Actual costing is used for measuring the actual cost of a batch and the average actual cost of making a specific product.
In this post, I will explain why you need actual costing, and how to calculate it.
What is actual costing?
We calculate the real cost that we spend on doing every batch by itself. We take the actual cost per batch, and we calculate it per product/per KG or any other unit we use.
Differences between actual costing and regular costing
1. Different purpose – The regular costing is used to calculate the cost of a product, so we will make sure the sale price will allow us to make a profit. The regular costing is made usually in the beginning of a product life in order to decide on a sale price. The regular costing is updated once in a while, usually a long while. Actual costing calculates the real cost of each batch, and therefore we always know what the real cost of production for each batch and each product is.
2. Assumptions – Regular costing assume ideal production cost or average production cost, while actual costing is taking the real cost of a batch. For example: Regular costing might assume 2% scrap while in actual batch production we might get only 1% or even 5%. We can see it in the following figure: Regular costing assume that 1000 units will cost 3000$ to produce, but each batch has a different cost. Sometimes more and sometimes less.
3. Actual ver. assumptions – We calculate the regular costing in order to find the right sale price and to make sure we will make a profit. Actual costing allows us to know just how much profit we made for each customer order.
4. Find production problems/opportunities – Actual costing will sort out the problematic production costs /shipping costs /support costs that we did not take into consideration in the regular costing we did in the past. On the other end of the scale, we will find the products that we are producing in a much cheaper way than we predicted in the regular costing that is based on averages.
Who needs actual costing?
First and foremost, the production people need it. The actual costing will easily show us product that needs a cost reduction process.
The result of the cost reduction process could be:
1. Change the default machine that produces the product to a faster or slower and cheaper machine.
2. Improve the tolerances of the expensive materials so you will use them as little as the spec allows you.
3. Reducing set up time for a product (see the following post)
4. Find the sources of waste and try to eliminate them or reduce them.
5. Use larger batches in each production and/or change the finish goods inventory level.
6. Much more
Actual costing will also find many products that we know how to produce with less cost than we anticipated. From those products, we can learn a lot. If we find out why they cost less, we can
In those cases where we have no success in reducing high and unplanned costs, we need to update the regular costing, so the product will get the right price. In any case, there is no point in producing products that have negative “contribution” (I will explain about contribution later or in another post).
Another solution that I used when we found a high-cost product, and we couldn’t reduce the costs, was to go back to R&D and reconstruct the product so it will take into consideration the production constraints. Usually, this is easy, and all we need is just to ask for it. We saved millions like that.
On the other hand, when we do better than regular costing we need to update the costing so the sales can offer a reduced price to special customers. If we keep the information and don’t share, we might lose a lot of easy sales.
As a summary, I will say that actual costing is used by production people, but people from R&D and management will also have great value in understanding the numbers.
How to calculate actual costing
Calculating the actual costing is a little bit lengthy and requires patience. If you don’t understand something, just send me an email to: theplanningmaster@gmail.com
Costing is based on 3 elements:
- Direct cost – All costs that will change if we produce one more product or one more KG of product.
- Indirect costs of production – For example: production labor cost. If we produce fewer products this month, we usually pay the same to the production employees.
- Indirect costs of the rest of the organization – CEO wages, sales salaries, and everything that is not related to production.
The result of the costing is a cost per product or a cost per KG or any other unit that sales use to sell our products. For the purpose of this post, I will use cost per product unit, but you can do the same with any other units that your organization is using.
Direct costs
These are the easiest costs to calculate. We only take into consideration costs that will change due to the number of units we want in a specific batch. These costs usually are made of:
1. Material cost – We should take the whole amount of material that we consume for the batch including all the waste and defects. You can calculate it like this:
Amount consume = Amount of raw material taken from the warehouse for this batch – Amount of raw material returned to the warehouse for this batch
We do the above calculation for every raw material. Then we multiply it by standard cost or purchase cost of raw material. We can now know the raw material of the whole batch by adding every cost.
Now we will divide the total cost by the amount of GOOD units we produce, that way the GOOD units take into consideration the cost of all the defects.
Material cost per unit = Total cost of raw material per batch / Number of Good units per batch
