Since most of our high tech and fabless semiconductor customers use standard costing, we’ve had quite a bit of experience advising companies on how to set up standard costing, and thought it might be of interest to a wider audience as well. As a starting point here then, I’d like to spend a little time discussing the theory of cost – what standard cost means, aside from semiconductor costing. I’ll follow up with more posts on topics around standard costing as well, so be sure to look for those in the near future!
Here’s a good working definition of standard cost for our purposes here: “The planned or expected costs. Often used in manufacturing for accounting for inventories and production. When actual costs differ from the standard costs, variances are reported.” (Source: AccountingCoach)
In terms of cost itself – since I know we may have some non-operations/non-financial people in the audience -I would add that I think it’s helpful to understand why we value inventory in accounting. Inventory is a company asset. It’s something that we’ve spent money on, but it doesn’t necessarily get flushed out as an expense. The goal is to resell your inventory and get cash back for it. (We sometimes jokingly say that inventory is more of an asset if you can actually sell it, which isn’t always the case!)
The accounting principle at work here is the matching principle. This means that you need to hold the inventory cost on the books until you sell it, and then recognize the cost of inventory units at the same time that you recognize the revenue for selling the units.
An example of how this works would be that -if we are the reseller of some inventory – we would go out and buy the inventory with the intent of reselling it, then we’d stock the purchased inventory, and then market and sell it. When we sell it, the financial transaction would be as follows:
Sell goods => price times quantity
Cost of goods =>cost times quantity
The cost in this scenario, thinking as a reseller of inventory, is the cost of inventory. For example, if you are buying 100 units of inventory at $20 each, your inventory balance for that transaction would be $2,000. Then, if you’re able to sell 10 units of that inventory for $40 each, you would have $400 of revenue. $200 of that would be your Cost of Goods Sold (COGS) and the remaining inventory is your balance of $1800.
This type of example – where we’re simply talking about the timing of inventory – is pretty straight forward. The challenge is when you move from this sort of scenario to where you understand inventory, revenue, and cost to everything that goes on with standard costing in semiconductor companies.
So, what makes inventory costing for semiconductor companies get so complicated? We start to add complexity into the equation when we purchase the same goods at multiple prices, not one price. Or maybe we purchase the same goods from multiple suppliers who have different prices. Or our customers may buy in different units – or across lots – for different purchases. Or we start to build the goods ourselves, and now the cost input doesn’t equal the cost output because of yield or scrap, for example. Sometimes the complexity that arises is simply because the velocity at which the transactions are moving is so fast. Ideally, inventory should be moving quickly, so it can be difficult to keep up and to know exactly what the cost actually is at any given time.
Semiconductor and high tech accountants have come up with costing methodologies that try to deal with these complexities, and to keep up with their Operations team. The bottom line is that Operations cannot afford to slow down – they can’t afford to wait to ship inventory to a customer because Accounting hasn’t figured out what the cost is yet.
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