Inventory costing 2 better understand

Inventory costing

Inventory costing – is about costs allocated to value inventory in stock at the end of a reporting period and calculate the costs of sales/gross profit earned in a period. Most operations comprise retail or wholesale operations, using relatively simple inventory costing systems such as FIFO, LIFO or Average Costs, other operations such as manufacturing or servicing/construction use standard or actual costing systems.

Also keep in mind that the general rule in IFRS is that inventory is measured as the lesser of cost or net realizable value.

For context – Net realizable value

There are a number of different inventory costing methods available for Inventory / Cost of Goods Sold (COGS) valuations/allocations. Perpetual systems continuously update the inventory, avoiding issues inherent with periodic based systems. For cost flow, there are three (3) regularly used cost methodologies in the world: FIFO, LIFO, and Weighted-Average Cost (also commonly referred to as Average Cost).

1. FIFO or First-In, First-Out, always assigns the cost of the earliest unit available at the time of sale to COGS, regardless of which unit from the inventory pool is used.
2. LIFO or Last-In, First-Out, always assigns the cost of the newest unit available at the time of sale to COGS, regardless of which unit from the inventory pool is used.
3. Average Cost calculates the cost that is assigned to COGS and inventory each period closing with new units purchased and added to the inventory.

However, there are also more complex inventory costing systems that facilitate the (financial and operational) management of manufacturing and servicing activities, reference is made to standard costs and actual costs.

To visualize the difference of these three systems (FIFO, LIFO and Average Costs) here is a simple case in quantities of one product in inventory only:

The Case:

Opening stock 1 March 20×2	4 items in stock, ST1, ST2, ST3, ST4
Purchases March 20×2	1st purchase order, 1 item PO1
Inventory costing Inventory costing Inventory costing Inventory costing Inventory costing Inventory costing	2nd purchase order, 2 items PO2, PO3
Inventory costing Inventory costing Inventory costing Inventory costing Inventory costing Inventory costing	3rd purchase order, 3 items P04, PO5, PO6
Sales March 20×2	6 items were sold in the period (COS1, COS2, COS3, COS4, COS5, COS 6)
Closing stock 31 March 20×2	4 items in stock at the end of the reporting period

This results in the following Inventory / Cost of Goods Sold (COGS) valuations/allocations:

 

 

In practice – What is the effect of each system?

Three retailing US giants, Amazon.com, Inc., (NASDAQ: AMZN), and Target Corporation (NYSE: TGT) and Best Buy Co., Inc. (NYSE: BBY) each use a different inventory costing method. Amazon uses FIFO, Target uses LIFO and Best Buy uses weighted-average cost.

Here is one simple case to show the differences in applying these three systems:

Assume that all three retailers sell a popular trouser that sells for $32/trouser. To compare the impact of inventory costing method, also assume that all three retailers have the following inventory and sales data for the same period. To keep the calculations simple, a “unit” represents one million trousers.

• Beginning inventory: 3 units @ $10.00
• Purchases: 2 units @ $15.00
• Ending inventory: 1 unit

Sales are calculated as follows:

begin 3 plus purchases 3 is 5 available for sale,

less ending (not sold) 1  ===> sold 4 units.

Amazon – FIFO

Sold 4 units, 3 from beginning inventory and 1 from purchases

Cost of sales: 3 units @ $10.00 from beginning inventory and 1 unit @ $15.00 from purchases = $45.00

Ending inventory: 1 unit @ $15.00 from purchases = $15.00

Target – LIFO

Sold 4 units, 2 from purchases and 2 from beginning inventory

Cost of sales: 2 units @ $15.00 from purchases and 2 unit @ $10.00 from beginning inventory = $50.00

Ending inventory: 1 unit @ $10.00 from beginning inventory = 10.00

Best Buy – Weighted-average cost

Sold 4 units, average cost calculation:

Beginning inventory: 3 units @ $10.00 plus purchases: 2 units @ $15.00 = total costs $60.00 for 5 units,

