The following three steps should be incorporated into companies’ inventory accounting processes setting and managing standard costs:
1. Review Capitalizable Costs
When setting standard costs, have all appropriately capitalizable costs been considered, both direct and indirect? There are many categories of eligible costs under GAAP.
Inventory costs include all the following:
- Direct materials and indirect materials, such as supplies, less relevant vendor discounts and rebates.
- Inbound freight, customs, and duties charges, if relevant.
- Direct labor, indirect labor related to production, as well as related payroll taxes, employee benefits, incentive programs, etc., and inspection costs.
- Production and warehousing rent, utilities, depreciation, repairs and maintenance, tools (not otherwise capitalized already), insurance, and other facility expenses and overhead.
- Handling and other storage/warehousing costs.
Typical cost accounting errors are due to omitting certain of these costs from the development of the standards. Said differently, often companies’ bills of material for key items are missing costs. Other common errors are due to materials and freight costs varying greatly depending on order size, method of transportation, and use of multiple vendors and carriers across geographies. Setting accurate standard costs requires having accurate historical data readily available along with knowledge of cost changes and market trends. Detailed cost reviews often also identify expenses not properly categorized or mapped on companies’ detailed income statements.
Reviewing and updating these capitalizable expenses can assist you in setting your standard costs at the true, fully loaded cost incurred.
2. Update Standard Costs Regularly
Updating standard costs each year is a good start; however, this may not be frequent enough for accurate inventory costing. Inaccurate inventory costing often will affect companies’ income statements when inventory is expensed. If the cost of purchasing and producing products has changed since the standard cost was set, inventory will be misstated accordingly.
Standard cost setting once a year or less frequent is a common mistake for manufacturers. Materials costs, labor rates, and other production can all vary, certainly during volatile periods in the market. Not monitoring these expenses regularly can lead to outdated standards and incorrect inventory values, and those can lead to significant financial errors and possible audit issues.
Take basic materials like steel or polymers, for instance, whose cost fluctuation is rather evident, particularly in recent years since COVID. Should the cost of these items rise (e.g. due to a change in a tariff) following your previous annual standard cost updates, your inventory will be undervalued, leading to potential financial statement errors. Updating standard costs for volatile costs categories at least every quarter can help prevent problems and maintain accuracy.
Guidelines for Effective Regular Updates:
- Quarterly reviews: Set up a system to update expenses at least once every quarter, particularly for erratic or expensive products.
- Automate changes: Track and automatically adjust standard costs using accounting tools or ERP systems, as fresh data comes in.
- Cooperation among departments: Make sure teams in manufacturing, procurement, and accounting cooperate to compile real-time cost data.
Regular standard cost updates not only help increase the accuracy of financial reporting, but also provide operational teams and sales with greater knowledge of production costs. This helps guide better decision-making all year long, including pricing to customers.
3. Maintain a “Standard-to-Actual” Reserve in the Balance Sheet
Inventory that is acquired and/or produced at actual costs different from the standard cost can lead to misreporting on the income statement. To avoid this, set up your income statement accounts to capture variances, by cost category across purchasing and production, and evaluate their significance each reporting period. Significant variances may be indicative of outdated standards, whereby those variances should be capitalized to inventory. Variances could also be indicative of unplanned rework, labor inefficiencies, equipment failures, and other operational issues, all which generally should be expensed.
Document any capitalizable variances and recognize their costs in a “standard-to-actual” inventory reserve/capitalization on the balance sheet. Such a capitalized reserve assists you in achieving compliance with GAAP (actual cost) even if standards have become inaccurate. If variances and the capitalized accounts trend consistently up or down, there is an indication that standards are understated or overstated, respectively.
Improving standard cost accounting can significantly impact companies’ financial accuracy, operational efficiency, and pricing decisions. At LBMC, we specialize in helping manufacturers optimize their cost accounting to implement data-driven process, identify potential costs savings, and ensure compliance with GAAP.
Ready to take control of your inventory costs?
Contact LBMC today for a consultation on how we can assist you in fine-tuning your standard cost practices, so your financials are accurate, and your production is cost-effective year-round.
Content provided by Andrew J. Usery, Audit & Advisory and Segment Leader – Manufacturing, Distribution, and Retail
