Asking if you know how much your inventory is worth or is it valued correctly might sound like a simple and insulting question. Of course you know the value as you approve the invoices, process the checks, however, if you manufacture your inventory, the valuation is not that simple.
Even before determining whether you are appropriately valuing your inventory, you should make sure all expense categories are properly categorized between cost of goods sold (above the line) and selling, general and administrative (below the line). Many times expenses that pertain to production being are incorrectly categorized below the line which can distort the gross margin and give the impression that a product is more profitable to produce than it really is.
Once you have determined your expense classifications are correct, it’s time dive into the components of inventory, which are comprised of the various cost of goods sold expense accounts. The inclusion of such direct materials as raw ingredients and packaging in valuation is pretty straight forward. Direct labor can be tricky if you apply labor based on a standard rate or you expense direct labor as a period cost. Such applications are fine if there are not any finished goods at the end of each period, but that is rather unusual. Once you know you are accounting for the low hanging fruit (pun intended?) correctly, you can move on to the exciting and confusing world of overhead or also known as indirect expenses, which are incurred during the production process.
Similar to direct labor, these costs can be applied using an overhead rate based on an estimated rate, which is calculated using a driver that most directly correlates to the expenses being incurred such as direct labor hours, pounds or units processed. Depending on the sophistication of your accounting system, you could have different drivers for different expenses; however, the cost benefit of using multiple metrics may not be worth it. Some of the typical costs that would be included in overhead are rent, utilities, depreciation, indirect labor, repair and maintenance, and supplies, some of these are variable and some are fixed, which can also be factored into the overhead rate. As with direct labor, maybe you simply expense these items as period costs, which if the case, could overstate or understate gross margin from one period to another, which can lead to making the wrong decision due to inaccurate reporting.
If you’ve decided to use applied rates for direct labor and overhead, it’s important to re-evaluate the rates periodically to ensure they are still accurate. If you only adjust at year-end, you may end up with a material adjustment to inventory and cost of goods sold; this is why we would recommend reviewing the rates at least on a quarterly basis.
While many people cringe at the mention of cost accounting, it’s what I live for, so much so, after the pain of the CPA exam wore off, I obtained my CMA certification. I’ve only given a high level view of all that is involved in world of inventory valuation and the impact on margin analysis, however, if that hasn’t scared you off and you have questions, please feel free to reach out to me or one of my team members, as we would be happy to help.
