Reporting the effects of excess inventories.

REPORTING THE EFFECTS OF EXCESS INVENTORIES

The trend toward manufacturing systems that emphasize lower inventories has caused manufacturers to recognize the problems of overproduction. Many company managements have realized they need to become less production-driven and more sales-driven.

The problem is that traditional cost accounting systems tend to reward overproduction and do not recognize the savings associated with minimizing inventories. Absorption costing actually increases net income when inventory levels are increased, even though sales may be unchanged. At the same time, the cost of capital required to carry excessive inventories is largely ignored because interest expense is treated as a financing rather than a manufacturing cost.

In a standard cost system, two basic measures are related to production levels:

1. Computing a volume variance (the usual approach), which shows that fixed overhead has been over-or underabsorbed due to producing above or below the planned production level.

2. Computing a marketing variance based on excess or lost contribution margins due to volume of sales above or below the planned sales level.

While either of these provides useful information, neither shows the cost of excessive production--in fact, overproduction results in a favorable volume variance. A better method is to compute overproduction variances, as some companies have begun to do.

Computing costs of excess production levels can be integrated into a standard cost system; the effect can be evaluated on a timely basis in much the same way price and efficiency variances are currently evaluated. From this output, cost of capital computations can be made and used internally for decision-making purposes.

VARIANCES FOR LABOR AND OVERHEAD

To understand a standard cost system that integrates overproduction variances into the system, consider EXHIBIT 1 Production variances for labor and overhead. The company has scheduled production of 1,000 units. This figure is obtained on a short-run basis by considering sales orders received and minimal inventory needs. The idea in just-in-time and other low inventory systems is to schedule from the sales end (the pull-through concept) rather than from the production end (the push-through concept).

If production exceeds the scheduled figure, an unfavorable production variance for labor is generated. The production variance is equal to the excess hours used for over-production multiplied by the standard labor rate per hour. Exhibit 1 shows 1,200 units, or 200 excess units, were actually produced, which results in an unfavorable production variance for labor of $2,000. Customary rate and efficiency variances are computed as usual.

If actual production exceeds scheduled production, an unfavorable production variance for variable overhead also is generated. Assuming a machine-hour basis for applying overhead, the production variance is equal to the excess machine hours used for overproduction multiplied by the standard variable overhead rate. Exhibit 1 shows an unfavorable production variance for variable overhead of $3,200. There is no production variance for fixed overhead because the increased production does not result in an increase in this fixed amount. The traditional overhead variances are computed as usual.

Production variances are used internally without being booked. However, a journal entry, such as the one in exhibit 1, can be used to integrate the variances into the cost accounting system. The production variances are debited, and an account called excess production is credited.

A credit balance in the excess production account can be viewed internally as a liability account even though generally accepted accounting principles would prohibit it from being treated as such in the financial statements. The production variance and excess production accounts can be offset against each other when the excess inventory is sold or, alternatively, at the end of the accounting period.

If excess inventories are regarded as liabilities, management should have no trouble seeing that working capital is tied up in them. However, looking on excess inventories as assets, as is usually done, encourages management to build them up even though there is no immediate opportunity for sales.

COST OF CAPITAL

The real penalty for holding excess inventories is the cost of capital associated with these inventories. This penalty is frequently over-looked because interest costs are usually treated as financial rather than manufacturing expenses. The exhibit 1 illustration assumes the cost of capital is 10% and the calculation of the cost of excess inventories is done weekly, which results in a $10 holding cost if the inflated inventories are carried for the entire week.

The most difficult part of trying to evaluate the cost of holding excess inventories may be arriving at a cost of capital figure. Capital budgeting specialists have argued about the best figure to use (marginal vs. average, inflation vs. non-inflation adjusted) for years.

Although a full discussion of the cost of capital amounts is beyond the scope of this article, some guidance is possible. For example, a short-run interest cost is probably superior to a long-run figure because inventory is a working capital item rather than a long-term asset. In addition, current funds are being tied up.

Consideration should also be given to adding a premium for increased handling, recordkeeping, insurance, taxes and the like due to excess inventories. Some authorities estimate such costs may be at least equal to the pure interest cost. Probably an available figure that would come close to a reasonable cost of capital amount would be the carrying cost used for optimal inventory ordering or calculation of optimal size production runs. Not having an absolutely accurate cost of capital figure should not deter managers from trying to assess the effects of excess inventories. Using an estimate is superior to ignoring the problem.

VARIANCES FOR MATERIALS

Materials present a problem that is somewhat different from that of labor and variable overhead because raw materials are inventoried. The materials investment occurs when they are purchased rather than used. In EXHIBIT 2 Production and purchases variances for materials, a purchases variance is calculated for materials purchased in excess of current (scheduled) needs. The purchases variance is offset by an excess materials purchases account. From an internal standpoint, a credit balance in this account can be considered a liability comparable to the excess production account. A price variance on materials purchased is calculated in the usual manner.

