Understanding Manufacturing and

Inventory Cost Accounting Practices

By Reid Biberstine

Preface: Technology can be a very powerful investment.  It was true yesterday, and it’s true today.  The key to benefiting from technology is as simple as the premise of business itself:  Warren Buffet is credited with the quote, “Price is what you pay. Value is what you get.”

The difference between good investments in technology and bad investments in technology follow the same logic: How much benefit (Value) will you receive from your investment in technology in return for the costs (Price)?

Recently, the owner of a prosperous manufacturing business asked me for help.  He was considering the purchase of new ERP software for his business.  I asked him several questions including, “Does your company use standard cost?”  He said he didn’t know …but would find out.  Upper management's understanding of accounting practices can benefit a company in many different ways.  In many companies, the “old school” accountant and poor accounting practices are undermining the entire company’s operations.

I about fell off my chair when the owner called back and said his controller wanted to make sure that any new ERP package would employ FIFO costing, like they were currently using.  It is very uncommon to see FIFO used in a manufacturing environment, since it generally causes your inventory value to be overstated, your cost-of-good-sold to be understated, and your tax liability to be increased.  I told the owner to check with his CPA and find out whether he preferred standard costing or average costing, since FIFO is very rarely the most beneficial method of product costing.

He checked with his CPA and then told me his CPA was mostly interested in software that would accurately track inventory quantities.  I nearly fell off my chair again. Inventory management and accounting are one function when it’s done right, and when it’s done well ...it can help to show exactly how to improve the bottom-line.

To understand the differences in accounting methodology, it will be easiest to review the challenges, and then address how cost accounting practices address these challenges.  One of the ways to identify the effectiveness of a costing methodology is to consider the type and size of a business ...and simply look at the tools being used to calculate profitability.  Most companies have computer systems that handle sales orders, A/R, A/P, G/L, and Inventory.  If these systems are properly designed, installed, and completely integrated …calculating profitability, COGS, and inventory value can be as simple as executing a single keystroke.

Many companies with poorly designed or outdated systems spend dozens of man-hours every month counting inventory, deciphering cost data, calculating the value of materials received into stock which have not been paid for, and using spreadsheets to accomplish the tasks.  When it’s all done, (typically days, or weeks after the period ends) they have wasted a ream of paper and built macros in spreadsheets to determine if the period was a profit or a loss.  If this approach and these tools indicate a profit, then management is happy …but they don’t know why.

Spreadsheets are a cumbersome tool to maintain and employ for these functions.  If a company is using spreadsheets for these purposes, they are using the wrong tool.

Managements often focus on production machinery, tooling, and distribution equipment, as tools that can be replaced, or upgraded, to reduce costs.   Accounting tools and their efficiency can be much more important, but it is much easier to look at a drill press and understand its effectiveness.

Replacing an old manufacturing machine can reduce labor costs, improve output, and reduce waste, while replacing old accounting practices can do that ...and more!  Management quickly accepts that new machinery takes time and money, and recognizes that if implemented correctly, it quickly pays for itself many times over.  Implemented correctly, a new accounting methodology produces even better returns on the same dollar investment.

Costing methodology is an important factor in all businesses, however, companies that Manufacture products face more perplexing challenges because products in inventory usually contain purchased material, purchased labor(outside processing) and added labor.  Inventory is constantly turning over as products are sold and inventory is refreshed with new stock.

The true and exact cost of inventory fluctuates as purchased material prices change and labor rates change over time.  Inventory is confusing in a manufacturing business, because assemblies in stock may be comprised of materials bought at different times and at different prices.  Stock sub-assemblies also have the same characteristics.

Accurate gathering of information is necessary, regardless of costing methodology.  The procedures (and costs) to gather and analyze information is critical for every business, yet is frequently overlooked.

Purchase Orders need to be created, although it is seldom necessary to print more than two copies, and many companies successfully print none at all!  Printing additional copies increases the cost of purchasing, receiving, and vouchering payments, plus printing generally makes every department that receives a printed copy less efficient than it would be to share the data electronically from a central database that is created only once. 

Printing unnecessary paper documents is very expensive.  Many companies estimate that printing documents costs the company at least one dollar per page.   That estimate includes the costs of paper (or forms), printing supplies, employee labor printing, sorting and distributing pages, sorting and filing of pages by each recipient, labor to retrieve and store completed forms each time they are referenced, plus the costs of filing cabinets and file storage areas distributed throughout the company.  Eventually, every company spends thousands of dollars increasing the company’s file storage capacity, or spends thousands of dollars on old files cabinets: emptying, cleaning, and disposing of contents.

Accurate costing of materials starts with purchasing.  The Purchase Order is the “control document” with the accurate information about the negotiated and agreed price (cost) of every item at the time it is delivered ...except for, freight, taxes, duty, and fees.  Inventory cost information begins with the purchase order price for each item delivered.

