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 ERP
system is selecting an appropriate Costing method for your organization. Two most commonly used costing methods are
Average and Standard Costing.
The Article presents a quick analysis of important considerations while selecting the costing method for your
manufacturing organization and presents a brief comparison of two Costing Methods. Based on my experience, I have
tried to cover the areas which I think are most important for selecting the right Costing Method.
Standard Costing Average Costing
Costing Method
Description
Predetermined costs are used for valuing inventory
in Standard Costing environment.
Predefined item costs are used or purchased items.
Whereas, for manufactured items, standard cost is
generally derived from Cost Rollups on the basis of
associated BOM and Routing; predefined resource and
overhead costs are used towards the same.
Differences between standard costs and actual
costs are recorded as multiple variances (such as
Purchase price variance, Material & Resource usage
variance for Job etc.)
Weighted Average Item Cost is used for valuing
inventory in Average Costing environment. Average
Item Cost is perpetually computed based on receiving
material transactions while all issue transactions use this
average cost.
For purchased items, this is a weighted average of the
actual procurement cost of an item, for manufactured
items, this is a weighted average of the cost of all
resources, materials and overheads consumed.
Formula for average cost computation:
Average Cost = (transaction value + current inventory value) /
(transaction quantity + current on-hand quantity)
Relevant Business
Scenarios
 Relatively steady procurement cost (for raw material,
components)
 Manufacturing environments where BOM/Routing
details can be standardized to a large extent: Build to
Stock 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 (no
differentiation of old vs. new stock)
 Non-standard production environment: Build to Order
scenarios

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several Manufacturing industries spanning across
Automotive, Electronic goods, FMCG, Food and
Dairy Products, Pharmaceuticals industries
 These scenarios are typically present in industries
such as Oil & Petro Chemicals, Agriculture, Heavy
Industry and Industrial Manufacturing involving large
commodities
Cost Control & Variance
Tracking
Standard Costing provides a very good control over
costs as inventory is valued based on predefined item
costs. It also provides robust performance measurement
as multiple variances are recorded based on the
differences between planned and actual costs.
Each of the variances can be monitored and analyzed to
identify the scope for efficiency improvements. Following
types of variances can be tracked:
Purchase Price and Invoice Price Variances
Material usage Variance
Resource, OSP & Overhead efficiency Variance
Standard Cost adjustment Variance
Average Costing perpetually updates the average cost
based on actual transactions and values the inventory
and Jobs based on actual transactions.
As compared to Standard Costing, there is a very limited
control on the Item Cost in Average Costing and very few
variances can be recoded. Invoice Price Variance can be
recorded.
Cost Administration Standard Costing needs active administration and
control. Following activities are typical towards
administering 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 control
the variances in future periods
 Perform standard cost adjustments whenever required
Average Costing requires less administration and
minimal intervention is required from business users.
Following activities may be required to administer
average costing:
 Review Item Cost History time-to-time
 Perform Average Cost adjustments if required
Product Pricing and
Profit Margin Calculation
Both pre-defined costs as well as recorded variances
need to be analyzed for validating Product Pricing and
estimating Product profitability accurately.
Since average costs are computed based on actual
transaction 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. Some
of them may be attributable to engineering design while
some may be due to operational inefficiencies. Doing
this analysis will help in deciding the Product pricing
realistically for the future.
Up-to-date Average Cost can be reviewed along-with the
cost 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 fix
responsibility for each kind of variance
 Easy to identify required operational improvements
 Automatically value inventory at moving average
item 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 overhead
o Define item costs for each period
o Perform cost rollups for each period
o Variance analysis for each period
 Product Profit Margin computation to include direct
costs (planned) as well as variances
 Higher standardization required in engineering
phase 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 operational
inefficiencies
PS: I have not covered any system related information or setups in this article (I shall be writing another article to present
a 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