The choice between the two depends on the nature of the business, the type of inventory, and the company’s management objectives.
Inventory costing plays a critical role in financial reporting because it directly affects asset valuation, profitability, and operational decision making.
Two commonly used costing methods are average costing and standard costing, each offering different advantages depending on the nature of the business and its inventory. Understanding the differences helps organizations determine which method aligns with their goals.
Average costing of inventory
Average costing, often referred to as the weighted average cost method, calculates the average unit cost of all inventory available for sale during a period. This method is appropriate when inventory items are homogeneous or when purchase prices fluctuate frequently.
How it’s calculated
Average cost per unit = total cost of goods available for sale ÷ total units available
Example
A company purchases:
- 100 units at $10 each, and
- 200 units at $12 each
- Total cost - (100 x $10) + (200 x $12) = $3,400
- Total units - 300
- Average unit cost - $3,400 ÷ 300 = $11.33
Advantages and disadvantages of using average costing of inventory
Advantages
It’s simple to calculate and apply, smooths out price fluctuations over time, and is suitable for homogeneous inventory items.
Disadvantages
This method may not reflect the actual cost of specific purchases, especially in volatile pricing environments.
Standard costing of inventory
Standard costing assigns a predetermined cost or "standard" cost to inventory items rather than using actual costs. This method is commonly used in manufacturing environments where budgeting and performance measurement are essential.
How it’s calculated
Total inventory value = units on hand × standard cost per unit
Example
If the standard cost per unit is set at $11, then 300 units are valued at $3,300, regardless of actual purchase or production costs.
Components of inventory
Product costs generally consist of direct materials, direct labor, and manufacturing overhead. The standard costs are often based on the combination of the estimated future costs or trends, historical data, and/or industry benchmarks. Historical information serves as a good starting point. However, using historical information might lead to incorporating past inefficiencies into the new standard.
Direct material standards
Direct material standards are calculated by multiplying the standard quantity by the standard price. Differences between standard and actual results create material variances. Favorable variance is when actual usage is lower than the standard quantity, or the actual purchase price is lower than the standard price. Unfavorable variance is when actual results exceed the established standards.
At the end of the accounting period, all variances are closed to cost of goods sold, directly affecting the period’s bottom line.
Variances are often unavoidable. Some are controllable (e.g., supplier discounts on bulk orders), while others are uncontrollable (e.g., unexpected freight increases due to events like a pandemic). Having a variance, including an unfavorable one, is not necessarily a bad thing. Managers must understand the underlying cause of the variance to evaluate its results.
Direct labor
Standard labor cost is based on the estimated labor hours required to produce one unit and the labor rate per hour. Labor hour standards can be developed by observing workers perform each task and averaging those results. Standard labor rates typically include the employee's base pay plus fringe benefits and should reflect expected increases in compensation.
An example favorable labor variance is when a company uses higher quality raw materials, it may allow for easier handling of material, which may lead to higher production volumes. In contrast, if employees have low morale and limited motivation to improve their skills, this may result in an unfavorable direct labor efficiency variance.
Overhead
Overhead standards are typically calculated by dividing a single overhead cost pool by one driver, such as machine hours or direct labor hours. Some companies use activity-based costing (ABC), which allocates overhead across multiple cost pools with more specific drivers. One advantage of ABC is improved pricing accuracy, particularly in target costing environments.
Favorable overhead variance might result from the installation of more efficient manufacturing equipment, resulting in fewer productions hours needed. In contrast, old machines might have more break-down time that slowed down production, resulting in unfavorable overhead variance.
Changes to standard cost
Companies commonly update standard costs annually. However, during economic uncertainty, more frequent updates may be necessary. Standards should also be revised when product designs or production processes change. Regular review of material prices and labor rates helps standards remain relevant.
Advantages and disadvantages of using standard costing of inventory
Advantages
- It helps with budgeting, provides variance analysis, and supports performance measurement. By analyzing variances, management can identify areas where costs can be controlled and where efficiency can be improved.
- It also helps management understand current costs and prepare for managing future costs. Variance analysis supports performance evaluation for both personnel and systems.
- Training based on standard costs allows organizations to control costs and reduce waste by eliminating unnecessary steps in the production process while striving to meet established standards.
- These practices also empower employees to learn from the standards and refine their processes. Management doesn’t need to analyze every variance; only those falling outside an acceptable range require further review.
Disadvantages
- It may not reflect current market conditions if costs fluctuate significantly and the standards have not been updated.
- This limitation can be reduced by performing regular updates to standard costs and verifying variances are closely monitored and properly explained.
Is standard costing acceptable under U.S. GAAP?
The use of standard costs is acceptable under U.S. GAAP provided the standards reasonably approximate actual costs under one of the permitted costing methods (e.g., FIFO, average cost, or LIFO). To achieve this, companies update standard costs at reasonable intervals to reflect current conditions and verify variances between actual and standard costs are absorbed into inventory at the reporting date.
When standards are updated only once a year, companies often record a one time potentially material adjustment to inventory and net earnings, to reflect the accumulated variances. When standards are reviewed and adjusted more frequently, the difference between standard and actual costs is likely narrowed, resulting in smaller adjustment to inventory and net earnings for the reporting period.
Key differences between average and standard costing
| Aspect | Average Costing | Standard Costing |
| Calculation method | Uses actual average cost of inventory | Uses predetermined standard cost per unit |
| U.S. GAAP | Acceptable method | Acceptable method if variances between standard and actual costs are allocated to inventory at period end |
| Impact on financial statements |
Reflects actual cost trends |
May overstate or understate inventory if variances between standard and actual costs are not allocated |
| Complexity |
Relatively simple |
Requires ongoing monitoring and updates |
| Use case |
Homogeneous items, fluctuating prices |
Budgeting, cost control, variance analysis |
| Examples |
Retail inventory, commodities |
Manufacturing operations, budgeting exercises |
How CLA can help assess average and standard costing options
Both average and standard costing methods play important roles in inventory valuation and management. Average costing is straightforward and well suited for businesses with uniform inventory and frequent price changes. Standard costing is beneficial for budgeting, variance analysis, and performance measurement, especially in manufacturing environments. Many companies use standard costing to improve operational efficiency and cost control.
The choice between the two depends on the nature of the business, the type of inventory, and the company’s management objectives. Understanding these differences helps businesses select the most appropriate costing method for accurate accounting and strategic decision making. CLA can help your company weigh the pros and cons.