expandable

Please note in order to cover this topic in a condensed format requires some order of simplification and therefore limits the complexity and depth that can be contained in this narrative. In addition, to understand how a standard cost system actually works is beyond the scope of this content. However, the underlying premises remain true and the benefits of Standard Costing are very real.

From my experience, combined with the minimal research available on the topic, my estimation is about 75%-80% of manufacturing companies use Standard Cost as the basis for the inventory valuation. The remaining 20%-25% is comprised of, in descending order of use, Actual Cost, FIFO – which is a form of Actual Cost and Weighted Average Costing.

This is somewhat comforting to me, as personally I fundamentally believe Standard Cost is the best approach except for specific industries or situations. For example, Actual Cost would be preferred for suppliers to the US government (e.g., DFAS) where the contract requires Actual Cost be used so government auditors can review the results against the invoices submitted to the government for payment to the supplier.

In fact, the right question to ask is why such a high percentage of manufacturing companies deploy a Standard Cost system if Actual Costing will give me what I want. The answer to that question is along the lines of the old adage “be careful what you wish for, because you might just get it.”

The key to understanding is what lies behind the curtain. In an Actual Cost system, to understand your business results, the company must review all the transactions to understand the underlying details and the actual materials purchased/used for a specific transaction. In addition, the mere requirement of tracking specific purchases throughout the manufacturing process in order to maintain traceability and accuracy of material costs consumed is an overhead burden and a discipline that must be deployed in support of using an Actual Cost system.

It is important to note, the below example is not meant as a complete condemnation of Actual Cost as it does have its place, but rather serves as quick illustration of how Actual Costing can lead one to an incorrect conclusion unless the proper (hint: inefficient) analysis is performed on your results.

Actual Cost

By way of example, let’s assume a company manufactured standard catalogue Product A and sold one each at the List Price of $1,000 to Company B and one to Company C. During the procurement process, Purchasing realized they had to expedite material to meet delivery schedules due to an oversight in planning. This material expediting caused the cost for the unit sold to Company C to be $900 as compared to a cost of $600 for the unit manufactured for Company B. As a result the gross margin for the sale to Company C was only $100 ($1,000-$900) while the gross margin for the sales to Company B was $400 ($1,000-$600).

The total revenue for the two sales was $2,000. The total cost equaled $1,500 therefore the total profit margin was $500. Upon reviewing the monthly results, the company executives decided to implement a new higher pricing structure for future sales to Customer C, because of the poor margins for this customer.

Standard Cost

The basic premise of a Standard Cost system is manufacturing /operations are measured against an approved standard cost. This enables management to focus and limit reviews of the results to significant variances to the standard established instead of reviewing each and every transaction. By using the same example as above and adding a standard cost of $600 for Product A, the clear difference in management philosophy becomes very apparent.

In this instance, the Standard Margin for each sale would be the same $400, because the revenue for each sales would remain at $1,000 while the cost would be the same $600 standard established for Product A. The company would also record an unfavorable Purchase Price Variance (PPV) as a result of the higher cost of expediting material to meet customer demand.

During the review of the monthly results, the total revenue presented was $2,000 ($1,000 x 2), standard cost of $1,200 ($600 x 2) and an unfavorable PPV of $300 ($900 actual vs the standard of $600). By summing the three elements, the total reported Gross Margin was reported $500 ($2,000-$1,200-$300), which is the same as the results in the Actual Cost example. However, management focused on the real fundamental issue which was the expediting fee as the profitability for sales to Company B and Company C were the same.

Conclusion

To assign the actual cost of the expediting fees to the next sale is completely arbitrary when manufacturing for a standard product offering. In addition, it can easily lead to inappropriate business actions. In essence, as the above examples highlight, Standard Cost enabled management to have a meaningful discussion on the causes of the expediting fees as compared to focusing on the false assumption of having a customer with unacceptable margins.

There are other benefits to the organization other than financial review of results. Two examples are 1) the Purchasing department can be measured against their procurement cost objective quite easily, from a top level perspective, by reviewing the Purchase Price Variance balance and 2) Inventory transactions do not need to be transacted by lot/serial number unless required for government compliance to warranty validation. This saves operations from this overhead burden.

The true elegance and simplicity of Standard Cost becomes even more apparent when manufacturing in large volumes as compared to the simple example discussed above. The basic point to remember is Standard Cost enables management by exception (i.e., variance to standard) as opposed to managing the entirety.

The CFO at any company is challenging in both its depth and breadth of responsibilities. At a start-up company, the most precious resource known is CASH. For technology and many other companies, Cash tends to first be allocated to R&D as they are the creators of the product. Once the product gets ready for production, the Sales and Operations organizations begin to grow to support growth in the ultimate chase for more cash.

Having spent about 30 years in Finance with multiple of those years at start-ups including being a CFO for 5 of those years, I have always understood and agreed (but not liked) that administrative functions, especially those at a technology driven company, are the last to get funded as product development and revenue generating activities will always get the lion’s share of the budget dollars.

Given this, since the CFO is typically responsible for administrative functions, the breadth of their responsibilities is typically quite wide. Expert knowledge in Finance is obviously mandatory, but strong working knowledge in the company’s business, Human Resources and Legal is often required.

The role of the CFO

The two primary roles of any CFO are 1) to control and protect the assets of the company, and 2) accurately and report timely the results and financial position of the company. After those two objectives are satisfied the CFO typically strives to be the key business partner to the CEO by providing insightful analysis and financial perspective to various aspects of the business.

A CFO in a start-up has the added burden of needing to obtain an exceptional solid working knowledge of HR and Legal in order to satisfy the first objective of protecting the assets of the company, because they may be the very person performing the day to day tasks given that many start-up companies cannot afford a lawyer or even a part time HR employee. With the knowledge that one mistake in either the handling (or lack thereof) of a personnel issue or in a contract negotiation with a customer can be so devastating it can break a company, one can quickly understand the importance of knowing when to call “time out” in order to seek expert advice from a professional in the field, before it is too late.

The importance of knowing what you do not know

Often, the most dangerous position that anyone can be in is when they do not know what they do not know. In that state, a person is not even aware of the potential landmines that need to be avoided and therefore will not seek critical advice at the right time. By way of example, a CFO without some strong legal experience, from which to draw upon, would very likely underestimate the significance of seemingly innocuous contract boilerplate items such as “warranties and representations” or the term “best efforts” when negotiating a supply agreement with a customer. However, these two legal definitions can have such significant and expensive obligations to ensure compliance and/or onerous remedies to correct a non-compliance condition that they should be avoided at best or fully understood before proceeding. Seeking the advice of a good lawyer at this point may be warranted, but you have to at least understand the situation to realize the criticality.