost to value their inventories, many may not realize that if they are not regularly reviewing and updating their costs, they may create problems in accounting (especially at year-end) and/or miss opportunities for improvement and cost savings.

By assigning and using standard costs for inventory, companies are making projected estimates of the expected value of inventory (on a per-item basis) based on historical information and other accumulated data such as pricing quotations from vendors. The most fundamental problem with that approach is that anything other than "actual cost" is not acceptable under generally accepted accounting principles ("GAAP"). GAAP requires that inventory be stated at actual cost – using FIFO, LIFO, or weighted average – however, standard cost may be acceptable as long as it materially approximates "actual cost."

Given that GAAP requires actual costs (or a close alignment to it) and it may not be practical or cost-effective to obtain actual cost data in real-time, what is the solution? Without completely altering the company's existing cost structure, there are ways to manage standard costs and help them more closely approximate actual costs.

What is Standard Cost?

Standard costing is when companies assign the expected (or standard) costs of material, labor, and overhead to inventory rather than the actual costs. This management tool helps plan budgets, manage and control costs, and determine how successfully a company controls costs.

Standard cost inventory comes from the company's historical data and reflects operations under normal circumstances. Companies use these costs targets in planning. A variance is a difference between the standard (target) cost and the actual cost. When negative variances occur, management must take action by identifying the root cause, improving its operations, and potentially making changes to the standard cost.

Companies that use standard costing systems usually produce variance reports to show the standard's and actual costs' differences. In the manufacturing environment, the materials price variance is the difference between the budgeted and actual cost for materials.

Standard cost is a predetermined cost assigned for units of material, labor, and other production costs for a specific period. At the end of this period, the actual cost incurred may differ from the standard cost. Thus a 'variance' may arise. Companies with repetitive business operations can successfully use standard Costing. Thus this approach is very suitable for manufacturing organizations.

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, increased profits, and accurate price setting of forecasted future jobs.

Using the more traditional standard costing method requires assigning predetermined estimated values to your materials, labor, and overhead. Typically, discrete manufacturers prefer standard costing, such as stock widget manufacturers with steady pricing scenarios who produce the same thing over and over in the long run. Regardless of what is being made, all transactions will use the standard cost, and any difference from the actual cost is considered a variance.

The ability to see actual variances is the most significant upside to standard costing. Variances can be due to various things, such as labor requirements and the number of components used, so your data must be 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 component of the manufacturing process (materials, labor, and overhead) 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.

In the end, your decision to deploy either standard costing or actual costing will have to be considered based on your specific accounting needs. A good ERP vendor should offer both options to not pigeonhole you into a method that may not be best for your business.

Setting Standard Costs

Two commonly used approaches are used to set standard costs are:

·       Using past historical records to estimate labor and material usage

·       Past information on costs can be used to provide a basis for present period costs

Using engineering studies

This may involve a detailed study or observation of material, labor, and equipment usage operations. The most effective control is achieved by identifying standards for quantities of material, labor, and services used in operation rather than an overall total product cost.

Standard cost provides an informed basis for effective cost allocation and evaluation of production performance. Once standard costs are compared with actual costs and variances are identified, this information can be utilized to take corrective actions for negative variances and future cost reduction and improvement purposes. Standard costing is a management accounting tool used in management decision-making to allow better cost control and optimal resource utilization.

When there are variances between the standard and actual costs, their reasons should be researched and analyzed. The management should introduce Remedies to minimize variances in the next accounting period. Standard cost cannot report results in year-end financial statements as both GAAP (Generally Accepted Accounting Principles) and IRFS (International Financial Reporting Standards) require companies to report actual incomes and expenses in financial statements. Thus, the standard cost is only used for internal management decision-making of the organization.

Analyzing actual and standard costs in isolation will not provide adequate results; both should be considered in amalgamation to generate helpful information for decision-making using variance analysis. A variance is a difference between the standard cost and the actual cost. Variances can be calculated between incomes as well as expenses.

Standard Cost vs. Actual Cost

Standard cost and actual cost are concepts associated with a product's manufacturing and pricing. Learn the difference between standard and actual costs and explore businesses' ideal and practical standards.

In the context of a manufacturing firm, a standard cost is a predetermined or pre-established cost to manufacture one unit of product. A standard cost has the components of the cost of direct materials, direct labor, and overhead to make one unit. Companies have a so-called standard cost card for each product, which shows the standard quantities and costs of inputs to make a particular product unit.

There are two categories of standards in business- the ideal and the practical standards. Ideal standards assume perfect operating conditions. Here, typical production inefficiencies are not taken into account. Machine breakdowns, downtime, employee errors, break periods, etc., are not considered. As a result, standard costs under this category are very tight and are often challenging to meet. On the other hand, practical standards consider these normal and reasonable production inefficiencies. Hence, the resulting standard costs are quite tight yet attainable.

