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Manufacturers, if you're not capitalizing direct overhead, you're wrong and here's why.

Alternative title: Three reasons why you should capitalize overheads.

Let's qualify the reader right out of the shoot. Here are prerequisites for if you should care about this content:

  • You're involved in a manufacturing business.
  • You manufacture products in repetition as opposed to single custom manufactured products (i.e. you're not a job shop).
  • You have an annual operating plan in which you know what you're going to make and the resources you're using to make it, particularly in direct overhead.
  • You've implemented some sort of costing system in which you know what your product(s) will cost in advance.

So here's why I'm writing, it's to your advantage to capitalize your overhead.

When I say capitalize, I mean you should take a credit on your income statement for the amount of your direct overhead expense per products you made multiplied by the number of said products you made. You should debit your inventory asset for the same amount. For purposes of this article I'm agnostic as to whether you use ABC (activity based costing), machine hours, or some other method to calculate costs. This brings me to my first point as to why you should capitalize overheads.

Reason 1: Capitalizing overhead can tell you if you're operating to plan.

Capitalizing overhead will allow you to see any variances that may exist from month to month with regards to your operating plan.  The math for capitalizing overhead is to multiply the quantity you manufactured of each product by the cost you estimate in direct overhead expense to produce the product.  For example, if you plan to produce 1.2 million units for the year and you anticipate your direct overhead expenses to be $1,560,000 for the year, your calculated overhead cost per unit would be $1.30 ($1,560,000 / 1,200,000 units).  Based on this calculation, you can now determine monthly variances in your direct overhead.  Assume during month 2 of your fiscal year you produce 120,000 units, your direct overhead for the month should be $156,000 (120,000 units x $1.30).  You can now compare the actual direct overhead for the month to projected overhead based on capitalization to determine the variance.  By identifying when there is a variance you can identify problems or at least that there may be a problem.  It will tell you whether you are operating to plan.  If you capitalize too much or too little (meaning you’re not operating to plan) then you may have issues with knowing your run times, or the utilities (and resources like consumable supplies) your machinery uses, among other things you may discover. Using this you'll have a complete feedback loop between planning and performance.

Reason 2: IT better matches income to expenses.

When you capitalize the overhead, you count the expenditures as an asset and you expense that asset at the point you sell the product, not when you manufacture it. Companies who don't follow this practice will show larger net income amounts in periods they sell the product and smaller net income amounts in periods they produce the product. Without any consistency in your numbers it's very difficult to judge performance against prior periods much less creating and judging against a budget.

In addition, Internal Revenue Code Section 263(a) requires producers to capitalize indirect cost, such as direct overhead, in order to properly report taxable income.  The concept of Section 263(a) is directly related to the matching principle of accounting.

Reason 3: You'll verify your product costs.

Although we may argue the value of various cost accounting methods or cost accounting itself, one thing we cannot argue is that you must sell products for more than the manufacture cost. I do not, under any circumstances, advocate using a cost-plus method of pricing. However, if you are capitalizing as much as you are spending then you know your costs are fairly accurate. Accurate costs can arm your business with the necessary tools to calculate things like break-even sales volume or max profit volume.

 

If I haven't convinced you yet, then lets take some time to talk. I promise you're better off spending the extra effort and expense to set up your accounting system to capitalize overhead and analyze expense variance.

 

James H Johnson, CPA.CITP, CGMA, MBA

Twitter: @james_h_j

Linkedin: linkedin.com/in/TWPJamesJohnson