Inventory Cost Accounting Tips and Tricks. Nick Bergamo, Senior Manager Linda Pei, Senior Manager

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2 Inventory Cost Accounting Tips and Tricks Nick Bergamo, Senior Manager Linda Pei, Senior Manager 2

3 Disclaimer The material appearing in this presentation is for informational purposes only and is not legal or accounting advice. Communication of this information is not intended to create, and receipt does not constitute, a legal relationship, including, but not limited to, an accountant-client relationship. Although these materials may have been prepared by professionals, they should not be used as a substitute for professional services. If legal, accounting, or other professional advice is required, the services of a professional should be sought. 3

4 Nick Bergamo Senior Manager Linda Pei Senior Manager Presenters 4

5 Objectives Session Objectives: Understand the principles, procedures and terminologies of inventory management and manufacturing cost accounting Understand the flow and accounting of inventory costs Understand various costing methodologies Describe basic controls around product costing Benefits and pitfalls of costing techniques

6 Agenda Overview Inventory and Cost Accounting Types of Inventory Manufacturing Product Cost Elements Types of Cost Systems Product Costing Standard Costing Inventory Controls

7 Overview: Inventory and Cost Accounting Inventory is defined as (FASB ASC ): Assets held for sale in the ordinary course of business ( FGs ), In the process of production for sale ( WIP ), or To be consumed in the production of goods and services to be available for sale ( RMs ). Typically excludes long-term assets subject to depreciation accounting (including fixed assets held for sale). The primary basis of accounting is cost.

8 Overview: Inventory and Cost Accounting (cont.) Issues related to inventory accounting include: Definition and classification of inventories RMs vs WIP vs FGs Transfer of ownership - purchasing / selling Costing inventories Cost flow assumptions Valuation methodologies FIFO / Average Cost / LIFO

9 Cost Chart: Manufacturing Company Total Cost Product Cost Period Cost Direct Materials Direct Labor Manufacturing Overhead Sales & Distribution Research & Development General & Administrative Prime Cost Conversion Cost

10 Cost Accounting: Definition and Importance The systematic collecting, classifying, recording and analyzing of costs of production. Considers cost (money) as the economic factor of production. If properly used, is suitable for: Sales control, Production control, and Financial/administrative control (budgeting and analysis).

11 Cost Accounting: Cost Flow in Manufacturing Action Cost Collected Cost Flow to and Through Purchase materials Materials Inventory Pay direct laborers Direct Labor Work in Process Finished Goods Cost of Goods Sold Incur overhead costs Manufacturing Overhead

12 Types of Inventory: Manufacturing 1. Raw Materials inventory that is to be consumed in the process of production of goods for sale to customers. 2. Work in Process inventory that is in the process of production of goods for sale to customers. 3. Finished Goods completed inventory units awaiting sale to customers.

13 Cost Accounting: Cost Elements 1. Direct Materials material costs that are conveniently and directly allocable to the production of goods. 2. Direct Labor labor costs that are conveniently and directly allocable to the production of goods. 3. Factory Overhead all manufacturing costs other than direct materials and direct labor. Fixed overhead (e.g. rent) Variable overhead (e.g. utilities)

14 Cost Accounting: Cost Systems Job Order Costing costs are accumulated and assigned to an individual product or batches of product. Used when the products manufactured are sufficiently different from each other. Create a job cost record for each item, job or special order to report the direct materials and direct labor actually used plus the manufacturing overhead assigned to each job. Example - building construction industry

15 Cost Accounting: Cost Systems (cont.) Process Costing costs are accumulated and assigned to the entire production process. This is sometimes allocated to the units produced. Used when nearly identical units are mass produced. Typically no job cost record for each item, but an allocation of total costs to each unit for a given period of time. Example Beverage industry

16 Cost Accounting: Cost Systems (cont.) Operational Cost Accounting costing method where neither process nor job-lot costing applies. Example Assembly industries

17 Polling Question #1 What cost system does your company currently employ? a. Job order costing. b. Process costing - actual. c. Process costing - standard. d. Other.

