What is the proper way to capitalize manufacturing variances (US GAAP)? Have you set a threshold and only capitalize variances over a certain amount?
Do you capitalize the entire variance and amortize based on inventory days, or do you expense specific variances in the current period (such as unfavorable variances attributable to abnormally low production levels)? Are there other variances to exclude?
What’s the best way to determine when to start amortizing the capitalized variances (a portion in the current period to represent any inventory consumed in the current period or just start the next period)?
Table of Contents
Standard costing & capitalized variances
Some general guidelines concerning the categories of variation
Tracking capitalized variances accurately can be more painful than the value
Standard costing & capitalized variances
Although standard cost is not a method of costing that is acceptable according to GAAP, many businesses still use it to analyze actual costs and performance.
Consequently, the variances must be adjusted on the balance sheet and the income statement to come as close as possible to the GAAP costing method the company has officially adopted.
As a consequence, even though you will initially record most inventory variances, the method you use to amortize them must adhere to the above principle.
Both the actual costing method and the standard costing method can result in differences in the costs of an inventory. A number of the variances are caused by inventory velocity (the inventory has been received, valued, and moved before the vendor payable, for example), and a number of the variances are caused by the variance from the planned inventory value.
Because some variances are caused by actions taken related to inventory (such as rework), and the revaluation can cause several variances.
You could add additional categories, such as the variance caused by currency revaluation, but I believe the above ones cover the most possible outcomes.
The treatment of each variance category is unique regarding the purposes of the profit and loss statement and the balance sheet. To minimize the risk of inventory value manipulation, which is possible with standard cost, and to optimize the match for COGS, the goals surrounding the timing of the move of variances to the profit and loss statement are as follows: (actual revenue, actual COGS).
The Process of revaluing inventory is more complicated than its treatment and is distinct from the variation resulting from pure purchases or manufacturing. In most cases, a write-down is recorded as an expense in the period’s profit and loss statement, whereas a write-up is amortized over the number of times inventory is sold.
On the other hand, if your inventory valuation is volatile (for example, if you sell computer memory), you might have to reevaluate it so frequently that it becomes an expense you incur every period.
Or, let’s say you use something in your production process, like gold, that has its independent value; in that case, there is a possibility that separate rules will apply to that.
Regarding inventory, however, practice is more complicated than theory, so your auditors typically work out general rules.
Some general guidelines concerning the categories of variation:
Any inventory model may have PPV Variances. PPV Purchase refers to the difference between the PO price and the standard cost.
PPV variations are typically considered a component of the actual cost of the inventory; consequently, they are frequently capitalized and moved to the profit and loss statement as the inventory is sold.
If you have the data to back up the model, the most common method is to amortize these variances to the profit and loss statement based on the number of days your inventory is turned over.
Significant fluctuations in raw materials through lengthy manufacturing processes may make capitalizing variances critical for accurate reporting
Significant fluctuations in raw materials prices can occur throughout lengthy manufacturing processes. This can make capitalizing variances critical for accurate financial reporting. Variances must be monitored and managed to avoid over- or under-capitalization, which can lead to distorted financial statements.
When raw materials prices fluctuate, it can significantly impact the cost of goods sold (COGS). If variances are not monitored and managed effectively, it can lead to over- or under-capitalization. This can, in turn, distort financial statements.
To avoid this, businesses need a system to track and manage raw materials prices. They also need to be able to adjust their COGS accordingly. Doing so can ensure that their financial statements are accurate and reflect the actual cost of goods sold.
Variations in the Process
Variations in the process arise whenever the goods in question are subjected to rework, or your bill of materials (BOM) includes costs not incurred for producing the goods (such as an alternative quality process included at times).
These transactions do not increase the value of the resulting inventory; as a result, they are typically regarded as period expenses. This is because they do not add value to the inventory.
Variations in the amount of yield or scrap
Variations in the amount of yield or scrap arise whenever there is a departure from the plan (in the form of a standard cost) and when actual costing systems are used. As a general rule, they are considered a component of the actual inventory cost (given the potential for manipulation in this context), and their treatment is analogous to the PPV variances.
The variation in inventory Write-off
If you have fewer items in stock than your records indicate you should have, you experience a financial loss. You make it appear that you paid for a particular inventory quantity but only benefitted from a portion of that quantity.
