What Is Actual Costing? (With Its Types and Benefits)

By Indeed Editorial Team

Published May 29, 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

When businesses examine their sales and profits, they may look at how much it costs to provide a product, from manufacturing to when the client receives it. This is a process called actual costing, and businesses use this method to help make accurate predictions on the true cost of a product. Knowing the actual cost of a product can help you understand profit margins and how to maintain a financially healthy business. In this article, we explain what actual costing is, explore some different types of costing, and discuss the benefits of this method.

What is actual costing?

Actual costing is the method by which a business determines how much it costs them to manufacture their goods. This is an effective accounting method that can help businesses determine the real costs associated with each of their products. When determining the actual costs, accountants may consider three criteria:

  • Materials: This accounts for any supplies or material, like wood, metal, plastics, that are used during the manufacturing of the product. The cost of materials also involves any waste that comes from scrapped or ruined materials, and can include the cost of overhead to store the materials.

  • Labour: This includes all people and departments that directly worked on producing the product. If the business is manufacturing a product, labour costs include positions like machine operator and assembly line operator, but if they're providing a service, it can be anyone with billable hours.

  • Overhead: Including legal fees, rent, utilities, and property tax, overhead fees account for all costs incurred while storing and shipping manufactured goods.

Examining all these factors together can create the most accurate picture of the actual costs involved with creating and distributing a product in the marketplace. It's important for businesses to know this information because it can help them understand their profit margins better and determine how to be more financially successful. For example, after taking into account materials, labour, and overhead, it's costing a toy company $35.00 per unit to get a product to market. This tells the company that they may want to charge over $35.00 per unit so that they can make a profit.

Related: What is Economic Profit? (With Steps to Calculate it)

Types of costing

Here are various types of costing methods you can use:

Historical costing

This type of costing looks at the original cost of a product and compares it to the asset's current value. Companies use this method when keeping track of products that they're holding onto for a long time. If the item gains significant value, then that shows it was a positive investment in the product. If the item loses a lot of its value, then the company subtracts the amount lost from the original cost of the product. Historical costing can allow companies to prepare for their future by predicting the popularity of new products and adjusting their plans accordingly.

Standard costing

Standard costing is similar to actual costing, with both methods looking at the cost of goods sold and everything that goes into the production of the goods. Standard costing differs because it looks at estimates, while other methods examine variable figures that adjust to the price of materials, labour, and overhead. A standard cost method develops its estimates based on predetermined budgets and uses them to calculate the cost of goods sold. Companies can perform a variance analysis between standard costing and true costing to help them see any discrepancies between their estimated costs and actual costs.

Related: Explaining the Costs of Goods Sold Formula and Its Importance

Activity-based costing

This is a method where a company can assign specific overhead costs to specific products as a result of the activities related to that product. These activities are also called cost drivers and they help to create a realistic picture of what each product is costing the company in overhead. By assigning specific overhead costs, activity-based costing can provide a more accurate breakdown of costs than a method that uses generic estimation. This method can also provide the company with a good estimate of potential profits.

Lean costing

Lean costing is a method that's used to help improve the financial management of a business. This method sets value-based prices on products instead of using actual costs or historical costs. This means that the value that the consumer gives a product determines its value to the company. Lean costing is effective at eliminating waste in production and can help to improve a company's productivity.

Marginal costing

Marginal costing can help a business assess the variable costs of production in relation to the volume of product being made and the company's output. This method adds an extra product to the production process to determine how volume may impact the costs associated with manufacturing. This is a beneficial system when assessing the potential profits of new products, making short-term decisions, developing marketing strategies, and when assessing current sales figures.

Benefits of actual costing

Below are some benefits of using this method:

Flexible

This method is a very flexible accounting system because it adapts to each business's individual data. Since calculating actual costs uses a mixture of fixed and variable figures when developing its cost, it can easily adapt to an increase in production costs. Unlike systems that use pre-made budgets, this method looks at the real costs of each step of production and uses that data to determine profitability. If there's a sudden change in the cost of materials, or labour costs increase, this method can adapt the new figures quickly and efficiently.

Provides complete financial profile

Having a complete financial profile is essential for the healthy operation of a business. Knowing the actual cost of production helps them to determine sales prices, their profitability, and any losses that they might have during production. This can help influence decisions to introduce new products or increase the production of a current good. By having complete knowledge of the financial health of the business, they can make decisions that can continue to benefit and improve the company.

Related: 33 Great Jobs in Accounting (With Salaries and Duties)

Simple

The method for determining actual costs is relatively simple as compared to other accounting methods. Since this method uses accurate figures from production, the business may already have all the information needed to complete the calculations. This method doesn't involve looking at sales history, creating new budgets, or assigning new values to all the products. It takes real data and uses that to produce an accurate picture of manufacturing costs and potential profits from those goods.

Accurate

Determining the actual costs of production is a precise and accurate process. Since there's no estimating involved, the figures that are determined provide a business with the most accurate depiction of their manufacturing costs. For example, if a business uses a standard costing method, they may develop estimated budgets and use those estimations to determine their true manufacturing costs. While it's an effective system, it doesn't consider variable costs, which can significantly affect a product's profitability. Determining the true cost can help to ensure a more exact figure for the manufacturing costs.

Accounts for sunk costs

Sunk costs account for any fixed costs that the company won't recover. Companies look at this figure when determining the actual costs for production overhead. Sunk costs can be items like infrastructure or manufacturing equipment. These are costs that are accounted for while manufacturing a product, but the business knows that they can't recover these costs through sales. This means that when developing the price to sell a unit at, businesses leave sunk costs out of the equation and accept the temporary financial loss.

Helps to determine waste in production

When manufacturing products, there's typically a small amount of waste that happens. Some costing methods account for that waste when determining the cost of manufacturing. Materials can account for a large portion of waste since there are usually scrap or ruined material items that the business can't use to create more product. By including the cost of waste in the cost of production, a business can develop the price per unit accurately and it can help them turn a greater profit with their goods.

Doesn't require pre-planning

This method is helpful because it requires little to no pre-planning when developing the actual costs. Production can start sooner and finish faster, without waiting for budgets to be created or for businesses to assess historical data. After completing manufacturing is when a business can gather most of its data. While it can take a little longer to compile and analyze the data in post-production, but this is because determining the actual cost needs exact numbers to produce accurate manufacturing costs and the price per unit.

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