18 Cost Accounting: Product Costing - Manufacturing 1. GAAP Absorption Costing All of the manufacturing costs are absorbed by the units produced. 2. Non-GAAP A. Actual Costing B. Normal Costing C. Standard Costing Variable / Throughput Costing Some indirect manufacturing costs are not allocated or assigned to (not absorbed by) the products manufactured.

19 Cost Accounting: Product Costing Manufacturing (cont.) Product Costing Method Comparison Direct Materials Manufacturing Costs Direct Labor Variable Overhead Fixed Absorption Costing Yes Yes Yes Yes Variable Costing Yes Yes Yes No Throughput Costing Yes No No No

20 Cost Accounting: Product Costing Manufacturing (cont.) Absorption Costing Method Comparison Manufacturing Costs Direct Materials Direct Labor Overhead Actual Costing Actual Actual Actual Normal Costing Actual Actual Applied Standard Costing Standard Standard Standard

21 Cost Accounting: Standard Costing Standard Costing Pre-determined costs are assigned as product cost Acceptable as long as adjusted at regular intervals for changes in fact patterns

22 Cost Accounting: Standard Costing (cont.) Material Cost Standards 1. Price Standard the price that should be paid for a unit of material 2. Quantity Standard the amount of material that should be consumed in the manufacturing of one unit of product

23 Cost Accounting: Standard Costing (cont.) Material Variance Price Variance (Actual Rate Standard Price) x Quantity Purchased Purchase Variance (PO Price Standard Price) x Quantity Purchased Purchasing Invoice Price Variance (Invoice Price PO Price) x Quantity Purchased Usage Variance (Actual Qty. Used Standard Qty.) x Standard Price Production

24 Cost Accounting: Standard Costing (cont.) Labor Cost Standards 1. Rate Standards the cost of labor that is applied to manufacture one unit of product 2. Quantity Standard the amount of time required to make one unit of product

25 Cost Accounting: Standard Costing (cont.) Labor Variance Rate Variance (Actual Rate Standard Rate) x Actual Labor Hours Efficiency Variance (Actual Hours Standard Hours) x Standard Rate Salary Negotiation & Production Production

26 Cost Accounting: Standard Costing (cont.) Manufacturing Overhead 1. Standard Overhead Cost (Budget) the cost of overhead that is applied to manufacture one unit of product 2. Standard Volume (Capacity) the normal activity expected or budgeted over the coming two to five years

27 Cost Accounting: Standard Costing (cont.) Manufacturing Overhead Variance Total Overhead Variance Two-way Analysis Budget Variance (Actual Cost-Budgeted Cost for Standard Hours) Three-way Analysis Four-way Analysis Spending Variance (Actual Cost-Budget for Actual Hours Worked) Variable Spending (Actual VOH- Budgeted VOH for Actual Hours) Fixed Spending (Actual FC- Budgeted FC) Efficienc y Variance (Actual Hours/unit) x Actual Production x Variable Standard Rate Volume Variance (Actual Units Budgeted Units) x Fixed Cost Application Rate

28 Polling Question #2 Does your company currently utilize the services of a third party manufacturer? a. Yes, we have an established relationship with our manufacturing partner. b. Yes, but the relationship is somewhat new. c. No, manufacturing occurs in-house. d. No, we do not manufacture any products.

29 Scenario of Actual Costing ABC, LLC is a beverage company founded in January 2000 with five Stock Keeping Units (SKUs). The Company has steady and stable production volumes from month to month and little to no variability in material, labor and overhead costs.

