Cookie Jar Reserves

In my last post I talked about a manufacturing company that had been using the direct costing method for valuing their inventory for many years and my conversation with the CFO concerning the effects on overall profitability by converting to the full absorption method of accounting.

The CFO prepared a simplified model of what would happen to profitability compared to full absorption costing in several dramatic scenarios. In one case, he presumed there were no sales whatsoever, just a buildup of inventory. In the other case, he presumed there was no increase in inventory, only sales. He compared the results of the direct costing method to those under a full absorption costing method. As you can assume, the results were dramatically different, resulting in less profit when implementing the direct costing method.

It then occurred why the management team was so interested in maintaining the direct costing method when it clearly is disallowed for both GAAP and federal income tax purposes.

Cookie Jar ReserveMy first thought was it may be a method of managing taxable income. However, I quickly realized that if the returns are being prepared by an outside accounting firm, they are very likely making modifications on the tax return to portion an appropriate amount of overhead both under Code sections 471 and 263A. So that is not likely to be the motivation.

Then the thought occurred to me that perhaps the management team is using this inventory valuation method as some type of a cookie jar. Meaning they are trying to build up a reserve in anticipation of something happening in the future to unexpectedly decrease profits. Something, such as, an adjustment required by the outside accounting firm to more correctly state accrued expense by dramatically increasing that accrual.

Years ago I was with a group of CFOs who were discussing that very circumstance and all had developed some sort of profit reserve accrual someplace on the balance sheet which had the sole purpose of being used if the outside accountants required some kind of an unexpected adjustment to reduce profits. Rather than let pre-tax book income be adjusted downward, the CFO would simply go to his cookie jar, reverse some of his excess accruals and bring profits right back to where they were pre-outside accountant required accruals. The goal of all of this, of course, is to eliminate any negative effects felt by stakeholders caused by a downward profit adjustment. For example, reductions in bonuses, problems with outside bankers or shareholders, or perhaps suppliers, who have been relying on a certain level of profitability as developed throughout the years.

At the time, I believed experienced CFOs who had lived through an event that unexpectedly reduced profits, soon learned to build up their own reserves as protection against some such future unexpected event.

However, the ability to use such reserves is dependent upon the nature of the accrual. Changes in accounting principles or corrections of an error are required to be spread over the number of years presented with the year-end financial statements and all are not permitted to be run through the most current year. However, change in accounting estimates can all generally be taken through one year. This is in accordance with GAAP rules today.

Direct costing of inventory is an accounting principle. Since the adjustment would have to be spread out over a number of years, attempting to use it as a cookie jar could result in unexpected effects on profitability. In general, the adjustment for the current year would not directly offset an accrual required by the outside accountants. However, changes in an accounting estimate, such as an accrual for warranty reserves or perhaps an accrual for bad debts, is permitted all in one year. This would be an appropriate area for a CFO looking to build a cookie jar. Cookie jars are a form of “creative accounting” and although I am sure not everyone uses them, I want to point out as a prudent CPA, I do not advocate their utilization.

The point is that a change in your inventory method or the use of an inventory method to create a cookie jar would be ineffective and, depending on the scenario, perhaps damaging as a reserve for a future negative profit adjustment.

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Who Said You Had To Put Overhead In Inventory

I had some communication recently with a CFO who was working for a company that for a long period of time valued their inventory using the direct costing method. By using this method, the company had excluded any overhead from the inventory values and was only using direct material and direct labor costs to value the inventory.

The CFO knew this was not in compliance with the rules, but he was really more interested in the logic behind the requiring of overhead in inventory for book and tax purposes.

