Inventory management is vital to lean manufacturing success. On that note, before we can improve our inventory management processes it’s vital that we grasp a few basics.
First, there are ultimately 3 different categories of inventory. Inventory accounts for all raw materials (RM), work in process (WIP), and finished goods (FG).
Second, all inventory must be accounted for on the manufacturer’s balance sheet, while all inventory changes must be accounted for on its income statement.
Third, the value of finished goods inventory includes the cost of the raw materials as well as the conversion costs such as overhead and direct labor needed to transform the raw materials into the finished products. Finished goods inventory is considered an asset since it will sooner or later be sold, and it’s expected that you will recover its cost plus a profit.
With those key concepts in mind, it’s important to understand how standard costing is used in inventory management.
Inventory Management and Standard Costing
Standard costing begins with budgeting which involves acquiring data from different departments such as sales, production and other supporting functions.
This data is used to forecast annual labor, raw materials, and manufacturing costs. These budget amounts are later compared to actual costs to identify negative and positive variances.
It’s important to recognize, that while seemingly straightforward, the actual process of tracking data and conducting variance analysis can be extremely time consuming and complex.
Additionally, in traditional accounting, numbers usually incorporate myriad assumptions that can lead to errors. As an example, a specific product’s cost of quality may assume that 10% of a company’s total quality costs are attributed to that product
However, when total quality assurance costs are calculated at month-end, 10% of those costs are then automatically incorporated into the actual cost of the product whether that in fact was accurate for that given month. Ironically, as a result of this inaccuracy, many organizations invest excessive amounts of time analyzing cost amounts dwarfed by the amounts of their initial underlying cost assumptions.
One common driver of excessive analysis is thousands of transactions that most manufacturers find it necessary to track on a regular basis. That said, one of lean accounting’s objectives is to significantly reduce the number of these transactions.
Monitoring budgets and variances by the department is a huge driver of siloed thinking within companies, which encourages anti-lean practices such as, bulk-buying for discount, and producing finished goods inventory to “absorb” (i.e. justify) manufacturing overhead.
Often, overproduction looks “good” on the books because (1) inventory is an asset, and (2) more inventory allows overhead to be amortized over more units, thus reducing the average unit’s cost. As such, when extra inventory units are finally reduced, which happens early on the typical lean journey-and maintained at a level in line with demand, the financials can appear worse, when standard costing is used.
Standard Costing Example
Consider the following scenario. A company with $1,000 of monthly manufacturing overhead plans to sell 100 units during a month. As such, the company allocates a standard overhead cost of $10 to each unit produced. Additionally, the company also has a standard material cost of $8 per unit and a standard direct labor cost of $4 per unit.
We’ll look at two months. To keep this simple, let’s assume that the company starts month one with no inventory. During the first month, the company produces 130 units (30 more than planned), but only sells 80 units (20 fewer than planned). Because the company began the month with zero units on hand and sold 50 units fewer than it made, it ends the month with 50 units of finished goods on its balance sheet (130 units made – 80 units sold) at a total value of $1,100 (Fig 1).
|Balance Sheet (Month 1)|
|Overhead (50 Units)||$||500|
|Std Direct Materials (50 units)||$||400|
|Std Direct Labor (50 units)||$||200|
Figure 1. Month 1 Balance Sheet
Let’s review the income statement, starting with revenue. The company sells its product for $30 which resulted in a revenue of $2,400 (Fig 2).
Now, let’s look at cost of goods sold (COGS). Multiplying 80 units sold by the per-unit cost for each of the costs drivers results in a total material cost of $640 (80 units x $8), the direct labor cost of $320 (80 units x $4), and absorbed overhead cost of $800 (80 units x $100 per unit planned overhead).
To calculate our total COGS seems straight forward. We simply total our 3 COGS related costs to get a total of $1,760. However, we have one more factor to consider; volume variance.
Recall that since the company is using standard costing and planned to amortize manufacturing overhead of $1,000 over 100 units that gave it a per-unit overhead cost of $10. As such, when the company overproduces by 30 units, more units than planned can “absorb” overhead costs.
To many managers, this sounds like a good thing. After all, we got more for less than we planned. In fact, using standard costing, we account for it as such by recording a positive volume variance of $300. Because we made $300 worth of overhead more during the month, we essentially got $300 worth of overhead in units for “free” reducing our total COGS $300 to $1460.
