Eliminating Standard Costing: A Step-by-Step Methodology
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1 Eliminating Standard Costing: A Step-by-Step Methodology Nick Katko COO & CFO Tenmast Software Company Lexington, KY Workshop Agenda 1. GAAP Principles 2. Lean Inventory Valuation & GAAP Compliance 3. Lean Inventory Valuation Examples 4. Wrap Up & Questions 1
2 GAAP Principles Inventory Valuation and Cost of Goods Sold Actual expenses incurred to get goods in condition for sale Production Costs Acquisition Costs involves many considerations Inventory at Cost 2
3 A major objective of accounting for inventories is the proper determination of income through the process of matching appropriate costs against revenues Expenses incurred to generate revenues recognized COGS Difficulties in matching specific costs to revenue recognized Products not sold in same period as produced Prices change over time Continuous nature of MFG Production costs change over time 3
4 GAAP: Use a Cost Flow Assumption Consistent: Over Time: Companies must use a consistent method Cannot change year-to-year Disclosed: In audit reports Change: Change in cost flow assumption is a change in accounting method Codified Cost Flow Assumptions FIFO: LIFO: Average Cost: Specific Identification: Most recent costs assigned to ending inventory Most recent costs assigned to COGS Inventory and COGS at average cost of all goods available for sale Exact specific costs of each product can be accumulated 4
5 Lean Inventory Valuation GAAP Compliance Lean Inventory Valuation Inventory levels Lean transformation is designed to reduce inventory levels in manufacturing companies days is a good target Materiality Financial risk of inaccurate inventory valuation decreases significantly, lowering materiality of misstated profits Methods Simpler valuation methods can be used to maintain GAAP compliance 5
6 Lean Inventory Valuation & GAAP Average Cost: Low Inventories: Inventory and COGS at average cost of all goods available for sale But not individual product costs Days Lean Inventory Valuation - Material Few Parts Many Parts Quantity Monthly physical Track in ERP Cost VSP&L: average cost per unit or per day Individual part: average cost or last price paid 6
7 Lean Inventory Valuation: Production Cost Capitalization Actual Production Costs Actual costs from value stream income statements Capitalization of Production Costs Capitalize total costs, not individual products Use journal entry Requirements Labor & OH rates set to zero Auditor buy-in on methodology Production Cost Capitalization Methods Days of Inventory Units of Inventory Days of Conversion Cost Historical Margins Count the inventory, calculate the days, calculate the value from the number of days. Calculate the number of units in finished goods as a percentage of total production that month. Inventory value will be that percentage of the total value stream costs. Used when the company tracks inventory but maintains inventory value for the material content only. The conversion cost is then applied based upon the number of days of material. Capitalize production costs to maintain historical standard margins, and re-calculate annually 7
8 Lean Inventory Valuation Examples Calculate the Inventory Value Using the Days of Inventory Method Materials Direct Labor Support Labor Machines Outside process Facilities Other Costs REVENUE TOTAL COST VALUE STREAM PROFIT Return on Sales Opening Inventory Closing Inventory Inventory Adjustment NET PROFIT TOTAL $2,048,686 $849,526 $312,984 $342,421 $116,550 $53,731 $41,200 $9,664 $1,726,076 $322,610 16% $1,186,035 $963,148 ($222,887) $99,723 5% Material Cost per Total Conversion Conversion cost Days in the month Total Material Cost Day Cost per day 20 $849,526 $42,476 $876,550 $43,828 Days Material Value Conversion Value Total Value Raw Material 10 $424,763 $0 $424,763 Work in Process 3 $127,429 $65,741 $193,170 Finished Goods 4 $169,905 $175,310 $345,215 TOTAL INV VALUE 17 $722,097 $241,051 $963, Calculate the material cost per day. 2. Calculate the conversion cost per day 3. Calculate Raw Material value (#days * material cost per day) 4. Calculate the Finished Goods value (#days *( material + conversion cost per day)) 5. Calculate WIP value (#days * material cost per day + #days/2 * conversion cost per day) 6. Calculate total inventory value by adding the three together 8
