Do you know how much your inventory is costing you? – Part 3
Costing methods can be a contentious issue where there is no definite right or wrong answer. The other day, while looking at my Quora feed, I came across a user who posed a question regarding a disagreement between two people. He wanted to know if at least one person will always be wrong.
The (brilliant) answer was as follows:
Two people sit opposed to each other. In between them is a cup. One person argues: “The handle is on the left”. The other person argues: “The handle is on the right”.
Which just goes to show that disagreements often rise as a result of different points of view.
In the previous weeks we looked at overhead costs and hidden costs associated with my pantry. Today I am going to look briefly at the actual, direct costs of my inventory. In SYSPRO, costs are usually associated with a location (warehouse) and we retain the cost with the stock code (SKU) warehouse record. We can retain the cost by lot or batch serial but I’d rather leave that for another discussion.
For today I need to walk away from my pantry for a bit but, never fear, we will go back there soon!
When creating a warehouse record you can choose one of the following costs:
- Average
- Standard
- Last cost
- FIFO (First In First Out)
- LIFO (Last In First Out)
Which costing method you choose is really up to you and it is often like the cup in my example above. I thought that I would share my point of view when debating which costing method to use.
For me, average costing is the method to use if the warehouse is primarily for distribution, where the product cost fluctuates rapidly, or when dictated by regulation or other industry conventions. These fluctuations include exchange rate variability and even production variability.
Average costing allows you to value inventory at a moving average cost, determine profit margin based on an almost ‘actual’ cost method and include all direct costs of manufacturing an item on the item’s inventory cost.
I find average costing the easiest method to use although it can be unforgiving when you need to correct an error in a busy environment. When your inventory moves from one warehouse to another the average cost gets recalculated and a cost correction can span many warehouses.
When I need a stricter performance measure, I opt for standard costing. Standard costing allows you to value inventory at a predetermined cost, determine profit margin based on projected costs and record variances against those expected costs. You usually perform a cost implosion through your bill of materials to revalue your inventory to a new standard cost.
For example, a salesperson can use standard costs to derive the selling price when supplying a customer with a quotation. It is then possible to measure the performance of the salesperson against that standard.
However, the factory manager applies cost savings during the manufacturing process. When you perform the job receipt you can account for those variances and you have a separate measurement for your factory performance. This is an effective separation of duty, responsibility and accountability that is easily measured.
Last cost will apply the last cost entered to all the quantity on hand according to the last cost entered for an item when it was received into stock. Instead of the stock on hand absorbing the price fluctuations as with average costing, the price fluctuations are now applied across the stock on hand resulting in many revaluation journals when capturing transactions.
FIFO and LIFO create cost buckets in the background upon receipt and deplete these buckets based on the outgoing rule chosen. In my pantry, I ensure a FIFO rule by placing my newest inventory right at the back and ensuring that the oldest inventory is right in front for first picking. LIFO is almost like having a basket with cleaning rags. When you buy more rags you just throw it on top of the others in the basket so when you decide that you need a new rag you grab from the top as well, depleting the last receipts first.
I love the history that cost buckets provide but it is not always easy for salespeople to manage their profitability benchmarks, especially if you invoice out of various cost buckets and have frequent price fluctuations. When reversing or correcting transactions there is also a higher responsibility to apply the correction against the correct bucket.
If you missed the other parts of this blog series click below:
