The past three to four years have wreaked havoc on supply chains. First came the imposition of stiff tariffs on foreign imports, then COVID-19 global supply bottlenecks, followed by labor and shipping container shortages, and the invasion of Ukraine. Does anyone remember that the Suez Canal was blocked for a hot minute? Input price volatility and supply-chain issues will only worsen before stabilizing, leaving companies using standard costing in the lurch.
Now, extreme heatwaves around the world are causing additional supply chain disruptions. Fortune Magazine reports that the Chinese regional manufacturing powerhouse, Sichuan, is experiencing a record heat wave that has exacerbated an ongoing drought and cut water levels in half in the month of August. “As a result, officials announced on August 15 that factories in 19 cities and prefectures would be forced to close their doors for five days to reserve electricity for ‘use by the people.’” This shutdown is expected to create additional pressure on the already stressed global supply-chain.
All of these disruptions have led to unprecedented inflation. The annual inflation rate in the United States accelerated to 8.5% in July 2022, down from the 40-year high of 9.1% in June. Now more than ever, companies must evaluate their pricing to maintain profitability.
Rising Commodity Pricing and Standard Costing
For manufacturers utilizing standard costing, the current volatility in commodity prices calls into question the traditional practice of annually reviewing and updating standard costs. The question is, how often should management be reviewing their standard costs to properly evaluate product and customer profitability? Lagging standard costs in an inflationary market allow sales orders to be written and fulfilled with marginal to no profit when analyzed on an actual cost basis. Companies that lock in prices without proper inflationary adjusters will find their cash flow dwindles and may even dry up.
Standard Costing vs. Actual Costing
In an actual cost system, the value of the item, whether bought or fabricated, is the sum of the actual cost of the inputs (actual cost of materials, labor, and overhead). Inventory cost is often recorded in “layers;” each layer contains the costing information for that transaction.
While one of the simplest methods available, the actual cost method can also be the most time-consuming since actual cost must be compiled and allocated. In times of input price and production volume volatility, current cost information may not be readily available for management to make timely pricing decisions.
In a standard cost system, the value of the item, whether bought or fabricated, is the stated standard cost of the item as determined by management. Any difference between the actual and standard cost is recorded in a variance account and reflected as income or expense.
While more time-consuming to set up, management can gain greater cost control by setting standards for each type of cost incurred and then highlighting exceptions or variances. This analysis can result in quicker adjustments to pricing during periods of input price and production volume volatility, but only if management analyzes the variances periodically.
There are many types of standard cost variances, including the following:
- Fixed overhead spending variance
- Labor rate variance
- Purchase price variance
- Variable overhead spending variance
- Freight-in cost variance
How to Update Standard Costs to Avoid Lost Profits
The process of reviewing and updating standard costs can be time-consuming. Management needs to ensure that before they consider updating standard cost their monthly review of positive and negative variances is timely and accurate. Properly identifying efficiency versus price variances allows for a more accurate monthly valuation of inventory and cost of goods sold. The next step is to evaluate your options:
Increase the Frequency of Standard Cost Updating
As a leading practice, management should consider volatility and recent variances– in addition to forecasted changes. From there, a threshold to trigger an adjustment of standard costs can be set or management can define an update frequency – and when to change the frequency to either have access to more current costing information or mitigate unnecessary efforts when costs stabilize. This evaluation should include input from other departments (e.g., operations, manufacturing/production, sales, and purchasing).
The process could be done bi-annually, quarterly, or even monthly to ensure access to accurate information and thus better decision-making on pricing. However, this process is time-consuming and may not be necessary to complete monthly. In addition, changing standard costs too frequently might cause management to inadvertently reflect temporary variations in their costing, leading to unnecessary variances in analysis.
Selectively Adjust Standard Costs On An Increased Frequency
Analyze and update the 20% of items that make up 80% of your costs on a semi-annual, quarterly, or monthly basis. This reduces your analysis time, as most items may only require analysis annually. This will also reduce the time spent on your monthly cost variance analysis.
Triggering Event Approach
Determine a specific threshold of change that triggers an analysis of cost-variance. For example, management will analyze and update any cost that fluctuates by 25% or more of the budgeted cost or any cost that comes in over a defined dollar threshold. This process requires judgment and additional consideration of temporary circumstances. For instance, your company’s primary vendor might be out of stock causing purchases with additional shipping costs and no volume discounts available from another vendor. This may trigger an adjustment to the standard cost, despite the fluctuation being due to a temporary circumstance.
An alternative approach would be to create a watch list for items that were triggered as a result of the monthly analysis. Management can track the watch-listed items for a period of time to determine whether the fluctuation was indeed temporary or if a standard cost adjustment is necessary.
Tips for Monthly Standard Costs Analysis
- Examine costs every month. Pull the accurate and complete data to build an analytical fact base. Be flexible and inquisitive.
- Cost benefit principles should be considered throughout the analysis process not to get bogged down in the details.
- Remember to not interpret variances in isolation from each other. The causes of variances in one part of the value chain can be the result of a decision made in another part of the value chain.
- Do not be misled by favorable variances. Favorable variances are often mistaken for good news. Be sure to understand the root cause.
- Review and monitor your supplier contracts for limits on pricing adjustments. Some contracts have incentives to bring prices down, but suppliers may ignore these clauses until they are audited.
Using Standard Costing
Selectively adjusting standard costs frequently and setting triggering events are the most cost effective and least time-consuming options to maintain accurate reporting while using standard costing. Try combining elements of each to optimize a solution for your business. There is no perfect option in an imperfect world, so work with your advisors to choose a solution that works best for your business and capabilities. Get in touch with our team today with any questions on how to maximize results with a standard costing method.