Costing Methods for Manufacturing in Microsoft Dynamics NAV
I am often asked by manufacturers, “Which costing method should we ue in our Microsoft Dynamics NAV system?” Before addressing the question, let’s set the stage with some important definitions.
In large part, “Cost Accounting” should be considered “Managerial Accounting,” not “Financial Accounting.” The exception to this is that cost accountants are responsible for providing and being able to validate the value of inventory items on the balance sheet. As for managerial accounting, cost accountants are responsible for providing “actionable information” to the management team so that management can make necessary adjustments to improve a company’s financial performance. There are no GAAP rules for managerial accounting, so a company’s cost accounting should be tailored to provide management with the information they need. Also, cost accountants are, at times, responsible of informing management with the future cost of items.
While the ultimate choice of which costing method to use should be left to your company’s financial management team and CPA, I can offer the following thoughts:
Microsoft Dynamics NAV gives us the choice of FIFO, LIFO, Average, Standard, and Specific costing methods.
FIFO: In Dynamics NAV, FIFO means that the items taken out stock for production or sales shipments will be taken out in the order of first received, first out and are costed with the actual cost of procurement for that FIFO layer (there are specific exceptions to this costing method if you are using lot or serial number tracking, but they are beyond the scope of this discussion). Using Dynamics NAV FIFO, the balance sheet will reflect the actual procurement/production cost of items remaining in inventory.
LIFO: In Dynamics NAV, LIFO means that the items taken out stock for production or sales shipments will be taken out in the order of last received, first out and are costed with the actual cost of procurement for that LIFO layer (Again, we will ignore specific exceptions here). Using Dynamics NAV LIFO, the balance sheet will reflect the actual procurement/production cost of items remaining in inventory.
Average: In Dynamics NAV, instead of using the actual cost when items are taken from inventory for production or sales shipments, the items are costed at the average cost for that item in inventory (before taking the items). The averaging period can be set to day, week, month, or accounting period. The balance sheet will reflect the actual procurement/production cost of items remaining in inventory.
Standard: Instead of using the actual procurement cost or the average of the costs, Standard in Dynamics NAV uses a fixed value set by cost accountants. In a distribution environment, cost accountants, with the cooperation of the purchasing staff, set the standard for the purchased items which ultimately becomes the COGS when shipped. This standard may contain provisions for overhead absorption and/or landed cost elements. In a manufacturing environment, not only do cost accountants set the standard for purchased items, but they also set the standard for produced items. The standard cost for a produced item may contain material, direct labor, overhead, or subcontracting cost. Cost accountants need the assistance of production engineers for establishing the standard cost of an item. The balance sheet will reflect the standard cost of items remaining in inventory. When there is a variance between the standard and actual costs, a Purchase Price Variance will appear on the P&L statement as a period expense.
Specific: For Specific, Dynamics NAV assumes that the company is going to buy, produce, and sell items one at a time. Specific requires that the items in inventory are serialized. In Dynamics NAV, Specific costing means that the items taken out stock for production or sales shipments will be taken out by serial number and the cost reflects the actual cost of procurement. The balance sheet will reflect the actual procurement/production cost of items remaining in inventory.
Advantages and Disadvantages to the Various Costing Methods for Manufacturing
Using any of the methods but Standard, you can provide an up-front estimate, but the actual cost and margins will vary from accounting period to accounting period. There is no easy way to provide an answer to the question, “Why are our margins what they are?” because all of the costs are coming out of inventory at the actual costs. We are only able to provide COGS analyses, because the margin at the end of the accounting period is either higher or lower than estimated, but why? Did you use more material and labor, or did it just cost more to procure them? It is easier with Standard costing because you can compare actuals against the standard to see where the costs originated.
An advantage of using Average cost is that COGS is smoothed and does not swing when emergency purchases are made to fulfill a special customer order. In this way, a salesperson is not penalized when a shipment goes out using the FIFO or LIFO layer that was procured at an inflated cost when sales commissions are based on margin.
In a distribution company, identifying the costs is easier: You purchase the product at one price; you sell it at another price.
But in manufacturing, there are often several stages of sub-assemblies, making it nearly impossible to understand why margins are high or low for a specific accounting period. Therefore, manufacturing companies typically use Standard costing when management is interested in tracking variances for the purpose of identifying where the process can be improved. Using Standard costing:
- COGS is fixed and you can provide management with purchase price variance, material usage variance, and labor efficiency variance.
- You can provide sales and marketing with a fixed cost number that can used to set sales prices.
- Margins will remain the same until new standards are set.
- A drawback for Standard is that there is a significant amount of up-front effort to set the standards.
Ultimately, costing accountants must choose the most appropriate costing method to provide management with the actionable information they require. However, it is important to understand how each method is handled within your Dynamics NAV system to make a well-informed decision.