Which of the following costs should be included as part of the cost of inventories of finished goods held by a manufacturing company?

Alert Published: Feb 21, 2022

Inventory initial costing and subsequent measurement historically is a challenging subject, both from a generally accepted accounting principles (GAAP) and an operational perspective. With broad guidance and varying industry practices, there is difficulty meeting daily operational needs and financial reporting requirements. With technology advances, a pandemic, and an evolving workforce, accounting and reporting implications grow increasingly complex.

This article explains the operational accounting considerations for standard inventory cost accounting, capitalized variances, purchase price variances, and current economic impact, in addition to GAAP implications of year-end inventory balances.

Other COVID-19 Inventory Considerations

Abnormal amounts of inventory cost should be recognized as current period expense. Allocation of fixed production overhead to the costs of conversion is required and should be based on the normal capacity of the production facilities. Companies need to consider if they have experienced any unplanned work stoppages, labor or material shortages, or production bottlenecks. If so, does this result in production that is abnormal, i.e., below the normal capacity range?

Declines in the overall economic environment can lead to impairment. If an entity has material inventory in a declining industry, management should consider if impairment or write-offs should occur given the net realizable value (first in, first out) or market (last in, first out or retail method) may be lower than cost. These could include seasonal, perishable, or products with short shelf lives. Topics to consider:
- Are there changes in consumer preferences or demand for products?
- Are sales for product lines significantly reduced or suspended for a period?
- Evaluation of any purchase or sales commitments and the ability to meet those commitments.

Accounting Guidance

As required in FASB’s Accounting Standards Codification (ASC) 330-10-30-1, initial measurement of inventories is primarily at cost. Defined generally as the price paid or consideration given to acquire the asset, cost includes the expenditures directly and indirectly incurred to bring items to current sellable condition. At this point, determination of total cost is challenging, as more costs than simply vendor expenditures need to be considered.

When a company purchases an item from a vendor, commonly referred to as a raw material, most situations allow the company to easily identify the cost paid per item. Often, companies will then add additional raw materials, processing, or design (including time of company personnel) to create a final sellable product (finished good). The allocation of direct labor and overhead should be included in the finished goods ending value as specified in ASC 330-10-30.

Practical Application

As described above, inventory cost includes any costs necessary to bring the item to sellable condition. That often involves direct labor. For example, direct labor includes an employee who is bagging fertilizer or operating a machine that is processing and creating a finished good. Similarly, an allocation of overhead based on normal production capacity is included in the finished good value. The amount of labor and overhead allocated to each unit produced is calculated in a separate process involving operations, sales, and finance team members. This allocation of indirect costs to produced goods should include both standard manufacturing and administrative overhead. Manufacturing overhead costs are costs incurred at the manufacturing location that are not direct labor. Overhead costs such as indirect production costs, facility rent, and utilities should be included in manufacturing overhead. Any unallocated overhead production costs should be expensed in the period incurred, as prescribed in ASC 330-10-30-7. Similarly, any general and administrative expenses unrelated to production should be expensed in the period incurred.

Under standard costing, cost pools consisting of materials, labor, and overhead are used to calculate a standard cost per unit. Budgeted standards are calculated by taking the total cost pool divided by the number of units expected to be produced for the year. For example, if in the previous period $1,000 of direct cost was incurred to produce 500 units of green fertilizer, the standard labor cost assigned to that specific green fertilizer would be $2/unit ($1,000 cost/500 units = $2). A similar calculation is made to arrive at the overhead standard cost per unit. This calculation can pose a challenge, as bifurcating inventory specific production data and related costs can prove difficult for certain enterprise resource planning systems.

Once standards are set, the common way to account for labor and overhead allocation is to use absorption accounts. These income statement accounts are credited when finished goods are created to capitalize costs into inventory with the intent that absorption accounts would exactly offset direct labor and overhead expenses incurred each period. The idealistic result is zero direct impact to the income statement. Capitalized costs would then flow through cost of goods sold (COGS) as finished goods are sold. That said, it is unlikely that budgeted standards will equal actual costs due to a variety of factors such as efficiency, unexpected costs, overruns, etc. When absorption accounts do not equal their corresponding expense accounts, the company’s ending inventory is either over or under absorbed. Some accounting systems will enable a revaluation of finished goods to add or reduce cost/value, properly valuing the finished goods. This is commonly known as “rolling standards.” For those enterprises without advanced accounting software, a capitalized variance calculation and one-time entry are necessary to adhere to ASC 330.

