Accounting For Dummies, 4th edition
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240 Part III: Accounting in Managing a Business
Puffing Profit by Excessive Production
Whenever production output is higher than sales volume, be on guard. Excessive production can puff up the profit figure. How? Until a product is sold, the product cost goes in the inventory asset account rather than the cost of goods sold expense account, meaning that the product cost is counted as a positive number (an asset) rather than a negative number (an expense). Fixed manufacturing overhead cost is included in product cost, which means that this cost component goes into inventory and is held there until the products are sold later. In short, when you overproduce, more of your total of fixed manufacturing costs for the period is moved to the inventory asset account and less is moved into cost of goods sold expense for the year.
You need to judge whether an inventory increase is justified. Be aware that an unjustified increase may be evidence of profit manipulation or just good old-fashioned management bungling. Either way, the day of reckoning will come when the products are sold and the cost of inventory becomes cost of goods sold expense — at which point the cost impacts the bottom line.
Shifting fixed manufacturing costs to the future
The business represented in Figure 11-1 manufactured 10,000 more units than it sold during the year. With variable manufacturing costs at $410 per unit, the business expended $4.1 million more in variable manufacturing costs than it would have if it had produced only the 110,000 units needed for its sales volume. In other words, if the business had produced 10,000 fewer units, its variable manufacturing costs would have been $4.1 million less — that’s the nature of variable costs. In contrast, if the company had manufactured 10,000 fewer units, its fixed manufacturing costs would not have been any less — that’s the nature of fixed costs.
Of its $42 million total fixed manufacturing costs for the year, only $38.5 million ended up in the cost of goods sold expense for the year ($350 burden rate × 110,000 units sold). The other $3.5 million ended up in the inventory asset account ($350 burden rate × 10,000 units inventory increase). The $3.5 million of fixed manufacturing costs that are absorbed by inventory is shifted to the future. This amount will not be expensed (charged to cost of goods sold expense) until the products are sold sometime in the future.
Shifting part of the fixed manufacturing cost for the year to the future may seem to be accounting slight of hand. It has been argued that the entire amount of fixed manufacturing costs should be expensed in the year that
Chapter 11: Cost Concepts and Conundrums 241
these costs are recorded. (Only variable manufacturing costs would be included in product cost for units going into the increase in inventory.) Generally accepted accounting principles require that full product cost (variable plus fixed manufacturing costs) be used for recording an increase in inventory. However, as the example in Figure 11-1 shows, producing more than you sell does boost profit.
Let me be very clear here: I’m not suggesting any hanky-panky in the example shown in Figure 11-1. Producing 10,000 more units than sales volume during the year looks — on the face of it — to be reasonable and not out of the ordinary. Yet at the same time, it is naïve to ignore that the business did help its pretax profit to the amount of $3.5 million by producing 10,000 more units than it sold. If the business had produced only 110,000 units, equal to its sales volume for the year, all its fixed manufacturing costs for the year would have gone into cost of goods sold expense. The expense would have been $3.5 million higher, and EBIT would have been that much lower.
Cranking up production output
Now let’s consider a more suspicious example. Suppose that the business manufactured 150,000 units during the year and increased its inventory by 40,000 units. It may be a legitimate move if the business is anticipating a big jump in sales next year. On the other hand, an inventory increase of 40,000 units in a year in which only 110,000 units were sold may be the result of a serious overproduction mistake, and the larger inventory may not be needed next year. In any case, Figure 11-2 shows what happens to production costs and — more importantly — what happens to the profit lines at the higher production output level.
The additional 30,000 units (over and above the 120,000 units manufactured by the business in the original example) cost $410 per unit. (The precise cost may be a little higher than $410 per unit because as you start crowding production capacity, some variable costs per unit may increase a little.) The business would need $12.3 million more for the additional 30,000 units of production output:
$410 variable manufacturing cost per unit × 30,000 additional units produced = $12,300,000 additional variable manufacturing costs invested in inventory
Again, its fixed manufacturing costs would not have increased, given the nature of fixed costs. Fixed costs stay put until capacity is increased. Sales volume, in this scenario, also remains the same.
242 Part III: Accounting in Managing a Business
Figure 11-2:
Example in which production output greatly exceeds sales volume for the year, thereby boosting profit for the period.