9 Calculate the Inventory Value Using the Number of Units Inventory Method Materials Direct Labor Support Labor Machines Outside process Facilities Other Costs REVENUE TOTAL COST VALUE STREAM PROFIT Return on Sales Opening Inventory Closing Inventory Inventory Adjustment NET PROFIT TOTAL $2,048,686 $849,526 $312,984 $342,421 $116,550 $53,731 $41,200 $9,664 $1,726,076 $322,610 16% $1,186,035 $963,163 ($222,872) $99,737 5% Average Total Units Average Material Total Conversion Total Material Cost Conversion cost cost Manufactured Cost per Unit Cost per Unit 22,861 $849,526 $37.16 $876,550 $38.34 Quantity Material Value Conversion Value Value Total Value Raw Material 11,430 $424,744 $0 $424,744 Work in Process 3,430 $127,460 $65,758 $193,218 Finished Goods 4,573 $169,898 $175,341 $345,276 TOTAL INV INV 19,433 $722,140 $241,098 $963, Calculate average material cost and average conversion cost 2. Calculate Raw Material value (#units * material cost per unit) 3. Calculate the Finished Goods value ((#units * material + conversion cost per unit)) 4. Calculate WIP value (#units * material cost per unit + #units/2 * conversion cost per unit) 5. Calculate total inventory value by adding the three together Calculate the Inventory Value Using the Days of Conversion Cost Method Materials Direct Labor Support Labor Machines Outside process Facilities Other Costs REVENUE TOTAL COST VALUE STREAM PROFIT Return on Sales Opening Inventory Closing Inventory Inventory Adjustment NET PROFIT TOTAL $2,048,686 $849,526 $312,984 $342,421 $116,550 $53,731 $41,200 $9,664 $1,726,076 $322,610 16% $1,186,035 $963,152 ($222,883) $99,726 5% Inventory Value Materials Only Number of Days in Number of Days of the Month Inventory $474, Total Conversion Cost Conversion Cost Cost Applied Total Inventory Cost $876,550 $489,115 $963,151 This method is used when the company tracks inventory but maintains inventory value for the,material content only. The conversion cost is then applied based upon the number of days of material. 1. Calculate the number of days of inventory. (Days in the month * Inventory value / Monthly Material Cost) 2. Calculate the Conversion Cost Applied. (Number of days of inventory * total conversion cost / Number of Days in the Month) 3. Calculate total inventory cost. (Add materials value plus conversion cost applied) 9
10 Historical Margin Process Steps 1. Calculate Labor & Overhead as a % of Material Cost 2. At FYE or any month end, set Labor & OH rates to zero 3. Revalue inventory in ERP system ( will be material cost) 4. AJE to recapitalize Production Costs prior to revaluation 5. Open new accounting and manufacturing period in ERP 6. Next month end: calculate change in capitalized production costs FYE 12/31/16 Standard Costing Stand Calibration Measurement Optical Tooling Total Material Cost 345,472 28,360 82, , ,084 Labor & Overhead 152,008 5,105 73, , ,754 Total Inventory 497,480 33, , ,209 1,453,837 Labor & OH as a % of Material Cost 44% 18% 89% 74% 62% Cost of Goods Sold Capitalized Production Costs Inventory DR CR DR CR DR CR Ending Balance - Standard Costing 1,453,837 #1 - Revalue Inventory (L&OH = 0) 556, , , ,084 #2 - Recapitalize Production Costs FYE 556, ,754 Ending Balance - Lean Inventory Valuation 0 556, ,084 10
11 01/31/17 Stand Calibration Measurement Optical Tooling Total Beginning Inventory 345,472 28,360 82, , ,084 Ending Inventory 344, ,784 51, , ,514 Labor & OH as a % of Material Cost 44% 18% 89% 74% 62% Ending Capitalized Production Costs 151,713 22,461 45, , ,529 Beginning Capitalized Production Costs 556,754 Increase (Decrease) Capitalized Production Costs 15,775 Cost of Goods Sold Capitalized Production Costs Inventory DR CR DR CR DR CR Beginning Balance 556, ,084 Month End AJE 15,775 15, ,430 Ending Balance - 15, , ,514 Wrap Up Practical Advice on achieving Lean Inventory Valuation 11
12 The Journey to Lean Inventory Valuation Beginning Lean GAAP Use Current Methods Lean Accounting VSP&L (Internal Use Only) In- Between Days Inventory Simplify Current Methods Lean Inventory Valuation using VSP&L VSP&L (Internal Use Only) VSP&L (Internal & External) Practical Advice Company- Specific Capitalization of Production Costs Material Value Design a lean inventory valuation methodology which works for your company Macro Valuation method rather than Micro Valuation method This is the key to success Use ERP system with average actual cost Auditor Buy-In Partner with them to create a methodology they can test 12
13 Thinking like a Lean Accountant GAAP Maintain GAAP compliance in the leanest way possible The Goal Continuous Improvement Customer Value Simplest methodology to capitalize actual production costs for your company Turn off standard costing Simplify current systems eliminate waste Achieve the future state your company s goal External Reporting: GAAP compliance Internal Reporting: usable financial information for Lean Operations Question Time Nick Katko Contact Information nkatko@gmail.com Lean Accounting Blog:
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