Explore the Benefits (and Avoid Potential Pitfalls) of Standard Inventory Costing
Applying standard inventory cost accounting principles can bring companies numerous benefits, including simplifying processes, providing benchmarks, and more.
However, they can also bring significant consequences if not applied properly.
Explore steps you can take to help leverage the benefits and avoid common mistakes.
Background on Standard Inventory Costing
US accounting standards state that the primary basis of accounting for inventories is cost. However, it does allow companies to use standard costs if they reasonably approximate costs computed under one of the recognized bases of inventory costing.
Standard costing method sets material costs and rates for labor and overhead. Material costs are based on material production costs, while rates for labor and overhead are based on budgeted or forecasted costs divided by a predetermined cost driver, such as labor hours, machine hours, or production volume.
When properly implemented, standard costing has the following benefits.
Simplified Accounting Close
With actual costing, management will need to track all the inventoriable costs to ensure they are all captured before amounts for inventory and cost of sales can be finalized.
Standard costing simplifies the costing of inventory and cost of sales by having a predetermined value for each item of inventory produced and sold. It facilitates automatic recording of inventory transactions as systems can use the predetermined value to record inventory movements.
Performance Management
Standard costing sets up a benchmark that can be used for evaluating the performance of various departments involved in the procurement and production of inventory.
By comparing actual costs incurred to standard costs, management can monitor and manage performance that can assist in managing costs, monitoring economic drivers impacting costs, and managing employee performance. It can also be used to motivate employees by awarding incentives when they meet or exceed their performance standards.
Careful considerations should be considered when setting up performance standards to ensure that expectations set by management to its employees are based on realistic and achievable standards. Otherwise, setting up unrealistic or unachievable standards could have a demoralizing effect to employees.
Cost Reduction
Standard costing can help management identify areas where improvement in efficiency can be made as well as where opportunity for potential cost reductions might exist.
Decision Making
Standard costing can assist management in making informed decisions by providing timely and accurate measure of cost and performance that can be used to benchmark the company against its peers and make strategic production decisions, such as consolidating production, buying, and decision making.
Common Pitfalls of Standard Inventory Costing
To achieve the full benefit of standard costing, management must be aware of the potential pitfalls. Here are some common pitfalls to watch when using standard costing.
Overly Complex Standard Costing Methodology
Setting up the standard costing methodology and maintaining it can require significant effort particularly when companies have one or more of the following:
- Multiple and diverse product lines
- Fluctuating production schedules
- Complex production cycle
- Multiple cost drivers in a volatile market
Management should perform a cost-benefit analysis of maintaining a complex but more accurate costing method versus the cost and effort of creating and maintaining the model.
Inaccurate Standards or Lack of Periodic Updates
Standard costing relies on accurate information, such as cost of labor and materials, budget, forecast, and production data to determine the material standard cost and labor and overhead rates.
If standards aren’t accurate and regularly reviewed and adjusted as necessary to reflect the most updated cost and production information, management may not be able to rely on or accurately report inventory value and cost of sales amounts. However, considerations should be given to the effect on inventory of changes in standard costs to ensure accurate financial reporting.
Management won’t be able to accurately and fairly assess performance if the benchmark used to measure it isn’t accurate.
If the standards are inaccurate, there’s also a risk that inventory may be misstated, which can have pricing implications and could also result in improper inventory write-downs. This could also result in misstatements in the cost of sales, gross profit/margin, other key earning metrics that could impact product pricing decisions, incentive bonus payouts, share prices, covenant compliance, borrowing base calculations, etc.
Inflexible or Rigid Standards
When setting up rates, management should use normal production capacity to allocate fixed overhead costs which includes consideration of regularly planned maintenance activities. Management may have the tendency to identify a fixed production capacity without accounting for historical production data and cyclical or seasonal fluctuations under normal circumstances and over several periods.
Setting up rigid standards can result in misleading cost information particularly when the Company operates in very dynamic or cyclical environment.
Lack of Cross-Functional Collaboration
Management has the tendency to assign responsibility for setting up and maintaining standard costs to the accounting team or cost accountant.
