NetSuite, a popular cloud-based Enterprise Resource Planning (ERP) system, offers two primary inventory costing methods: Standard Costing and Average Costing. Each method has its strengths and limitations, making them suitable for specific business scenarios. To understand how these costs flow through your financial statements and impact your bottom line, you may want to review the foundational principles of inventory cost accounting methods.
Key Takeaways
- Standard Costing Works Best for Stability: Ideal for manufacturers with predictable production and stable material costs, enabling accurate budgeting and variance analysis.
- Average Costing Reflects Market Reality: Better for retailers and distributors facing volatile prices. It automatically updates costs with each purchase, requiring less manual maintenance.
- The Cost of Complexity: Standard costing requires managing variance accounts and regular updates. Average costing simplifies accounting but can obscure cost trends.
- Choose Based on Your Business Model: Your production process, supply chain volatility, and reporting needs determine which method aligns with your strategy.
NetSuite Standard Costing
Standard costing assigns predetermined, fixed costs to inventory items. You set a “standard” cost for materials, labor, and overhead at the beginning of a period. This cost remains unchanged throughout that period, regardless of what you actually pay suppliers or spend on production.
Here’s how it works in practice: You set a standard cost of $10 for a component. You then track the difference between that $10 standard and what you actually paid (say, $11 or $9). NetSuite captures this variance in a separate account, letting you see exactly where costs exceeded or fell below expectations.
When Standard Costing Works Well
Standard costing shines in stable, mature manufacturing environments. Think large-scale automotive suppliers, food processing plants, or precision component manufacturers where production routines are established, and material sourcing is predictable.
Standard costing is especially powerful in manufacturing environments. For a more complete understanding of how manufacturers track inventory costs throughout production, explore our guide to implement cost accounting in NetSuite for better financial insights.
When manufacturing companies track production variances, they’re monitoring costs across all stages of production. Understanding how WIP (Work-in-Progress) and routing work in NetSuite helps explain how standard costs flow through the manufacturing lifecycle.
Predictable Budgeting and Planning: Fixed costs make forecasting straightforward. You know what each unit should cost, making it easier to set product pricing, plan capital investments, and prepare board forecasts. This consistency helps when you need to secure financing or commit to customer contracts at fixed prices.
Performance Visibility: Variances tell a story. A large Purchase Price Variance means your suppliers raised prices. A Production Quantity Variance signals inefficiency in your manufacturing. By isolating these variances, you can quickly identify root causes and take corrective action. This is why manufacturing companies doing lean or six-sigma initiatives often rely on standard costing.
Simplified Accounting Periods: You don’t recalculate costs with every purchase. This reduces transactional complexity and makes month-end closing faster in many cases.
The Real Drawbacks of Standard Costing
Standard costing doesn’t come without cost. The method demands ongoing maintenance and creates accounting complexity that surprises many users after implementation.
High Maintenance Burden: When material prices shift significantly, you need to update standard costs across all affected items. In a large manufacturing company with thousands of SKUs, this can demand substantial time and coordination. Updating standard costs at the wrong time can distort your financial statements, so timing matters.
Variance Proliferation: Standard costing creates multiple variance accounts: Purchase Price Variance, Material Usage Variance, Labor Rate Variance, Labor Efficiency Variance, and more. Managing and reconciling these accounts adds to your accounting workload and creates more opportunities for reconciliation errors.
Delayed Accuracy: Because standard costs lag behind actual market conditions, your balance sheet doesn’t reflect current replacement costs. In industries with volatile prices (like electronics or commodity-linked manufacturing), this gap can be material.
Who Should Use Standard Costing
- Manufacturers with stable, high-volume production where material and labor costs change infrequently
- Companies with long-term supplier contracts and fixed-price purchase agreements
- Organizations that prioritize variance analysis and operational efficiency improvements over real-time inventory valuation
NetSuite Average Costing
Average costing works differently. Instead of setting a fixed cost, the system calculates a weighted average cost each time inventory changes. When you purchase 100 units at $10 and then 100 units at $12, the average cost becomes $11. When you sell units, they cost out at $11, regardless of which batch they came from.
Average costing is NetSuite’s default inventory costing method. This tells you something important: it’s designed to work out-of-the-box for most businesses, with minimal configuration needed.
Here’s the key insight: the average cost updates automatically with each transaction. No variance tracking, no manual updates, no accounting surprises. Your inventory balance sheet always reflects the blended cost of what you actually purchased.
The Advantages of Average Costing
Real-Time Market Reflection: Because costs update with each purchase, average costing reflects current market conditions. If supplier prices rise 20% overnight, your inventory costs reflect that reality immediately. This is especially valuable for businesses in industries like electronics, chemicals, or commodities where prices fluctuate frequently.
Less Administrative Overhead: You don’t manage variance accounts or update standard costs manually. The system does the calculation. This means fewer transactions to reconcile, fewer manual journal entries, and faster month-end closes.
Fair Cost Distribution: Average costing smooths out short-term price spikes or dips. If you have a supply chain disruption that temporarily drives prices up, the impact is spread across your entire inventory pool rather than hitting just one batch or production run. This prevents individual items from being over- or undervalued during price volatility.
