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Inventory Cost Accounting Method selection for a Manufacturing Organization: Average Vs Standard Costing

One decision which is often considered as one of the most important decision to make while implementing an ERP
system is selecting an appropriate Costing method for your organization. Two most commonly used costing methods are
Average and Standard Costing.
The Article presents a quick analysis of important considerations while selecting the costing method for your
manufacturing organization and presents a brief comparison of two Costing Methods. Based on my experience, I have
tried to cover the areas which I think are most important for selecting the right Costing Method.

Costing Method
Description

Standard Costing

Average Costing

Predetermined costs are used for valuing inventory


in Standard Costing environment.

Weighted Average Item Cost is used for valuing


inventory in Average Costing environment. Average
Item Cost is perpetually computed based on receiving
material transactions while all issue transactions use this
average cost.

Predefined item costs are used or purchased items.


Whereas, for manufactured items, standard cost is
generally derived from Cost Rollups on the basis of
associated BOM and Routing; predefined resource and
overhead costs are used towards the same.
Differences between standard costs and actual
costs are recorded as multiple variances (such as
Purchase price variance, Material & Resource usage
variance for Job etc.)

Relevant Business
Scenarios

Relatively steady procurement cost (for raw material,


components)
Manufacturing environments where BOM/Routing
details can be standardized to a large extent: Build to
Stock or Assemble to Order scenarios
Standard Costing method is commonly used across

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For purchased items, this is a weighted average of the


actual procurement cost of an item, for manufactured
items, this is a weighted average of the cost of all
resources, materials and overheads consumed.
Formula for average cost computation:
Average Cost = (transaction value + current inventory value) /
(transaction quantity + current on-hand quantity)

Large variation in procurement cost (for raw material,


components) on a frequent basis
Large stockpile of inventory is maintained (no
differentiation of old vs. new stock)
Non-standard production environment: Build to Order
scenarios

Cost Control & Variance


Tracking

several Manufacturing industries spanning across


Automotive, Electronic goods, FMCG, Food and
Dairy Products, Pharmaceuticals industries

These scenarios are typically present in industries


such as Oil & Petro Chemicals, Agriculture, Heavy
Industry and Industrial Manufacturing involving large
commodities

Standard Costing provides a very good control over


costs as inventory is valued based on predefined item
costs. It also provides robust performance measurement
as multiple variances are recorded based on the
differences between planned and actual costs.

Average Costing perpetually updates the average cost


based on actual transactions and values the inventory
and Jobs based on actual transactions.

Each of the variances can be monitored and analyzed to


identify the scope for efficiency improvements. Following
types of variances can be tracked:

As compared to Standard Costing, there is a very limited


control on the Item Cost in Average Costing and very few
variances can be recoded. Invoice Price Variance can be
recorded.

Purchase Price and Invoice Price Variances


Material usage Variance
Resource, OSP & Overhead efficiency Variance
Standard Cost adjustment Variance

Cost Administration

Standard Costing needs active administration and


control. Following activities are typical towards
administering Standard Costing:
Revise Predefined Item Costs for each period
Perform Cost Rollups for make items in each period to
reflect revised cost for "Make" assemblies
Analyze cost variances and root cause analysis for the
recorded variances; take remedial actions to control
the variances in future periods
Perform standard cost adjustments whenever required

Product Pricing and


Profit Margin Calculation

Both pre-defined costs as well as recorded variances


need to be analyzed for validating Product Pricing and
estimating Product profitability accurately.

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Average Costing requires less administration and


minimal intervention is required from business users.
Following activities may be required to administer
average costing:
Review Item Cost History time-to-time
Perform Average Cost adjustments if required

Since average costs are computed based on actual


transaction values, no variances are being recorded.

Detailed root-cause analysis must be undertaken to


identify the exact reasons for recorded variances. Some
of them may be attributable to engineering design while
some may be due to operational inefficiencies. Doing
this analysis will help in deciding the Product pricing
realistically for the future.

Benefits

Challenges

Up-to-date Average Cost can be reviewed along-with the


cost history to validate Product pricing and estimate the
product profitability.

Good control over item cost and inventory valuation


Accurate tracking of variances
Good Performance Management tool: Easy to fix
responsibility for each kind of variance
Easy to identify required operational improvements

Higher administration overhead


o Define item costs for each period
o Perform cost rollups for each period
o Variance analysis for each period

Automatically value inventory at moving average


item cost
No need to define any pre-defined costs
No need to track variances
Easily determine profit margin based on actual cost
Very limited control over item costs
No Variances are recorded and all operational
inefficiencies are included as part of actual costing
Difficult to assign responsibility for operational
inefficiencies

Product Profit Margin computation to include direct


costs (planned) as well as variances
Higher standardization required in engineering
phase in order to account for all operational issues.

PS: I have not covered any system related information or setups in this article (I shall be writing another article to present
a solution to reap benefits of both costing methods in one organization based on Oracle Applications ERP platform).
Hope you will find this analysis interesting; your suggestions and feedback are most welcome!
Regards,
Manu Singhal

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