Tips on When to Apply Capitalized Variances in Inventory Management

Holding and managing inventory levels in a fast-changing market with challenging customer requirements can be tough enough. But is your cost accounting system incorrectly valuing your inventory, creating issues in your P&L?

One of the challenges in managing inventory is determining your production costs and if they are being properly applied to the inventory valuations. Without going down a cost accounting rabbit hole, standard cost accounting systems have been developed to help figure this out.

All relevant production costs are considered — direct material cost, direct labor, and variable and fixed overhead. Materials and labor costs can be straight forward, whereas variable and fixed costs can be challenging to determine on a per unit basis.

The why behind clean costing: Budget analysis

Standard cost systems are just another system of budgeting considering material and production costs on a per unit basis. What then are these variances, and why are capitalizing some or all the variances required?

In any budget or standard cost system, both the actual and budgeted results for each financial period are prepared. The next step is to analyze these results against the current business operating plans. Variances are the differences between what was expected, compared to what occurred.

Capitalized variances example

To help understand what these variances are and why they’re important, consider an example from International Widgets, LLC, where the cost variances are deemed material enough to warrant an adjustment to both the inventory and the related cost of goods sold accounts. In this example, the net amount of the variances is unfavorable, thereby increasing the cost of sales over the cost of sales at standard.

The total variances reported of $587,000 equate to 9.8% of sales. This large percentage of the variances to net sales is material enough to suspect the standard cost and manufacturing operations are out of synch. It could be the prices of the inputs assigned are incorrect and need to be updated. It could also indicate the variance is indicative of other operating and cost issues that need to be addressed by management.

Until there is a resolution of what’s causing the variances, these variances need to be capitalized and put back into inventory. The unfavorable conditions are also creating a drag on the P&L that needs to be adjusted for. One common approach for allocating the capitalized variances is to use the inventory turnover ratio. The ratio is indictive of how quickly the inventory is cycling through the business and, how much inventory is still on hand related to the variances created.

If the variances were favorable, then the same approach would be used.

In the example, an inventory turnover of 8.2 equated to 1.46 months of inventory on hand. Therefore, only capitalize the variances related to the remaining inventory. Of the $587,500 in total variances, only $71,356 should be capitalized and adjusted back to the balance sheet from the P&L.

Virtues of variance analysis

Why is the periodic analysis of variances important?

Accurate financial reporting

Due to materiality of the variances, the valuation of the inventory was not appropriate without the capitalization of the variances.

Compliance with accounting standards

ASC 330-30-12 – “Standard costs are acceptable if adjusted at reasonable intervals to reflect current conditions so that at the balance-sheet date standard costs reasonably approximate costs computed under one of the recognized bases. In such cases descriptive language shall be used which will express this relationship, as, for instance, "approximate costs determined on the first-in first-out basis," or, if it’s desired to mention standard costs, "at standard costs, approximating average costs." For IFRS guidance, see IAS 2 Inventories.

The matching principle

ASC 330-10-10-1 “… proper determination of income through the process of matching appropriate costs against revenues.” Basically, making sure costs included in the cost of goods sold match the revenues included in the net sales for the same period.

Consistency and comparability

“Consistency in accounting practices is essential for stakeholders to make informed decisions. It allows for reliable comparison of financial statements across entities and time periods, ensuring transparency and trust in financial reporting. Achieving comparability requires balancing standardization and flexibility within accounting frameworks. Understanding this interaction provides insights into maintaining consistency in financial disclosures.”

Internal controls and company policies

Internal controls are designed to verify all the above are in place and a part of the company’s accounting policy and procedures manual.

How CLA can help with capitalized variances

Hopefully this introduction to capitalized variances has given you an idea of how and when to use them for inventory valuation. Including any inventory capitalizations for tax purposes is outside the scope of this article; but be aware there are additional rules to follow for tax compliance.

Cost accounting is a critical pillar of your business and key for measuring profitability. If cost accounting hasn’t been touched for a while, consider starting with a labor and overhead study. Contact us to learn more.