Actual Costing

What is Actual Costing?

Definition: Actual costing is a cost accounting system that uses actual cost, direct-cost rates, and actual qualities used in production to determine the cost of specific products. Usually an actual costing system traces direct costs to a cost object or something that has a measurable cost.

Actual costing is a method of costing manufactured items that differs from normal costing and standard costing. Under actual costing each accounting period’s actual manufacturing overhead costs and each accounting period’s production volume are used to assign manufacturing overhead to the output.

In other words, managers go back to the source of the costs (cost objects) like labor and materials. Managers can analyze how many hours of manufacturing time a product requires to calculate the actual costs of producing that product.

What Does Actual Costing Mean?

Actual costing is a product costing system when an entity measures actual costs of direct materials, direct labor, and factory overhead. An actual costing system is rarely used because it does not provide accurate information on a timely basis: many costs can be measured only at the end of the production, and some actual costs fluctuate a lot leading to potential errors in price recording.

Actual costing is the recording of product costs based on the following factors:

  • Actual cost of materials
  • Actual cost of labor
  • Actual overhead costs incurred, allocated using the actual quantity of the allocation base experienced during the reporting period

Thus, the key point in an actual costing system is that it only uses actual costs incurred and allocation bases experienced; it does not incorporate any budgeted amounts or standards. This is the simplest costing method available, requiring no pre-planning of standard costs. However, it can take longer to formulate a valuation for ending inventory and the cost of goods sold, since actual costs must be compiled and allocated.

A similar costing system is normal costing, where the key difference is the use of a budgeted amount of overhead. Actual costing will result in a greater fluctuation in overhead allocations, since it is based on short-term costs that can unexpectedly spike or dip in size. Normal costing results in less fluctuation in overhead allocations, since it is based on long-term expectations for overhead costs.

A company having relatively stable production volumes from month to month will have few problems with actual costing. However, one that experiences continual variation in its production volumes, and especially one that regularly faces questions from its investors may be better off using normal costing, since that method offers greater stability in reported costs.

Actual costing determines the actual costs for externally procured materials and materials produced in-house. In addition, actual costing uses actual costs to value inventories of raw materials, semifinished products, and finished products.

Actual costing calculates an actual price (periodic unit price) for each material, into which all actual costs for the particular period flow.

Due to its ability to roll up costs and perform final costing at actual costs, actual costing is particularly useful for businesses that require a large number of raw materials in multilevel production processes. Businesses that have high inventory levels and that are interested in analyzing their inventory and consumption cost variances more closely can also use the functions provided by actual costing.

By calculating actual prices for materials, actual costing can aid you in make-or-buy decisions. Because data in actual costing is updated at the level of the procurement alternatives, it is possible to compare different sources of supply.

Example

Managers can use these formulas to calculate the total production costs. For instance, managers first need to find out how many hours it took the company to produce the product and how much the company is paying its employees per hour. Using the first actual costing formula, these numbers make up the labor portion of the production costs. The same is done for materials. Overhead is a little different.

Since overhead like utility usage is a little difficult to assign to a single product, managers usually make estimates. They estimate how much overhead was used and how long the overhead was used. Using the second actual costing formula, management can determine the indirect productions costs for producing the product. After all the calculations are done, add up the totals and you’ll get the actual cost of producing your product.

After the actual cost is known, management can change the production process in order to meet budget goals.