When to Use Standard or Actual costing in Business Central Manufacturing

Standard vs Actual Costing

One of the most common questions I am asked about setting up manufacturing in Business Central is whether to use Standard or Actual (FIFO) costing.

What is the Difference?

To decide which we should use, it's useful to understand them. In the two examples below I am assuming that we created two purchase orders to buy A-100 Raw Material and B-200 Raw Material.  We bought 10 of each at $100 and $120 respectively on PO-10101.  Later we bought 20 of A-100 Raw Material at a great price of $80 on PO-20202.

What is Actual Costing in Business Central

Actual Costing in Business Central is also referred to as FIFO (and sometimes Specific) costing.  In any standard ERP system this refers to the way the costs of inventory are tracked in the Inventory Sub Ledger (and by extension the General Ledger).

Essentially, when you look at the total dollar value of your inventory, Actual costing keeps track of the real purchase or production costs and creates a "FIFO Layer" to track them.

For example consider the following inventory sub ledger entries for a really simple case in January of 202x.

Assume the Trans. No. are in chronological order and all occur in January.

We are purchasing raw materials and the actual price we buy them at is being kept in the transaction history.  When we use them, we use them IN THE ORDER THEY WERE PURCHASED and this removes that amount of cost from the history. 

In my example, we need 15 pieces of A-100 Raw Material for the production order WO-1000 (and some B-200 also). We use the materials from Trans No. 00001 first, then a few more from Trans No. 00003 to add up to 15. You can also see that the Remaining Qty of Transaction No. 00001 is now zero.  This is because we "used all that material up." The remaining qty is updated as inventory is removed.

In the real world it's unlikely we used the material in exactly this order but that's fine. FIFO is an abstraction of inventory use meant to allow us to keep an inventory cost that can be audited and accepted by GAAP (Generally Accepted Accounting Practices).

What is Standard Costing in Business Central

Standard Costing in Business Central is different from Actual costing in a few ways.  In any standard ERP system standard cost always books the inventory value of a product at a "standard" that is set on the item card.

Let's use the same example, except we'll say that all our raw materials have a Standard Cost of $90 on our item cards.

Here is our simple case again with Standard Cost.

This looks a whole lot simpler.  Everything is booked at $90 regardless of the Purchase price. I added a field to show what the difference against the PO are. We don't need to track how many "remain" because we always use the same cost.

If this is new to you, you should be saying "wait a minute, I didn't pay $90 for these things.  What happened to all the differences?" and that is a great question. The Variance column shows the net difference which is a total of -$200.

The variance you booked in inventory goes to Cost of Sales - so in this case our company will book a $200 additional cost of sale in January.

I added a fake variance column to make this easier to see. My increased COGS of $200 is blended into all other COGS variances in January - it's not order specific.

When to Use Standard or Actual Cost

Let's summarize.

Standard Cost will blend all the variances and mistakes together, and move them to Cost of Sales. Increases or decreases in production or purchase costs at the individual order level will be smoothed out. Instead of analyzing specific orders to see how they did and why they might have been more costly or less, you will analyze your production families or overall production.

FIFO Cost will pass actual costs through to the inventory ledger and will then (in a simplified abstraction) assume you use the oldest items first and collect what it "actually" cost you to make the item.  With FIFO you can monitor the cost to manufacturer each order and compare it to the expected costs.  

So to answer the question of when to use Standard or Actual cost, you need to first answer the question:

Do I want to analyze my job costing at a job by job level for production orders, or do I want to blend all my cost savings and overages together and just look at it holistically?

Standard Cost: Repetitive High Volume Low Mix Manufacturing

Standard cost requires cost accounting activities in your business, and is usually viable when you have a repetitive product done in high volumes with low product mix. What I mean by that is that you make a lot (100s of thousands) of items, but you don't make a lot of different items. Example industries include automotive stamping, injection molding, consumer electronics and appliance components etc. 

These businesses tend to make the same item over and over, and they want to track the trends of manufacturing costing more than the specific examples of manufacturing costing.

Standard costing allows these businesses to see month-over-month if their variances are increasing or decreasing in the aggregate. They aren't likely to look at specific jobs or production orders to find out why the variances happened.  They are much more likely to look at overall trends of raw material pricing or worker efficiencies.

Actual Cost: Lower Volume and/or High Mix Manufacturing

Actual cost works better when you are analyzing the costs of making a product one job or order at a time. This tends to be true if you make very small numbers of products at a time (usually because they are high value) or you have a large mix of products and make those products infrequently.  

Actual costing (FIFO) lets your team look at each order and see what your margin was for that order.  You can evaluate if you need to make changes to pricing for future deliveries.  

Final Thought

Choosing Standard vs Actual cost won't make much of a difference in cleaning up mistakes or simplifying your accounting. The big difference is just where the mistakes end up in your books.  Standard moves mistakes to the Income Statement.  Actual keeps mistakes in the Balance Sheet.

Actual cost tends to work better in environments where you are revising your pricing on each order. If you are estimating pricing for customers on most or all your orders, actual cost is very important because it lets you effectively compare your estimated costs to your actual costs.

Standard Cost will hide the actual costs making it harder to compare to estimates.

You can read more of my Business Central manufacturing blogs for other thoughts. You can also watch content on our Sabre Limited YouTube channel as we post videos on topics like this all the time.