Pros and Cons of Standard Versus Actual Costing for Manufacturers

Part 2 of a 5-Part Series. Read Part 1, Part 3, Part 4, Part 5.

Standard versus actual costing is an important decision point for manufacturers.  Synergy Resources’ Patricia ‘Pat’ Bumbaca, Katie Farrand and Jack Hughes share their insights on the issue to help manufacturers choose what may be best for their individual businesses.

Q: Why do some of Synergy Resources’ customers in the manufacturing industry prefer to use standard cost?

Pat: Customers who prefer standard cost have very valid reasons. One of them is what they’ve learned in school. That’s where they’ve come from.  Another reason is that standard cost customers can get covenants from the bank to borrow money against their inventory. The manufacturer can say, ‘My inventory is going to be X. I know that I can borrow against that inventory because standard costing tells me what it’s going to be’. There is no fluctuation in the carrying cost of the inventory. However, when using actual costing, there may be fluctuations in material or labor costs.

One of the challenges with migrating to actual costing is having trust in the process. The standard cost customer might say, ‘You’re telling me the actual cost is going to come from the end users when they process transactions?  I’m at their mercy if they don’t issue the inventory to the work order correctly or if they don’t process labor correctly.  No way am I going to take that risk!  I’m going to say that my inventory is X using standard cost’.

Q: Can manufacturers simultaneously use both standard and actual costing?

Pat: There are ways to configure the software to mimic standard costs.  ERP is a transactional database so regardless of costing methods the financials are a result of users performing transactions.  All manufacturers use analytics to figure out their costs and to base their sell price.  And most all manufacturers have to respond to market environments where costs are rising; although in some cases, costs are being reduced, perhaps due to pressure from their customers.  For practical purposes there doesn’t need to be a differentiation between the two methodologies. If they truly are standard cost then their actuals will support that and the results will be the same.

Jack: If a customer elects to use standard costing, there are opportunities for our Continuous Improvement group, after a period of time, to offer helpful advice and expertise.  Continuous Improvement comes from users who learn how to transact more appropriately; then you gain the benefit of harvesting better costing information to work with.  If you are using actual cost you can always run your inventory in standard.  Obviously the bank wants to tie the financials to prove the numbers.  The point is that you can go either method and still analyze.  It just depends on whether you want to analyze the actual ups and downs or analyze the variances from standard.

Q: Talk about the pros and cons with respect to the manufacturer’s pricing and costing strategy.

Pat: The pace of business is fast, not slow.  Suppose that a manufacturer has built a new part and its customer now wants to buy it, in volume.  The manufacturer can’t afford to wait for their financial people to crunch the numbers at the end of the month and figure out if there might be a variance against what the manufacturer just did.  The manufacturer doesn’t have time because sales is moving faster than that. Sales needs to know now: can we resell this part again for that same price, or not?

If the manufacturer is using standard cost, they’re not going to be able to turn the analysis around fast enough.  Since all of the analysis on the P&L is done after the fact, the manufacturer will have to wait to see if anything falls out of the variance bucket.  In most cases, there will be a level of guesswork involved in their decision about whether taking this job is going to croak them, or not.

If you, the manufacturer are using actual cost, then you can look right away to see what happened before the job even closes, in realtime.  Actual cost means that you can do the analysis then and there – before you get pressured to make the next sale on that same part.

Q:  How about inventory?

Jack: You can always run your inventory at standard in an actual cost database. So, you can always see the outliers if you need to.  In case there’s someone who’s always run standard and is leery of actual, you can always revert back to standard by doing a journal entry. It can help until they become more comfortable and get over the hump with using actual cost.

Q: Who makes the decision about what the customer is going to do?

Pat: Typically, the financial people. It’s seen as a financial decision: ‘How will our inventory be valued?’  From the operational side, they’re going to transact and do the same regardless. They’re going to buy inventory, issue inventory, apply labor, track their production capacity – all of that stuff doesn’t change. It’s purely a financial decision on how you want your ledger to behave.

It’s true that we do frequently recommend actual costing to our customers but that’s because it’s more liberating. Your hands aren’t tied!  Actual costing offers more options, more flexibility, more readily available information.  We want our customers to be successful.  In fact, nine out of ten Synergy Resources’ customers recognize the advantages and prefer to use actual costing.

Q: Do customers ever change their minds about the costing method they’d prefer to use?

Pat: Sometimes, management changes.  The new management team might say, ‘We want our costing to be this way’.  We can help our customers flip from standard to actual, or actual to standard, depending on their preferences.  In fact, we had a customer ask the question last week:  Could they switch to actual cost?

There is definitely interest among Synergy Resources’ customers.  They want to know about the pros and cons; and which costing method may be best for their individual businesses.

About the Experts

• Patricia ‘Pat’ Bumbaca has worked for Synergy Resources since 1999. Pat specializes in financials and accounting process improvements.
• Katie Farrand has worked in the Continuous Improvement group at Synergy Resources for the past six years. Katie specializes in helping customers improve business performance through the implementation of process improvement strategies.
• Jack Hughes is a CPA who joined Synergy Resources in 1998. Jack specializes in financial software applications and business process consulting.