Inventory in Mergers & Acquisitions (M&A)

If your company is acquired or looking to expand its footprint or capabilities through acquisition, be aware that inventory on the opening balance sheet is valued at fair value, in accordance with ASC 805. 

As part of the due diligence process, don’t forget to consider when standards were last updated and if current costing reflects an accurate view of overall inventory, which is an important net working capital consideration.

Below is an example showing the purchase of materials and payment of labor and overhead:

To determine inventory cost, the company calculates standard labor and overhead rates. In the prior year, the company produced 100 units of a particular finished good, with direct labor related to that finished good of $500, to arrive at a standard labor rate for the subsequent year of $5 for each unit.

• Processing of 10 units of finished goods at standard rates ($16 of raw materials, $5 of direct labor, and $4 of overhead per unit)

Often at the end of a reporting period, the absorption accounts will not offset the expense. At this point, the example company is currently over absorbed with respect to labor. This means there is (credited) $50 absorbed while incurring (expensing) only $40, which is the actual cost incurred. The current income statement is showing a net $10 credit balance. If this is the only item the company produces, and the inventory is not sold, the company would be incorrectly over costed and not accurately reflecting the proper inventory value on its balance sheet at period end. The process to account for these variances is through a capitalized variance account (see entry below).

The result of the entry above is to reduce the inventory balance by $10 to arrive at $40 of direct labor being currently capitalized into that respective inventory item. The debit side of the entry records an additional $10 of COGS, with the net result reducing the credit balance of $10 down to $0.

One may ask, why does only ending inventory need to be revalued for under or over absorption? See the example below if inventory is sold during the period assuming, besides any cutoff discrepancies, the income statement is correct.

At this point, the company has recorded $100 of direct and overhead costs (debit) from Entry 1, $90 of direct and overhead absorption (credit) from Entry 2 during production of finished goods, and $90 of direct and overhead COGS (debit) from Entry 3 from the sale of items. The net result is $100 of expense (debit) in the income statement, which appropriately equates to what is actually paid in Entry 1 above.

Purchase Price Variance

Inventory items are regularly costed at actual acquired (purchased) cost and inherently result in a weighted average on the balance sheet at any given time. For example, if a company purchases two blue doors for $100 each ($200 total) then subsequently purchases three blue doors for $75 ($225 total) each, the blue doors would be held on the balance sheet at $85 each ($425 total purchase price divided by five blue doors). For inventory relief and COGS during a sales transaction, if a company uses FIFO and three blue doors were to be sold using the above example, the total COGS would be $275 (two initial doors at $100 each, then one door at $75). This costing approach is very common across industries. 

Some companies will use a standard purchase price to account for purchase price variances. Individual items are costed using a standard price preset in the company’s inventory system. The standard price used for these items is based on the cost of purchasing the item individually from the same vendor or could be set at a budgeted amount. After the standard price is set, actual purchase prices will vary. As such, there will be a difference between cost assigned to inventory and what was actually paid for the inventory. To appropriately account for these items, the company would use a purchase price variance account. The company then analyzes the purchase price variance account (inventory asset account) and relieves a portion of the capitalized variance to appropriately reflect COGS on an overall basis. See an example of the entries below for the purchase of an assembled door purchased for $500.

Purchase Price Variance Example

It is necessary to complete an analysis on a regular basis and, when necessary, post entries to relieve purchase price variances to appropriately present the income statement. Management benefits using a purchase price variance account, as they can easily determine if the company is purchasing items at above or below standard/budgeted amounts.

Tariffs, Freight, Labor Shortages, & Supply Chain Impact on Inventory

How do significant supply chain disruptions, inflation, and tariffs impact your inventory costing? Historically, companies have evaluated standards once per year. The current economic environment may require standards to be updated multiple times per year for internal reporting. Budgeting for inventory levels and COGS also should be considered, as labor shortages may result in decreased production or increased costs.

Conclusion

Navigating operational needs and financial requirements of inventory costing is a key component of internal and external reporting yet often is not given the attention it deserves. With the added complexities of COVID-19, freight and supply chain issues, and potential M&A activity, inventory costing is a critical component of any reporting framework.

To learn more about inventory costing, reach out to your BKD Trusted Advisor™ or submit the Contact Us form below.

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Which costs should be included in valuing the inventories of a manufacturing company?