Standard Costing vs. Average Costing - Which To Use
Average Costing
- Average Cost is simple system to implement, and outputs are unambiguous.
- Provides clear views of actual costs throughout the manufacturing process. Actuals are compared against historical costs for performance management.
- Low-maintenance inventory accounting system that requires fewer people and resources to maintain.
- Determine profit margin based on actual costs.
- Average costing is better for new businesses without historical data in a relevant range and stable inventory and production volume levels.
- Overhead is allocated based on actuals over the volume.
Standard Costing
- Standard Costing is a process which involves assigning “set”, predetermined costs to inventory items for valuation.
- With Standard Costing, differences between actual costs and standard costs will appear as variances, which can be flagged for investigation.
- ]Requires more maintenance than other costing methods and requires more people to manage it.
- Determines profit margin based on projected costs.
- Standard costing is better for established businesses with strong processes in place and stable inventory and production volume levels.
- Overheads are applied at a standard rate and require true-ups to actuals.
Key Factors & Questions
1. What level of resources can you dedicate to managing your accounting processes?
- If you have a few people who are responsible for many things, then Average costing is easier to manage.
- If you have established baselines and sufficient resources to manage your system, Standard Cost that will provide visibility into where and how you can optimize your spending.
2. Do you have enough historical information on your inventory costs and quantities to determine a solid baseline for what is normal?
- Without a good baseline of volume, or price history, variances will cause accounting chaos.
- Without historical information to identify Standard Costs, we should select Average Costing.
3. What output do you need from your data?
- Do you want inventory valuations to fluctuate with the cost of components, labor, etc.? Or do you want to standardize your valuation and be able to analyze variances as costs fluctuate with shifts, such as market changes?
Bonus: Internal Standard Costing w/ Data Modeling
- Using Excel data modeling, we can adopt average cost AND build an internal standard cost system in Excel.
- We can define what variances matter and set standards for material prices, volumes, product cost, etc.
- Highly flexible and dynamic.
For many manufacturing organizations, standard costing has been the default option for the last several decades. As far back in the 1920s, the Ford Motor Company was one of the first mass producers to champion and adopt the practice. Standard costing was praised and adopted as an innovation in production control. Since then, businesses and business schools worldwide have taught it as the preferred system to control production efficiencies and costs.
Standard cost has primarily appealed to companies with large and complex business models, many products, locations, and sales channels for a good reason. It allows the accountants to input prices and quantities captured during the budget cycle and “roll” the estimate upwards to help an organization plan profitability and make decisions. Managers and executives use the standard costing process to steer the company along and ensure that operations is aligned with the company strategy and direction.
However, the time has come to perform a thorough analysis of our inventory costing systems to determine if what we already have is really good enough.
Business leaders must take a pause and really assess whether a standard cost system is producing accurate results and delivering what they need when they need, and how they need it.
From my perspective, a combination of perennial pain points and new technologies suggests that a new, better approach is warranted.
No matter where I’ve worked, I’ve found that business leaders have four main questions:
- What price did we pay for raw materials and labor?
- How efficient were we with each?
- What was the total cost of goods produced?
- What is the value of our inventory?
Standard costing makes answering these questions a nightmare.
Looking forward, then, what we must do is equally as straightforward.
The creation of any costing and inventory system should be built directly to serve the purpose of answering the four critical business questions in real-time and with complete accuracy.
People are beginning to wake up and realize standard costing isn’t the only option and that the cost and effort to maintain standard costing produces a negative business value.
The follow-up question that I received from various readers was the following: “What will you replace standard costing with, and how will you do it?”
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