Businesses need to know their Actual Cost to make informed decisions about where to allocate their resources.
Without accurate information, businesses can’t possibly hope to make sound decisions about allocating resources.
The actual cost is the real cost of a product or service after the deductions and adjustments have been made. It’s essential to understand this definition to make sound business decisions that reflect a product’s or service’s actual costs.
This blog post will explore the actual-cost definition and details. We’ll also provide some examples to help illustrate this concept.
Actual Cost Definition
The actual cost is a product or service’s correct, accurate price. It should include all expenses incurred in producing and delivering one item to its final destination, including indirect costs such as administrative overhead, depreciation charges for capital equipment used in production, labor, delivery costs, and other related items.
Actual costing is recommended when each production process is analyzed to determine the production costs at each phase.
Actual costing is essential when determining the production costs because it can give a more accurate estimate than other methods like estimating or break-even analysis.
This concept has been around since 1938, when it was first introduced by professor Jules Mairesse who published his theory on the subject in an article titled “The Economic Role of Accounting.” Today, we use this process with manufacturing and services where there are typically no tangible assets to account for, like consulting firms.
Actual cost formula
The formula for calculating it is as follows.
Actual Cost = Direct Costs + Indirect Costs + Fixed Costs + Variable Costs + Sunken Costs
Below is the meaning of the factors used in the actual cost formula.
- Direct costs: This is the precise cost that is directly related to your processes, such as fixed costs and variable costs
- Indirect costs: These costs are additional or extra costs to support your process, like administrative charges
- Fixed costs: A fixed cost is a cost that cannot be lowered or increased. Fixed Costs refer to expenses that do not change with changes in output or sales volumes – instead, they remain constant regardless of the level of business activity. Examples may include property taxes, equipment rent/lease payments, and labor-related expenses such as a company secretary.
- Variable costs: This is the cost that varies during the process—for example, labor charges.
- Sunken costs: This is the cost that occurs due to the error during the process
If you are manufacturing products, the actual cost calculation is as follows.
- (Number of units of material used) X (Per unit cost) = Actual material cost
- (Labor hours used in production) X (Wage paid per hour) = Actual labor cost
- Addition of all overhead expenses (electricity, rent, insurance ) = Actual overhead cost
- (A+B+C) / (Number of units produced) = Actual production cost per unit
Actual cost example
The actual product cost includes the price it took to make it. So, for example, a manufacturing company estimated $1500 for product repair. But the actual cost was $2000. So the company had a cost variance of $500.
Cost variance is the difference between planned or estimated costs and actual costs.
Here the actual cost is more than the estimated cost. Hence the cost variance is considered an unfavorable variance.
- It helps to calculate fixed costs for different stages of production.
- It is widely used in manufacturing sectors where more raw materials are utilized. It also enhances the inventory system and makes procurement easy.
- It assists in making several outsourcing decisions and also helps in setting up the correct prices for the products.
- It helps streamline procurement as it depicts the cost of all alternative sources of supply and helps choose the most feasible option.
Actual cost uses realistic numbers to ascertain the prices and helps decision-making an easy task. However, the disadvantage lies in the overhead expenses that can never be exact.
Even the labor charges vary, making it more challenging to use this technique than normal costing.
Also, this is useful in industries where the raw materials and other related factors are consistent with significantly fewer changes. It is ideal for standardized products.
Also, the process is time-consuming, requiring several technical skills.
Normal costs or regular costs
Normal costs are the cost that is pre-planned. That means you calculate the cost of the product before production based on the previous data.
What are the differences between Actual costing(AC) and Normal costing (NC)?
|Normal Costing||Actual Costing|
|The cost is calculated before the production process.||The cost is calculated after the production process.|
|It includes direct costs and indirect costs.||It consists of the costs of the production process in real-time. That means AC includes the costs like any variations in labor charge and raw material price.|
|Costs update once in a while||With this, costs of the product update for each batch after calculating the actual expenses.|
|It assumes the cost of the production.||It takes the actual expenses of each batch.|
What is the total fixed cost?
Total fixed costs, also called direct costs, are all the expenses directly associated with a project that you cannot avoid (recurring costs) or allocated in whole or in part to more than one cost object.
Total fixed costs are future cash expenditures for rent, utilities, debt service, insurance premiums, etc. Fixed cost does not include operating expenses such as labor, materials, and supplies.
For example, an organization might claim 1 million dollars in revenue per year, but $50% or $500 000 is committed to cover overhead/fixed expense items that cannot achieve the goal of generating revenue.
What are the disadvantages of actual costing?
Actual costing is disadvantageous because it takes longer to calculate and can be more expensive to implement.
In actual costing, the direct materials, direct labor, and overhead costs incurred in producing a product or service are assigned to that product or service. This approach is more accurate than allocation-based methods, but it’s also more time-consuming and costly to implement because of the need to track actual costs.
The actual cost is a fundamental financial calculation that can help you understand the actual price of your product.
The actual costing definition and examples we’ve provided today should give insight into how this concept works in business.