Most of my manufacturing implementations have included setting the inventory costing as “Standard”. There are great benefits in doing so. An item’s standard cost is based on the Bill of Materials (ingredients’ cost), Routing (manufacturing process cost), and subcontractor costs. These costs are pre-determined based on expected processing time and ingredients consumption. If a product takes longer to produce or requires more ingredients, the difference shows up as “variances” within the production reports as well as the chart of accounts.
Variances allow the production supervisor to stay on top of plant efficiencies and provide a great way of monitoring the overall consumption of materials and processing capacity.
Within the manufacturing setup, there is a clear demarcation of responsibility between sales and production if the inventory is set up as “standard costing”.
From an accounting perspective, this allows the chart of accounts to be structured in the following way:
- Revenue Account #1
- Revenue Account #2
Cost of Sales
- Cost of Goods Sold #1
- Cost of Goods Sold #2
Sales Gross Margin
- Sales Gross Margin #1 (Revenue #1 – Cost of Sales #1)
- Sales Gross Margin #2 (Revenue #2- Cost of Sales #2)
Cost of Production
- Material Variances
- Capacity Variances
- Subcontracting Variances
Production Gross Margin
- Production Gross Margin (Sales Gross Margin – Cost of Production)
This structure separates the accountability of sales vs production. The Sales Staff sell the products based on a standard cost. If there are too many variances during production, this becomes the responsibility of the Production Manager.
It is important to note that variances are posted at the time of stock production but the revenue and cost accounts are posted at the time of product sales. Since there is always this time-lag between the two, a wash-out occurs after the first few months of operation within NAV and the difference smoothens.
There are a few scenarios where standard costing finds its limitations such as:
- Varying batch sizes for the same product: In the cases where one bulk product goes into multiple finished products, the batch sizes for the same bulk product vary significantly for different production orders. Since the standard cost of the product is built on a standard lot size this will invariably create variances that are not directly linked to production efficiency.
- Varying Setup time requirements for different production runs: When the products being manufactured need to be safe from contamination, the production lines may need to be flushed, unless the product that was manufactured before contains the same ingredients. This means that setup time may not always be needed. Since the standard product recipe includes the setup time, not using it will create favorable variances within the capacity.
On the manufacturing Setup screen, it is possible to exclude the setup cost from the item cost. This may seem to be an easy solution but this means that the setup costs may not be included in the cost of the product, and the gross margin may not be as accurate and reliable as one would otherwise expect them to be.
There are many ways to tackle this problem, and it certainly makes for a good workshop discussion. The solution involves adjusting the processing costs of the plant, making the variances report more comprehensive, and sometimes excluding the setup cost in the item cost calculation. Almost never, do we recommend going to average costing. This completely takes away the opportunity to monitor and track plant efficiencies.
Do you run into these standard costing issues?