The following is a transcript of the video clip below, which was taken from the Tensoft SemiOps (previously known as Tensoft FSM) customer webcast entitled “Standard Cost: Theory and Practice in Tensoft FSM,” featuring Bob Scarborough, Tensoft’s CEO. This complimentary training was originally presented live for Tensoft SemiOps customers. Since the instructional material covered in this video blog is appropriate to anyone who’s interested in standard cost theory, we’re making it available here. Tensoft SemiOps customers who are interested in viewing the entire recording can do that on Tensoft Knowledge Base.
“Good morning everyone and welcome. This presentation covers some background on standard cost, so we’re going to begin with what inventory value and inventory cost are, and how the heck it gets so hard to do!
So, starting with inventory value and standard cost, the core question is: why value inventory? Basically, because it’s an asset – it’s something that your get cash for. And, from a pure accounting perspective for inventory value, one of the reasons that we track it and hold it is so that we can recognize the cost of inventory when we sell it later. So we have a timing need to value the inventory and hold it until a future point in time when we sell it to a customer or when it’s used in some other way.
Some of the more basic examples would be someone like a distributor that you sell to. They buy inventory to sell. They stock it. They market it. And then they sell it. So the inventory comes and goes off their shelves as an uncomplicated transaction. So if you think of how simple this transaction could be, it would like something like: you sell the goods at price times quantity, you cost the goods at cost times quantity, and inventory cost is then the cost of whatever we spend to buy the goods. What could be simpler, right?
If you take this scenario and put some numbers on it for our example of “the basics,” you would end up with something like this. Say you’ve some inventory where we bought 100 units at $20 each. So we have $2,000 worth of inventory potential to sell. And then when we go to sell it, we may have 10 units that we sell at $40 each, so we have revenue of $400 and our cost of goods is $20 per unit. So that’s $200 and we have a remaining inventory balance. In this example, everything’s valued very simply, so that’s all we really need to know about the inventory. It’s the sort of example that you’d see shown as a T account in an accounting text book.
That’s the basics of an inventory and timing-related product cost, so the question becomes “how the heck does this simple thing get so crazy and difficult to do?” In the real world, how do inventory transactions and inventory management get so complex? Well, here are 3 of the general reasons to illustrate how this happens.
One of the significant reasons is just simply that volume and velocity – the speed at which transactions occur – get added to the basic equation. So, we say we purchase and sell the inventory faster than we can keep up with the financial documents. For example, let’s say that you have a transaction volume that’s so high that it becomes impossible to keep up. Or, let’s say that the purchase price varies from time to time, so that now we have faster procurement with multiple prices. And maybe even the prices change by timing within the quarter, because we negotiate an agreement with our supplier if we buy so much per quarter, we get one price and we get a better price if we buy more. Or, let’s say we even double-source some things and we pay multiple suppliers for these goods at multiple prices. So now we’ve taken our simple model and added multiple prices, and enough volume and velocity that it becomes hard to keep up. And we all know that when a decision comes to “are we going to spend time touching and analyzing each unit before it goes out the door” or ‘are we going to sell as much as possible as fast as possible and catch up the costing later” the company priority is to get the sale done. In other words, get the inventory moved out and turned into cash – and your inventory valuation system needs to keep up.
A second significant reason inventory value gets harder is market timing – where you have issues like the customers don’t buy the way you sell. The customers have their own timing, plan and ways that they want to do things. So, they’re not going to buy things in even lots, the way that you purchased them. They’re not going to buy things in any manner that matches how your data comes in, so we don’t have a clean match between these things, so that adds some complexity. Or, let’s say that we sell through a distributor, and then to an end customer. And, now the distributor has the ability to return goods to us. So, maybe we bought at one price, send to a distributor and then they send the goods back to us. So at this point we’re buying those goods for an entirely different price. So we now have an inventory return policy and complexity that happens because of buying and selling goods in the market.
The third significant reason is production, where we will spend a lot of time on with examples in the semiconductor industry. In this industry, 1 plus 1 doesn’t equal 2 because we have yield in the process. There are just some times when the inputs don’t equal the outputs in a literal sense – we put 2 units in and we get 1.5 units out. So it doesn’t exactly match – it gets a little muddied. In the semi industry we also have multiple input steps. So we might add value at several steps, and the question then becomes, what is the value of the inventory. It’s no longer as simple as we bought it and we sold it. We need to account for all of the different production steps.
So we really have this nice clean concept of “inventory comes in and we’re going to postpone recognizing it on our P&L, until we get the timing of when we make the sale.” It should be simple, and yet we have this complexity that increases based on how many, how fast, how the customer transactions work, how our process works. All of that adds complexity to the inventory evaluation model.
So – in the real-world – you end up with a variety of inventory valuation methods that try to support these complexities. There’s no one right method for every company, but you do need to select a method.
I tend to think of these options in 2 general categories: those that attempt to approximate actual cost and standard cost. I would say that every inventory method is an assumption of some sort. You can say that something is an approximation of actual cost, but all inventory methods are really attempts to do valuation in a dynamic world.
Some examples of actual cost models are “Specific Identification” where items are very expensive and you’re buying and selling just one at a time, and track that one unit’s cost. “Moving Average” tries to keep track of changes over time and adjusts to that. “FIFO” is first in, first out. “LIFO” is last in, first out and is often used in situations where you have a huge amount of inventory cost variability, like the memory market. And, there are other methods as well.
I think of these Actual Cost methods as very passive – they’re really historical reporting. They attempt to let the past dictate what the inventory is. In the semiconductor industry – where you have the opportunity to influence cost and help your company do good inventory management – there is a real distinction between the effectiveness of using actual cost and standard cost.
Standard Cost is more typically what someone in the semiconductor industry will use. To me, Standard Cost is a plan – a stake in the ground. You might think of this in the same way that your company does an operating budget. Standard Cost is the same sort of plan, but for inventory. You’re looking forward and saying “I’m going to make an educated decision on what my costs will be over the next quarter.” Standard costing is active management of inventory, where you decide on your expected costs and then measure against that. So variances to cost literally become the deviation from the plan. Rather than trying to completely eliminate variances, most of us need to look at variances as the simple reality that the real world isn’t as predictable as we’d like it to be. What do the variances tell us about how we’re doing against plan, and how should we alter our plan going forward?
So, let’s look at some of the assumptions that support Standard Cost. One of the values of the standard cost method is that the standards are pre-set, so there’s no delay at all in turns of valuing something that comes in. You already know what it is – it can quickly be assigned a value. And, you can define what the drivers or costs are.
So that’s a quick overview of inventory costing, from the simplest to some more complex scenarios. Standard costing, of course, is what most companies in the semiconductor industry use. It’s both the most commonly used method and a best practice. Smaller companies may start with Moving Average or Approximation of Cost, but Standard Cost is normally what most of the semi industry does. It’s an active approach where we set goals, measure against goals, evaluate and plan, and then re-set the goals. It allows for velocity, which is not an issue with the standard costing model.”
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