Being regularly involved in consulting and auditing manufacturing and distribution companies, I have become accustomed to dealing with “standard cost” accounting for inventory. While it’s commonplace for manufacturing and distribution companies to use standard cost to value their inventories, many may not realize that if they are not regularly reviewing and updating their costs, they may create problems in accounting (especially at year-end) and/or miss opportunities for improvement and cost savings.
By assigning and using standard costs for inventory, companies are making projected estimates of the expected value of inventory (on a per-item basis) based on historical information and other accumulated data such as pricing quotations from vendors. The most basic problem with that approach is that anything other than “actual cost” is not acceptable under generally accepted accounting principles (GAAP). GAAP requires that inventory be stated at actual cost—using FIFO, LIFO, or weighted average; however, standard cost may be acceptable as long as it materially approximates “actual cost.”
Given that GAAP requires actual costs (or a close alignment thereto) and it may not be practical or cost-effective to obtain actual cost data in real time, what is the solution? Without completely altering the company’s existing cost structure, there are ways to manage standard costs and help them more closely approximate actual costs.
The following three steps should be incorporated into a company’s inventory accounting processes to assist in managing its standard cost:
1. Review the company’s capitalizable costs. When setting standard costs, have all appropriately capitalizable costs been considered, such as incoming freight for procured inventories or overhead for produced inventories? For instance, freight is subject to potentially significant variations due to factors such as the carrier or the quantities being ordered.
2. Update standard costs regularly. Updating standard costs on an annual basis is a good start but is probably not frequent enough to ensure accurate inventory costing (not to mention the potential effects on the company’s income statement every time inventory is expensed inaccurately). If the cost of procuring or producing a product has changed since the standard cost was last modified, inventory will be misstated accordingly.
3. Maintain a “standard-to-actual” reserve in the balance sheet. Every time that any component of inventory is acquired or produced at a cost different than the assigned standard cost, that variance hits the income statement and inventory is misstated. If feasible, at the end of every reporting period an analysis of purchase and production costs for capitalizability should be performed. When complete, capitalizable variances should be recorded in a “standard-to-actual” reserve within inventory on the balance sheet with the remainder being appropriately expensed through the income statement. This reserve has the effect of adjusting the company’s inventory balances to “actual,” which is appropriate under GAAP.
By performing these steps, potentially material year-end adjustments to inventory and the income statement might be minimized if not avoided altogether.
What’s more, getting closer to actual costs throughout the year allows accounting to have a better handle on financial reporting and gives operations a greatly improved understanding of their actual production costs and the opportunity to adjust them if needed to save the company money—which is always a desirable result.
Chris Crowder is a senior manager in the Accounting and Assurance practice at LBMC, a Tennessee-based accounting and financial services family of companies.