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ABSTRACT: Managers in many firms are using information based on current cost accounting methods to make crucial business decisions, and these decisions may be somewhat misleading. What is needed is a method to handle inventory valuation so that managers can understand the implications of Work in Process (WIP) and how it affects their business. Accurate reports will help managers make better business decisions. As an example, in many instances, WIP inventory actually loses "real world" value if it goes through the manufacturing process, and this loss of value is not considered on the financial statements. Managers need to know the market value of WIP inventory as it goes through the manufacturing process because only then will managers be able to make knowledgeable decisions that affect the goal of their organization, which should be profits, not assets. This article looks at the pros and cons of what is currently referred to as generally accepted accounting principles and changes that could improve accuracy.
KEY WORDS: Cost accounting, cash flows, overhead, inventory management, valuation and WIP
A Theoretical Scenario
A manufacturing plant manager has managed his company's plant for the past two years. The manager, being an ambitious man, wants to move up in the company to a position with more prestige. He needs something to give his upward mobility a boost, something that will allow his plant to look better on the company financial statements, so he'll look better. How can he do it?
Production has kept an even pace although excess production capacity exists. He can increase production, but sales are at their lowest level in five years and inventory has been increasing steadily over the last several months. He perceives this as a problem until the next quarterly financial statements are published. He notices that the plant assets have increased in spite of a drop in sales. He even gets a call from the regional manager saying, "good job; the plant's assets have increased even with the downturn in sales."
The manager learns that the financial statements of the company are kept in accordance with GAAP (generally accepted accounting principles), and inventory is considered an asset for financial accounting purposes. Increasing production and inventory levels (work in process or finished goods), without increased sales,...