It is important to remember that direct costing is a disallowed method for both GAAP purposes and federal tax purposes. The only method of valuing inventory, permissible by both, is full absorption costing. With the additional factor that current tax law requires even more overhead to be added into inventory under Code section 263A. Even further, for a business that is on LIFO, the use of direct cost for inventory valuation could be considered as a false representation of the true cost. Therefore, putting the LIFO election at risk.

overheadAs we discussed the issues surrounding direct cost, we decided that a possible way to demonstrate the effects of direct cost would be to provide a radical example of the effects on profitability and inventory if there were no sales, only a buildup of inventory. Or the reverse, if there was no buildup of inventory, only sales. The CFO managed to put together a great presentation of what the effects on profitability would in those two scenarios. I’m sure you can imagine there were dramatic effects on growth margin and overall profitability between absorption costing and direct costing.

The discussions with management following the presentation revolved around the fact that they were comfortable doing what they had always done. Even more surprising to me, the outside accountants, who were preparing financial statements and tax returns for the company, were also comfortable in allowing them to continue to use the direct costing method. The CFO’s conclusion was that although he knew full absorption costing was the proper method, he felt the current state of affairs would continue to stand as they had for years.

He further recognized that the comparability of his data to others in his industry, particularly as it related to ratios and gross margins, would likely be skewed. This of course was due to his inventory values being grossly understated compared to those of his competitors. Further, he understood that radical changes in the levels of his inventory from one year to the other could dramatically affect his profitability because of the lack of overhead being included in with the inventory.

As I thought more about this scenario, it occurred to me that the management team was possibly using this as a method to reduce earnings which therefore reduced taxable income, and, as a result a tax deferral.

However, since the outside accountants knew about the direct costing issue, it was likely they were preparing the tax returns in strict accordance with code section 471 and 263A. Meaning they were adding appropriate amounts of overhead to the inventory in spite of the fact that the books were on the direct costing method. This would effectively override management’s intention to minimize their taxable income by using this lower method of valuing inventory.

If that is indeed what was happening, then I believe the outside accountants are following the strict interpretation of the law. This will benefit the company when it comes to an audit, but it may be unintentionally overriding one of their profit control devices.

Another possible concept  is the creation of a cookie jar, which could be beneficial sometime in the future. More to come regarding this theory with my next blog post on Monday. Stay tuned. . .

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Is Standard Costing Outdated?

Have you ever walked into an outdated home or business and think you just did a time-warp back to 1976? The shag carpet, the deep brown color, and the kitchen with its orange flowers make you want to put on a pair of tight bell bottom jeans. I’m sure most you are getting the picture. It seems that many of the once outdated fads always end up becoming popular again.

Some people say standard costing is outdated due to alternative contemporary methods. My personal experience does not agree with this statement. At least 80% of all those clients and prospects I encounter are currently using standard cost. A few years ago the Institute for Management Accountants (IMA) completed a survey, which resulted in a staggering 86% using standard cost.

OutdatedThose individuals I have worked with who use standard cost do so because it is used specifically to value inventory. If your organization utilizes this method to value your inventory, why not utilize it for your entire costing system? It also provides variance reporting. Some managers prefer to manage with variances. This can be very valuable information if reported in the correct manner and time. Others use it for the simple reason that they always have and it is understandable. Many of the new costing systems are very complicated and lack transparency which can cause a significant problem.

Whatever costing system you utilize, make sure it is reasonable, provides timely information, and is transparent. If you have those elements then you are on the right track. If standard costing is outdated then just about everyone is outdated for continuing its implementation.

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Your Manufacturing Standards And Costs: To Change Or Not To Change?

One re-occurring topic at our cost forums and other seminars involves the frequency in which standards and costs should be changed.

I believe this is really a two-part question. The first part should be, without any radical changes in cost or activities, how frequently should you schedule standard cost revisions? The general rule of thumb is annually. I usually suggest that businesses go through their budgeting process in the fourth quarter of the old year, to determine expectations for activity levels and costs. As those are approved by senior management and then implemented, it provides the foundation to do a standard cost revision. This revision usually takes place in the latter part of the fourth quarter of the old year, or sometimes very early in the first quarter of the new year.

Further, it’s my recommendation that cost managers keep an open file relative to issues or problems they see with standards or costs throughout the year. This offers pertinent information in an organized fashion, so that part of the annual cost revision process can be to review those issues that are most problematic and create difficulty during the old year.

