Manufacturing companies use product costs to determine inventory values and the cost of products sold. These companies use different methods to determine their inventory costs, such as actual costing or standard cost systems. Actual costing requires the company to maintain specific records regarding each inventory item and its cost. Standard cost systems assign a cost to each product. Companies that use standard cost systems base these costs on the company budget and use the same costs throughout the year.
The budgeting process involves anticipating the events that will occur during the budget period and the impact the events will have on the company's expenses. The plant manager works with the plant accountant to review the current year's financial data along with the budgeted production needs. Together, they estimate the expenses for the budget period. The numbers entered into the budget form the basis for the standard costs the company will use during the following year.
Standard costs represent the typical cost the company incurs each time it manufactures a particular product. Standard costing systems work well for companies that produce identical products on a regular basis. The company expects the costs for these identical products to remain the same each time it produces the products throughout the year.
After completing the budget process, the company uses the budgeted information to create the standard costs. The standard cost of each product consists of standard material costs, a standard labor cost and standard overhead. The standard material costs use the required quantity of materials and multiplies this by the budgeted material cost. The standard labor cost multiplies the estimated number of labor hours by the budgeted labor rate. The overhead uses the manufacturing expense budget and allocates this to the product based on labor hours.
Companies use standard costs to calculate the inventory value, the cost of goods sold and product variances. The company calculates the inventory value by multiplying the standard cost by the quantity remaining in inventory at the end of the period. The inventory value appears on the balance sheet and increases the asset value at the end of the period. The company calculates the cost of goods sold by multiplying the standard cost by the quantity sold. The cost of goods sold appears on the income statement and reduces the company's net income. The company calculates variances by comparing the standard cost to the actual cost. The company investigates large variances to identify errors in standard costs or production issues.
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