30 Actual Costing Recording of Transactions ABC, LLC purchases raw material on account for $10,000 (10,000 units). Db Raw Material $10,000 Cr Accounts Payable $10,000 ABC, LLC spent $5,000 on payroll (direct labor for 10,000 units). Db Inventory (labor) $5,000 Cr Cash $5,000 ABC, LLC spent $5,000 on rent and utilities for warehouse (overhead for 10,000 units) Db Inventory (Overhead) $5,000 Cr Cash $5,000 ABC, LLC just manufactured 10,000 units of the SKU for $2/unit.

31 Actual Costing Recording of Transactions ABC, LLC sells 5,000 units of the SKU for $4/unit on account. Db Accounts Receivable $20,000 Cr Revenue $20,000 Db COGS $10,000 Cr Inventory $10,000 At year-end, the Company s remaining inventory balance is valued at $10,000 for the 5,000 units of the SKU.

32 Pros & Cons of Actual Costing Pros Cons Real time true margins All data entered must be accurate Straight forward inventory valuation Requires system capabilities to allocate to jobs (multiple SKUs)

33 Polling Question #3 What are the characteristics of a Company that should use actual costing? a. Few SKUs and stable volumes b. Multiple SKUs c. System capabilities to allocate costing to jobs d. A and C

34 Scenario of Standard Costing ABC, LLC is a beverage company founded in the 1970s. The Company has international operations with over 2,000 SKUs. Most SKUs are matured products with stable and steady volumes. However, the Company consistently adds new products and strive to obtain efficiency on all productions.

35 Standard Costing Recording of Transactions For SKU , the standard cost of the item is $1.0/unit ($0.6 for material, $0.2 for labor, and $0.2 for overhead) ABC, LLC purchases raw material on account for $10,000 (10,000 units). ABC, LLC spent $5,000 on payroll (direct labor for 10,000 units). ABC, LLC spent $5,000 on rent and utilities for warehouse (overhead for 10,000 units) Db Inventory Db Material Price Variance Db Labor Rate/Price Variance Db Overhead Spending Variance Cr Account payable Cr Cash $10,000 $1/unit per standard) $4,000 (actual vs. standard) $3,000 (actual vs. standard) $3,000 (actual vs. standard) $10,000 (for raw materials) $10,000 (for labor & overhead)

36 Standard Costing Recording of Transactions ABC, LLC sells 5,000 units of the SKU for $4/unit on account. Db Accounts Receivable $20,000 Cr Revenue $20,000 Db COGS $5,000 Cr Inventory $5,000 At year-end, the Company s remaining inventory balance is valued at $5,000 for the 5,000 units of the SKU ($10,000 under actual costing). However, an analysis and adjustment needs to be done to capitalize certain labor and overhead for those inventories not sold (i.e. potentially $5,000).

37 Standard Costing Variance Analysis and Capitalization Variance Analysis Why did materials cost more? Efficiency issues in production? How to improve? Permanent or temporary? Capitalization Machine hours Labor hours Inventory turnover

38 Pros & Cons of Standard Costing Pros Cons Benchmark to measure performance Needs to update standards Budgeting and forecasting tool Requires more resources for analysis

39 Polling Question #4 What are the characteristics of a Company that should use standard costing? a. Multiple SKUs b. Complex inventory structure (numerous components for finished goods) c. Good budgeting and forecasting controls d. All the above

40 Long-Term Benefits 1. Helps to identify unprofitable activities, losses or inefficiencies. 2. The cost structure is often a target review area of a potential acquisition. Critical in determining purchase price. 3. Provides information to management and serve as guide in making decisions involving financial considerations. 4. Useful for price fixation; test the adequacy of selling prices. 5. Identify idle capacity in order to provide efficiency.

41 Inventory Controls Sample Inventory Controls Standard Cost Review Variances, Inventory Revaluation, and Absorption Costing Review and Allocation Inventory Cut-off Controls Inventory Count, Confirmation and Enterprise Unified Process (EUP) Estimation Inventory Reserves Calculation Inventory Reconciliation Inventory Roles Segregation of Duties

42 Questions? Nick Bergamo Senior Manager Linda Pei Senior Manager