Why You Need To Keep Inventory Standard Costs Current During Inflationary Periods

According to a CNBC survey of businesses in 2022, 74% of businesses are dealing with supply cost increases. It is not uncommon for businesses to utilize standard costing inventory in their internal ERP system and update the standard cost for products on an annual basis.

Standard costing is based on the expected costs of material, labor and overhead (typically established at the inception of a year) instead of the current actual costs incurred months later. For standard costing to be effective, a company needs to monitor and analyze the standard costs with actual costs and adjust the standard cost for these variances when there are significant changes in actual compared to expected costs.

When costs to manufacture goods remain relatively consistent, management may not need to perform as frequent of an analysis of inventory costs. However, based on the state of the economy in the past two years with the continuing increase in all aspects of their production that companies are seeing across industries from supply chain disruptions and inflation pressures, it may be time to evaluate if updating their standards on an annual basis is frequent enough to make informed and accurate business decisions.

If standard costs do not approximate actual costs, management may not truly understand the cost of sales and gross margin on a specific product level. Being able to easily see and understand the actual cost of sales and gross margin by product line or individual items, in turn, allows management to determine which products provide the company with the best value. Management will monitor which suite or individual product lines are generating the highest gross profit and make operational decisions about where to focus selling efforts.

Management may want to shift selling efforts to the higher-margin items or focus on how to improve operating costs on some of the lower-margin items. If a product line is making a lower margin than they were expecting it to be, they can drill down further to determine what is causing there to be a lower margin. One thing that management can consider is whether a significant increase in vendor costs can be passed along to the customer. Updating the standards more than once a year can allow management to see more easily when margins are being impacted and at what point costs should be passed along.

In addition to the above items, inventory valuation plays a part in the budget process. If standard costs are not reflective of actual costs, how much can management rely on budgets and forecasts to see how the company will perform in the upcoming years? The forecasted cost of sales will be understated if standard costs are not updated to reflect the continued increases that are being seen from supply chain disruptions and inflation.

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For more information on this topic, please contact a member of Withum’s Manufacturing, Distribution and Logistics Services Team.