Overhead Calculations and Inventory

Feb 01, 2016

One question we often hear is, who must include overhead in their inventory, how much should be included, and how should it be calculated? There are three important factors associated with overhead and inventory which must be considered before answering these questions. One, the Generally Accepted Accounting Principles (GAAP) which require overhead to be included in inventory. Two, the federal income tax rules which require overhead to be included in inventory. Three, management reporting considerations which may or may not include inventory in the product cost.

These three factors are completely separate and in many cases, are unrelated. In addition, each may have completely varying objective which must be considered before the question of how much overhead in inventory can be answered.

For the consideration of GAAP, there is an entire section of new Generally Accepted Accounting Principles devoted strictly to how much overhead should be included in inventory. The rules are rather general which provides the preparer of the financial statements latitude in determining exact methods of computation and amounts. The rules are specific with regard to the overhead being included. The inventory will be misstated if the type of business requires the inclusion of overhead and is not completed. This rule has far-reaching implications in many business situations, particularly those where a buyer is purchasing a certain amount of inventory and a seller is selling a certain amount of inventory in a merger or acquisition transaction. The accuracy of the inventory can be crucial to determining the correct price and inventory value not in accordance with GAAP, which can have a large negative impact depending on the size of the misstatement and when it is discovered.

The second consideration involves federal income tax rules. Many years ago, the Internal Revenue Service developed code section 471 which has to do with the inclusion of overhead in inventory for tax purposes. The IRS was specific about manufacturers which meet certain criteria being required to allocate a certain amount of overhead to inventory. The regulations did, in fact, provide specific guidance as to how this would be achieved. Code section 471 was the standard of tax accounting of overhead in inventory for many years until code section 263A was developed in the mid-80s. These new rules expanded the definition of who was required to include overhead into inventory and added certain elements of cost that must be included in the inventory calculation excluded from the 471 regulations. Code section 263A was not in replacement of 471, but rather was an addition to 471 should be considered by every manufacturing taxpayer and many distribution taxpayers. It has been my experience that IRS auditors are trained to look for the inclusion of 263A in manufacturing inventories and regularly do so as part of their normal auditing procedures associated with the manufacturer.

The last item of consideration associated with overhead inventory is related to management reporting. This consideration has little or no rules associated with it and is highly dependent on the specific need for the management information.

For instance, if management is attempting to use individual product cost for a make versus buy decision, then the cost of the product might exclude certain overheads which may normally be included in the inventory calculation. However, if management is requesting information associated with product profitability by customer or product type, then it may include overheads not included with inventory valuations. The specific nature of management information as it relates to product cost and especially overhead in inventory or overhead is in each case unique and dependent on the ultimate uses by the management team of the information. General rules and guidelines can sometimes develop misleading results and should be reconsidered every time there is a recalculation of product costs for management purposes.

Categories: Cost Accounting