This is usually the first point of error in costing.   The receiving department needs to have accurate information on exactly what material is coming into the enterprise, what quantity, which vendor is supplying the material, and information about the characteristics of the materials. 

A good example of the problems resulting from poor “control documentation” allows a company to receive the correct quantity of materials …which are not packaged in accordance with the purchase agreement.  The quantity received is correct and the quantity matches the vendor’s packing slip.  If the receiving department doesn’t have access to the purchase order details (like packaging instructions), the receipt appears to be correct …but the cost to the company of the material received may be very wrong …because incorrectly packaged materials are worth less.  Packaged incorrectly, they will require additional labor and/or materials to facilitate their use or resale …their actual cost to the company may be significantly higher than the price shown on the vendor’s invoice.

Accurate costing is impossible without a system that assures a “3-way match.”  This term means that the following three things “match”:

1)     materials ordered

2)     material received

3)     vendor’s invoice

A 3-way match is simple if all three departments share the appropriate information from a common database.   Failure to issue Purchase Orders and employ the 3-way match concept can cause errors in costing that can easily increase the total material costs by10-12% …without the business owner knowing he frequently pays too much! 

It should go without saying that the receiving department need not have any information relating to prices or costs.  Making the 3-way match requires management to insist that the accounting department has no business paying a vendor who cannot furnish a Valid Purchase Order Number on the Invoice.

If your company matches only two, of the three match components, it is likely  your costs are wrong, your inventory is wrong, your COGS is wrong, and your P&L Statement is wrong.   Almost never is the error in your favor!

Many accounting systems keep more than one set of figures for every item in inventory:

• Current Cost –        this is the most recent cost paid for the item
• Standard Cost -      arbitrary cost figure established to represent “usual” or                                       “normal” cost
• Average Cost-         this is a weighted average of established by automatically                                   smoothing fluctuations in costing
• Frozen Cost-           typically a frozen cost is established whenever a physical                                   inventory is taken.  It is stored as a point of reference that                                    reflected the cost of each item at the time when the                                          inventory was taken.
• Landed Cost-          Some systems provide extra fields to track additional                                            components of cost (e.g. freight, duty, excise, brokerage)

The purpose of cost accounting is to accurately identify both COGS (Cost of Goods Sold) and maintain an accurate valuation of “On Hand” Inventory.  Different sizes and types of businesses have different challenges.  Very small businesses often calculate both Inventory Value and COGS without details by “backing into the numbers.”  This term means that they take frequent physical counts to determine both current inventory ...and COGS:

Backing into Numbers

Calculation –

Beginning Inventory + Purchases – Ending Inventory = COGS

1. Beginning inventory is the ending inventory value of the previous period.

2. Purchases are calculated by totaling the invoices paid since the last inventory.

3. Companies compute ending inventory by physically counting items in inventory and then multiplying each item times its current cost to value the inventory on hand. 

While this formula is simple, it is inefficient, error prone, and it conceals the information and the detail that the business owner needs to understand and improve the company’s bottom line.  Here are three problem areas:

Calculation Errors –

1. Beginning inventory is only as accurate as the last ending calculation.

2. A large inaccuracy arises because the total amount of invoices paid is not necessarily for the inventory counted.  Purchased materials are usually received before their invoice arrives.  Often inventory is received and put on the shelf many days before its invoice arrives from the vendor.   It is possible that it can be received and resold before the invoice is ever received.  The opposite problem may occur at other times …because of an advance deposit (or a variety of other reasons.)  Inventory on the shelf must be meticulously valued to catch the potential errors. 

One of the ways to address this problem is to calculate the value of the items received into in inventory for which no payment has been made.  Then deduct this amount from the value of the ending inventory.

3. The manual inventory valuation process is not accurate, because the current (or most recent) price paid may not fairly represent the price actually paid for the materials that are still in inventory from previous inventory periods.

4. The fourth problem encountered from “backing into numbers” results from the inaccuracy of the physical count.  The inventory count is often taken by employees who are unable to identify the inventory items correctly, or to accurately count and report their findings.

The “backing into numbers” method is employed by companies with inadequate business accounting software.  These errors can allow a business to appear profitable, and possibly pay taxes on profits never received.  In reality, they don’t know how much money is actually earned or the true value of their inventory. 

To make matter worse

1)     they seldom realize how much money is wasted every month paying employees to take unnecessary inventories

2)     they don’t  recognize that much of the staff in the accounting department is performing unnecessary calculations

3)     the status of current operations is always overshadowed by the fact that numbers aren’t available because the numbers for the previous period haven’t finished the month-end processing

4)     It is fair to say that such business owners (when profitable) are happy …but they don’t now why!  The unprofitable business are unhappy ...but they don’t know why either.

Standard Costing

Standard Costing has traditionally been the favored method used by accountants and accounting software packages for manufacturing.  It solves many of the problems which are introduced by trying to “back into numbers”.  Standard Costing is accomplished by establishing a “Standard Cost” for each item in inventory.