Average costs $60.00 / 5 = $12.00/unit

Cost of sales: 4 units @ $12.00 = $48.00

Ending inventory: 1 unit @ $12.00 = $12.00

OR in comparison:

	FIFO	LIFO	AC
Revenue from sales 4 units @ $32.00	128.00	128.00	128.00
Cost of sales 4 units	45.00	50.00	48.00
Gross profit	83.00	78.00	80.00
In % of revenue	65%	61%	63%
Ending inventory	15.00	10.00	12.00

FIFO results in the remaining items in inventory being accounted for at the most recent purchase/market price (purchase input side), so inventory costing on the balance sheet is relatively high, with potentially higher risks for obsolescence. In addition FIFO also results in matching older purchase costs with current sales prices, so one may argue this does not reflect a proper matching of revenues and costs. The FIFO valuation method is the most commonly used inventory valuation method as most of the companies sell their products in the same order in which they purchase it.

LIFO is just the other way around, remaining items in inventory are valued prudently at low(er) old purchase prices, but matches current purchase costs with current sales prices. However LIFO is not allowed under IFRS! It assumes that the most recently purchased or manufactured items are sold first.

Average costs results in something in between, with the advantage that the perpetual system does not have to take into account layers of beginning inventory, purchases and sales. This method is mainly used by businesses that don’t have variation in their inventory. Average costs is allowed under IFRS.

Note: increases or decreases in sales and purchase prices may lead to very different outcomes, the example is hypothetical.

Standard costing

Standard costing is generally applied to manufacturing activities, but can be applied in other environments (i.e. service environment):

• Common / repetitive operations
• Input to produce output can be specified
• Can be applied where different products are produced, as long as there are common operations / processes

Standard costing is predetermined per product type/production department/production phase, and represent target costs under normal efficient operating conditions.

The difference between a budget and standard costing is that a budget is for a total activity, whereas standard costing represents the budget per unit of the units of budgeted production.

A standard cost is effectively a budget or target cost that is applied to both purchased and manufactured items. With standard costing, every item that is bought or made is given a standard cost. If a manufacturer holds routing information (i.e. details of resources such as labor and machines, along with process times) on the system, it would be normal to just enter standard costs for materials and resources and then have the system calculate the processing costs via a process usually known as a “cost roll-up”.

Traditionally, standard costs are re-calculated yearly and, if companies find they are re-calculating them much more frequently, that is usually a sign that standard costing is not appropriate for them.

Having set a standard cost for each item, all transactions for that item are then costed at that standard until it is changed. In real life, of course, the actual cost will frequently differ, as purchase costs can vary, as will manufacturing costs because process times can vary from batch to batch. This is actually the strength of standard costing because every time there is a variance between standard (budget) and actual costs, that variance is written to a variance account in the financial system.

By monitoring the variance accounts regularly, companies can check that costs are broadly in line with expectations and that profitably, in consequence, is likely to be on target also. Of course, companies can get positive variances when costs are less than expected. This can be a sign that it may be possible to increase market share by reducing selling prices, but it would be wise to check carefully first!

If costs are out of line with expectations, the system should be able to identify where the problems are; be they problems with the cost of particular materials or with a failure or inability to manufacture products within expected times. Only by knowing where the problems are can they be remedied and, for that reason, it is imperative that the variance accounts are structured carefully and checked regularly. It is not good enough to get to the end of the financial year before noticing that costs are higher than budgeted and products, perhaps, have been sold at a loss.

Standard cost variances also give excellent trending information: companies can’t change the past but they can certainly influence the future. So, in an industry where items are manufactured repeatedly, standard costing may be the answer. But, when moving along the manufacturing spectrum from continuous process to job shop, it becomes less so.

Actual Costing

At the other end of the manufacturing spectrum are companies that manufacture, and sometimes even engineer, to order. Frequently, manufacturing volumes are low but the key thing is that these companies need to look at profitability by order, and not by batch as standard costing does.

