Actual Costing

Actual costing is a method of measuring the cost of manufactured products using only the costs actually incurred: actual direct materials, actual direct labor and actual manufacturing overhead, with overhead spread over the actual volume of production for the period. No budgets or standards are used. The result is a unit cost that reflects exactly what was spent, but it can only be finalized after the period has ended and every cost is known.

Actual costing is one of three broad approaches in cost accounting. The others are normal costing, which uses actual materials and labor but applies overhead with a predetermined rate, and standard costing, which uses budgeted standards for all three elements and tracks differences as variances. Each can be combined with job order costing or a process costing system, and all are forms of absorption costing when fixed factory overhead is included in product cost.

Imagine a group of friends who share a holiday house and split the bills by the number of nights each person stayed. With actual costing, nobody knows their share until the trip is over and every bill, from electricity to cleaning, has arrived. The split is exact, but it is late, and it changes a lot depending on how many nights were booked overall.

If few people came in a quiet month, each night looks expensive, because the fixed bills are shared among fewer nights. In a busy month the same house seems cheap. Actual costing has the same habit: unit costs swing with the level of activity rather than with any real change in efficiency.

Direct materials and direct labor are traced to each product or job from requisitions and time records, as in any system. The difference lies in overhead. At the end of the period, total actual overhead is divided by the actual quantity of the allocation base, such as machine hours or direct labor hours, to produce an actual overhead rate. That rate is then used to assign overhead to each product.

For example, a plant incurs $90,000 of manufacturing overhead in January and works 3,000 machine hours. The actual rate is $90,000 ÷ 3,000 = $30 per machine hour. A job that used 40 machine hours, $2,000 of materials and $1,500 of labor costs $2,000 + $1,500 + (40 × $30) = $4,700.

Much factory overhead is fixed: rent, depreciation and supervisors' salaries are similar each month. Suppose July overhead is again $90,000 but the plant works only 1,800 machine hours because of a holiday shutdown. The actual rate rises to $50 per hour, and the same 40-hour job now carries $2,000 of overhead instead of $1,200. Nothing about the job changed. The swing comes purely from spreading fixed costs over fewer hours, and it can mislead managers who use unit costs for pricing or performance review.

• Accuracy after the fact. Actual costing leaves no over- or underapplied overhead to dispose of, because every dollar incurred is assigned.
• Simplicity of concept. No budgets, standards or variance analysis are needed, which suits very small manufacturers.
• Delay. Costs cannot be finalized until all bills, including utilities and depreciation, are recorded, so job costs and inventory values are late for quoting and interim reporting.
• Volatility. As shown above, seasonal changes in volume make similar products appear to cost very different amounts in different months.
• Weak control signals. Without a budget or standard to compare against, it is harder to spot waste or inefficiency.

Because of these drawbacks, most manufacturers use normal costing, applying overhead through a predetermined rate to produce applied overhead, or standard costing. Actual costing survives mainly in small or simple operations, in annual calculations where all costs are known, and as a check on the reasonableness of rates used during the year. Whatever system is used for internal management, inventory in external financial statements must ultimately reflect costs actually incurred under US GAAP, so normal and standard costing systems adjust for significant differences at period end, bringing cost of goods sold and inventory close to an actual-cost basis.