Raw Material Prices Are So Volatile -What Do I Do?

Aug 12, 2013

Occasionally we run across a company whose raw material prices are subject to highly volatile price changes. In many cases the raw material is a commodity that due to world markets, seasonality or just supply and demand is subject to radical changes in its base cost.

This circumstance raises questions about how prices should be adjusted on the company’s books to reflect the changes in the raw material costs. Raw material prices that change modestly over a long period of time can probably be properly accounted for using a standard costing method. This will work primarily because the price changes are infrequent and in relatively small increments, which would mean that no adjustment would be necessary to the standard cost of the product any more frequently than annually. However, if the opposite is true then the questions is, could standard costing even work?

I think there are always at least three considerations relative to radical pricing adjustments. First is the accounting adjustments, and what is appropriate for recording on the books of the company in accordance with Generally Accepted Accounting Principles. Second, is income tax and what does the Internal Revenue Service require companies to do with their inventory in times of radically changing prices. And of course the final is, management information related to not only inventory values but also product pricing relative to radically fluctuating inventory values.

Generally Accepted Accounting Principles require that inventories be stated at the lower of cost or market with consistency as an inventory valuation as one of the standard measures of the accuracy of the inventory. This means that any method that accurately reflects income if it’s consistently applied and meets with the lower gross margin rules should be acceptable for GAAP. Meaning, if you were to use a standard costing method for valuing inventories then a methodical method of apportioning variances between inventory and cost of goods sold must be developed to deal with radical price changes and its effect on the ending inventory. I have clients who are maintaining their actual perpetual inventory on their general ledger using a stratified method of building and using layers based on different price increments as raw materials are purchased. This is not intended to specifically identify goods but to take goods that are fungible and simply measure by quantity and dollars as those values go up and down. This would almost always use the FIFO method to identify, by quantity used and quantity acquired, the different pricing levels so that a reasonable case can be made for actual costs.

A similar case exists for income tax purposes. IRS requires that inventories be valued in a method that consistently and reliably reports income.. Any standard costing methods used that include periods of significant price changes would have variances that need to be apportioned back to inventory in a reasonable way. Some systems attempt to use average cost of their inventories and for income tax purposes, as most tax rules go, usually is not allowed. Specific identification by layers of course is allowed but that requires substantial recordkeeping to keep track of the various layers as they are created and used up.

The final concern is for management information related to inventory and cost of goods sold. If inventories are small and not diverse by nature, then the stratified method of keeping raw material cost by layer on the FIFO basis represents a reasonable alternative if management understands that unit cost for products produced can fluctuate radically thereby impacting gross margins and profitability by job or customer dramatically in one direction or another. I personally believe that in the long haul, a standard cost method that apportions variances to inventory and is adjusted periodically throughout the year, perhaps quarterly, to reflect radical changes in inventory pricing can be an effective method to provide both management information and meet the tax and accounting rules. The impact of keeping a stratified inventory and its radical effects on overall margin efficiencies and profitability is difficult to deal with and manage in an environment where prices change frequently. I believe that the greater control offered by standard costing as well as the lack of substantial time related to managing the accounting records that keep track of your inventory may be worth while for purposes of the most cost effective method for valuing product for gross margin analysis and inventory control.

Categories: Cost Accounting