Standard Costs vs Average Costs

One of the most important decisions for manufacturing firms to make when implementing NetSuite is whether to use standard costs or average costs.

Once you set the cost method of an item, you cannot change it. You must delete the item and recreate it which can be challenging if you already have transaction history.

Each comes with their own benefits and drawbacks.

Average Costs

Average costs work by taking a moving average of the inventory currently in stock. When inventory is added to the system, the average cost is updated in proportion to how much you currently have in inventory.

Suppose you buy 100 of an item for $100 each. Then the average cost will be $100. Now suppose you buy another 50 for $75. The average cost will be $\frac{100 * 100 + 75*100}{100 + 100} = 87.5$.

Now if you use or sell 20, the rate on the transaction will be $87.5 and the total will be $87.5 * 20 =$1750$. We now have 180 of the item at $87.5.

Now if you receive another 50 at $80 each NetSuite will calculate the new average as follows:

$\frac{18087.5 + 2080}{180+50} = 85.86$

The costing engine doesn’t run after every transaction. It runs every hour or custom interval.

Standard Costs

Standard costs work by assigning a fixed price to each item. This price has to be set manually, although tools such as NetSuite’s cost rollup can help simplify this process.

When a transaction posts a line item, the price is set to the standard cost. Then, NetSuite will post the difference in the actual cost in the variance account.

For example, suppose we have an item which we usually purchase at $100 and has a standard cost of $100. For various reasons, we are buying 80 of it this time at a markup of $120.

When we receive the transaction, the rate is set to $100 and the variance account is posted with the difference of $20 * 80 = 1600. Our Asset Account will be credited with $100 * 80 = $8000.

Our balance sheet will look like this:

Account Debit Credit

Accounts Payable 9600

Asset Account 8000

Variance Account 1600

When revaluing inventory and changing the standard cost of an item, the variance account will be posted with the difference of the new standard cost * the quantity in inventory.

So I have 100 of an item at $100 and I want to change the standard cost to $120, the variance account will be posted with $20 * 100 = 2000.

Drawbacks of Costing Methods

Standard costs have a high maintenance cost associated with them. Managing the standard cost of all your items can be challenging. In addition, you must also create, configure and track multiple variance accounts for each item.

Average costs are easier to manage but can cause issues if you have mistakes in your transactions. If you have a mistake in the rate of one transaction, you will have mistakes on future transactions that use the same item. If you close the period when you have such a mistake it can get very complicated trying to untangle the mess.