Understanding Business Accounting For Dummies, 2nd Edition (93 page)

In this example the business manufactured 120,000 units and sold 110,000 units during the year. As just computed, its product cost per unit is £760.The 110,000 total units sold during the year is multiplied by the £760 product cost to compute the £83,600,000 cost of goods sold expense, which is deducted against the company's revenue from selling 110,000 units during the year. The company's total manufacturing costs for the year were £91,200,000, which is £7,600,000 more than the cost of goods sold expense. This remainder of the total annual manufacturing costs is recorded as an increase in the company's stock asset account, to recognise the 10,000 units increase of units awaiting sale in the future. In Figure 12-2, note that the £760 product cost per unit is applied both to the 110,000 units sold and to the 10,000 units added to stock.

Note:
As just mentioned, most manufacturers determine their product costs monthly or quarterly rather than once a year (as in the example). Product costs likely will vary each successive period the costs are determined. Because the product costs vary from period to period, the business must choose which cost of goods sold and stock cost method to use - unless product cost remains absolutely flat and constant period to period, in which case the different methods yield the same results. Chapter 13 explains the alternative accounting methods for determining cost of goods sold expense and stock cost value.

Fixed manufacturing costs and production capacity

Product cost consists of two very distinct components:
variable manufacturing costs
and
fixed manufacturing costs
. In Figure 12-2 note that the company's variable manufacturing costs are £410 per unit, and that its fixed manufacturing costs are £350 per unit. Now, what if the business had manufactured just one more unit? Its total variable manufacturing costs would have been £410 higher; these costs are driven by the actual number of units produced, so even one more unit would have caused the variable costs to increase. But, the company's total fixed costs would have been the same if it had produced one more unit, or 10,000 more units for that matter. Variable manufacturing costs are bought on a per unit basis, as it were, whereas fixed manufacturing costs are bought in bulk for the whole period.

Fixed manufacturing costs are needed to provide
production capacity
- the people and physical resources needed to manufacture products - for the period. Once the business has the production plant and people in place for the year, its fixed manufacturing costs cannot be easily scaled down. The business is stuck with these costs over the short run. It has to make the best use it can from its production capacity.

Production capacity is a critical concept for business managers to grasp. You need to plan your production capacity well ahead of time because you need plenty of lead time to assemble the right people, equipment, land, and buildings. When you have the necessary production capacity in place, you want to make sure that you're making optimal use of that capacity. The fixed costs of production capacity remain the same even as production output increases or decreases, so you may as well make optimal use of the capacity provided by those fixed costs.

The fixed cost component of product cost is called the
burden rate
. In our manufacturing example the burden rate is computed as follows (see Figure 12-2 for data):

£42.0 million total fixed manufacturing costs for period ÷ 120,000 units production output for period = £350 burden rate


Note that the burden rate depends on the number divided into total fixed manufacturing costs for the period; that is, the production output for the period. Now, here's a very important twist on our example: Suppose the company had manufactured only 110,000 units during the period - equal exactly to the quantity sold during the year. Its variable manufacturing cost per unit would have been the same, or £410 per unit. But, its burden rate would have been £381.82 per unit (computed by dividing the £42 million total fixed manufacturing costs by the 110,000 units production output). Each unit sold, therefore, would have cost £31.82 more simply because the company produced fewer units (£381.82 burden rate at the 110,000 output level compared with the £350 burden rate at the 120,000 output level).

In this alternative scenario (in which only 110,000 units were produced), the company's product cost would have been £791.82 (£410 variable costs plus the £381.82 burden rate). The company's cost of goods sold, therefore, would have been £3,500,000 higher for the year (£31.82 higher product cost × 110,000 units sold). This rather significant increase in its cost of goods sold expense is caused by the company producing fewer units, although it did produce all the units that it needed for sales during the year. The same total amount of fixed manufacturing costs would be spread over fewer units of production output.

Shifting the focus back to the example shown in Figure 12-2, the company's cost of goods sold benefited from the fact that it produced 10,000 more units than it sold during the year - these 10,000 units absorbed £3.5 million of its total fixed manufacturing costs for the year, and until the units are sold, this £3.5 million stays in the stock asset account. It's entirely possible that the higher production level was justified - to have more stock on hand for sales growth next year. But, production output can get out of hand - see the following section, ‘Excessive production output for puffing up profit'.

Managers (and investors as well) should understand the stock increase effect caused by manufacturing more units than are sold during the year. In the example shown in Figure 12-2, cost of goods sold expense escaped from £3.5 million of fixed manufacturing costs because the company produced 10,000 more units than it sold during the year, thus pushing down the burden rate. The company's cost of goods sold expense would have been £3.5 million higher if it had produced just the number of units it sold during the year. The lower output level would have increased cost of goods sold expense, and would have caused a £3.5 million drop in gross margin and earnings before income tax. Indeed, earnings before income tax would have been 27 per cent lower (£3.5 million ÷ £13.2 million = 27 per cent decrease).

For the example illustrated in Figure 12-2, the business's production capacity for the year is 150,000 units. However, this business produced only 120,000 units during the year, which is 30,000 units fewer than it could have produced. In other words, it operated at 80 per cent of production capacity, which is 20 per cent
idle capacity
(which isn't unusual):

120,000 units output ÷ 150,000 units capacity = 80% utilisation


Running at 80 per cent of production capacity, this business's burden rate for the year is £350 per unit (£42 million total fixed manufacturing costs ÷ 120,000 units output). The burden rate would have been higher if the company had produced, say, only 110,000 units during the year. The burden rate, in other words, is sensitive to the number of units produced. This can lead to all kinds of mischief, as explained next.

Excessive production output for puffing up profit

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 stock 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). The burden rate is included in product cost, which means that this cost component goes into stock and is held there until the products are sold later. In short, when you overproduce, more of your fixed manufacturing costs for the period are moved to the stock asset account and less are moved into cost of goods sold expense, which is based on the number of units sold.

You need to judge whether a stock 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 stock becomes cost of goods sold expense - at which point the cost subtracts from the bottom line.