My job was to help our Venezuelan subsidiary install their inventory cost system. It was an interesting assignment for me due to Venezuela’s hyper-inflationary history. This led us to not use a standard cost system as was the practice in the United States. Most people in American manufacturing have at least heard of the standard cost system, although, they may not fully understand what it means. Essentially, It means you put all raw materials purchased into your inventory at a preset standard cost regardless of what you actually paid for it.
So why would companies want to put material purchases into inventory at a cost other than what they paid? It’s a management tool that allows managers to gauge how good of a job they are doing with managing their purchasing function. If you negotiate a good price, this will show up in your variance to standard. Or conversely, if poor planning leads to purchasing smaller lots or alternate suppliers you could see higher prices than the standard. Managers also like these unfavorable issues quantified so that they have a target to chase for future improvements.
But a standard cost system only works if inflation is low. Otherwise the variance data as a management tool becomes meaningless and you start to undervalue your balance sheet.
When I installed a cost system in our Venezuelan subsidiary I use a FIFO system. Instead of putting purchases into inventory at a standard cost, we used the actual price paid. But when we sold that inventory, we used the oldest layer of inventory first. So it was a First-In-First-Out system. This kept our balance sheet accurate without having to resort to large inventory revaluation entries that can whip-saw the company. It also boosted profitability since it matched up older purchases that were at a lower cost with future sales when prices were higher.
I wouldn’t say that the FIFO system is better than a standard cost system. Different jobs require different tools and in a hyper-inflationary climate like Venezuela it works much better.
I remember while I was in Venezuela listening to our local staff talking about this brash new politician Hugo Chavez. He was a Bernie Sanders populist type who talked about trying to bring the wealth down to the people so that everyone could enjoy it. He demonized the rich corporations and the wealthy politicians who he accused of being the minions of business. Unfortunately, many of the citizens of Venezuela fell for his fiery rhetoric.
Twenty years later we can now judge the fruits of Chavez’s efforts. He failed at getting everyone in the country to share in the wealth. But he succeeded at income equality. Everyone is now poor.
Now available in iBooks ---> The Tesla Bubble