11.5. Puffing Profit by Excessive Production

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 inventory 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). Fixed manufacturing overhead cost is included in product cost, which means that this cost component goes into inventory and is held there until the products are sold later. In short, when you overproduce, more of your total of fixed manufacturing costs for the period is moved to the inventory asset account and less is moved into cost of goods sold expense for the year.

You need to judge whether an inventory 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 inventory becomes cost of goods sold expense — at which point the cost impacts the bottom line.

11.5.1. Shifting fixed manufacturing costs to the future

The business represented in Figure 11-1 manufactured 10,000 more units than it sold during the year. With variable manufacturing costs at $410 per unit, the business expended $4.1 million more in variable manufacturing costs than it would have if it had produced only the 110,000 units needed for its sales volume. In other words, if the business had produced 10,000 fewer units, its variable manufacturing costs would have been $4.1 million less — that's the nature of variable costs. In contrast, if the company had manufactured 10,000 fewer units, its fixed manufacturing costs would not have been any less — that's the nature of fixed costs.

Of its $42 million total fixed manufacturing costs for the year, only $38.5 million ended up in the cost of goods sold expense for the year ($350 burden rate × 110,000 units sold). The other $3.5 million ended up in the inventory asset account ($350 burden rate × 10,000 units inventory increase). The $3.5 million of fixed manufacturing costs that are absorbed by inventory is shifted to the future. This amount will not be expensed (charged to cost of goods sold expense) until the products are sold sometime in the future.

Shifting part of the fixed manufacturing cost for the year to the future may seem to be accounting slight of hand. It has been argued that the entire amount of fixed manufacturing costs should be expensed in the year that these costs are recorded. (Only variable manufacturing costs would be included in product cost for units going into the increase in inventory.) Generally accepted accounting principles require that full product cost (variable plus fixed manufacturing costs) be used for recording an increase in inventory. However, as the example in Figure 11-1 shows, producing more than you sell does boost profit.

Let me be very clear here: I'm not suggesting any hanky-panky in the example shown in Figure 11-1. Producing 10,000 more units than sales volume during the year looks — on the face of it — to be reasonable and not out of the ordinary. Yet at the same time, it is naïve to ignore that the business did help its pretax profit to the amount of $3.5 million by producing 10,000 more units than it sold. If the business had produced only 110,000 units, equal to its sales volume for the year, all its fixed manufacturing costs for the year would have gone into cost of goods sold expense. The expense would have been $3.5 million higher, and EBIT would have been that much lower.

11.5.2. Cranking up production output

Now let's consider a more suspicious example. Suppose that the business manufactured 150,000 units during the year and increased its inventory by 40,000 units. It may be a legitimate move if the business is anticipating a big jump in sales next year. On the other hand, an inventory increase of 40,000 units in a year in which only 110,000 units were sold may be the result of a serious overproduction mistake, and the larger inventory may not be needed next year. In any case, Figure 11-2 shows what happens to production costs and — more importantly — what happens to the profit lines at the higher production output level.

The additional 30,000 units (over and above the 120,000 units manufactured by the business in the original example) cost $410 per unit. (The precise cost may be a little higher than $410 per unit because as you start crowding production capacity, some variable costs per unit may increase a little.) The business would need $12.3 million more for the additional 30,000 units of production output:

$410 variable manufacturing cost per unit × 30,000
additional units produced = $12,300,000 additional
variable manufacturing costs invested in inventory

Again, its fixed manufacturing costs would not have increased, given the nature of fixed costs. Fixed costs stay put until capacity is increased. Sales volume, in this scenario, also remains the same.

Figure 11.2. Example in which production output greatly exceeds sales volume for the year, thereby boosting profit for the period.

But check out the business's EBIT in Figure 11-2: $23.65 million, compared with $15.95 million in Figure 11-1 — a $7.7 million higher amount, even though sales volume, sales prices, and operating costs all remain the same. Whoa! What's going on here? The simple answer is that the cost of goods sold expense is $7.7 million less than before. But how can cost of goods sold expense be less? The business sells 110,000 units in both scenarios. And variable manufacturing costs are $410 per unit in both cases.

The culprit is the burden rate component of product cost. In the Figure 11-1 example, total fixed manufacturing costs are spread over 120,000 units of output, giving a $350 burden rate per unit. In the Figure 11-2 example, total fixed manufacturing costs are spread over 150,000 units of output, giving a much lower $280 burden rate, or $70 per unit less. The $70 lower burden rate multiplied by the 110,000 units sold results in a $7.7 million lower cost of goods sold expense for the period, a higher pretax profit of the same amount, and a much improved bottom-line net income.

11.5.3. Being careful when production output is out of kilter with sales volume

In the example shown in Figure 11-2, the business produced 150,000 units (full capacity); therefore, its inventory asset absorbed $7.7 million of the company's fixed manufacturing costs for the year, and its cost of goods sold expense for the year escaped this cost. But get this: Its inventory increased 40,000 units, which is quite a large increase compared with the annual sales of 110,000 during the year just ended. Who was responsible for the decision to go full blast and produce up to production capacity? Do the managers really expect sales to jump up enough next year to justify the much larger inventory level? If they prove to be right, they'll look brilliant. But if the output level was a mistake and sales do not go up next year . . . they'll have you-know-what to pay next year, even though profit looks good this year. An experienced business manager knows to be on guard when inventory takes such a big jump.

Summing up, the cost of goods sold expense of a manufacturer, and thus its operating profit, is sensitive to a difference between its sales volume and production output during the year. Manufacturing businesses do not generally discuss or explain in their external financial reports to creditors and owners why production output is different than sales volume for the year. Financial report readers are pretty much on their own in interpreting the reasons for and the effects of under- or over-producing products relative to actual sales volume for the year. All I can tell you is to keep alert and keep in mind the profit impact caused by a major disparity between a manufacturer's production output and sale levels for the year.