You can deduct the entire variance from your taxable income and report that as a loss on your tax return. Your taxable income for the year you show the loss will, as a result, be reduced.
Variation in Capitalization of Inventory
If you have fewer items in inventory than you paid for, and the difference represents a sizeable proportion of your total sales for the year, you may be able to depreciate the loss over time. No universally accepted definition of “significant” exists in this context; however, you can capitalize on a variation in inventory between 25 and 50 percent.
This means you can deduct a portion of your loss during the current tax year and then deduct the remainder during the following year. When you are attempting to find a balance between your income and your expenses, you should employ this method.
Since your sales do not equal the amount of inventory you show you should have, you can wait until next year, when you will have sold more, to show the remaining inventory loss as a charge against that income. This is because your sales do not equal the amount of inventory you show you should have.
Improper Capitalization of Manufacturing Variances
It would help to make financial reporting if you did not capitalize the labor expenses associated with inventory, even though it is appropriate to capitalize inventory variances. These costs ought to be deducted in the same year they were incurred.
According to the Securities and Exchange Commission (SEC) findings, many businesses incorrectly capitalize expenses to present a higher annual income. Because capitalized expenses are deducted over a more extended period, their impact in any given year is reduced. This resulted in a higher income figure in the first year because the total expenses were not deducted from the income then.
Examining the Valuation Methods for the Inventory
If your records indicate that you have less inventory, then you should check to see if the discrepancy is caused by a different valuation method.
To put it another way, the person taking the inventory might have given the units the wrong value, although you have the correct quantity of items available. Ensure that the inventory count is based on the valuation of a single criterion, such as the amount that was invoiced or the item’s retail value.
When discussed in manufacturing, the portion of a manufacturing variance capitalized as part of the inventory values is referred to as a capitalized variance.
Taking a straightforward example of a new business venture, let’s say that your standard or Bill of Materials (recipe) specifies that you need $100 worth of raw materials to produce 10 units of the finished product. In the final moments before you begin production, your assistant trips and knocks over the raw materials, which are worth one hundred dollars.
After you have picked him up off the ground and cleaned up the mess, you start the process of producing those 10 units all over again. This time, you can collect the raw materials, and the Process runs so smoothly that you can complete the production of the 10 units at the price that your standard cost indicated you should have made them for.
You stop all production for the month, and you’ve only managed to sell five of the ten units at the end of the month. Now that the month ends, you evaluate your inventory and notice fewer raw materials on the shelf than your standards indicate. You are then reminded of the accident and begin pondering how you are going to explain away the spill.
If you assume that your only manufacturing cost is materials, then your cost of goods produced at standard would be $100 (for the 10 units), and to account for the spill, you would have an efficiency variance (it took more materials because of the spill) of $100. Together, these two numbers would make up your total Cost of Goods Produced. Assuming everything is standard, your cost of Goods Sold would be $50. Then you would have to determine how much of the $100 variance you should recognize in the current period and how much of the spill is a capitalized manufacturing variance.
According to the accounting theory of matching revenue with expenses, the correct method of accounting would be to recognize half of the negative variance of $50 in the current month (given that half of the goods produced were sold to third parties in the month), and then capitalize the remaining $50 negative variance on the balance sheet alongside the product’s standard cost.
This would bring the total amount of recognized negative variance to $100. When you sell the remaining 5 units, each one will have a cost basis of $100 ($50 at standard plus $ recognition of the $50 negative variance). This will occur when you sell all of the units. This is a very simplified example, and other rules must be followed, one of which is that certain variations of a one-time-only nature must be left out of the calculations.
Many manufacturers are concerned about capitalizing variances when they produce more units than they sell in a period. However, manufacturers don’t have to worry about capitalized variances if all units produced are sold in the same period.
This is because the variances offset the sales revenue from the additional units sold. Therefore, manufacturers can focus on producing enough units to meet demand without worrying about capitalizing variances.
Tracking capitalized variances accurately can be more painful than the value
There’s no doubt that tracking capitalized variances accurately is essential for businesses. However, the process can often be more painful than it’s worth. Here’s a look at why this is the case and what you can do to ease the burden.
One of the biggest challenges with tracking capitalized variances is the many factors to consider. For instance, you must consider the cost of materials, labor, and overhead. This can quickly become overwhelming, particularly for businesses with complex operations.
