A company's inventory can be valued using different methods. The method you choose depends upon the type of goods that the business is producing. Two such costing methods are job order costing and standard costing.
Overview of Inventory Costing
Companies must track production costs so they can determine how much to charge for their goods and services. Production costs include:
- Raw materials
Raw materials are unprocessed items that are converted to a finished product. Labor includes the salaries of employees who are directly involved in producing the item. Overhead includes rent and salaries of those employees who are not directly involved in the production process, such as office employees. Products can be costed using several different methods. Let's look at two ways a business can track its costs: job order costing and process costing.
Job Order Costing
Job order costing is used when the product or service is unique or custom-ordered. Costs are traced directly to the product or service and can be tracked separately. For example, the cost to produce a custom-ordered chair for Wood's Fine Furniture would be calculated using job order costing.
Let's assume that Mr. Maple received an order for an oak chair to be completed next month. In his accounting system, Mr. Maple would track the cost of the raw materials (wood) and the time to cut and sculpt the wood and assemble and stain the chair. Let's assume that the chair for this special order required $200 in raw materials (or wood), 10 hours of Mr. Maple's time at a cost of $50 per hour, and overhead of $200 was allocated to the chair. The total cost to manufacture the chair using job order costing would be $900, which we would calculate as follows: $200 + (10 hours x $50 per hour) + $200. Since each cost can be traced to the chair that was made, Mr. Maple can easily calculate the price to charge in order to make a profit. If Mr. Maple were to charge his customer $1,500 for the chair, he would make a profit of $600, which would calculate as follows: $1,500 - $900.
In standard costing, an expected or pre-determined cost or standard is calculated for manufactured items. Just like job order costing, standard costing includes costs for raw materials and labor, as well as an allocation of overhead. In this method, all items are assumed to be the same to manufacture. A standard cost is calculated for each product and is then used as the cost basis for all items of that type that are produced. When calculating a standard cost, companies must consider how much raw material is needed to manufacture an item including the quantity, quality, and price of materials used. Labor costs must include the skill level of employees, and overhead costs must also be calculated.
Let's assume that one of Mr. Maple's competitors, Mr. Pine, owner of The Knotty Pine, mass produces its chairs and uses a standard costing system. Mr. Pine determined that each dark pine chair consisted of $125 in raw materials, $150 of labor costs, and $175 of overhead costs. Therefore, the standard cost of each pine chair would be $450, which we can calculate as follows: $125 + $150 + $175.
Variance Analysis in Standard Costing
Since standard costs are an estimate, there will be differences between the actual costs to produce the item and its calculated standard cost. This difference is known as a variance, and it can result from a difference in price or volume. A price or rate variance can exist in materials, labor, or overhead costs.
The formula for calculating a price variance is:
- Quantity purchased * (actual price paid - budgeted price)
The formula for calculating a volume variance is:
- Standard cost per unit * (actual sales volume - budgeted sales volume)
Variances can be favorable or unfavorable. A favorable variance means that the actual cost of producing an item is less than its standard cost. An unfavorable variance means that the actual cost is greater than the standard cost. All variances should be investigated, but management would pay more attention to unfavorable variances as they could suggest that the company should adjust its standard cost to more closely reflect the actual cost of producing the item. Adjusting the standard cost could also result in a change in the selling price of the item to cover the additional costs of production.
Let's assume that Mr. Pine's standard cost for materials is $125 per chair. If the actual cost of materials is $150, then Mr. Pine would have an unfavorable material price variance of $25 per chair, which is 1 chair * ($150 - $125). Mr. Pine would want to know about the unfavorable variance so he could investigate and make changes to the standard cost, and possibly the selling price of the chair, as quickly as possible.
Job order costing is used to value inventory when the product or service is made-to-order, and standard costing is used when products are identical to each other. Costs for raw materials, labor, and overhead are calculated and included in an item's standard cost. Standard cost is an estimate and will differ from actual cost. Management must calculate this difference, or variance, and identify if it is favorable or unfavorable. Variances may require changes to a product's standard cost and/or its selling price.