Controlling costs is important for every business. But understanding how to track them can be incredibly complex. That’s where understanding the difference between standard and actual costs comes in. Comparing the two can make your business more profitable and efficient.
We’ll walk you through what you need to know about the difference between standard and actual costs and how they fit into your overall cost accounting strategies.
The Difference Between Standard Cost and Actual Cost
If you want to better understand how companies keep costs in check, it starts with understanding these two critical cost accounting terms.
Here’s the breakdown.
What is Standard Cost?
Standard cost is a predetermined amount for a product or service based on the expected levels of material, labor, and overhead. This term is commonly used for everything from budgeting to performance evaluations, and companies calculate it based on historical data, industry benchmarks, and estimates of future conditions.
One example: A company sets a standard labor rate of $20 an hour for transcribing a call or troubleshooting tech issues.
What is Actual Cost?
The actual cost of something represents the real amount of money associated with producing a product or service. Companies primarily use this figure for financial reporting and compliance. They calculate the actual costs based on total expenditures for martials, labor, and overhead.
Case in point: That same company trying to hire someone to transcribe calls or troubleshoot tech issues for $20 an hour, winds up paying $22 for those tasks.
Key Differences Between Actual and Standard Cost
Companies set standard costs in advance to serve as a guide, while their actual costs don’t become clear until that same company produces a product or carries out a service. Standard costs might not always match actual expenses due to changes in prices or other factors. When this occurs, companies typically perform what’s called a variance analysis to figure out what accounts for the difference between the two numbers. Doing so helps identify ways to reduce costs in the future.
Why Companies Use Standard Cost Accounting
Companies use standard cost accounting to improve their financial management and help with strategic planning. The goal is to make better, more efficient business decisions, whether it’s budgeting or estimating future costs.
Standard cost accounting, for example, plays a key role in performance evaluation. By comparing standard costs with actual costs, companies can identify areas where expenditures were higher or lower than expected and identify opportunities for cutting them.
How Companies Determine Standard Costs
To determine standard costs, companies generally use historical data, industry benchmarks, and forecasts for future conditions. Doing so allows businesses to compare their performance in terms of materials, efficiency, and overhead. It also helps them account for changes in prices, labor rates, and overhead, plus make informed assumptions based on economic conditions, advances in technology, and other factors.
How to Define and Calculate Cost Variance
The cost variance is the difference between actual cost and standard cost. The basic formula to calculate it is: Actual cost – standard cost = cost variance.
Three common causes of cost variance include:
- Material Variance: This measures the difference between the actual and standard cost of materials used.
- Labor Variance: This measures the difference between the actual and standard cost of labor.
- Overhead Variance: This measures the difference between the actual and standard cost of overhead expenses.
Each of these cost variances can be broken down into specific price and quantity variances to provide businesses with a more detailed accounting picture.
How to Manage Unfavorable Cost Variances
When the actual cost is higher than the standard cost, that’s called an unfavorable cost variance, and companies can take the following steps to address the issue:
- Investigate and Analyze: Use data analysis tools to determine the reasons for the unfavorable variance by identifying trends and patterns.
- Implement Corrective Actions: Update internal processes and procedures to make them more efficient. Renegotiate existing contracts with suppliers to obtain improved pricing.
- Monitor and Review Variances: Use key performance indicators (KPIs) to track the impact of corrective measures and monitor cost variances to identify recurring issues.
- Utilize Standard Costing Systems: Compare actual costs to standard costs to identify trends, patterns, and areas of improvement.
- Create a Cost Consciousness Culture: Take measures to encourage employees to participate in cost-saving initiatives and reward them for identifying and implementing them.
- Consider Outsourcing or Offshoring: Evaluate whether outsourcing or offshoring specific tasks or functions can reduce costs, and assess the risks and benefits associated with them.
- Review Pricing Strategies: Consider adjusting prices to keep profits stable and offset increased costs, while making sure you’re still providing value to customers.
The Advantages of Using Standard Costs for Budgeting
Standard costs give businesses a stable and predictable starting point for budgeting. With standard costs in place, it’s easy to spot where actual spending veers off course, so you can fix the problem.
The Limitations of Standard Cost Accounting
Since companies set standard costs in advance, they may not always accurately reflect current conditions if prices or production shift unexpectedly. Standard costs can also oversimplify things, especially complex manufacturing processes, and may not always show the full picture of what’s driving up expenditures. Plus, variances between standard and actual costs aren’t always easy to interpret, especially when there are multiple factors contributing to the difference.
How Often Should Standard Costs Be Updated?
The question depends on your specific business and industry. If a company is in a fast-moving field with frequent changes in technology or market conditions, standard costs should be updated more frequently. The frequency of the updates may also be impacted by the size and complexity of the company, and the level of control it has over its operations. Generally, industries with relatively stable conditions can update their standard costs annually. Industries with more moderate costs or market shifts should consider semiannual updates. For industries with rapidly changing conditions, or companies that require more frequent monitoring of costs, quarterly or even monthly updates may be necessary.
If you find significant cost variances, this often indicates a need for more frequent updates.
Applying Standard Cost Accounting to Service-Based Businesses
Standard cost accounting can still be a powerful tool for service-based businesses, even if it’s a bit trickier than in manufacturing. Services are often harder to measure because they’re not tangible products, and it can be tough to set reliable standards when delivery varies so much. If your business customizes services for each client, figuring out exact costs can feel like a moving target. But even with these challenges, applying standard costs can help track performance and improve cost control, giving you a clearer picture of where you’re spending and saving.
To learn more about standard and actual cost strategies, or to schedule a call with one of our cost accounting experts, contact us today.
