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Capitalization of manufacturing variances

Capitalization of Manufacturing VariancesWhat 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 certain 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)? Thanks for your help!

Answers

Chris Holtzer
Title: Senior Manager - Strategic Analysis
Company: Sargento
(Senior Manager - Strategic Analysis, Sargento) |

I am not fully sure I understand your question, but I'll attempt to answer based on my interpretation.

Variances should be reported in your financial package on your income statement (P&L) as part of your COGS. They should be recognized as they occur.

Variances also impact your balance sheet because your inventory is typically based on a frozen standard cost which does not account for variances. Most companies have a schedule of when they make inventory valuation adjustments. Your inventory policies are going to effect how and when you adjust. You will need to make an adjustment to essentially roll your variance into your standards for proper valuation.

The part of your question that has me a little confused is what you mean by "Capitalize" a variance. Typically when someone talks about capitalizing, I assume they are speaking of a fixed assets. The deprecation for that asset could be a mfg variance, but that is handled the same way as all mfg variances. Your depreciation policy will determine how the expense is allocated, and over what period of time.

Can you provide a more specific example?

Deanna Miller
Title: Chief Financial Officer
Company: Professional Plumbing Group
(Chief Financial Officer, Professional Plumbing Group) |

Standard cost is not an acceptable GAAP costing method, but it is used by many companies to analyze actual costs and performance. As a result, the variances have to be adjusted on the balance sheet and income statement in order to approximate the GAAP costing method officially adopted by the company. As a result, while you will put most variances into inventory initially, how you amortize them needs to fit that principle.

There are two instances where you would adjust the "normal" practice of amortizing variances from the balance sheet into the income statement (COGS). The first is when your costs are running in excess of realizable value. In that case you may not be able to "capitalize" any unfavorable variances in order to stay under the lower of cost or market rules. The second is when you have a significant unusual and costly event in your manufacturing - an extended shutdown due to operational issues or market events were our most common. I don't know what the new codification number is because we still refer to these variances as "FAS 151 variances." Those unusual spike costs are required to be expensed immediately.

Topic Expert
Bob Scarborough
Title: CEO
Company: Tensoft, Inc.
(CEO, Tensoft, Inc.) |

Inventory cost variances can occur with standard costing as well as actual costing methods. Some variances occur due to inventory velocity (the inventory has been received, valued, and moved prior to the vendor payable for example), some are due to the variance from planned inventory value, some are due to actions taken related to inventory (such as rework), and some can be due to re-valuation. You can add others - such as currency revaluation variance - but I believe those four categories cover the majority of scenarios.

Each variance category is different in its treatment for P&L and balance sheet purposes. The goals around timing the move of variances to the P&L are to minimize risk related to inventory value manipulation (possible with standard cost) and to optimize the match for COGS (actual revenue, actual COGS). Reality is more complicated than theory with inventory - so general rules are usually worked out with your auditors.

Some general rules related to variance categories:
1) PPV Variances. These can occur in any inventory model. Some people distinguish between PPV Purchase (the difference between the PO price and the standard cost - an operations decision) and PPV Invoice (the difference between the PO and what the vendor invoices you - an evaluation of your procurement processes). Both of these variances are usually considered part of the inventory actual cost - so they are often capitalized and moved to the P&L as inventory is sold. The most common model - if you have the data to support it - is to amortize these variances to the P&L based on your inventory turn days.
2) Process Variances. These occur when goods are reworked or when your BOM includes costs that are not actually occurred for the goods production (such as an alternative quality process that is included at times). From an inventory value perspective these types of transactions do not add value to the resulting inventory - so they are usually treated as period expenses.
3) Yield or Scrap Variances. These occur with deviation from plan (standard cost) and in actual costing systems as well. They are also usually treated as part of actual inventory cost (since there is manipulation risk here) and are treated the same as the PPV variances.
4) Revaluation of inventory is more complex in its treatment - and it is different from a pure purchase or manufacturing variance. In general a write down is taken as a period P&L expense, while a write up is amortized over inventory turns. However if you have very volatile inventory valuation (say you are selling computer memory) you may have revaluation both ways that occurs so often it is always a period expense. Or say you use something in your manufacturing process like gold that has an independent value you will have separate potential rules for that.

Bob Scarborough

Anonymous
(Sr. Manager Financial Planning) |

Thanks Bob, Deanna, & Chris!

Anonymous
(Executive Advisor) |

What's a simple example of how to amortize a variance using inventory turns data? Thank you for further help here.

Prabhakar BV
Title: Finance Manager
Company: PETROLEUM COKE INDUSTRIES CO.
(Finance Manager , PETROLEUM COKE INDUSTRIES CO. ) |

Thanks Bob, what would be the treatment of Overhead variances? Usually actual overheads like maintenance, labor costs, etc. deviate from the standard/budget and so when you follow standard costing system, how would you treat these variances?

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