Cost is divided into two broad categories: historical cost and predetermined cost.
Historical costs are computed after the production of goods is complete. Therefore, the cost figures have value only from a historical point of view.
Although the figures obtained at the end of the production process may have a definite value in correcting past practices if they are carefully analyzed, a key limitation is that inefficiencies and errors in production are not identified until after the damage is done.
Cost analysis requires the use of predetermined cost estimates, which are made on a more or less scientific basis, to generate standard costs.
These costs are prepared in advance of production or supply, and they are based on a correlation of the technical specification of materials and labor to the prices and wage rates estimated for a selected period of time.
The following differences exist between historical costing and standard costing:
1. Costs used: Standard costing includes cost figures that are predetermined based on past experience and expert advice. In historical costing, data are included from costs that have actually been incurred.
2. Cost calculation: Standard costs are determined and known before the start and completion of production, but historical costs are known only after production is finished.
3. Cost control: Standard costs are helpful to control costs, judge efficiency, and improve the operations of the organization. By contrast, historical costing does not provide these advantages to the management.