Inventory Valuation and Manufacturing Costing for Inventory-Centric Businesses
Inventory valuation and manufacturing costing features are crucial for wholesale distributors and manufacturers. Entry-level applications support limited inventory valuation with marginal features for manufacturing costing. These restrictions often serve as a catalyst, prompting growing companies to move to more robust midmarket ERP systems. In this guide, we discuss inventory valuation and manufacturing costing for inventory-centric businesses.
Many companies never consider the importance of inventory valuation and manufacturing costing during their ERP evaluation process. Should you use a simple method like standard cost, or would you be better served by using average costs, actual (lot) costs, first-in-first-out (FIFO), last-in-first-out (LIFO), or a combination of valuation strategies? Each strategy may manifest vastly different corporate financial reporting results. In addition, there are many caveats to the choices you make. Further, some methods produce lower taxes than others.
Larger companies have cost accountants to help them select the best valuation and job cost strategies for their businesses. However, smaller distributors and manufacturers often make these decisions with little input from accounting professionals. Unfortunately, many companies choose the wrong options, which negatively impact their financials and lead to costly conversions to alternate valuation and job cost methods. Lastly, every ERP system features a unique way of supporting each method, and some systems do not fully support all valuation and costing strategies.
This guide provides an overview of inventory valuation and manufacturing costs. It features detailed examples of each strategy, including each method’s advantages and disadvantages. In addition, the eBook offers guidance to help you select the proper costing and valuation methods for your unique business needs and insights into how different ERP applications support valuation and costing strategies.
Fundamentals of Inventory Valuation and Manufacturing Costing
Since the middle of the 19th century, cost accounting has been critical for businesses in railroad, textile, oil, steel, and other industry segments. Cost accounting evolved significantly through the 20th century and remained relatively unchanged for decades.
Today, inventory valuation and manufacturing costing methods are crucial to every wholesale distributor and manufacturer. In addition, valuation and costing options may contribute to significant tax savings. Yet few companies consider these essential features when they evaluate ERP systems.
A certified cost accountant or accredited accounting firm should review inventory valuation and manufacturing costing. A professional review ensures that financial documents, like income statements and balance sheets, accurately represent the cost of goods sold (COGS) and inventory valuation. In addition, the selection of valuation and costing methods should align with the nature of the products used and sold. Auditors may question companies using techniques uncommon for their industry.
Further, international organizations are restricted from using LIFO valuation methods banned under International Financial Reporting Standards (IFRS). While permissible in geographies governed by Generally Accepted Accounting Principles (GAAP), LIFO is no longer considered a best-practice valuation method and has fallen out of favor with most accounting professionals. Consequently, modern ERP applications like Acumatica support best practices and do not support LIFO valuation.
Inventory valuation directly impacts COGS, gross profit, net income, and current assets. Combined, they deliver a crucial measure for establishing pricing. Inventory is categorized as either raw materials or finished goods (for both distributors and manufacturers) and work in process (for manufacturers only). Some companies also track consigned inventories. However, these inventory quantities in the possession of the distributor or manufacturer are not legally owned until they sell them or use them. As such, they have no bearing on inventory valuation or manufacturing costing.
Some systems require a single costing and valuation method across all items and warehouse locations. Modern ERP systems provide more flexibility and support multiple methods for specific items or items by warehouse location. However, most companies only use multiple methods if they have sound business reasons as a best practice. These may include variability in the products they buy or make. They may also choose multiple methods to simplify business processes for smaller locations better served with standard or average methods. Consult a certified accountant to determine appropriate cost strategies for your unique needs.
WHAT IS INVENTORY VALUATION?
The total value of inventory at the end of a financial reporting period is based on purchased costs for inventory items. Perpetual inventory systems like Acumatica continuously update inventory values. For manufacturers, inventory valuation combines purchased costs for raw materials with value-added manufacturing operations for finished goods.
WHAT IS MANUFACTURING COSTING?
Costs of direct materials plus laboUr, overhead, outside processing, and resources to convert materials into finished goods. Raw material valuation methods are used to determine material costs plus value-added manufacturing costs. The results are used for inventory valuation and the cost of goods sold. Work in process (WIP) is evaluated in Job Cost reports and inquiries.
MANUFACTURING COST ELEMENTS
• Fixed Overhead
• Variable Overhead
• Outside Processing
Manufacturing costs can be challenging to estimate. Manufacturing costs include fixed, variable, indirect, and direct costs such as known raw material costs and estimated costs for labor and scrap. Therefore, manufacturers must get close to the actual manufacturing cost to determine profitability, evaluate prices, and identify issues occurring on the shop floor that inflate costs. Choose a cloud ERP solution like Acumatica to simplify inventory Valuation and Manufacturing Costing for Inventory-Centric Businesses.
Manufacturers monitor and capture work in process (WIP). WIP represents the sum of material costs for materials issued to the production job, work order, or manufacturing order plus value-added labor operation costs. WIP includes fixed and variable overhead costs and outside processing costs where applicable. However, WIP serves as a temporary cost since finished goods are processed into inventory when manufacturing is completed.
In manufacturing, fixed overhead costs are typically defined by a work center or group of similar machines. Fixed overhead costs remain constant over the production process and account for overhead cost elements such as rent, supervision, and depreciation of equipment.
Variable manufacturing overhead costs are also defined by the work center and vary in proportion to production. Examples of variable overhead include indirect labor such as supervisory costs and electricity.
Engineer-to-order (ETO), assemble-to-order (ATO), configure-to-order (CTO), and make-to-order job shop manufacturers tend to focus on job costing. Job cost reports provide insights to understand production order costs, which are often unique to each job.
Job Cost reports typically include work order information, bill of material and routing definitions, items produced, quantities for raw materials and finished goods, scrap pieces, setup and run times, outside process costs, and other details. In addition, the job cost report identifies cost deviations and highlights problems before completing the order by comparing current WIP to estimated costs from routing and bill of material standards.
“Acumatica helps us make sure all components are reflected accurately in inventory. It also makes sure we know what each component is related to what light and accurately reflects the true cost of a kit assembly.”