Balancing profit and loss

Nov. 1, 2003
Date-driven software removes erratic month-to-month financial fluctuations

Owners of small job shops often puzzle over the fact that one month's financials look good, while high expenses and low profitability appear the next month. These unexpected fluctuations are the usual result of improper application of labor and burden absorption concepts.

When work in process (WIP) jobs extend beyond month end, it is common to incur monthly labor and burden expenses (for example, direct labor payroll) that are not offset by sales of the goods being produced. When steps are not taken to absorb those expenses off the company's income statement to its balance sheet's WIP inventory account, those WIP expenses are not aligned with the sales of in-process goods. The result is an unbalanced view of company profitability on the income statement, due to overstated or understated expenses.

Working almost daily with shop owners during the past 15 years revealed the constant need for a formalized mechanism to support this activity. For both traditional and contract manufacturing, the missing tool in most shop management software has been a simple means to move expenses/costs off the balance sheet accounts—assets like work in progress and finished goods—and onto cost of goods based on sales and shipment activity.

Absorption is the process of aligning the cost of goods with sales, which gives a truer, more balanced profit representation.
  1. Moving costs to WIP for Open/Active Shop Orders
  2. Moving from WIP to COG (expenses)
  3. Moving from WIP to finished goods
  4. Moving from finished goods to COG (expenses)
Click here to enlarge image

Ann Gross, office manager at PMC Lone Star (Willoughby, OH), had a similar problem: "Before using Henning's software [Henning Industrial Software (Hudson, OH)], we had volumes and volumes of printouts to prepare—just tremendous amounts. Our other software was not date driven—you literally had to go in and empty the batch at month end, because once people started working in the system, you couldn't go back.

"Running the batch reports moved expenses from raw material to WIP, from WIP to finished goods, and yet another report had to be run to take parts out of finished goods when sold. Then, to post the cost of goods sold entry, you would have to run still another report."

Making appropriate monthly adjustments to move expenses back and forth between the income statement and the balance sheet is necessary to accurately reflect profit and loss on the income statement. The goal is having expenses reflected in cost of goods occur during the same fiscal period as the sales of the goods sold.

Avoiding the wild fluctuations when a company's manufacturing system does not provide a formal way of setting up absorption accounts requires an extra effort to apply the expenses against the income statement. Then, later, based on job activity, these expenses need to be moved off the income statement so they can be absorbed into WIP. The expenses reflected in cost of goods must occur during the same fiscal period as the sales of the goods sold.

Typically, almost any shop management software can produce reports showing material, labor, burden and purchases related to shop orders. Company bookkeepers often must effect the movements between income statement and balance sheet, often choosing to calculate and enter these monthly adjustment entries manually. They may use their own spreadsheets to calculate and post the necessary monthly inventory reconciliation adjustments. Each of these adjustments must be made as monthly general journal entries.

Gross likes the new convenience afforded her. "Henning's software tracks each raw material purchase to WIP to finished goods." That may require a simple new discipline not all companies enforce. "To do so," Gross points out, "every item that flows through needs to have a product code. If it doesn't, that could throw you out of balance. At month end, I can reconcile the inventory a week later and still see what needs to be done to close out the month. I'm not tied to doing so before any new entries are made for the new month. The guys can continue in the shop, clocking in and putting things into work in process or finished goods. It's not going to affect April while they are doing May."

In summary, for each shop order it is necessary to track all WIP costs (that is, direct labor, burden, material and other subcontracting costs) that occur during the life of the order. A monthly procedure is used to adjust general ledger inventory and cost of goods. These monthly adjustments move expenses from the income statement to the balance sheet's WIP account for in-process shop orders. Similarly, these summarized component costs are moved off the balance sheet inventory accounts (either from WIP or finished goods) back to the income statement's cost of goods accounts when the shop order closes. This aligns these expenses with the shipment/sales of finished goods sold providing management with a balanced picture of their company's true profitability.

There's no more need to run reports to effect postings at PMC Lone Star. "It's date driven now, and we can do it anytime, right on the monthly inventory reconciliation screen. You see those entries that were posted during the week or see all the transactions that month. You can check the numbers, trace everything and their valuations, display your balance for finished goods at the end of last month, or view a listing that has all the parts components or dollar amounts for the end of the month. That number agrees with your general ledger."

Rich Henning is the president of Henning Industrial Software (Hudson, OH). Access the company website at

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