The cost of inventories for manufacturing consists of three components:
1. Raw materials the cost of the basic materials used to manufacture the product.
2. Labor the cost of the direct labor required to transform the product to a finished state.
3. Overhead the indirect costs incurred in the manufacturing process, such as depreciation of the manufacturing equipment, supervisory wages, and utilities.
Companies can estimate the first two components fairly accurately from design specifications and time and motion studies on the assembly line. Overhead is often the largest component of product cost and the most difficult to measure at the product level. In total, overhead must be allocated to all products produced. But which products get what portion of the total? Accountants generally subscribe to the notion that those products consuming most of the resources (e.g., requiring the most costly production machinery or the most engineering time) should be allocated most of the overhead.Inventory costing for manufacturing companies is generally covered in managerial accounting courses and is beyond the scope of this text. Analysts need to be aware, however, that overhead cost allocation is not an exact science and is highly dependent on the assumptions used.
1. Raw materials the cost of the basic materials used to manufacture the product.
2. Labor the cost of the direct labor required to transform the product to a finished state.
3. Overhead the indirect costs incurred in the manufacturing process, such as depreciation of the manufacturing equipment, supervisory wages, and utilities.
Companies can estimate the first two components fairly accurately from design specifications and time and motion studies on the assembly line. Overhead is often the largest component of product cost and the most difficult to measure at the product level. In total, overhead must be allocated to all products produced. But which products get what portion of the total? Accountants generally subscribe to the notion that those products consuming most of the resources (e.g., requiring the most costly production machinery or the most engineering time) should be allocated most of the overhead.Inventory costing for manufacturing companies is generally covered in managerial accounting courses and is beyond the scope of this text. Analysts need to be aware, however, that overhead cost allocation is not an exact science and is highly dependent on the assumptions used.
Analysts also need to understand the effect of production levels on profitability. Overhead is allocated to all units produced. Instead of expensing these costs as period expenses, they are included in the cost of inventories and remain on the balance sheet until the inventories are sold, at which time they are reflected as cost of goods sold in the income statement. If an increase in production levels causes ending inventories to increase, more of the overhead costs remain on the balance sheet and profitability increases. Later, if inventory quantities decrease, the income statement is burdened by not only the current overhead costs, but also previous overhead costs that have been removed from inventories in the current year, thus lowering profits. Analysts need to be aware, therefore, of the effect of changing production levels on reported profits.
Lower of Cost or Market
The generally accepted principle of inventory valuation is to value at the lower of cost or market. This simple phrase masks the complexities and variety of alternatives to which it is subject. It can significantly affect periodic income and inventory values. The lower-of-cost-or-market rule implies that if inventory declines in market value below its cost for any reason, including obsolescence, damage, and price changes, then inventory is written down to reflect this loss. This write-down is effectively charged against revenues in the period the loss occurs. Because write-ups from cost to market are prohibited (except for recovery of losses up to the original cost), inventory is conservatively valued.
Market is defined as current replacement cost through either purchase or reproduction. However, market value must not be higher than net realizable value nor less than net realizable value reduced by a normal profit margin. The upper limit of market value, or net realizable value, reflects completion and disposal costs associated with sale of the item. The lower limit ensures that if inventory is written down from cost to market, it is written down to a figure that includes realization of a normal gross profit on subsequent sale. Cost is defined as the acquisition cost of inventory. It is computed using one of the accepted inventory costing methods—for example, FIFO, LIFO, or average cost. Our analysis of inventory must consider the impact of the lower-of-cost-or-market rule. When prices are rising, this rule tends to undervalue inventories regardless of the cost method used. This depresses the current ratio. In practice, certain companies voluntarily disclose the current cost of inventory, usually in a note.
Lower of Cost or Market
The generally accepted principle of inventory valuation is to value at the lower of cost or market. This simple phrase masks the complexities and variety of alternatives to which it is subject. It can significantly affect periodic income and inventory values. The lower-of-cost-or-market rule implies that if inventory declines in market value below its cost for any reason, including obsolescence, damage, and price changes, then inventory is written down to reflect this loss. This write-down is effectively charged against revenues in the period the loss occurs. Because write-ups from cost to market are prohibited (except for recovery of losses up to the original cost), inventory is conservatively valued.
Market is defined as current replacement cost through either purchase or reproduction. However, market value must not be higher than net realizable value nor less than net realizable value reduced by a normal profit margin. The upper limit of market value, or net realizable value, reflects completion and disposal costs associated with sale of the item. The lower limit ensures that if inventory is written down from cost to market, it is written down to a figure that includes realization of a normal gross profit on subsequent sale. Cost is defined as the acquisition cost of inventory. It is computed using one of the accepted inventory costing methods—for example, FIFO, LIFO, or average cost. Our analysis of inventory must consider the impact of the lower-of-cost-or-market rule. When prices are rising, this rule tends to undervalue inventories regardless of the cost method used. This depresses the current ratio. In practice, certain companies voluntarily disclose the current cost of inventory, usually in a note.
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