Auditing Manufacturing Costs

Auditing Manufacturing Costs

Teresa Kilpatrick

Electronic data analysis helps internal auditors to meet the rigorous demands of manufacturing audits.

HE COMPLEXITY OF CURrent manufacturing processes extends far beyond the scope of traditional cost and financial accounting. Enterprise resource planning (ERP) and other subsidiary production systems used by manufacturers require audit programs with powerful data extraction and analysis capabilities. Manufacturing auditors must therefore equip themselves with technological tools to analyze data beyond the “tick and tie” approach.

Manufacturing systems typically contain a large volume of transactions and some particularly detailed calculations. Auditors need to trace transactions through a multi-step production environment and accumulate costing calculations at each level of operation. With so many factors to consider, computer assisted audit tools (CAATs) become a necessity to ensure accurate and efficient data analysis. The following aspects of standard-cost auditing illustrate the use of one particular CAAT–IDEA–to facilitate the manufacturing audit process.


Most manufacturing systems contain numerous reports that may be designed for production and material requirements planning management rather than accounting. For example, companies that are job-cost based may filter out data for dosed jobs on some reports. A preliminary discussion with the controller will help to identify the distinction between reports, allowing the auditor to focus on those that serve as the basis for accounting entries.

Often, half the battle is gathering the costing and production data. Once the auditor has identified report sources, information can be imported for analysis. IDEA utilizes open database connectivity (ODBC) drivers that convert a wide range of common spreadsheet and text formats. In addition, the software includes an import feature that translates AS400 and SAP files.

Using IDEA’s file extraction and summarization techniques, auditors can perform several tests to verify the integrity of the data itself, as well as the calculation extensions and totals in each report. For example, a summarization of a labor report by employee, combined with a duplicate key detection, quickly highlights potential reporting errors. Because the summarization is generated with the assumption that most employees will not work outside their assigned departments, it produces a report that is summarized by employee and department. Therefore, the software’s duplicate key feature–designed to extract multiple occurrences of user criteria–must be employed to create an exception report of employees whose labor is reported in more than one department. Auditors can then investigate the exceptions and determine the validity of department charges or identify any corrections required.

To avoid the possibility of omitted data from filtered reports, the auditor should request a file extraction of the raw data elements from the customer’s mainframe. The user can then import this file into IDEA and test the completeness of the captured data for items such as labor hours, footage, work center, and date.


An important yet often time-consuming step when auditing manufacturing ERP systems involves replicating the cost of a product and verifying this amount to the calculation generated by the costing system. Auditors can use IDEA to import files that contain cost calculation fields such as quantity of raw material components, raw material prices, labor hours per piece, and machine rates. The equation editor can be used to perform an independent calculation of cost. IDEA can then automate the process of comparing this item cost file with the system item cost through its file comparison feature.

A more discrete yet potentially significant costing impact may reside in some “behind the scenes” switches on the client’s database, which may not appear on costed inventory reports. For example, auditors should look for any “Y” or “N” codes, which are typically found in a product structure or product router table on the mainframe production database. These flags will indicate a “Yes” or “No” to critical costing issues such as waste accumulation, prior cost accumulation, or alternate material or processing.

In addition, auditors will likely encounter fields with only one or two digits, such as issue code and receipt code. Including these types of codes in the data import ensures that any potential costing implication will be

recognized when independent cost calculation is reconciled to the client’s system calculation of item cost.


Manufacturing auditors need to determine how often the company updates standard costs and identify what controls are in place to ensure that costs do not change at unscheduled times. Using IDEA, the auditor can request a product cost file from two periods-during which the costs should not have changed-and use the software’s file comparison feature to identify any discrepancies. The costing impact of identified exceptions can be quantified by joining the exception file to the cost of sales and inventory files.

By adding a new field and employing the software’s equation editor, the auditor can isolate the financial impact of the changes in standard costs between periods on an exception report. IDEA has the capacity to analyze large volumes of data, providing the auditor a 100 percent verification of cost changes and a complete calculation of the financial impact to inventory valuation and cost of sales.