That’s not to say the only issues that require change are those that create the most difficulty during the year, but they certainly are high on the priority list. I believe the entire standard cost process should be reviewed and changes made as standards cost rates are adjusted due to changing conditions.

changeHowever, there is also a second part to this question, which has to do with costs or standards that have changed due to radically changing conditions. This could relate either to material costs that are fluctuating because of market conditions related to a raw material that is dramatically driving prices up or down. Or, it could relate to operating standards that have been radically affected because of a change in operations, new equipment, or other fundamental changes that affect the output of a manufacturing process, whether it be greater or lower output.

My general advice on that subject is that if rapidly changing prices or standards change modestly, even if frequently, those can likely be held off until the end of the year. However, as standards or costs change more than 30% up or down from the previous standard cost, I believe those modifications should be made on the fly during the year to provide accurate guidance for management.

Fluctuating prices or standards will be reflected in positive or negative variances, which generally should be manageable, and thoroughly analyzed to gain a good understanding of what the effects of these modestly changing prices are doing to the total cost of the product. However, radically changing prices in large amounts should be revised as they change to avoid large variances and to properly cost the product in spite of rapidly changing prices for standards.

Every operation is different and many times today’s manufacturing businesses rely on their standard cost for limited uses such as inventory valuation. As long as those costs are modified for these materially changing prices or standards, the risk of a financial misstatement is reduced. Ignoring such radical changes opens the door for financial statement errors that could be material.

Just like most questions in accounting when should you revise your standards is answered with….it depends. There are different scenarios to look consider, but it’s important to note, the answer “never” should not be an option.

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Statistical Analysis in Cost Accounting? It’s Not Just For Football!

I live in Ohio, so yes I am a real Ohio State Fan. I have been my whole life! I know there are many people jumping on the Ohio State bandwagon and I’m ok with it because I know how much fun it can be. I had the pleasure of being at their one loss this whole year against Virginia Tech. It was the first Ohio State game I had ever been to and the whole game-day experience was exciting.

I know many people bet on the outcome of last evening’s game. The point spread was a range of 6-7 points in favor of Oregon. While there is some chance involved in betting, statistical analysis determines the odds. There are stats kept on almost every aspect of sports. I would hope those betting on the game considered some of those stats before making their bet.

statistical analysisStatistical techniques are also utilized in cost accounting. When attempting to determine a cost driver using multiple regression can be an excellent tool. This helps determine how much one activity is affected by another. If, for example, labor does not seem to affect production, then it is most likely not the correct cost driver. Continuing to guess wastes time and money. Stop guessing and continuing to do things the way they have always been. No need to gamble when using statistics. While statistics are not fool proof, your business is better off relying on valuable data rather than guessing! Statistical techniques can be a very viable part of your business. Take some time to learn more about these techniques and how they can positively impact your business.

Would anyone like to share their experience with statistical techniques in their cost accounting environment? What kind of an impact have you observed?

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The Evolution of Costing and What Does It Mean For The Future?

One of the topics frequently brought up in my conversations with cost managers is the delayed conversion by today’s manufacturers to alternative costing methods. There seems to be a general lack of willingness for today’s businesses to consider changing their methods of costing to something that is perhaps more suitable to their needs.

I am constantly amazed by the number of very successful and technically advanced businesses which continue to employ costing models that were developed 40 or 50 years ago.

The_Future_of_ CostingThe IMA has completed formal research regarding common costing systems utilize in contemporary manufacturing companies. It is my recollection that close to 80% still use standard costing for their method of product costing, as well as valuing inventories. Based on my personal experience, I believe the percentage to be much greater as I rarely hear of organizations that are not using standard costing. Many businesses have attempted other methods, more specifically those that have converted to activity-based costing 10 or 20 years ago. However, almost all of them abandoned the system due to the complexities in maintaining ABC. I have heard of other companies that have actually developed two systems: one system to determine product cost for profitability and the another simply for the purpose of valuation of inventory.

