The Ultimate Guide for Mastering Inventory Valuation and Manufacturing Costing
Inventory valuation and manufacturing costing are critical considerations for wholesale distributors and manufacturers. While entry-level applications may offer limited features in this regard, growing companies often need more robust midmarket ERP systems — like Acumatica — to meet their requirements. However, many businesses need to pay more attention to the importance of inventory valuation and manufacturing costing during their ERP evaluation process. Choosing the right valuation method is crucial as it can significantly impact financial reporting results and tax obligations.
This blog overviews inventory valuation and manufacturing costs, explores different strategies, and offers guidance for selecting your business’s appropriate methods.
Fundamentals of Inventory Valuation and Manufacturing Costing
Inventory valuation and manufacturing costing have been essential aspects of cost accounting since its beginning. These methods are critical for wholesale distributors and manufacturers today, contributing to tax savings and accurate financial representation.
Reviewing inventory valuation and manufacturing costing with a certified cost accountant or accredited CPA firm to ensure accurate financial reporting and compliance with industry standards is crucial. The chosen valuation and costing methods should also align with the nature of the products used and sold, considering industry-specific requirements and regulations.
Inventory valuation determines the total inventory value at the end of a financial reporting period, based on the purchased costs of inventory items. It directly affects financial metrics such as cost of goods sold (COGS), gross profit, net income, and current assets.
Inventory is typically categorized as raw materials or finished goods for distributors and manufacturers, with work in the process included for manufacturers. It’s important to note that consigned inventories only impact inventory valuation or manufacturing costing once sold or used.
Manufacturing costing involves the costs of direct materials, labor, overhead, outside processing, and resources required to convert materials into finished goods. Manufacturers must estimate manufacturing costs accurately to determine profitability, evaluate prices, and identify cost-related issues on the shop floor. Work in process (WIP) is a temporary cost representing the sum of material costs and value-added labor operation costs. Fixed overhead costs remain constant throughout the production process, while variable overhead costs vary in proportion to production volume. Different manufacturing methods, such as engineer-to-order (ETO), assemble-to-order (ATO), configure-to-order (CTO), and make-to-order, require specific job costing approaches.
Strategies for Inventory Valuation and Manufacturing Costing
Companies have multiple strategies for inventory valuation and manufacturing costing, each with advantages and disadvantages. Here are some commonly used methods:
- Standard Cost Valuation: This approach involves predefined standard costs for items and remains unchanged until manually updated. Variances between legal fees and actual costs are tracked separately.
- Specific Cost Valuation: Also known as actual purchase cost or lot cost, this method assigns the exact cost to each inventory item. It is commonly used with a lot or serial tracking to track units purchased or manufactured simultaneously at the exact cost.
- Average Cost Valuation: Average cost calculations can vary depending on the weighted average, weighted moving average, or simple average method used. ERP systems like Acumatica often employ moving average costs that update with each purchase at a different price.
- FIFO (First-In-First-Out) Cost Valuation: FIFO assumes that the oldest inventory items are sold or used first, resulting in higher inventory valuation and lower COGS. This method tends to produce higher gross profit and taxable income.
- LIFO (Last-In-First-Out) Cost Valuation: LIFO assumes that the most recently purchased or manufactured items are sold or used first. It often leads to lower ending inventory valuation and higher COGS, resulting.
Acumatica offers real-time WIP reporting and detailed job cost management through its native project accounting application. It supports three production cost calculations for manufacturing operations:
- The ACTUAL method calculates costs using only the actual WIP balance.
- The ESTIMATED method combines actual and planned costs and is particularly useful for reporting material and labor transactions after the produced items are received in stock.
- The STANDARD method allows manufacturers to set a standard cost for finished goods and post costs to the general ledger at that predetermined cost, with variances posted to off-setting accounts.
Acumatica provides support for a range of production cost drivers, which include:
- Materials: Monitor costs of stock and non-stock items used in production.
- Labour: Track labor costs based on work center or employee labor rates.
- Fixed Overhead: Allocate fixed production costs, such as administrative overhead.
- Variable Overhead: Apply variable costs based on labor, material, and machine usage.
- Machines: Include costs associated with machines and their usage in production.
- Tools: Account for costs based on the rate of tool usage.
- Subcontracts Services and Materials: Track costs of vendor services and materials used in production.
Acumatica supports three costing methods: Standard Cost, Actual Cost, and Estimated Cost, each with its implications for inventory and WIP balances. Acumatica allows flexibility in choosing the appropriate costing method based on specific requirements, such as protecting inventory valuations or billing customers on a cost-plus basis.
To select the right inventory valuation and manufacturing costing strategies for your industry, consider the following factors:
- Wholesale Distribution: Companies distributing durable goods with stable costs often choose average or FIFO inventory valuation. Specific valuation strategies are preferred for perishable or nondurable goods, mainly when lot tracking or significant price fluctuations occur.
- Make-to-Order Manufacturers (MTO): Engineer-to-order, configure-to-order, assemble-to-order, and job shops tend to use specific inventory valuation and estimated manufacturing costs since they produce unique products. Capturing actual production costs can be challenging due to fast-paced production, but alternative cost strategies may also be employed.
- Make-to-Stock Manufacturers (MTS): MTS and repetitive manufacturers producing consistent products typically use standard costing for easier cost predictability. FIFO and average costing are standard, while actual costing suits products tracked by lot or serial number.
- Material Considerations: The nature of your raw materials and finished goods can influence the choice of inventory valuation methods. Nondurable goods and process manufacturing industries (e.g., chemicals, oil, food, pharmaceuticals) often favor specific and FIFO valuation. Durable goods or discrete product industries (e.g., electronics, industrial equipment, plastics) lean towards standard, average, or typical valuation methods.
When selecting an ERP system for costing and valuation, it’s important to consider the following:
- Variations in ERP Systems: Each ERP system follows accounting standards but may have different calculations for valuation and costing. Lower-end and older legacy systems may have limited methods available, while others offer flexibility in tracking without actual cost. Ensure that the ERP systems support your desired valuation and costing methods.
- Consult with a Cost Accountant or CPA: Work with a cost accountant or CPA firm to discuss current and potential future valuation and costing methods. Ensure the evaluated ERP systems can effectively support your present and future requirements.
- Vendor Demonstrations: Ask ERP vendors or resellers to demonstrate each valuation and costing method to understand how their application supports different scenarios. Inquire about their future development plans to ensure they align with your evolving needs.
- Industry-Specific Features: Industries with co-products, disassembly processes, by-products, or varying manufacturing costs across locations must evaluate ERP systems that can handle these specific features.
- Co-products involve producing multiple unique products in a single run;
- Disassembly occurs when finished goods are raw materials;
- By-products have value but are not the desired finished goods; and
- Warehouse costing considers location-specific cost variations.
Consider these complexities when evaluating ERP systems, and pay attention to their capabilities in meeting your specific industry requirements. Some legacy systems or entry-level accounting software may lack support for variable cost or valuation by stocking location.
With specialized functionality to manage costs by manufacturing warehouses and unique sub-item codes, Acumatica provides comprehensive solutions. Contact us now to schedule a complimentary discovery call. Whether you’re a make-to-stock, make-to-order, configure-to-order, engineer-to-order, repetitive, or project-centric manufacturer, Acumatica is designed to meet your needs and enable future growth.