Where Average Costing Falls Short
Limited Cost Visibility: Without variance accounts, average costing doesn’t tell you why costs changed. You see that your average cost went from $10 to $12, but you lose the detail about which purchases drove that change. This makes variance analysis and performance measurement harder.
Complexity in Volatile Markets: In periods of rapid cost swings, average costing can create unintuitive results. A large purchase at a spike price temporarily inflates the average for all units, even those purchased before the spike. Accountants sometimes find this misleading when analyzing inventory valuations.
Harder Performance Measurement: If you want to evaluate procurement performance or production efficiency, average costing doesn’t give you the isolated signals that variances provide. You can’t easily see if a supplier is delivering at negotiated prices or if production used more material than expected.
Who Should Use Average Costing
- Retailers and distributors where inventory moves quickly, and replenishment happens frequently
- Businesses in industries with volatile material costs (electronics, metals, chemicals)
- Organizations where the administrative burden of standard costing outweighs the benefit of variance analysis
- Companies prioritizing real-time financial accuracy and ease of month-end closing
Implementation Considerations for NetSuite
Choosing a costing method isn’t a one-time decision. You need to align it with your operational processes, financial reporting needs, and team capacity. Here are the practical considerations that often get overlooked during implementation.
Data Quality and Costing Setup
Both methods depend on accurate transaction records. Every purchase receipt, inventory adjustment, and bill must be recorded correctly. For standard costing, this accuracy is even more critical because errors in baseline standard costs compound throughout the period. One incorrect standard cost on a high-volume item can throw off variance analysis for months.
The costing engine in NetSuite processes transactions asynchronously. This means inventory values on your balance sheet aren’t instantaneous. The system processes updates periodically (typically hourly), so there can be a lag between when a transaction posts and when the cost is calculated. Understanding this timing is crucial for period-end reconciliation.
Month-End Closing Process
Average costing generally results in faster month-end closes. You don’t have to update costs or reconcile variance accounts. Standard costing often requires a variance review and sometimes manual adjustments before you can close the books.
If your organization has tight closing timelines (say, you need financials published within two business days), this operational difference matters. Factor this into your decision.
Scalability and Future Flexibility
Your costing method should accommodate future growth. If you’re growing into new markets or adding product lines, consider whether your current method scales. Standard costing can become unmanageable as you add SKUs. Average costing scales more gracefully.
That said, switching costing methods after going live is difficult. You’ll need to revalue all inventory, restate historical financials, and potentially reconcile with auditors. Plan ahead.
The Real-World Impact on Your Business
To bring this to life, consider a midsize electronics distributor and a precision machining manufacturer, both using NetSuite.
The Distributor: Semiconductors are volatile commodities. A chip that cost $50 one month might cost $40 or $60 the next. The distributor chose average costing because it automatically adjusts inventory values to reflect market prices. No variance accounts, no manual updates. This lets the distributor quickly adjust customer pricing to match current market conditions and makes month-end reconciliation straightforward. The trade-off: the distributor can’t easily measure which suppliers are outperforming on price or which product lines are most profitable on a cost basis.
The Machinist: Steel prices fluctuate, but the machinist has multi-year contracts with two primary suppliers, locking in prices. Production volumes are predictable. The machinist uses standard costing because material prices rarely change and production is stable. When a supplier delivers substandard material causing rework (a production variance), the standard costing setup immediately highlights the impact. This signals the need to audit that supplier or find an alternative. The trade-off: when steel prices finally do move, the machinist spends two weeks updating standard costs across 800 items.
Making Your Decision
To choose between standard and average costing, honestly assess these questions:
- How volatile are your material costs? Rising more than 10-15% per year? Average costing is likely easier.
- How complex is your production? Do you need to isolate variances for different production stages or processes? Standard costing enables this.
- How many SKUs do you manage? Thousands? Average costing scales better. Hundreds? Standard costing is manageable.
- What are your closing timelines? Need to publish financials in two days? Average costing is faster.
- How much does your team value operational insights? Do you actively use variance analysis for process improvement? Standard costing delivers more detail.
Conclusion:
Both NetSuite Standard Costing and Average Costing methods have their advantages and disadvantages, making them suitable for different business scenarios.
Standard Costing and Average Costing aren’t right or wrong. They’re different tools for different contexts.
Standard Costing requires planning, maintenance, and discipline, but it gives you visibility into what costs should be and where reality diverges. If your business relies on cost control, variance analysis, and operational discipline, standard costing pays dividends.
Average Costing is simpler, faster, and better for volatile environments. If your business thrives on market responsiveness and you don’t have the operational discipline or team bandwidth for variance management, average costing is less risky.
Ultimately, the choice between these methods depends on your business’s specific needs and requirements. Businesses should carefully consider their production processes, inventory dynamics, and market conditions to determine which costing method aligns best with their goals and objectives. Furthermore, it’s essential to monitor the effectiveness of the chosen costing method regularly and be prepared to adapt to changing circumstances if necessary.
Folio3, with its expertise in ERP implementations, can help your business successfully navigate the challenges posed by different costing methods. By providing customized solutions, training, and ongoing support, we ensure that the ERP system aligns with the your business processes and optimally handles standard costing or average costing scenarios. With Folio3’s assistance, your business can maximize the benefits of their ERP investment and streamline their operations for improved efficiency and profitability.