I believe in the second case that is overkill. I understand the desire for accurate and timely cost information but the expense and necessities of maintenance that go along with maintaining two systems is certainly onerous and probably not necessary if the one system is designed with enough versatility.

The real question is why are companies continuing with standard costing when there are other methods available? I believe the answer lies in several common themes. The first is that business managers must have, at least, a rudimentary understanding of their cost system to be able to utilize it effectively. Many of today’s managers started their careers with standard costing systems and, as a result, have become comfortable. To suggest a new approach is not well received.

Secondly, I believe standard cost is viewed as being a relatively simple system which is easier to implement and sustain. Therefore, it is labeled worthwhile for those purposes alone.

Thirdly, product costing and overall costing techniques have been de-emphasized over the last 20 years for reasons I do not fully understand. I imagine the amount of resources devoted to accurate product costing in today’s society is just a fraction of what was required 30 or 40 years ago which could explain why companies have de-emphasized the need for costing information. To me, this signifies that today’ manufacturing managers have found other methods of handling production.

I continue to hear over and over that the main purpose for modern costing is simply for inventory valuation. In my mind, this change is by far the most significant cause for the de-emphasis of new and robust cost system and management’s unwillingness to consider the investment of resources it takes to make that conversion. As I work in this arena more and more, I have come to accept the status quo and am now more concerned about getting American businesses to get their standard cost systems working.

What have your experiences been? What is the purpose of your cost system and does it get the attention it requires?

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Choosing the Right Cost Accounting Software

I was recently talking to a controller who is in the process of selecting a new software program for his manufacturing business. I often feel sympathetic to those that are going through this process. It has led me wonder why I perceive this to be such a negative experience? You should be selecting a software that makes your life easier, it should be something that streamlines operations, and provides usable data with ease. The features should be more advanced than anything you have previously implemented. This should be relatively true, otherwise, why engage in such a process.

Cost Accounting SoftwareThe challenges involved in establishing a new software often come from learning the software itself and making the transition. Converting from a software that does not meet your needs to one that is more efficient should be painless, however there is much more that is involved than meets the eye.

In the end, the challenges prove to be worth it. So how do you know if you are choosing the right software? Some questions I  think are essential when reviewing new or old software include:

• What type of training is offered upfront and ongoing?
• What type of support is offered?
• Will the software work well with other software programs I have?
• Is the price reasonable considering what the software offers?
• Will it improve operational reporting?
• Are external purchases required, i.e. IPads, barcode readers, etc.?
• Ability to determine cost drivers and rates independently?
• Ability to query data for decision-making?
• Reporting capabilities?
• Budgeting capabilities?
• Reconciliation capabilities?

This list is not all inclusive,  but these are some of the essential pieces of information to consider. What necessary information do you use to qualify a given software? Bottom line, do your homework and don’t afraid to ask questions.

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Resolution 2015: Question Your Reports

It is the time of year for resolutions. Something about a fresh start of a new year gets most people in the spirit of improvement. Many common resolutions are to get into shape, to lose weight, to eat healthier, etc. I know the advertisements for gym equipment and memberships seem to increase this time of year since that is on the forefront of many people’s minds. I generally don’t make resolutions, but I do often reflect on things I can do to improve myself. What kind of resolutions do you make?

When we think about resolutions we often think about our own personal life and personal gains. I challenge you to think about your professional life as well. Maybe resolve to be more efficient at work, improve your work-life balance, etc. What could you improve in aspects of your career?

questionOne thing I challenge any controller, or role that generates reports for others, would be to think about those reports. Why are you generating the reports that you are? What is their purpose? What is the benefit? Would anyone notice if you stopped? If you have attended any of our seminars where you have heard me talk about reporting you have heard me ask that very question. When I ask that question most people chuckle and then realize, wow you’re right, so many people wouldn’t notice. Then why are you doing so?