2. Energy costs – We need to quantify the amount of energy that we use in each batch. 
If you have electricity meter in front of your tool, then you can take the information from there. If we don’t have that, we can calculate the amount of energy we use per tool hour. We can take it from the tool book or calculate it like this:
Energy cost per tool hour = cost of electricity per hour X (electricity use per month or year / number of working hours)
Energy cost per batch = number of working hours per batch X Energy cost per tool hour
Energy cost per unit = Energy cost per batch / Good units
3. Direct labor cost – We only take costs that can be connected directly to the amount of product that we produce. For example: The tool operator will get almost the same salary if he produces X amount of units or 2X amount of units. Even if the tool does not work, he will still get his salary. On the other hand, if you have a packaging contractor, he will get his money only if there are products for packaging. His payment is a direct cost that depends on the units produced. So in this section, we will only have people that get money only when we actually produce. Possible calculation if the packing workers are getting paid by the hour goes like this:
Direct labor cost per unit = (Number of packing hours in the batch X number of workers X Hourly payment) / Good units
4. Packing materials – the cost of materials used for the batch / Good units
Indirect production costs
This is the hardest part to calculate since it requires a lot of thinking on which cost should we take and how to distribute it. The regular costing will take all the costs and distribute it equally upon units/KG/working hours or any other unit. We will do almost the same but with a small change and a big impact. For example, we will calculate the average cost of a working tool hour, and then we will multiply it by actual working hours instead of an average number of hours we use in the regular costing. That will show us exactly when we did have a more expensive batch and less expensive one. Wait… let’s start from the beginning…
Elements we will take into accounting: Every production cost that have no direct link to a batch but have a connection to the volume of production. For example: Cost of labor; we will pay the workers their salaries if we are producing a lot or less in the short term, but the number of workers is connected to the volume of production (less volume usually means fewer workers in the long term). Also included are the warehouse personnel, the production control, energy and water that were not included in the direct cost. What’s not to include: IT cost, COO salary, property taxes, etc. Those expenses will go to the fixed costs section.
If we have only one production phase that is similar among the products, then we can just sum all the annual expenses and divide it by the number of good units we produce in a year. The result will be added to each unit.
In many cases, we will have a different and more complex production. We might have more than one step production. Each step will have tool hours or working hours. Let’s assume we will take the working hours of the people that worked on the batch.
Example:
Assumptions:
1. The organization has 30 million USD costs in indirect production costs a year.
2. The production is based on 2 steps: Production and packing (no packing contractor).
3. We have 150 workers in the factory that works 300,000* hours a year.
Let’s calculate:
1 Worker hour = 30,000,000/300,000 = 100 USD (that is not his salary; it is the cost of all indirect production costs that is divided to working hours).
Cost per batch:
A. Let’s assume we had 2 tool operators that worked on this batch for 10 hours and 6 packaging workers that worked 5 hours each on this batch.
B. Total hours per batch = 2*10+6*5=50 hours
C. Indirect production costs per batch = 50 hours * 100 USD (cost per hour) = 5,000 USD
D. Let’s assume we produce 1000 units in this batch:
Indirect production cost per unit = 5000 USD / 1000 units = 5 USD per unit
So, 5 USD is what we need to add to each unit. Please notice that we picked worker hours as the unit that we distribute the costs. We assume that salaries are the largest cost in the production. If the machines cost is larger than workers cost, use tool hours instead.
*Remarks –
1. The total working hours is not the actual “working hours” that we pay the workers, but it is the sum of all the hours that the workers are actually working on the batches (We don’t take into consideration holidays, sick days, happy hours…)
2. In case there are special skills people in each phase that have very different wages then we will have a different distribution of the indirect costs (send me a mail, and I will explain).
Indirect costs of the rest of the organization
All other costs that we did not take in the last 2 sections, we will take them now. We will divide the annual costs per good unit/KG that we produce. That will be our indirect cost per unit. This value will be the same as the regular costing so instead of calculating it just take in from your financial department.
Let’s sum it all:
Let’s calculate the cost of a batch:
Direct cost (Material+packaging materials+energy+direct labor force)
+
Indirect production cost =Number of working hours X the value we calculated as indirect cost per hour.
+
Indirect costs of the rest of the organization = Number of units X constant indirect cost per product
The total cost will be the cost of producing the batch !
What to do with the result?
- Calculate the profit per batch: Batch Profit = Sales revenue by batch* – actual costing of production per batch.
- Sort the batches from very profitable to the least profitable. I can guess you will find some batches will have negative profit.
- Anyway, look at the batches list from the top and from the bottom. You will find batches that are very profitable, try to understand why and apply the reason to other products.
- Check the losing batches and try to understand what happened there. What happened to that specific batch and how you can avoid it in the future?
- Now try to sum all the batches per product and see which product is very profitable and which one loses money. Show it to sales and see how it will help them be more competitive in the profitable products and try less on the losing (or much less profitable) products.
*Remark: In case you have inventory left from the batch, subtract the cost of that units from the profit calculation so you will get the actual profit of the batch. If you disregard this, you will get funny results 🙂
Contribution
Contribution is the amount we actually profit from each additional unit. The contribution is not taking into consideration any indirect cost that we will pay no matter if we produce one more unit or not.
Contribution = Sales price – Direct cost
This is a very important part of costing and what to do with it, so I will write a post that will only deal with contribution.
Actual costing is one of the strongest tools we have for a production organization. The amount of information that we can get out of it is enormous. It is one of the strongest tool I use, and I was the one that introduced it to the organization and made it a working tool.
The actual costing reveals problems that the production people are already aware of, but they don’t understand the monetary impact.
This tool also has a huge impact on sales and R&D since they try to develop more complex products, but they don’t really know how much it cost to produce it.
If this is the first time you’re introducing actual costing to your organization, you will find out that some products are not producing any money.