Another issue is that capitalized variances can fluctuate significantly from one period to the next. This makes it challenging to understand your business’s financial health clearly. As a result, you may find yourself constantly chasing after variances that are nothing more than noise.
Ultimately, tracking capitalized variances can be more trouble than it’s worth. You could spend more time and money than necessary if you’re not careful. Fortunately, you can do a few things to make the process easier.
First, consider using software to automate the task of tracking capitalized variances. This will free up your time to focus on more critical aspects of your business. Several software programs are available, so find one that meets your specific needs.
Second, make sure that you have a clear understanding of your company’s accounting policies. This will help you avoid potential mistakes when tracking capitalized variances. If you’re not sure about something, be sure to ask your accountant or financial advisor.
Finally, keep in mind that tracking capitalized variances doesn’t have to be a time-consuming process. By taking the time to plan and prepare, you can make it much easier on yourself. With a little effort, you can ensure that tracking capitalized variances is painless and efficient.
Improperly tracking capitalized variances can lead to significant one-time adjustments
If you are not tracking capitalized variances properly, it could lead to significant one-time adjustments on your financial statements. This could cause your business to appear more profitable or less profitable than it actually is.
As such, ensuring that you have a system in place to track and manage these variances is crucial. Doing so will help keep your financial statements accurate and reflect your business’s true profitability.
When you capitalize a variance, you’re essentially booking it as an asset on your balance sheet. And if you don’t have a sound system for tracking these variances, they can quickly add up.
One way to avoid this problem is to use a software tool that can help you track your capitalized variances. This way, you’ll always know exactly how much money you have tied up in assets and can make sure that your books are balanced.
Another way to keep on top of your capitalized variances is to set up a regular review process. This way, you can catch any errors or omissions before they become problematic.
Whatever system you use, tracking capitalized variances is essential to keeping your financial statements accurate
Otherwise, you could end up with a sizeable one-time adjustment that could throw off your whole budget.
Enterprise Resource Planning (ERP) systems are increasingly being used by organizations to manage their finances and operations more effectively. ERP systems can significantly improve efficiency and accuracy when correctly tracking and recording variance capitalizations.
There are a few key things to keep in mind when utilizing ERP systems for variance capitalization purposes:
Ensure all relevant data is adequately captured in the system. This includes both financial and operational data.
Ensure that the system is configured correctly to meet your organization’s specific needs.
Train employees on using the system properly to enter data accurately and efficiently.
Regularly review and audit data entered into the system to ensure accuracy.
By following these simple tips, you can maximize the effectiveness of using ERP systems for variance capitalization purposes. Doing so will help to improve organizational efficiency and avoid costly errors.
As your business grows and changes, your ERP system should be able to adapt with you. A one-size-fits-all approach simply isn’t practical or sustainable in the long run.
By customizing your ERP to match your specific needs, you can get the most out of the system and avoid having to track manual variances.
This may seem daunting, but working with an experienced consultant can make it much more manageable. They will be familiar with tailoring an ERP to a business and can help you choose the suitable modules and settings for your company.
Ultimately, you’ll have an ERP perfectly suited to helping you run your business more efficiently.
When capitalizing variances, ensure the process is well thought through to avoid creating more confusion
When capitalizing variances, it is crucial to ensure that the process is well thought through to avoid confusion. Capitalizing variances can be complex.
Not being done carefully can result in more confusion and frustration than necessary. When capitalizing variances, be sure to consider the following:
The purpose of the variance: Why is the variance being created? What is its purpose?
The impact of the variance: How will the variance impact other areas of the business? Will it have a positive or negative effect?
The timing of the variance: When will the variance take effect? Is there a specific timeframe that needs to be considered?
By carefully considering these factors, you can ensure that capitalizing variances does not create more confusion than it solves.
Having an expert cost accountant on staff de-risks the capitalized variance process
Many potential risks are associated with the capitalized variance process, but having an expert cost accountant on staff can help mitigate these risks. For example, an expert cost accountant can ensure that all relevant data is captured and properly analyzed, helping to prevent errors and omissions.
An expert cost accountant can also provide valuable insights into trends and variances, allowing management to make more informed pricing and other strategic decisions. Ultimately, having an expert cost accountant on staff provides peace of mind and helps to protect your bottom line.
Capitalization of Manufacturing Standard Cost Variances- Recommended Reading
1.3 Inventory costing – Viewpoint – PwC
Inventory accounting: IFRS® Standards vs US GAAP