So often as accountants we do things because that is the way we have always done them. We fall into a pattern of continuously repeating each month and period end in the same manner year after year. Stop and think about why you are generating a report. Is it giving the user the best information that he or she needs? Is there a better report with additional information what would be more appropriate? Go and talk to the end user and ask them what they need. I challenge you to look at it as your job to know what they need as well, and to help them determine what they need.

Make a resolution to stop following last year and to really focus on what would be the most beneficial. I think you will be surprised how much better things can be when everyone has what they truly need.

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And then there were two…

The traditional cost accounting theory typically breaks cost to be recovered into three general categories, materials and all the costs associated with materials, labor and all its associated cost, and then overhead. Much of what I learned in college and what I see in practice today still holds that those three components make up the body of costs to be recovered in a costing system.

However, recent experiences have shown that those three categories are more and more being turned into two categories. This is due, simply to automation and the diminishing focus of labor as a significant factor in the cost structure. In earlier and different manufacturing times, labor could sometimes be as much as 20% of cost of goods sold and in some cases even more. If labor represents that large of a segment of the costs, then it is certainly worth the additional effort to manage it and provide insight as to how to be more efficient.images

However, as productivity gains became more and more important to be competitive in the world market; American manufacturers had to turn to more and more automation, and use every possible technological advantage to remain competitive in the world market. As a result, more and more manually controlled operations have now become machine controlled as automation and technology has taken over more of the duties that were once simply controlled by direct labor.

It is common for us to see businesses today where direct labor is being recovered as part of the machine rate for fixed overhead, which thereby reduces the cost categories to be recovered to two: material and overhead.

Some businesses, for a variety of reasons, feel it is necessary to have variance reporting on the labor component even though they are recovering it as part of fixed overhead. I suspect it has to do with the fact that labor is still viewed as a highly manageable cost that can be manipulated and therefore is worth the additional effort to control it even though it’s in a machine controlled environment. However, it has been my experience in more than one occasion that labor is so embedded into the machine process that a separate productivity measure is almost meaningless. That is to say if the machine is working properly, then productivity will be measured on machine output and labor crew sizes. These environments are strictly controlled by machine operations and it is not possible to have much larger or smaller productivity gains without fundamentally changing the machine process.

It certainly seems to me that future generations will likely consider labor as one more component of fixed overhead and therefore not worth substantially greater effort to manage than is any other fixed overhead.

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What is a variable cost?

What is a variable cost? That seems like such a simple question, and I am sure many of you reading this right now are thinking really. Of course a variable cost is simply a cost that increases as production increases and decreases as production decreases. I’m sure many of you are thinking this time of year my patience and available time are pretty variable too! I know I sure wish there were more hours in a day right now with all the holiday preparations yet to be done!

var vs fixedA fixed cost is a cost that does not change regardless as to the level of production. Fixed costs are things like rent and insurance. Even if you only produce one widget you will still have to pay the same amount in rent and insurance, as well as several other items. However; fixed is only within a relevant range. Most likely over a certain period of time the rent you are paying will increase, or the insurance premiums will increase. Notice I did not say decrease-I’m not living in a dream world! If you have a three year lease, then your rent is fixed within those three years. Outside if that time it would not be, as it will most likely change, or vary.

Some people argue that all costs are variable-it just depends on the time-frame, because in the long-run all costs vary. Although that may be true, it is vital to classify costs correctly as fixed or variable. If you classify a variable cost as fixed, depending on your level of production you will have either over or under accounted for that cost, this can be catastrophic. Some costs are more difficult to classify, such as, supervisor costs. You may have to add another shift, which would add another supervisor that you had not expected. If you were just looking at this supervisor cost as fixed you will most certainly under recover this cost.

Direct, or variable costs, are directly related to production. These are things like material and production labor. These costs will in theory, only be incurred if production occurs. The recovery of those costs are directly related to their production. Fixed costs have to be recovered over production regardless as to how much or how little you produce.

There are statistical techniques, like regression, available to determine how dependent a cost is on production to determine if it is variable or not. These techniques can be quite helpful especially if you are unsure as to the classification of a cost. In the end the answer to what is a variable cost is not always black and white, but is very important.

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