Average vs Standard Costing1

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Inventory Cost Accounting Method selection for a Manufacturing Organization: Average Vs Standard Costing

One decision which is often considered as one of the most important decision to make while implementing an ERPsystem is selecting an appropriate Costing method for your organization. Two most commonly used costing methods areAverage and Standard Costing.

The Article presents a quick analysis of important considerations while selecting the costing method for yourmanufacturing organization and presents a brief comparison of two Costing Methods. Based on my experience, I havetried to cover the areas which I think are most important for selecting the right Costing Method.

Standard Costing Average Costing

Costing MethodDescription

Predetermined costs are used for valuing inventoryin Standard Costing environment.

Predefined item costs are used or purchased items.Whereas, for manufactured items, standard cost isgenerally derived from Cost Rollupson the basis ofassociated BOM and Routing; predefined resource andoverhead costs are used towards the same.

Differences between standard costs and actualcosts are recorded as multiple variances(such asPurchase price variance, Material & Resource usage

variance for Job etc.)

Weighted Average Item Cost is used for valuinginventory in Average Costing environment.AverageItem Cost is perpetually computed based on receivingmaterial transactions while all issue transactions use thisaverage cost.

For purchased items, this is a weighted average of theactual procurement cost of an item, for manufactureditems, this is a weighted average of the cost of allresources, materials and overheads consumed.

Formula for average cost computation:

Average Cost = (transaction value + current inventory value) /(transaction quantity + current on-hand quantity)

Relevant BusinessScenarios

Relatively steady procurement cost (for raw material,components)

Manufacturing environments where BOM/Routingdetails can be standardized to a large extent: Build toStock or Assemble to Order scenarios

Standard Costing method is commonly used across

Large variation in procurement cost (for raw material,components) on a frequent basis

Large stockpile of inventory is maintained (nodifferentiation of old vs. new stock)

Non-standard production environment: Build to Orderscenarios


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several Manufacturing industries spanning acrossAutomotive, Electronic goods, FMCG, Food and

Dairy Products, Pharmaceuticals industries

These scenarios are typically present in industriessuch as Oil & Petro Chemicals, Agriculture, Heavy

Industry and Industrial Manufacturing involving largecommodities

Cost Control & VarianceTracking

Standard Costing provides a very good control overcosts as inventory is valued based on predefined itemcosts. It also provides robust performance measurementas multiple variances are recorded based on thedifferences between planned and actual costs.

Each of the variances can be monitored and analyzed toidentify the scope for efficiency improvements. Followingtypes of variances can be tracked:

Purchase Price and Invoice Price VariancesMaterial usage VarianceResource, OSP & Overhead efficiency VarianceStandard Cost adjustment Variance

Average Costing perpetually updates the average costbased on actual transactions and values the inventoryand Jobs based on actual transactions.

As compared to Standard Costing, there is a very limitedcontrol on the Item Cost in Average Costing and very fewvariances can be recoded. Invoice Price Variance can berecorded.

Cost Administration Standard Costing needs active administration andcontrol. Following activities are typical towardsadministering Standard Costing:

Revise Predefined Item Costs for each period

Perform Cost Rollups for make items in each period to

reflect revised cost for "Make" assemblies Analyze cost variances and root cause analysis for the

recorded variances; take remedial actions to controlthe variances in future periods

Perform standard cost adjustments whenever required

Average Costing requires less administration andminimal intervention is required from business users.Following activities may be required to administeraverage costing:

Review Item Cost History time-to-time

Perform Average Cost adjustments if required

Product Pricing andProfit Margin Calculation

Both pre-defined costs as well as recorded variancesneed to be analyzed for validating Product Pricing andestimating Product profitability accurately.

Since average costs are computed based on actualtransaction values, no variances are being recorded.


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Detailed root-cause analysis must be undertaken to

identify the exact reasons for recorded variances. Someof them may be attributable to engineering design whilesome may be due to operational inefficiencies. Doingthis analysis will help in deciding the Product pricingrealistically for the future.

Up-to-date Average Cost can be reviewed along-with thecost history to validate Product pricing and estimate the

product profitability.

Benefits Good control over item cost and inventory valuation Accurate tracking of variances

Good Performance Management tool: Easy to fixresponsibility for each kind of variance

Easy to identify required operational improvements

Automatically value inventory at moving averageitem cost

No need to define any pre-defined costs

No need to track variances

Easily determine profit margin based on actual cost

Challenges Higher administration overheado Define item costs for each periodo Perform cost rollups for each periodo Variance analysis for each period

Product Profit Margin computation to include directcosts (planned) as well as variances

Higher standardization required in engineeringphase in order to account for all operational issues.

Very limited control over item costs No Variances are recorded and all operational

inefficiencies are included as part of actual costing

Difficult to assign responsibility for operationalinefficiencies

PS: I have not covered any system related information or setups in this article (I shall be writing another article to presenta solution to reap benefits of both costing methods in one organization based on Oracle Applications ERP platform).

Hope you will find this analysis interesting; your suggestions and feedback are most welcome!

Regards,Manu Singhal

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Average vs Standard Costing1