However, developing standard costs requires collaboration and input from various departments that support the manufacturing process. Responsibility for developing standard costs should be assigned to a group of individuals from various departments that provides input to standard costing—not just the accounting team.
Lack of Detailed Review of Variances
One of the benefits of standard costing is that it allows management to monitor the performance of specific elements of the manufacturing process.
By not having a periodic and thorough review of the variances by each of the departments responsible for them, management will lose a key benefit of standard costing and therefore, the company may miss the timely identification of process inefficiencies, waste, or cost improvement opportunities may.
Lack of System Integration
For accurate data to be captured, a system must be designed that would allow the variances to be captured.
To do that, management should identify the specific types of variances that it would like to capture and design its manufacturing and accounting systems to be able to capture and calculate the variances that would allow management to generate reports from the system that management can use to facilitate a detailed and substantive review and recording of those variances.
Considerations When Implementing or Assessing Standard Costing Methodology
Following are the most common areas that management should review when transitioning to standard costing, or if management experiences issues like large unexplained variances, inconsistent gross margin by product, period over period, or pricing challenges.
General Ledger (GL) Accounts and Mapping
Review and update the chart of accounts as needed to ensure that the appropriate and necessary accounts exist in the system to support recording and reporting of relevant transactions, including valuation adjustments to inventory and proper recording of variances.
Management should also ensure that the GL accounts are properly classified in the financial statements.
Management should additionally consider deactivating accounts that are no longer relevant or needed. For example, if management intends to separately track both purchase order variance and invoice price variance, then separate GL accounts may be needed to record and track these separately.
Bill of Materials (BOM)
The BOM is used to list the various components needed to manufacture a product. This can also include the labor hours, machine hours, yield, and other information needed to capture the cost of production.
By periodically performing an audit of the BOMs, management can ensure that changes in any of the cost component of manufacturing the product are accurately and completely captured.
Updating the BOM may require management to perform time studies to make sure that labor and machine hours are still appropriate and perform detailed variance analysis to determine variances that resulted from inaccurate BOM.
Overhead Cost Pool
To ensure that all the costs necessary to produce the product are captured and appropriate per US GAAP, management should periodically review the components of the cost pool to includes all indirect costs from supporting departments, such as supply chain, information technology, or corporate allocations, and excludes costs that are not appropriate for capitalization, like shipping costs finished goods warehousing costs, abnormal production related costs like rework, scrap, and spoilage, casualty or theft losses, bidding costs, research and development costs, marketing, advertising, and selling expenses, and other general and administrative expenses attributable to general business activities as a whole and not directly or indirectly related to the manufacturing or wholesaling operations (e.g., billing/collections, officer salaries, etc.).
System Configurations
If management has difficulty tracking or reporting variances, management should consider reviewing how each inventory transaction or movement is recorded in the system. This may require management to follow various transactions to identify any potential scenarios and evaluate if the system is:
- Capturing the transaction completely and accurately
- Accurately assigning the cost to the inventory and the variances are accurately recorded
- Recording transactions to the appropriate general ledger account. For example, whether the system was configured to properly account for abnormal material loss, product substitutions, or abnormally low yields?
If these transactions aren’t captured properly—as in being expensed immediately as opposed to capitalized—it can result in improper valuation of inventory and cost of goods sold.
Cost Accounting Period-Close Procedures
Implementing standard costing also requires management to implement additional accounting period close procedures to ensure that capitalized variances, including standard revaluations, are amortized to cost of goods sold account on an appropriate basis. If variances are expensed automatically by the system, then an analysis is necessary to determine if a portion of the variance should be capitalized to balance sheet, if deemed material.
This would require management to determine the most appropriate method to amortize variances when such accounts are initially capitalized in inventory or alternatively, if variance accounts are initially charged to cost of sales, management must determine the appropriate method to determine the portion of the variance that should be capitalized to inventory. The accounting close procedures should also include the review and investigation of material variances to ensure that abnormal losses such as excessive scrap, rework and downtime, aren’t capitalized, but instead are charged to cost of goods sold in the period when such occurred.
We’re Here to Help
If you have any questions about standard costing for inventory, please contact your Moss Adams professional.