As figure 2 illustrates, we end month one with a gross profit of $940 or $39%. The key point that month one illustrates is that with standard costing, behaviors that produce an inventory (one of the seven deadly lean wastes) can create positive looking results on paper.
|Income Statement (Month 1)|
|Sales (80 Units)||$||2,400|
|Volume Variance (positive)||$||300|
|Absorbed Overhead (80 sold)||$||800|
|Std Direct Materials (80 sold)||$||640|
|Std Direct Labor (80 sold)||$||320|
|Gross Profit $||$||940|
|Gross Profit $||39%|
Figure 2. Month 1 Income Statement
To keep our example simple, the company has the same planned sales and production rates for month two as it did in month one. However, during month two, the company reins in production in order to burn off some of the excess inventory it produced in month one. After all, inventory is a waste. As such, the company only produces 70 units of finished goods during the month (30 units fewer than planned). Yet, the company actually sells 110 units; 10 more than planned.
Starting again with the balance sheet, the company starts month two with 50 units and ends the month with 10 units of finished goods inventory on the books (50 units starting + 70 units made – 110 units sold) or $220 worth of finished goods, using standard costing (Fig 3).
|Balance Sheet (Month 2)|
|Overhead (10 Units)||$||100|
|Std Direct Materials (10 units)||$||80|
|Std Direct Labor (10 units)||$||40|
Figure 3. Month 2 Balance Sheet
On the income statement (fig 4), revenue is $300 better than plan at $3,300 ($30 x 110 units).
Now, let’s look at cost of goods sold (COGS). Multiplying 110 units sold by the per-unit cost for each of the costs drivers results in a total material cost of $880 (110 units x $8), the direct labor cost of $440 (110 units x $4), and absorbed the overhead cost of $1,100 (110 units x $100 per unit planned overhead).
Again, the company needs to account for any volume variance before calculating the total COGS.
This time, since the company only produced 70 units in month two, 30 fewer units than the 100 planned can “absorb” overhead costs. In other words, this time, the company is getting fewer units for more manufacturing overhead, so overhead-related COGS are higher than planned. In this case, costs are $300 more than planned (fig 4).
|Income Statement (Month 2)|
|Sales (110 Units)||$||3,300|
|Volume Variance (negative)||$||300|
|Gross Profit $||$||580|
|Gross Profit $||18%|
Figure 4. Month 2 Income Statement
Before Lean vs After Lean
From a lean perspective, month two was the better of both months because the company sold more than planned while simultaneously reducing its inventory. Yet, as illustrated in table 1, using standard costing, month 2 looks worse. After all, both gross profits and assets declined during month 2.
|Standard Costing (Pre LEan vs Post Lean)|
|Month 1||Month 2||Difference|
able 1. Standard Costing Results before and after lean.
This effect is absolutely vital to recognize. Judging by these results, the lean journey appears to be an unmitigated failure. In fact, this is an all too common reason why many lean journeys die quick deaths and end up being just another flavor of the month. After all, once positive lean results (such as less overproduction and less inventory) start to happen, decision-makers often become disillusioned when they see the apparent “negative” effects on their financials. Thus, standard costing can tend to unintentionally reinforce non-lean behaviors such as over-ordering and overproducing.
Remember that truly lean organizations will always opt to cut out waste which includes inventory. With standard costing, when you overproduce, costs get lost in determining profit and loss, not to mention the variances that come along with that. As the month’s pass, it becomes harder for decision-makers to determine how much to procure or produce.
Keep in mind also that we used a very simple example. In reality, most plans, costs, and prices vary far more month to month, and inventory can become obsolete. These are just a few factors that make standard costing analyses exponentially more complex and confusing. Furthermore, the inability of standard costing to effectively control the random results of these variables often drives the perceived need to adopt arduous and unnecessary systems such first-in-first-out (FIFO) or last-in-first-out (LIFO) inventory management.
Lean Inventory Valuation
As previously mentioned, with traditional standard cost accounting, often, the waste of overproduction can appear good from a financial point of view. Unfortunately, this mirage often drives managers to make wasteful mistakes. Fortunately, lean gives us a better way to value and track inventory that eliminates the many transactions and needlessly complex math. It’s called lean inventory valuation.
