I often see that indirect costs that are incurred in the production of inventory are not capitalized, especially with smaller companies. Direct labor costs may be captured in the inventory valuation but not always indirect costs. So, what are indirect costs? Indirect costs (or “overhead”) include such items as:
- Building/factory rent
- Supervisory payroll
- Payroll taxes and benefits associated with production personnel
- Shop supplies
The nature of each business will impact what indirect costs are applicable for capitalization.
Accounting Standards do not allow for all overhead to be excluded from inventory. To have financial statements in accordance with U.S. GAAP, an organization should determine a way to properly capture these costs within inventory. If a formal system is not maintained, the simplest way to account for inventory overhead is to perform an allocation at each period-end. This can be done by determining what the overhead cost pool is for the period and dividing this by the number of units that are produced during that period. This rate per unit is then multiplied by the number of units in inventory at the end of the period to determine how much overhead should be capitalized into inventory.
However, this approach is not a “one size fits all” approach for each company. Overhead could be based upon the number of hours that are incurred for the period, which is then applied to the number of hours that are in inventory at the end of the period. Determination of the best approach for calculating a period-end inventory overhead amount will need to be carefully considered on a company-by-company basis. Furthermore, this approach may need to be modified as the operations of the business change.
A more robust approach for accounting for inventory overhead is to determine an overhead or burden rate that is applied directly to the cost of production for a unit. This is determined by reviewing the overhead cost pool over a period of time and coming up with a specific rate that is captured in the inventory costing records during production of a unit. Often, I have seen these based upon labor hours. For example, if the total overhead cost pool has historically calculated to be $55 per direct labor hour incurred, the cost of a piece of inventory will be increased by $55 for each direct labor hour that is incurred in the production of the product. This information is usually accounted for in the company’s ERP software, where the inventory value is increased by the capitalized overhead amount, while a related offset to overhead expenses is captured at the same time. This will follow the same approach that direct labor costs are included in the cost for inventory production. Ultimately, these costs are captured within costs of goods sold as the inventory is sold.
In summary, the value of inventory on the balance sheet and cost of goods sold on the income statement must include indirect costs to be in conformity with U.S. GAAP. The manner of capturing these and getting there can be a little tricky, however.
Jonathan Poppel, CPA