Overview of Manufacturing Costing for Non-Accountants

The aim of this blog is to give an overview of costing in manufacturing. This blog is written to be read by non-accounts personnel. From a costing point of view, Business Central offers ‘Standard’, ‘FIFO’, ‘LIFO’, ‘Specific’ & ‘Average’. When discussing manufacturing costing, we are going to consider only standard and FIFO costing.

Technically you could also use average costing for manufacturing costing, but in our long experience, we have never seen it used without issues. So let’s take a closer look at the two aforementioned.

Standard costing

An item with a standard cost of £10 will always be transacted in Business Central at £10. Therefore, if we purchase/manufacture the item at a greater or lesser cost, it is still held in the system at its standard cost of £10. The deviation from the standard cost of £10 is held in the Variance Accounts in the General Posting Setup and the Inventory Posting Setup.

From a manufacturing point of view, standard costing is relatively straightforward as all the components costs will not change with time. Therefore, any manufacturing variances created will be due to the actual manufacturing process on the shop floor. ‘Material variance’ relates to the difference between the cost of items specified and the cost of items used during the manufacturing process. Whereas ‘capacity variance’ is the difference between the planned labour hours and the number of labour hours actually used.

FIFO costing

FIFO is an acronym for ‘first in, first out’. If we purchase or manufacture an item with a quantity of 20, at £10 each, then those 20 items are costed at £10. If we subsequently purchase or manufacture a quantity of 10 at say, £11 then those 10 items are costed at £11.

FIFO costing in manufacturing is a more accurate representation of the actual costs as it uses the individual costs of each component. Therefore, potentially each production order will create the finished item at a slightly different cost, depending on the actual costs of the individual components and labour actually used. 

Standard costing – purchasing

Let’s review the purchasing of components and then the manufacture of a parent item, the Widget. In our example, the Widget is manufactured from Component-A and Component-B, taking 15 minutes to process. The costing method will be standard costing.

Consider the components, which have their costing method set to standard costing. Let’s review Component-A which has a standard cost of £2.

  • Purchasing a quantity of six using a purchase order at £2 each, will result in an increase of inventory quantity of six at £2 each. No variance is created.
  • If we purchase a quantity of six using a purchase order at £2.50 each, the result will be an increase in inventory quantity by six at £2 each. However, here there will be a purchase order variance of £3. This is generated by multiplying the 50p overspend by six. This example is something known as a ‘unfavourable variance’ as the cost is higher than the standard cost.
  • Alternatively, if we purchase a quantity of six using a purchase order at £1.80 each, we will again see an increase in quantity by six at £2 each. The purchase order variance here amounts to £1.20. This is calculated by multiplying the 20p underspend by six. This example is something known as a ‘favourable variance’ as the cost is lower than the standard cost.

In the above scenarios the inventory is always set at the standard cost of £2. The Purchase Variance Account is used to aggregate the differences.

You can see these posting to the Purchase Variance Account if you review the value entries on the Item Ledger Entry (ILE). I’ve used the last example above to display this.

Standard costing – manufacturing

The variance accounts associated with standard costing in manufacturing can be found in the Inventory Posting Setup. In this overview we will only be using the two main variance accounts we spoke about earlier, those being ‘material variance’ and ‘capacity variance’.

Let’s now review the manufactured widget with a costing method of standard cost. The standard cost has been calculated from the production BOM and routing using the menu option from the item card. To reach this from the item card, click ‘related’, ‘bill of materials’ and then ‘calc. standard cost’.

The standard cost, calculated at £10, comprises of £6 worth of material and £4 worth of labour. The material costs consist of two of Component-A at a standard cost of £2 each and two of Component-B at a standard cost of £1. The labour cost comes out at £4, comprising of 15 minutes work at a rate of £16 per hour.

This breakdown can also be reviewed in the ‘detailed calculation’ report.

Similar to what we did in the ‘purchasing’ section, let’s look at a couple of scenarios in order to highlight the differences between cases where standard costs are accurately representative of the situation and those where they are off slightly.

Manufacturing scenario one

In this scenario the production order consumed no additional components and labour.