As manufacturers grow accustomed to lean practices it’s expected that they should see inventory levels shrink and become far more stable which makes it a reality to eradicate full standard costing practices.
This likewise means, they can eliminate convoluted tracking of labor and expenses. While some immediately appreciate this, many are initially apprehensive as they aren’t fully aware of how to value inventory or the costs of goods in the absence of standard costs. In fact, a great deal of resistance should be expected until everyone fully understands and experiences that inventory valuation does not necessitate standard costing practices in order to be GAAP compliant
As a reminder, GAAP only calls for a consistent and fair valuation of inventory. This simply means that the inventory cannot be either overvalued or undervalued. That said, when inventory levels significantly drop, stabilize, and start to see returns monthly, as a result of lean, inventory valuation becomes irrelevant. With this, errors aren’t such a worry to auditors. That said, keep in mind that it’s best to have your auditors participate in the change at the onset when you transition to changing the way you value inventory and retire your standard costing approach.
To be clear, you will continue to need to continue tracking the standard costs of raw materials. However, you will no longer need to allocate standard costs for overhead and labor to products. Thus, overproduction will cease to “absorb” overhead. Instead, the actual direct labor and actual manufacturing overhead costs for each period are added to the cost of goods sold for the period. Recognize that to ensure GAAP compliance, these conversion costs must also be added to inventory on the balance sheet.
A common practice is to base monthly conversion costs on historical data such as the average conversion cost for the previous three months. Calculating this is as simple as dividing the total overhead and direct labor costs for the last 3 months by 3. To be clear, you can use whatever number of whatever periods make sense to your decision-makers, as long as you’re consistent. Remember, to be GAAP compliant your lean organization must be consistent.
Daily conversion costs are simply the average monthly conversion costs divided by the total days in the month. Thus, total inventory conversion costs are the total days of the inventory on hand multiplied by the daily conversion cost.
Raw materials are automatically calculated by multiplying unit standard raw material costs. However, since conversion costs are based on total days of inventory, we must account for this change on both the income statement as well as the balance sheet.
It’s important to understand that if inventory days decrease, conversion costs decrease on the balance sheet by the same amount as a result, and the inverse of that same difference is applied to the cost of goods sold on the income statement. Likewise, if inventory increases, inventory conversion costs also increase, and the cost of goods sold on the month’s income statement decreases by the same amount. Table 2 illustrates an example of this.
Table 2. Monthly inventory valuation adjustment. The difference in on hand conversion costs is accounted for on the balance sheet and the inverse of the amount is accounted for on the income statement, under COGS
That said, don’t fret if this seems complex or unintuitive at first. Review this content a few times to ensure you understand the key concepts. Finally, consider the relevance of this process as lean behavior reduces inventory close to zero. The necessity to track and value inventory decreases and the effects on financial performance measures become negligible.
Figure 5. Month 1 Lean Accounting income statement and balance sheet
Figure 2. Month 2 Lean Accounting income statement and balance sheet
Before proceeding it’s worth noting that there is also an alternative calculation for conversion cost that can also be utilized. I say, your company has experienced finished goods material to conversion cost ratio of 2:1, then if your finished goods inventory is $20,000, the conversion cost would be $10,000. As a reminder, just as with the conversion cost computation based on days of inventory you would continue making journal entries reflecting the adjustment to the balance sheet and the monthly cost of goods sold on the income statement.
Inventory monitoring is vital. After all, inventory represents waiting for the money invested in raw materials, labor, and overhead to deliver a return on investment.
That said, a few commonly utilized inventory metrics follow.
- Actual $ value of inventory
- Inventory % of total assets: This metric shows the relationship between inventory levels and business activity.
- Day of inventory: This tells us how many days of demand that we have on hand. A good lean goal to work towards achieving is to hold more days of demand than production lead time.
- Inventory turns: This metric tells us how often we sell our total inventory. Lower inventory turns may signify overproduction. On the other hand, higher inventory turns shows production is more in line with customer demand.
Whatever inventory metrics you use, when considering inventory metrics keep a few points in mind. As with all lean metrics, ensure they are easy to calculate, easy to comprehend, and actionable for decision-makers.