The “Standard Costs” of manufactured items have two components: Labor and Material.

Consistency and uniformity in cost calculation is one benefit to Standard costing.  At any point in time, the total G/L inventory value should equal the summation of items in inventory times the standard cost of each item.  Furthermore, the standard cost of every assembly should equal the sum of the standard costs of the item’s components. 

Each item’s standard cost can be used to calculate beginning inventory, COGS, and ending inventory.   Since the item value is stable, it is easy to use the standard cost to calculate the COGS (at the line item level) and determine a contribution margin from each sale during the accounting period.

As new inventory is purchased, it is placed into inventory at “Standard Cost.”  The total inventory valuation (appearing as an asset on the General Ledger) can be calculated by multiplying the Quantity of each item in inventory, times its standard cost.

If the actual price paid is different from the Standard Cost (or the value of the added labor varies from the established labor standard) this is considered a Cost Variance.   In a manufacturing environment, employing a standard cost for each item resolves the complicated problem of establishing new standard costs for every assembly containing the component part whose cost has changed.

The biggest drawback of employing a standard cost system is the time and experience required to oversee the establishment and maintenance of the standard cost values.  In addition to estimating a “standard labor” component, job costing becomes somewhat more complex, since standard costs may or may not fairly represent the current or future profitability of products or lines.

Rather than establishing a new “Standard Cost” each time an item’s cost changes, the variance (or difference from the standard) is recorded into a “Variance” account and the inventory is valued at “Standard.”

The Variance account is typically an “Expense” (and sometimes a gain) in the current accounting period.   Audits by taxing authorities or independent accountants can consume a tremendous amount of time when huge variances or costing issues move the bottom line up and down.

All inventory records are maintained based upon standard costs, as well.  The product's inventory value is maintained at the standard cost for each item.  Any variances to those estimates are expensed on the income statement immediately in the reporting period in which they occur. Periodically, (usually once a year), new standards are developed for all items.  At that time a “cost roll” is usually performed. 

During a roll, most companies replace each item’s cost with the item’s current cost.  To make the adjustment work, all items with Bills of Material have to be re-costed too, so that every item’s new standard will still be the sum of the item's components (including labor.)  During the cost roll, the total inventory valuation is recomputed by summing the value of all items in inventory times their new standard cost.  This valuation is affected by inventory quantity, changes in purchased costs, changes in labor rates, and changes in manufacturing efficiency (as reflected by increases or decreases in the time required to produce each part).

The total inventory adjustment (markup or markdown resulting from the cost roll) is posted to the same variance account, so this annual adjustment becomes a counter-balancing entry to the variances posted throughout the year (since the last roll.)

Average Costing

Average costing is a much simpler system.  Each time an item is sold or removed from inventory, the QOH is decreased by one, and the value of inventory is reduced by the average cost of one.  The total value of inventory is always equal to the QOH time the average cost for each item.

Rather than performing periodic cost rolls to reflect changes, a new weighted average is simply calculated each time inventory is acquired or replenished.  The average cost of the item when consumed or sold, is valued at the established inventory average at that point in time. 

This system does not require the monitoring and maintenance demanded by a standard cost system.  Many software packages do not offer “Average” cost in manufacturing environments, because there are several issues which can cause the simple weighted average calculation to produce unacceptable results.

One good example of “why“ a simple weighted average does not always work is the result of transaction timing.  It is not uncommon or unusual in manufacturing environments, for an inventory transaction to occur in a “time warp.”  New inventory arrives at the receiving dock, and because that particular item is in short supply …part of the inventory is rushed to the manufacturing floor.  Then, manufacturing completes work order (consuming the inventory item) before receiving has official announced its arrival ..which results in a temporary inventory position of appearing to have a negative quantity “on-the-shelf.”

Now, when received replenishes inventory by entering the new receipt, the weighted average would require that the negative quantity n hand be “averaged” with the positive quantity being received.  If the unit price of the incoming stock varies from the current average, what should the new average calculation produce?

The answer is simple.  Those units that when used, drove the inventory balance below zero, were consumed or sold with an inaccurate cost.  The average that existed in the item file (at the time of consumption), was actually the last known average, but it could not take the value of the new inventory …which must have been present, even though the system does not yet know its value.

Because of this scenario, whenever inventory is received against an item showing a negative balance on-hand, extra consideration are necessary when receiving or replenishing stock.  An immediate adjustment can now be made, to compensate for that quantity of items, which were valued incorrectly, at disposition time.

We at Xdata support both “Standard” and “Average” costing in all of our current software packages.   We are able to accurately support average costing by applying additional calculation logic that follows both Generally Accepted Accounting Practices and straightforward business logic.

If your business objectives include: meeting your customer’s requirements, maintaining minimum inventory levels, accurately calculating your profitability in every transaction, and minimizing the time and effort required to produce accurate and timely business data and financial information, then Xdata’s experience in manufacturing, distribution, and accounting can help you reap larger rewards. 

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