It is the job of managerial accountants to work in conjunction with the manufacturing department to identify the cost of each product manufactured and make an assessment. Direct materials mainly consist of the most direct costs associated with the manufacturing or production process. Managerial accountants not only assist the manufacturing staff in differentiating direct materials from indirect ones, but also assess the key difference between expected and actual material costs by way of variance estimation.
Inventory Systems
Perpetual Inventory System – Perpetual inventory system updates inventory accounts after each purchase or sale.
Periodic Inventory System – Periodic inventory system records inventory purchase or sale in “Purchases” account.
Identification
Manufacturing organizations make use of various kinds of raw materials in the manufacturing process; these are used directly by the manufacturing staff in the production of the final product. Such materials are called direct materials. Other materials used by the staff ease down the entire process, through maintenance of the manufacturing facility, the production equipment or through their use in very low quantities in the manufacturing process. Managerial accountants are responsible for working closing with the manufacturing staff to make a difference between direct and indirect materials.
Cost
Manufacturing organizations need to determine their costs incurred on direct materials for various reasons, which account for a relevant part of the total product costs in order to make informed pricing decisions and determine profitability. Direct material costs that includes shipping charges as well; also help organizations in making a comparison among suppliers. These costs can be minimized by discounts that maybe offered by the suppliers, such as quantity or payment discounts.
Direct Material Variances
Direct Material Variances refer to the dissimilarities between actual direct material costs and expected direct material costs – these can be in terms of usage as well as price. These variances could be favorable or unfavorable. Nevertheless, they should be properly examined to understand the cause for such variances.
Direct Material Usage Variance
It measures the variance between the actual quantity of material used and its expected quantity to be used. Favorable direct material usage variance would mean that the actual quantity used is less than the expected quantity. Similarly, unfavorable direct material usage variance would mean the actual quantity used is more than the expected quantity. Any variances between actual and expected quantity usage can be attributed to poor quality of materials, problems in equipment and even not making ample of materials on the manufacturing line.
Direct Material Price Variance
This measures the variance between the actual price of unit materials used and their expected price. Favorable variance shows actual costs to be lesser than expected, and unfavorable variance indicates the opposite. These variances emanate from vendor price changes or sudden discounts.
Accounting Methods
Inventory includes the raw materials, work-in-process, and finished goods that a company has on hand for its own production processes or for sale to customers. Inventory is considered an asset, so the accountant must consistently use a valid method for assigning costs to inventory in order to record it as an asset.
The valuation of inventory is not a minor issue, because the accounting method used to create a valuation has a direct bearing on the amount of expense charged to the cost of goods sold in an accounting period, and therefore on the amount of income earned. The basic formula for determining the cost of goods sold in an accounting period is:
Beginning inventory + Purchases – Ending inventory = Cost of goods sold
Thus, the cost of goods sold is largely based on the cost assigned to ending inventory, which brings us back to the accounting method used to do so. There are several possible inventory costing methods, which are:
Specific identification method. Under this approach, you separately track the cost of each item in inventory, and charge the specific cost of an item to the cost of goods sold when you sell the specific item to which that cost has been assigned. This approach requires a massive amount of data tracking, so it is only usable for very high-cost, unique items, such as automobiles or works of art. It is not a viable method in most other situations.
When you buy inventory from suppliers, the price tends to change over time, so you end up with a group of the same item in stock, but with some units costing more than others. As you sell items from stock, you have to decide on a policy of whether to charge items to the cost of goods sold that were presumably bought first, or bought last, or based on an average of the costs of all items in stock. Your choice of a policy will result in using either the first in first out method (FIFO), the last in first out method (LIFO), or the weighted average method. The following bullet points explain each concept:
First in, first out method. Under the FIFO method, you are assuming that items bought first are also used or sold first, which also means that the items still in stock are the newest ones. This policy closely matches the actual movement of inventory in most companies, and so is preferable simply from a theoretical perspective. In periods of rising prices (which is most of the time in most economies), assuming that the earliest units bought are the first ones used also means that the least expensive units are charged to the cost of goods sold first. This means that the cost of goods sold tends to be lower, which therefore leads to a higher amount of operating earnings, and more income taxes paid. Also, it means that there tend to be fewer inventory layers than under the LIFO method (see next), since you will continually use up the oldest layers.
Last in, first out method. Under the LIFO method, you are assuming that items bought last are sold first, which also means that the items still in stock are the oldest ones. This policy does not follow the natural flow of inventory in most companies; in fact, the method is banned under International Financial Reporting Standards. In periods of rising prices, assuming that the last units bought are the first ones used also means that the cost of goods sold tends to be higher, which therefore leads to a lower amount of operating earnings, and fewer income taxes paid. There tend to be more inventory layers than under the FIFO method, since the oldest layers may not be flushed out for years.
Weighted average method. Under the weighted average method, there is only one inventory layer, since the cost of any new inventory purchases are rolled into the cost of any existing inventory to derive a new weighted average cost, which in turn is adjusted again as more inventory is purchased.
Both the FIFO and LIFO methods require the use of inventory layers, under which you have a separate cost for each cluster of inventory items that were purchased at a specific price. This requires a considerable amount of tracking in a database, so both methods work best if inventory is tracked in a computer system.
Ending Inventory
At its most basic level, ending inventory can be calculated by adding new purchases to beginning inventory, then subtracting costs of goods sold. This makes ending inventory the value of goods available for sale at the end of an accounting period. Although the number of units in ending inventory won’t be affected at the end of an accounting period, the dollar value of ending inventory is affected by the inventory valuation method chosen by management.
During a period of rising prices or inflationary pressures, FIFO (first in, first out) generates a higher ending inventory valuation than LIFO (last in, first out). As such, certain businesses strategically select LIFO or FIFO methods based on different business environments.
Average Age of Inventory
Also referred to as days’ sales in inventory (DSI), the average age of inventory is a metric that analysts use to determine the efficiency of sales. It tells the analyst how fast inventory is turning over at one company compared to another. The faster a company can sell inventory for a profit, the more profitable it is. However, a company could employ a strategy of maintaining higher levels of inventory for discounts or long-term planning efforts. While the metric can be used as a measure of efficiency, it should be confirmed with other measures of efficiency, such as gross profit margin, before making any conclusions.
Inventory Reserve
An accounting entry that represents a deduction from earnings for the purpose of fairly and reasonably representing the value of inventoried assets on a balance sheet. The inventory reserve is used to make up for the fact that all inventory will not be sold at the cost to the firm.