Once materials move into production, a production variance may occur for the materials in excess production. Exhibit 2 assumes 200 extra units were produced and the extra production requires 2,000 extra pounds of materials, resulting in an unfavorable production variance of $2,000. This is recorded by a debit to the production variance account and a credit to excess production similar to the labor and overhead entries.

Part of the excess purchases have now been used for excess production. To avoid double counting the same items, it is necessary to decrease the excess purchases account when excess production is calculated. In exhibit 2, the excess purchases and materials purchases variance accounts are offset against each other to the extent of the $2,000, which is now shown as excess production, leaving $3,000 in the accounts.

Some assumption must be made concerning which materials flow into production first. Are excess purchases the top layer of inventory to be moved out first or the bottom layer to be moved out last? This illustration assumes they move out first. In other words, as the raw materials inventory balance is normalized, the excess purchases balance is decreased.

As with labor and overhead, the real penalty for holding the excessive materials inventories is the cost of capital associated with them. Assuming the excess purchases are held one week, the first week's cost is $9.62. Assuming part of the excess moves into production in the second week, the cost of capital on that portion is $3.85. For the $3,000 still in raw materials the week's cost of capital is $5.77.

PERFORMANCE REPORT

EXHIBIT 3 Performance report, week 2 illustrates a sample performance report showing the effects of holding excess inventories. The top part of the report shows the number of excess units produced and the excess materials purchased. The variance section indicates the variances for the week. In week 2, the extra 200 units produced resulted in production variances of a total of $7,200. (It is assumed that the labor and overhead variances in exhibit 1 take place in week 2.) There were no purchases variances because they had occurred in week 1.

The next section shows the excess inventories currently being held. Assuming the units in production have been finished but not sold, there is $7,200 of excess finished goods. There is also $3,000 extra in raw materials as a result of overbuying in week 1.

The last section of the performance report shows the cost of holding the excess inventories for the week. Holding the $3,000 of raw materials has cost $5.77 while holding the finished goods has cost $13.85. These figures are the result of calculating a 10% cost of capital on the investment in inventory.

A report such as the one in exhibit 3 highlights the important information associated with excessive inventories. The variance section indicates the effect of exceeding the production schedule for the current week and is comparable to other variance reports in a standard cost system. The excess inventories held section indicates the cumulative effect of both past and current weeks' extra production and purchases. The impact of holding these excess inventories is given in the cost of holding excess inventories section.

One consideration about such a performance report is how frequently it should be generated. Although the report's cost should be balanced against its value, it is desirable to have this information on a timely basis. Knowing the cost of excess inventories weekly allows for much quicker corrective action than knowing such costs monthly.

TOWARD A BETTER SYSTEM

The system described here has two major elements--the identification of excess production and purchases and the calculation of the cost of capital for carrying those inventories. Such information often is ignored in current systems.

However these items are entered into the decision-making system, they should be available for internal management use. The approach could range all the way from merely calculating the amounts to including them in the financial statements (although this would not be permitted under current GAAP).

This middle-of-the-road proposed approach records the information similarly to variances in a standard cost system for internal management use. The accounts are reversed as inventory levels are reduced or at the end of the accounting period and are not used in the financial statements.

The adaptation outlined is, admittedly, only the bare bones of a system that includes a workable measure of excessive inventories and overproduction. It is perhaps too close to the traditional standard cost system and changes the basic account structure very little.

However, it does represent a start. If managers can see the costs associated with excessive levels of inventory, they will be able to make more accurate purchase and production decisions.

EXHIBIT 3

Performance report, week 2

ABC Industries Excess inventories report for week 2 Excess units produced: 200 Excess materials purchased: 0

Variances: Production variance

  Materials                           $2,000
  Labor                                2,000
  Overhead                             3,200
  Total production variance                    $ 7,200
  Materials purchases variance                       0
  Total variances                              $ 7,200

Excess inventories held:

Raw materials                                  $ 3,000
Work in process                                      0

Finished goods

  Materials                           $2,000
  Labor                                2,000
  Overhead                             3,200
  Total finished goods excess                    7,200
  Total excess inventories                     $10,200

Cost of holding excess inventories:

Raw materials (3,000 x .10 x 1/52)             $  5.77
Work in process                                      0
Finished goods (7,200 x .10 x 1/52)              13.85
Total cost                                     $ 19.62

[Exhibit 1 and 2 Omitted]

Carole Cheatham, CPA, PhD, professor of accounting at Northeast Louisiana, Monroe, proposes adapting the usual standard cost accounting system to help managers make better purchase and production decisions.