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Income Statement for Year |
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Sales volume |
110,000 |
units |
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Per Unit |
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Totals |
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Sales revenue |
$1,400 |
$154,000,000 |
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Cost of goods sold expense |
(690) |
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(75,900,000) |
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Gross margin |
$710 |
$78,100,000 |
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Variable operating expenses |
(300) |
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(33,000,000) |
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Margin |
$410 |
$45,100,000 |
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Fixed operating expenses |
(195) |
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(21,450,000) |
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Earnings before interest and income tax (EBIT) |
$215 |
$23,650,000 |
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Interest expense |
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(2,750,000) |
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Earnings before income tax |
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$20,900,000 |
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Income tax expense |
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(7,106,000) |
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Net income |
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$13,794,000 |
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Manufacturing Costs for Year |
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Production capacity |
150,000 |
units |
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Actual output |
150,000 |
units |
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Production Cost Components |
Per Unit |
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Totals |
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Raw materials |
$215 |
$32,250,000 |
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Direct labor |
125 |
18,750,000 |
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Variable manufacturing overhead costs |
70 |
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10,500,000 |
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Total variable manufacturing costs |
$410 |
$61,500,000 |
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Fixed manufacturing overhead costs |
280 |
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42,000,000 |
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Total manufacturing costs |
$690 |
$103,500,000 |
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To 40,000 units inventory increase |
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(27,600,000) |
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To 110,000 units sold |
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$75,900,000 |
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But check out the business’s EBIT in Figure 11-2: $23.65 million, compared with $15.95 million in Figure 11-1 — a $7.7 million higher amount, even though sales volume, sales prices, and operating costs all remain the same. Whoa! What’s going on here? The simple answer is that the cost of goods sold expense is $7.7 million less than before. But how can cost of goods sold expense be less? The business sells 110,000 units in both scenarios. And variable manufacturing costs are $410 per unit in both cases.
Chapter 11: Cost Concepts and Conundrums 243
The culprit is the burden rate component of product cost. In the Figure 11-1 example, total fixed manufacturing costs are spread over 120,000 units of output, giving a $350 burden rate per unit. In the Figure 11-2 example, total fixed manufacturing costs are spread over 150,000 units of output, giving a much lower $280 burden rate, or $70 per unit less. The $70 lower burden rate multiplied by the 110,000 units sold results in a $7.7 million lower cost of goods sold expense for the period, a higher pretax profit of the same amount, and a much improved bottom-line net income.
Being careful when production output is out of kilter with sales volume
In the example shown in Figure 11-2, the business produced 150,000 units (full capacity); therefore, its inventory asset absorbed $7.7 million of the company’s fixed manufacturing costs for the year, and its cost of goods sold expense for the year escaped this cost. But get this: Its inventory increased 40,000 units, which is quite a large increase compared with the annual sales of 110,000 during the year just ended. Who was responsible for the decision to go full blast and produce up to production capacity? Do the managers really expect sales to jump up enough next year to justify the much larger inventory level? If they prove to be right, they’ll look brilliant. But if the output level was a mistake and sales do not go up next year . . . they’ll have you-know-what to pay next year, even though profit looks good this year. An experienced business manager knows to be on guard when inventory takes such a big jump.
Summing up, the cost of goods sold expense of a manufacturer, and thus its operating profit, is sensitive to a difference between its sales volume and production output during the year. Manufacturing businesses do not generally discuss or explain in their external financial reports to creditors and owners why production output is different than sales volume for the year. Financial report readers are pretty much on their own in interpreting the reasons for and the effects of underor over-producing products relative to actual sales volume for the year. All I can tell you is to keep alert and keep in mind the profit impact caused by a major disparity between a manufacturer’s production output and sale levels for the year.
244 Part III: Accounting in Managing a Business
Part IV
Preparing and
Using Financial
Reports
In this part . . .
Financial reports are like newspaper articles. A lot of activity goes on behind the scenes that you may not
be aware of. In reading a financial report, you see only the finished product. Chapter 12 gives the inside story of how financial reports are put together.
Outside investors in a business — the owners who are not on the inside managing the business — depend on its financial reports as their main source of information. Chapter 13 explains financial statement ratios that investors use for interpreting profit performance and financial condition. Serious investors must know these ratios.
The financial report is the end of the line for the outside investors and lenders of a business. They can’t call the business and ask for more information. But the financial statements are just the starting point for the managers of the business. Chapter 14 explains the more detailed and highly confidential accounting information they need for identifying problems and opportunities.
Chapter 15 explains the reasons for audits of financial reports by independent CPAs. Investors and lenders definitely should read the auditor’s report, which is explained in this chapter. The chapter also discusses the ugly topic of accounting fraud. Unfortunately, some businesses resort to accounting fraud, which is not only unethical but illegal.
