Myth-Busting – 3 Common Accounting Myths in Manufacturing

Posted by Colin Quinn on February 28, 2019

Three Common Accounting Myths in Manufacturing

By Colin Quinn, Guest Author, Deltek Partner Kinetek

Original post appeared on the Kinetek Blog January 25, 2019.

What if I told you that everything you learned in school was wrong. Ok, not everything, but most things that relate to accounting in manufacturing I’m pretty certain. Let's dive into the three of the most common myths people hold about accounting in manufacturing—myths that, can throw a business off balance and create major problems.


 

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Myth 1 – Inventory is an Asset

Accountants today are playing a modern game using ancient rules. These rules made sense a century ago when Model T's were rolling off the Ford shop floor on wooden wheels, but in 2019, these ancient rules create problems.

From the old world of manufacturing:

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. Once COGS is subtracted from revenue, the result is a business’ gross profit. The more ending inventory a business has, the less COGS, resulting in a greater profit.

With today’s measures of success, classifying inventory as an asset can lead to a company’s demise. Material costs can 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 try to make payroll with a lot of inventory sitting on the shelves. It’s basically mission impossible.

Myth 2 – Direct Labor Is Consistent

Going back to 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 materials were cheaper and the product life cycles were longer. So, the odds were that the inventory would eventually be sold. By today’s standards, however, 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. Where it sits, unsold, burning cash until a crisis occurs. When the inventory sits idle, a company is unable to 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, which can mean eventually the company shuts its doors and files for bankruptcy.

In this extreme case, 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 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 a company’s financial decisions.

Take a minute to think about what happens to cash in relation to per-unit costs. If only what is needed is produced, the purchase of excess raw materials becomes unnecessary. Therefore, a company doesn’t have to warehouse the material, hire additional people, pay overtime, or pay the associated storage costs.

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

More Myths to Bust

Get additional guidance on key ways to align materials management with accounting during the webinar The Balancing Act: Materials & Finance. Kinetek expertly reviews best practices, real-world examples, as well as how Deltek Costpoint integrates materials management and finance processes to keep companies even keel.

 

About the Author

Colin Quinn is a dedicated marketing veteran with 7+ years’ experience in maximizing brand awareness through content marketing, social media and advertising. He is the current director of product marketing for Kinetek Consulting in Reston Virginia.