Processing the production order for a quantity of five, will create the five finished goods. These widgets cost £10 each. To achieve this, the production order processed £30 worth of material and £20 worth of labour. Let’s take a look at how we arrived at these figures.

  • Material=£30
    • 5×2 Component-A  at Standard Cost of £2 each=£20
    • 5*2 Component-B at Standard Cost of £1 each=£1
  • Labour=£20
    • 5x¼ hr at £16 an hour

In this scenario, because no additional material or labour was used, no material or capacity variances were created.

Manufacturing scenario two

In this scenario, the production order consumed additional components and labour. In terms of material, two additional Component-A and one Component-B were used. The labour needed, equated to an extra 15 minutes work.

  • Material – 2 addition Component-A at £2 each=£4
  • 1 additional Component-B at £1 each = £1
  • Labour – an additional ¼ hour was used = £4

To achieve this, the production order actually processed:

  • Material=£30
    • 5×2 Component-A at standard cost of £2 each=£20
    • 5×2 Component-B at standard cost of £1 each=£10
    • Additional 2 Component-A at standard cost of £2 each=£4  
    • 1 Component-B at standard cost of £1 each=£2
  • Labour=£20       
    • 5 * ¼ hour at £16 an hour
    • Additional ¼ hour =£4

In this scenario the following variances would be created:

  • Material variance of £6
  • Capacity variance of £4

Using the FIFO costing method

Let’s review the purchasing of the components and then the manufacture of the parent item, the widget. Keep in mind we are using FIFO costing here.

FIFO costing – purchasing

  • If we purchase a quantity of six using a purchase order, at £2 each, our inventory will increase by six at a cost of £2 each. 
  • Purchasing a quantity of six using a purchase order at £2.50 each, will result in an increase in inventory by six at £2.50 each. 
  • Following the trend, if we purchase six using a purchase order at £1.80 each, the result will be an increase in inventory by six at £1.80 each. 

Something worth noting is that with FIFO costing, no variance is created. Another thing to note is that the unit cost on the item card will give the average cost of the inventory in stock.

FIFO costing – manufacturing

Let’s now review the manufactured Widget with a costing method of FIFO, comprising of:

  • Material
    • 2 Component-A (£2×2)                                         
    • 2 Component-B (£1×2)
  • Labour                                 
    • A quarter of an hour at £16 an hour

Processing a production order for a quantity of five will create the finished goods. In this case, the ‘finished good’ is the Widget. Using FIFO, the actual cost is determined by the actual cost of the components consumed and actual labour required. 

  • Material                              
    • 5×2 Component-A = quantity of 10                                             
    • 5×2 Component-B = quantity of 10
  • Labour                                
    • A quarter of an hour at £16 an hour=£4

The complexity in FIFO costing is that the components ‘Component-A’ and ‘ Component -B’ have different costs.

For Component-A consider we have six costing £2, another six costing £2.50 and finally, six more costing £1.80. For Component-B, our 18 widgets are comprised of eight at £1 and 10 at £1.05.

The production order will consume the inventory in the order it was effectively purchased. We require 10 of Component-A and as we are using FIFO, the system will therefore consume the six that costed £2, at a total of £12. The remaining four will be from the stock that costed £2.50 each, at a total of £10.

In order to create the Widgets, we need 10 of Component-B. This would use the eight at £1 each, amounting to £8. The final two components would be at a cost of £1.05, or £2.10 total. The total material cost is therefore £32.10. Finally, the labour of one and a quarter hours at £16 an hour equates to £20. So with a total cost of £52.10 for five widgets, they would cost £10.42 each.

Processing subsequent production orders to manufacture the Widget would consume stock at potentially different costs and hence the cost of the production for the Widget will vary.

Additional points

  • You can mix standard and FIFO costing within Business Central manufacturing, but the calculation mathematics become more laborious.
  • It is important to note that once an item is transacted you cannot change its costing method. Therefore, it’s critical to set the costing method at go-live. It is usually one of the first decisions made during the implementation workshops.

In conclusion, both Standard and FIFO costing methods can be easily utilised within Business Central. If you have any questions or wish to contact us, click here.

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