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Chapter 5
agree on how data would be collected and stored. Then, questions regarding company
performance could be answered in a few minutes by any accountant (or manager or
salesperson, for that matter) who understands how to execute a query in the database
language or how to use built-in management reporting tools.

Inaccurate Inventory Costing Systems
128 Correctly calculating inventory costs is one of the most important and challenging accounting
tasks in any manufacturing company. Managers need to know how much it costs to make
individual products, so they can identify which products are profitable and which are not.
In the next section, we will first review the fundamentals of inventory cost accounting.
Then, we will explore how an ERP system can improve the accuracy of inventory cost
accounting. Finally, we will discuss the rationale behind activity-based costing as a method
to further improve the accuracy of inventory cost accounting.

Inventory Cost Accounting Background
A manufactured item’s cost has three elements: (1) the cost of raw materials, (2) the cost
of labor employed directly in the production of the item, and (3) all other costs, which are
typically called overhead. Manufacturing overhead costs include factory utilities, general
factory labor (such as custodians or security guards), factory managers’ salaries, storage,
insurance, and other manufacturing-related costs.
Materials and labor are often called direct costs because the constituent amounts of
each in a finished product can be estimated fairly accurately. On the other hand, the
overhead items are indirect costs, which are difficult to associate with a specific product
or a batch of specific products. In other words, the direct cause-and-effect relationship
between an overhead cost (such as the cost of heat and light) and making a particular
product (NRG-A bars) is difficult to establish.
Nevertheless, overhead costs are part of making products, so companies must have
some way to allocate these indirect costs to the products they make. A common method is
to use total machine hours, on the assumption that overhead is incurred to run the
machines that make the products. With this approach, overhead costs for a certain time
period are added up and then divided by the expected total machine hours for that time
period to get an overhead per machine hour rate. This value is then used to allocate
overhead costs to products. Suppose Fitter used this approach and calculated its overhead
rate at $1,000 per machine hour. If Fitter can make 10,000 bars in an hour, then each bar
would be allocated $0.10 of overhead ($1,000 ÷ 10,000). Overhead can also be allocated to
a product using direct labor hours or material costs. A company makes the decision on
how to allocate overhead costs based on what makes the most sense in its production
environment.
Companies such as Fitter that produce goods for inventory typically record the cost of
manufacturing during a period using a standard cost. As explained in Chapter 4, standard
costs for a product are established by studying historical direct and indirect cost patterns
in a company and taking into account the effects of current manufacturing changes. At the
end of an accounting period, if actual costs differ from standard costs, adjustments to the
accounts must be made to show the actual cost of inventory owned on the balance sheet
and the cost of inventory sold on the income statement.
For example, Fitter might determine that each NRG-A bar should cost $0.75 to
make—that is, the cost of raw materials, labor, and overhead should equal $0.75 per bar,

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