Benefits of In Store Automation
The retail business runs on wafer thin margins. As a result, every additional dollar that the store is able to generate in sales or save by reducing costs matters to the bottom line. It is for this reason that retail stores across the world have felt the need to automate their in-store operations. Retail automation […]
What is Accounting? – Meaning and Important Concepts
Accounting has been hailed by many as the “language of business”. There are many quotations like “A pen is mightier than the sword but no match for the accountant” by Jonathan Glancey which tell us about the power and importance of accounting. The text book definition of accounting states that it includes recording, summarizing, reporting […]
Behavioral Life Cycle Theory
There have been many economic theories developed in order to understand how and why human beings save and spend their resources. Up until now, most of these theories have been developed based on the principles of theoretical finance. The first theory to be put up in this regard was developed by Modigliani in the year […]
Income Approach to Valuation of Sports Franchises
From the previous articles, we now know that sports franchises across the world are now being viewed as commercial entities. Hence, it is vital to derive the correct valuation for them in order to ensure that buy and sell as well as restructuring transactions can take place at the correct valuation. However, we also know […]
Investment Banking and Special Purpose Acquisition Companies (SPACs)
Special Purpose Acquisition Companies (SPAC) have become all the rage in the investment banking industry. They are not a new concept. They have been around for quite some time. However, they have become quite popular in the recent past. For instance, in the first half of 2020, $13.5 billion dollars were raised by Special Purpose […]
The relationship between when cash is spent and when it is recognized as an expense is fairly complex in job order costing. Costs flow through the inventory accounts and finally become an expense when the sale is complete. This relationship and the complexities that arise have been tracked in this article.
To understand this relationship better we have to take a back track to financial accounting. There, we defined the difference between an outlay and expenditure. An outlay is when resources are utilized whereas expenditure is defined as a loss of value. Hence, when a firm spends money to create inventory it is not an expense. It is an outlay of cash. Cash has changed form and is now another asset called inventory. There is no loss of value, instead there is only transfer of value.
Also, in the previous article, we defined the types of costs that are likely to be incurred in a job costing scenario. They were direct materials, direct labor, manufacturing and non-manufacturing overhead. We classified non-manufacturing overhead as period costs and all others as product costs.
When costs are incurred one of the two things happen depending upon the type of costs. If the cost is product related, we add it to the inventory. This cost is not recognized as an expense until the sale is complete and loss of value has occurred. On the other hand, when it comes to period costs, they are expensed immediately because they have no cause and effect relationship with production.
It is important because the treatment of two costs is very different. When direct materials are purchased, they are directly allocated to their respective jobs. Same is the case with manufacturing related overhead and direct labor. They can be seen immediately in the job cost sheet. On the financial statements, they are considered as inventory. Inventory shows up under assets and not under the expense column.
The problem does not end there. Firms have to carefully calculate the breakup of inventory. Inventory is a big account with 4 sub accounts viz. raw material, work in progress, cost of goods manufactured and cost of goods sold. Companies need to carefully check the manufacturing overheads to ensure that they are not overstating or understating the value of any of these assets.
Once again, companies follow subjective treatments while allocating costs to separate sub inventory accounts. The amount of manufacturing overhead that is actually spent on work in progress cannot be precisely known. Accountants make estimates stating that relative proportions that they think have been spent on work in progress.
From an examination point of view, calculating the values of WIP, raw materials and finished goods may not be such a hassle since the percentage allocations are already given. However, in reality, determining these percentage allocations is a tough task that needs a lot of expertise and experience.
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