Understanding the cost of inventory and monitoring it over time is critical to pricing your product, controlling costs and ultimately driving profitability. Unfortunately, it’s not uncommon to see production runs of a product line that is not profitable (or has low profitability) due to a lack of understanding over proper inventory costing.
When speaking with manufacturers, we’ve witnessed a lot of confusion around how to properly determine the cost of inventory. And understandably so; there is no single right answer, and each manufacturer has a different process and cost inputs. There are also multiple types of inventory costing systems—actual cost, standard cost, activity based costing, lean, FIFO, LIFO, average cost and more.
We’re going to focus on the basic costs that drive inventory value. Before we do, however, let’s first discuss the basic types of inventory. A manufacturing company generally uses three types of inventory, and they should be segregated into the following separate ledger accounts:
- Raw materials: goods purchased for further manufacture.
- Work in process: goods presently started into production but not completed at the end of the period.
- Finished goods: goods that have been completed and are ready for sale.
Typically, inventories would include items that are:
- Physically on hand, other than items received on consignment or for which the significant risks of ownership have not passed to the buyer;
- In transit to the company with free on board (FOB) shipping point terms;
- Held by a vendor when the significant risks of ownership have passed to the buyer;
- On consignment to prospective customers or others;
- In possession of others for storage, processing repair, shipment, and so forth (bailments); and
- In transit to a customer with FOB destination terms.
Now that we have the types of inventory, let’s begin diving deeper into inventory costing. Raw materials inventory and goods purchased for sale by retailers should include the amount invoiced by vendor, less any discounts, plus freight based on the FOB point.
Work-in-process inventory contains product cost components: raw materials, direct labor and overhead. (We’ll discuss the composition of product costs in more detail later.)
Finished goods inventory for a manufacturer should only include product costs transferred from work in process. Finished goods warehousing is recorded as a selling expense.
Inventory costs should include conversion expenditures—what you pay for things other than your product’s direct materials. Examples include the wages of employees directly engaged in the production process and certain aspects of overhead (indirect production expenses). Include these costs for goods manufactured, assembled, processed, or otherwise changed in form, content, or utility. Overhead should be allocated to inventory items on a rational and systematic basis and should include both variable and fixed expenses.
We can further define the costs as follows:
- Materials – Vendor invoiced cost less any discounts plus shipping.
- Direct Labor – Employees who work directly on manufacturing the product (including fringe benefits).
- Overhead – indirect factory related costs necessary to produce a manufactured product. Overhead includes: utilities, rent (related to the manufacturing area), insurance, indirect labor, repairs and maintenance, maintenance personnel, supplies, depreciation, etc.
Overhead is generally the area that tends to create problems for manufacturers. The first step is to develop the overhead pool, which includes all the expenditures captured for indirect factory costs. The key is to make sure all proper costs are included and improper costs excluded.
For example, rent on a building likely has two components: the production area (indirect overhead) and the administrative area. The accounting for this should be carefully analyzed and allocated between the two areas. This same thought process happens for other areas as well, such as insurance, real estate taxes, maintenance, etc.
Once the overhead pool is developed, then determine how to allocate to inventory. This is usually based on a driver such as the number of direct labor hours in producing the inventory. There may be more appropriate drivers for your company depending on your business model, and they should be carefully considered.
To properly cost inventory requires a careful analysis of the cost inputs, the production process and even the accounting system available to automate the process should be performed. Errors in developing the inventory costing model can lead to potentially bad decisions as it relates to pricing and production.
However, truly understanding your costs can help you make decisions on how to potentially make greater profits. This is where having a manufacturing CPA like James Moore can make a difference. By having a thorough understanding of your industry’s operations and challenges, we can help you make sense of the intricacies of inventory costing. Contact us to see how you can increase the profitability of your products through proper costing methods.
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