Chapter 12
Getting a Financial Report
Ready for Release
In This Chapter
Keeping up-to-date on accounting and financial reporting standards
Assuring that disclosure is adequate
Nudging the numbers to make things look better
Comparing private and public businesses
Dealing with financial reports’ information overload
Looking at changes in owners’ equity
In Chapters 4, 5, and 6, I explain the three primary financial statements of a business:
Income statement: Summarizes sales revenue and other income (if any) and expenses and losses (if any) for the period. It ends with the bottomline profit for the period, which most commonly is called net income or net earnings. (Inside a business this profit performance statement is commonly called the Profit & Loss, or P&L, report.)
Balance sheet: Summarizes financial condition at the end of the period, consisting of amounts for assets, liabilities, and owners’ equity at that instant in time. (Its more formal name is the statement of financial condition.)
Statement of cash flows: Reports the cash increase or decrease during the period from profit-making activities (revenue and expenses) and the reasons this key figure is different than bottom-line net income. It also summarizes other cash flows during the period from investing and financing activities.
These three statements, plus the footnotes to the financials and other content, are packaged into annual financial reports so a business’s investors, lenders, and other interested parties can keep tabs on the business’s financial health. In this chapter, I shine a light on the preparation process so you can recognize the types of decisions that must be made before a financial report hits the streets.
248 Part IV: Preparing and Using Financial Reports
Recognizing Management’s Role
Whether a business is a small private company or a large public corporation, its annual financial report consists of
The three basic financial statements: income statement, balance sheet, and statement of cash flows.
A statement of changes in owners’ equity (if needed). Although it’s called a “statement,” this item is more properly described as a supplementary schedule. It reports certain information regarding changes in owners’ equity accounts during the year that is not included in its three primary financial statements. (See “Statement of Changes in Owners’ Equity” later in the chapter.)
And more.
In deciding what “more” means, the business’s CEO and top lieutenants play an essential role — which they (and outside investors and lenders) should understand. The CEO does certain critical things before a financial report is released to the outside world:
1.Confers with the company’s chief financial officer and controller (chief accountant) to make sure that the latest accounting and financial reporting standards and requirements have been applied in its financial report. (The president of a smaller private company may have to consult with a CPA on these matters.) In recent years, we’ve seen a high degree of flux in accounting and financial reporting standards and requirements. The private sector Financial Accounting Standards Board (FASB) and the governmental regulatory agency, the Securities and Exchange Commission (SEC), have been very busy in recent years — to say nothing of the federal Sarbanes-Oxley Act of 2002 and the creation of the Public Company Accounting Oversight Board.
A business and its auditors cannot simply assume that the accounting methods and financial reporting practices that have been used for many years are still correct and adequate. A business must check carefully whether it is in full compliance with current accounting standards and financial reporting requirements.
2.Carefully reviews the disclosures in the financial report. The CEO and financial officers of the business must make sure that the disclosures — all information other than the financial statements — are adequate according to financial reporting standards, and that all the disclosure elements are truthful but, at the same time, not damaging to the business.
Chapter 12: Getting a Financial Report Ready for Release 249
This disclosure review can be compared with the notion of due diligence, which is done to make certain that all relevant information is collected, that the information is accurate and reliable, and that all relevant requirements and regulations are being complied with. This step is especially important for public corporations whose securities (stock shares and debt instruments) are traded on securities exchanges. Public businesses fall under the jurisdiction of federal securities laws, which require very technical and detailed filings with the SEC.
3.Considers whether the financial statement numbers need touching up. The idea here is to smooth the jagged edges off the company’s year- to-year profit gyrations or to improve the business’s short-term solvency picture. Although this can be described as putting your thumb on the scale, you can also argue that sometimes the scale is a little out of balance to begin with and the CEO should approve adjusting the financial statements in order to make them jibe better with the normal circumstances of the business.
When I discuss the third step later in this chapter, I’m venturing into a gray area that accountants don’t much like to talk about. Some topics are, shall I say, rather delicate. The manager has to strike a balance between the interests of the business on the one hand and the interests of the owners (investors) and creditors of the business on the other. The best analogy I can think of is the advertising done by a business. Advertising should be truthful, but, as I’m sure you know, businesses have a lot of leeway regarding how to advertise their products and have been known to engage in hyperbole. Managers exercise the same freedoms in putting together their financial reports. Financial reports may have some hype, and managers may put as much positive spin on bad news as possible without making deceitful and deliberately misleading comments.
Keeping in Mind the Purpose
of Financial Reporting
Business managers, creditors, and investors read financial reports because these reports provide information regarding how the business is doing and where it stands financially. Indeed, these accounting reports are the only source of this information! The top-level managers of a business, in reviewing the annual financial report before releasing it outside the business, should keep in mind that a financial report is designed to answer certain basic financial questions:
Is the business making a profit or suffering a loss, and how much?
How do assets stack up against liabilities?
Where did the business get its capital, and is it making good use of the money?