The process of establishing standard cost is quite tedious. It requires inputs from people performing various functions in the organization, from purchasing, engineering, production, and accounting. The company's historical records of production inputs and purchase prices are often instrumental in the standard cost-setting process.

As the term implies, actual cost is the actual cost of direct materials, direct labor, and overhead to make a unit of product. It is the historical cost of resources given up to make an item.

Standard Versus Actual Cost

The difference between standard and the actual cost is called variance. If actual cost is higher than the standard cost, the variance is unfavorable. This means that the company spends more on the actual manufacturing cost components - items like materials, labor, and overhead - than the determined pre-established standard costs for manufacturing that product. Conversely, if actual cost is lower, the variance is favorable. The company can make savings on some or all of the components of manufacturing cost.

Difference Between Standard Cost vs. Actual Cost

Standard costs are the estimated costs for predetermined products and arise from the units of material, labor, and other production costs for a specific time period. Actual costs refer to the costs that are actually incurred. It's the realized value and is not an estimate. The most common Actual Costing methods in manufacturing units are – First In First Out (FIFO), Average Costing, and Last In First Out(LIFO).

Every company and segment within a business prepares a budget for costs and an estimate for revenue streams at the beginning of the financial year. The actual numbers are recorded throughout the year. At the end of the financial year, the actual costs incurred are compared with the standard costs, as was put in the budget plan, and the variance is derived. The same approach is taken for revenue as well. Standard cost vs. actual costs are terms used in management costing and are used frequently.

Critical Differences Between Standard Cost vs. Actual Cost

Let us discuss some of the significant differences between Standard Cost vs. Actual Cost:

1. Standard costs are the estimated costs of labor, material, and other production costs. On the other hand, Actual Costs are those realized during the period and compared at the end of the period.

This difference between the standard cost vs. actual cost is termed Variance. If the Actual cost is higher than the standard, it creates an unfavorable variance.

2. The standard costs are included in the net sales amount and are not a part of the financial statements. On the other hand, actual costs are realized during the same period but later than the date of sales made. Hence, a separate entry must be done in the book of accounts- financial statements.

3. Under standard costing, the stock or inventory is valued at any predetermined or pre-established cost, and any variances are expensed as manufacturing variances. These costs are added up to the costs of products going for production and, hence, are used to establish the price of the finished good. Under actual costing, these costs are the actual manufacturing costs and show the final production cost – but this does not drive the total inventory value, unlike the standard costs.

Standard Cost vs. Actual Cost Comparison Table

Let's look at the top 5 Comparison between Standard Cost vs. Actual Cost

Meaning

Standard Cost

Standard cost refers to the estimated costs of a product regarding the material, labor, and other overhead costs.

Actual Cost

The actual cost is the realized cost and is not based on the same estimates.

Accounting Treatment

Standard Cost

Standard Costs cannot be included in the financial statements of a company.

Actual Cost

Actual Costs are shown as an expense in the financial statement.

Recording the Costs

Standard Cost

These costs are recorded when the budget is planned at the beginning of the year.

Actual Cost

These costs are incurred and realized during the entire year and recorded similarly.

Accuracy of Data Capture

Standard Cost

In case of any errors in data capture, the inventory valuation does not change but is shown as Variance.

Actual Cost

In case of errors in data capture, it would lead to distorted costs and actual inventory valuation.

Visibility of Issues

Standard Cost

Method of cost using standard costs provides better visibility and chances to improve the performance, as the variances can be helpful to identify the issues in the production and manufacturing process.

Actual Cost

In the costing method using Actual costs, specific issues can be hidden by capitalizing them on the inventory cost.

Average and Standard Cost- Conclusion

Companies should first understand how the different methods will change their balance sheets and income statements to choose a cost accounting method. Regardless of the company's method, it is most important to use the same method to present numbers year after year.

The standard Costing method requires working on them yearly or for every period the management decides. Also, the variance observed after the actual costs needs to be monitored and checked for the accuracy of the decided standards. On the other hand, the actual costs need not be decided annually or periodically. The changes in the costs are decided on an ongoing basis. The costing method to apply for the inventory entirely depends on the management and its style.

While it might be recommended by many that actual costing is better when compared as it is more liberating, offers more options, readily available information, and ultimately more flexibility. Still, there also be some thoughts around standard costing practices being more usable and better. Based on the standard costs, it becomes easier to attract bank loans and plan the unit well in advance based on the estimated costs.

It is essential to clearly understand the difference between actual and standard costs to understand many management accounting aspects. The main difference between actual cost and standard cost is that actual cost refers to the cost incurred or paid, whereas standard cost is an estimated product cost. Once a budget is prepared, there should be a control mechanism to evaluate how successfully the budget was achieved. Actual and standard cost enables such comparison.

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