Thursday, March 08, 2012

Costing Methods

Standard Cost

When to use standard costing to value the inventory depends on two issues. 

Firstly, if you in the business of make to stock manufacturing, making the same things in the same way over and over. Make to stock environments make sense for standards since most things are made over and over again, and are supposed to use the same effort, and have the same input costs. If they don't, management should know about it promptly to get things back on track. That's the role of standard cost variance reporting.

Secondly, do you have the resources on staff that can manage standard costs in a timely manner, before any transactions happen? In early days with the missing sofistication of the business systems Standard costing was an easy substitute for the vast amount of data accumulation required to aggregate actual cost information. Also in business scenarios where there is a possibility of negative stock there might be challenges to cost these negative transactions where standard cost works well.


The average costing method is the preferred method of costing for distribution and other industries where the product cost fluctuates rapidly. The fluctation in the reported profits (monthly/ yearly) are reduced when using this method as the increase in the cost would be lesser when compared to the increase in the average cost.


It is very common to use the FIFO method if one trades in foodstuffs and other goods that have a limited shelf life, because the oldest goods need to be sold before they pass their sell-by date.


In the LIFO method the last inventory cost is consumed first so in most cases this increases the COGS and hence reduces the margins that are reporting in the P&L, because the cost of goods generally goes up over time; which also reduces the income tax liabilities of the company this method however is used in US but due to the above mentioned flaw is disallowed in non-US countries.


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