Even a company with processes in place to control spending may be using arbitrary or outdated means of allocation that can affect product costing. As a result, marketing strategies may be based on costs and profitability analyses that do not reflect the true economic contribution of a product. Proper data analysis can provide an objective view of the collection and allocation of overhead costs to products.

Auditors can import general ledger or application files into IDEA and, if general ledger account coding is machine- or department-specific, utilize the software’s field summarization feature to compare actual spending by department to the “standard” earned for the month. The standard earned calculation would normally involve a computation of standard machine or labor hours multiplied by overhead rates by machine hour or labor hour. Comparing the standard earned by department with actual spending by department may uncover a potential error of over- or under-applied costs. In either case, the auditor’s findings could result in a financial correction to the inventory balance and cost of sales.


Competitive markets introduce new variables to the process of auditing a manufacturer’s pricing of raw materials. Exclusive supplier arrangements, volume rebates, and consigned inventory agreements must be reviewed carefully. Auditors need to determine whether or not the manufacturer’s standard costs reflect vendor rebates and trace the actual price, standard price, and price variance through the system to the general ledger.

For example, auditors can analyze prices paid for raw material by importing the accounts payable file into IDEA and then using the equation editor to extract all purchases of the material to be analyzed. If the standard cost system lists the price of a raw material at $1.05 per pound, for instance, and the extracted file reflects a total of 40,000 pounds purchased for $44,000–indicating $1.10 paid per pound–a cents-per-pound difference would be reported. This exception could be discussed with the controller to identify the reason for the discrepancy, as the standard of $1.05 per pound could have been set based on a 5 cents-per-pound rebate. Further investigation, however, might disclose an unrecorded receivable, which wouldn’t be uncommon in circumstances where the rebate might be awarded at year-end. Likewise, a similar test could disclose an unrecorded liability. Auditors would need to review exceptions relative to the audit threshold and discuss these with management.


Perhaps one of the most difficult manufacturing audit tasks is the valuation of work-in-process. If the company maintains a perpetual inventory, auditors must determine whether or not the material has visibility and costing at each stage of the manufacturing process. Obviously the greater the “gestation” period for inventory, the higher the risk for under- or overvaluing inventory. Auditors should trace through the system and determine whether or not the costing reflects the physical process of the material and whether the costs are added at the end of each process or at the beginning.

Using data analysis, auditors can perform a simple test to compare a file of work-in-process valued items with finished-goods items. Some companies maintain the same product number when costing the interim levels by operation or sequence levels. Under such circumstances, auditors can use IDEA’s “join file” routine to identify work-in-process items that have the same unit cost at the finished operation level. The join function identifies one file as primary and the other as secondary; the files are joined together by a common field such as item number. By joining all matching items, costs for items carrying the same unit cost in work in process as finished goods can be isolated for further investigation.


As the auditor analyzes data in IDEA, a detailed history log is maintained of all tasks performed. This feature is especially useful in standard-cost audits, where auditors will likely encounter a high concentration of data requiring a multitude of individual tests and comparisons that may be otherwise difficult to track. The history log can be copied into the auditor’s workpapers, which may be useful to audit managers in their review of the work performed and can serve as a reference for future audits.

The ability to establish a thorough electronic audit trail may also enable auditors to fine-tune data analysis processes and increase efficiency, as all decisions may be revisited and examined more critically. In a manufacturing environment, as in any other audit setting, the effectiveness of technology depends on the auditor’s ability to utilize it properly. Thoughtful application of CAATs and regularly monitoring processes will help to ensure that the full potential of these tools is realized by the auditors and, more importantly, the client.

TERESA KILPATRICK, CPA, is a manufacturing accounting and management consultant in Kilgore, Texas.

COPYRIGHT 2000 Institute of Internal Auditors, Inc.

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