When manufacturing against a contract, for example, they need to know exactly what the job has cost and that can’t be done easily with standard costing because the variances, at least for materials, will have been written away separately. The problem can be compounded in an ETO (engineer to order) environment when the customer requests design changes after production has commenced. Sometimes these changes result in the purchase of extra materials for which premium prices (or special delivery charges) have to be paid to ensure quick delivery. In these circumstances, there is no alternative to knowing exact (i.e. actual) costs.

Everything comes at a price though. If companies want to know exactly what a manufactured item has cost, they need first to know exactly what components, in terms of item and quantity, went into making it. But some companies have variable material usages. For example, waste can vary greatly in industries that use wood because wood is not uniform. The number (and distribution) of knot holes varies, so waste is only approximately predictable.

Material is only part of the problem. Labor and processing times can also vary; particularly if rework or rectificationwork is required. So, to get accurate costs, it is necessary to measure, record and report actual usage of both materials and labor.

This can be a problem in some industries that use bulk materials when the cost of those materials varies. Imagine that two batches of liquid are going into the same tank and those two batches have come in at different actual costs. When drawing liquid from the tank, it is impossible to know which batch is being used (in fact, it is almost certainly some of both). Luckily most Enterprise Resource Planning (ERP) systems get around this problem by allowing the issue on a theoretical FIFO (first in, first out) basis, so the oldest batch is ‘assumed’ to have been used.

FIFO issues may not be a true reflection of reality, of course, but on the occasions when cost allocation to particular jobs has to be precise, ERP systems usually allow users to override this automatic selection and record a different batch. As the batches must have been of essentially identical material in order to have been mixed, it is of course generally irrelevant which was actually used. An exception would be when handling things like foodstuffs but, in these circumstances, if a batch of product is recalled because of a problem with an ingredient, it would be normal to also recall the product that theoretically used ingredients from batches either side of the suspect batch.

So, in a manufacturing environment where precise costings for each individual job or batch are essential, Actual (or FIFO) Costing is obviously more appropriate even though it is harder to identify trends that show up easily in Standard Costing. Be aware, though, that Actual or FIFO Costing tends to not work well in back-flushing environments where material or labor variances are common, unless the ERP system chosen allows easy adjustment of resources used.

Overhead allocation

In the standard costing and actual costing systems above the subject was primarily with charging the direct costs of production to inventory. In many businesses, the cost of overhead is substantially than direct costs, so it is also important to discuss the selection of a proper method of allocating overhead to inventory.

In general, there are two types of overhead, which are administrative overhead and manufacturing/servicing/construction overhead. Administrative overhead includes this costs not involved in the development or production of goods or services, such as the costs of front office administration and sales; this is essentially all overhead that is not included in manufacturing/servicing/construction overhead. Manufacturing/servicing/construction overhead is all of the costs that a factory incurs, other than direct costs.

The costs of manufacturing/servicing/construction overhead should be allocated to any inventory items that are classified as work-in-process or finished goods. Overhead is not allocated to raw materials inventory, since the operations giving rise to overhead costs only impact work-in-process and finished goods inventory.

The following items may be included in manufacturing/servicing/construction overhead, however, each reporting entity with manufacturing/servicing/construction operations should tailor such allocation to its operations:

Manufacturing/servicing/construction overhead costs

Depreciation of factory equipment	Quality control and inspection
Factory administration expenses	Rent, facility and equipment
Indirect labor and production supervisory charges	Repair expenses
Indirect materials and supplies	Rework labor, scrap and spoilage
Maintenance, factory and production equipment	Taxes relates to production assets
Officer salaries related to production	Uncapitalised tools and equipment
Production employees’ benefits	Utilities

Typically allocating overhead comprises of accumulating all manufacturing overhead costs into one or more cost pools, and then use an activity measure (for each cost pool) and then use that activity measure (for each cost pool) in the costs pools to produced units. As a result, the overhead allocation is:

Cost pool expenses / Total pool activity measure = Overhead allocation per unit

Inventory costing Inventory costing Inventory costing Inventory costing Inventory costing Inventory costing Inventory costing Inventory costing Inventory costing Inventory costing Inventory costing Inventory costing Inventory costing Inventory costing Inventory costing Inventory costing Inventory costing Inventory costing