January 25, 2019

(Myth-busting) 3 Common Accounting Myths in Manufacturing

by Colin Quinn

What if I told you that everything you learned in school was wrong.. Ok, not everything but most things as it relates to accounting in manufacturing. Let’s dive into the three most common myths people have about accounting in manufacturing – myths that, often throw your business off balance and create major problems.

  1. Inventory is an asset

  2. Direct labor is consistent

  3. Making (or Buying) more reduces per-unit costs

Myth No. 1 – Inventory is an Asset

Today’s accountants play a modern game using ancient rules. These rules made sense a century ago when the Model T’s were rolling off the shop floor on wooden wheels, but today these ancient rules create a lot of problems.

From the old world of manufacturing emerged the Cost of Goods Sold (COGS) formula: COGS = Beginning inventory + Purchases during the period – Ending inventory. The inventory numbers incorporate the material value and total production costs, including labor. You then subtract COGS from your revenue, and you get your gross profit. The more ending inventory you have, the less your COGS, the greater your profit.

Today, classifying inventory as an asset can lead to a company’s demise. Material costs today burn cash quicker than anything else. All manufacturers need some inventory on hand to function, especially raw materials. Yet, those materials burn cash, and therefore they are truly a liability NOT an asset.

Like any liability, inventory can be controlled. This is a great example of “more isn’t always better.” More inventory may reduce COGS and increase profits on paper, but you can’t make payroll with a lot of inventory sitting on the shelves.

Myth No. 2 – Direct Labor Is Consistent

In the old world of manufacturing, the more products workers produced, the more inventory they had on hand to sell, and the more their costs could be offset; but this increased the “ending inventory” in the COGS formula, and thus increased profits.

Warehousing excess finished-goods in inventory wasn’t a huge cash drain back then, because the material was cheaper and the product life cycles were longer, so odds were inventory would eventually be sold; but employing an inefficient direct-labor workforce – which cuts into revenue – can be detrimental.

In a quest to “make the numbers,” managers push people to produce more products that end up in inventory. And there it sits, unsold – burning cash until a crisis occurs. The company now can’t pay its bills, employees, or vendors. So what does management do? Layoffs.

“Companies shoot themselves right in the foot letting all that knowledge walk right out the door.”

Meanwhile, the remaining workers continue to produce products (consuming material, the largest cash burn) that will never be sold and eventually the company shuts its doors and files for bankruptcy.

In these extreme cases, manufacturers could learn something from the small, build-to-order and engineer-to-order shops. When orders arrive, they buy the material and produce the product. When the orders aren’t there, or sales are slow they stop producing, they don’t consume material, and therefore they don’t burn through cash, people, and labor.

Myth No. 3 – Making (or Buying) More Reduces Per-Unit Costs

While the quickest and easiest way to reduce per-unit costs is usually to increase production volumes, not everyone has the budget to scale up.

Common knowledge states that if a manufacturer produces more products, its cost-per-unit decreases. This is thanks to absorption costing, which is required for external reporting to abide by generally accepted accounting principles (when valuing inventory) but, it shouldn’t be used to guide the companies financial decisions.

Let’s take a minute to think about what happens to cash in relation to per-unit costs. If you produce only what’s needed, you don’t have to purchase excess raw material. Therefore, you don’t have to warehouse the material, hire additional people, pay overtime, or pay the associated storage costs.

Making more may reduce your per-unit costs, but it can end up costing you more in the long run..

Coming soon:

Join us for our webinar on March 13th – “The Balancing Act: Materials and Finance” to learn more about materials and finance in accounting.