Does an inventory related accounting standard encourage overproduction?

September 26, 2015

New accounting standards are issued by standard setters (e.g., Financial Accounting Standards Board) on a somewhat regular basis. They are aimed at improving financial reporting. However, sometimes such standards may also have unforeseen results. In this article, we discuss such results of SFAS No. 151, a standard related to accounting for inventory production costs.

1. Abnormal fixed overhead production costs

SFAS No. 151 was issued in 2005 and indicates that fixed overhead related to abnormal production levels should be expensed as period costs.

Period costs are expenses related to the current accounting period.  Examples include selling and administration costs.  Such costs are not deferred and this gives them their name.  Product costs, on the other hand, are attributed to inventory and expensed when the inventory is sold.  Product costs include direct labor, direct materials and manufacturing overhead.  You can review this tutorial for more information about period and product costs: accounting in merchandising companies.

Fixed overhead costs vary by business.  By definition, they are fixed costs which means they don’t change when the number of units produced changes. They also can’t be associated with a single product directly which is why they are overhead costs.  Examples include depreciation of manufacturing equipment, salary of manufacturing supervisors, and property taxes related to manufacturing facilities.

In the past, before SFAS No. 151, all fixed overhead costs would be allocated to inventory produced during the period.  If the production level was low, the inventory would have higher production overhead costs per unit.

SFAS No. 151 requires that fixed overhead be applied to inventory based on rates for “normal” production levels.  Normal levels can be determined by taking into account production levels over several typical years for the company.  At the same time, the accounting standard does not give a precise definition of what a “normal” production level is.  If production levels are lower than normal in the current accounting period, then any fixed overhead attributable to the shortage in the production level should be expensed and not allocated to the ending inventory balance.  This amount is probably not shown on the income statement separately, but it should be known to management (and the company’s financial auditors).

The standard setters’ goal with SFAS No. 151 was to require that during the years of lower production levels some fixed overhead be expensed and not hidden in the ending inventory balance.  Were there any unforeseen results of implementing this standard?  An article titled “Does SFAS No. 151 Trigger More Overproduction?” Journal of Management Accounting Research 2014, provides the answer.

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