For a manufacturer, inventory is usually the largest asset and cost of sales the largest expense. Both come out of the cost system. A count can confirm the units on the floor, but it says nothing about whether each unit carries the right cost. A client can pass the observation and still overstate profit by pushing overhead into ending inventory. This guide covers the standard cost system, the overhead rules that matter and the tests that catch the problem.
For FIFO, average cost and net realizable value, see inventory costing under ASC 330. This guide focuses on how the cost is built.
Revenue and the cost cycle
Product sales are recognized when control transfers to the customer, at shipment or delivery depending on the terms, so cutoff is the revenue risk. The cost side is where the accounting judgment lives. Inventory carries material, labor and a share of production overhead, and the cost of what ships leaves the balance sheet at the same rate.
What the rules say about standard cost
Standard costing is acceptable when the standards are updated at reasonable intervals and variances are absorbed so that inventory approximates actual cost under an accepted method: FIFO, average cost or LIFO. At each balance sheet date, test whether standard cost approximates actual cost, and adjust inventory for variances if it does not.
Full absorption costing is the norm. ARB 43 states that excluding all overhead from inventory cost is not an accepted accounting procedure. Changing the cost elements included or the cost flow assumption is a change in accounting principle under ASC 250 and must be justified as preferable.
Overhead absorption and normal capacity
Variable production overhead is allocated on the actual use of production facilities. Fixed production overhead is allocated on normal capacity, defined as the production expected to be achieved over a number of periods under normal circumstances, taking into account planned maintenance. It is not theoretical capacity and it is not the prior period's actual output. Determining normal capacity takes judgment and should be documented.
Two consequences follow:
- In a period of abnormally low production or an idle plant, fixed overhead per unit does not rise. The unallocated portion is expensed in the period, not deferred in inventory.
- Abnormal freight, handling and wasted materials are current-period charges, not inventory cost.
Overhead pools matter too. A single plant-wide rate based on direct labor hours can misstate product cost in a plant with mixed processes: automated products look more expensive and labor-intensive products look cheaper. Departmental pools with separate bases, such as machine hours for machining and direct labor hours for assembly, reduce the distortion. Activity-based costing assigns overhead by setups, material handling, inspection and scheduling, and is only as good as the cost-driver data behind it.
Risk areas
- Normal capacity set too low. If the denominator is below true normal volume, the rate per unit is high and more overhead lands in inventory. A persistent unfavorable volume variance signals normal capacity was set too high. A persistent favorable one may indicate it was set too low.
- Stale standards. Standards not updated after price, yield or labor changes create variances that the client may leave in cost of sales or push into inventory without analysis.
- Variance disposition. Normal variances should follow the product through inventory and cost of sales, while abnormal ones are expensed. Some clients write all variances to cost of sales, or capitalize none.
- Capitalized abnormal costs. Scrap, rework, idle time and expedited freight sitting in inventory.
- Overhead pool composition. Selling and administrative costs included in the pool, or production costs excluded.
- Cutoff and in-transit. Receipts without invoices and shipments at period end change both cost and revenue.
Worked example
This is an illustrative example. A manufacturer sets normal capacity at 120,000 units a year. Budgeted fixed overhead is $1,200,000, so the fixed rate is $10 per unit. Standard cost per unit is $40 material, $15 labor, $5 variable overhead and $10 fixed overhead, for $70.
The plant produced 90,000 units because a major customer paused orders. It sold 70,000 and holds 20,000 in inventory.
- Fixed overhead absorbed: 90,000 x $10 = $900,000. The unabsorbed $300,000 is expensed in the period.
- Material price variance: Purchases cost $180,000 more than standard. Normal variances follow the product, so 20,000 of 90,000 units produced, or $40,000, is capitalized in inventory and $140,000 goes to cost of sales.
- Ending inventory: 20,000 x $70 = $1,400,000 at standard, plus $40,000 of variance, for $1,440,000.
Suppose the client instead divided its $1,200,000 by actual output of 90,000 units. The fixed rate becomes $13.33. Ending inventory carries 20,000 x $13.33 = $266,667 of fixed overhead rather than $200,000, an overstatement of $66,667. The client reports $66,667 more income, and a slow year looks better than it was. The test the auditor needs is on the denominator.
Typical audit procedures
- Obtain the cost system documentation: standard cost roll-up, bills of material, routings and labor and overhead rates.
- Test the standards. Compare material standards to recent vendor invoices, labor standards to payroll and routing records, and yields to production reports.
- Evaluate normal capacity: how it was set, its support and its consistency with prior years. Compare to actual volume over several periods and to planned maintenance.
- Recompute the overhead rate and test the pool for what it includes and excludes. Reconcile applied overhead to the general ledger.
- Analyze variance accounts by type and by period. Trace the disposition between inventory and cost of sales and test the allocation.
- Test abnormal costs: scrap, rework, idle capacity and freight. Confirm they are expensed.
- Test inventory at year end: observation (inventory observation procedures), roll-forward, and extension of unit cost to quantities. See AU-C 501.
- Test lower of cost and net realizable value and obsolescence. See obsolescence reserve and NRV.
PBC items
- Standard cost roll-up by item at year end and the prior year
- Bills of material, routings and rate build-ups
- Overhead pool listing and allocation bases
- Normal capacity analysis and approval
- Variance reports by account and month, with the disposition entry
- Scrap, rework and idle time reports
- Perpetual inventory and the roll-forward to the count date
Red flags
- Normal capacity changed in a year of falling volume
- Volume variance near zero in a year the plant was visibly idle
- All variances written to cost of sales, or none to inventory
- Gross margin that improves as production falls
- Standards unchanged for years in a period of price changes
- Overhead pool that includes selling or administrative costs
Sources
- FASB ASC 330-10-30, Inventory, Initial Measurement
- Journal of Accountancy summary of FASB Statement No. 151, Inventory Costs, source for the abnormal cost and normal capacity rules
- AICPA, AU-C Section 501, Audit Evidence, Specific Considerations for Selected Items
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AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error