Components of Inventory Cost

Cost of Goods

The cost of goods produced in the business should include all costs of production. The key components of cost generally include:

• Parts, raw materials and supplies used,
• Labor, including associated costs such as payroll taxes and benefits, and
• Overhead of the business allocable to production.

Most businesses make more than one of a particular item. Thus, costs are incurred for multiple items rather than a particular item sold. Determining how much of each of these components to allocate to particular goods requires either tracking the particular costs or making some allocations of costs.

Parts and Raw Materials

Parts and raw materials are often tracked to particular sets (e.g., batches or production runs) of goods, then allocated to each item.

Labor

Labor costs include direct labor and indirect labor. Direct labor costs are the wages paid to those employees who spend all their time working directly on the product being manufactured. Indirect labor costs are the wages paid to other factory employees involved in production. Costs of payroll taxes and fringe benefits are generally included in labor costs, but may be treated as overhead costs. Labor costs may be allocated to an item or set of items based on timekeeping records.

Overhead Costs

Determining overhead costs often involves making assumptions about what costs should be associated with production activities and what costs should be associated with other activities. Traditional cost accounting methods attempt to make these assumptions based on past experience and management judgment as to factual relationships. Activity based costing attempts to allocate costs based on those factors that drive the business to incur the costs.

Accounting cycle

Image of the accounting cycle

Overhead costs are often allocated to sets of produced goods based on the ratio of labor hours or costs or the ratio of materials used for producing the set of goods. Overhead costs may be referred to as factory overhead or factory burden for those costs incurred at the plant level or overall burden for those costs incurred at the organization level. Where labor hours are used, a burden rate or overhead cost per hour of labor may be added along with labor costs. Other methods may be used to associate overhead costs with particular goods produced. Overhead rates may be standard rates, in which case there may be variances, or may be adjusted for each set of goods produced.

Variable Production Overheads

Variable production overheads are allocated to units produced based on actual use of production facilities. Fixed production overheads are often allocated based on normal capacities or expected production. More or fewer goods may be produced than expected when developing cost assumptions (like burden rates). These differences in production levels often result in too much or too little cost being assigned to the goods produced. This also gives rise to variances.

Example

Jane owns a business that resells machines. At the start of 2009, she has no machines or parts on hand. She buys machines $A$ and $B$ for $10 each, and later buys machines $C$ and $D$ for $12 each. All the machines are the same, but they have serial numbers. Jane sells machines $A$ and $C$ for $20 each. Her cost of goods sold depends on her inventory method. Under specific identification, the cost of goods sold is:

$$10+$12=$22$

which is the particular costs of machines $A$ and $C$. If she uses FIFO, her costs are:

$$10+$10=$20$

If she uses average cost, her costs are:

$\dfrac{$10+$10+$12+$12}{$4} \cdot $2=$22$

If she uses LIFO, her costs are:

$$12+$12=$24$

Thus, her profit for accounting and tax purposes may be $20, $18, or $16, depending on her inventory method.