Production Costs

Production Costs

University of Phoenix, School of Business

Accounting

ACC/561

Introduction

I was tasked with preparing an informal memo and explain to Mr. Skaros why his production cost report showed only 2,000 equivalent units in ending inventory. I will explain to him clearly why my report is accurate. The compiled messages below are examples provided from the course textbook along with other outside sources describing each.

Memo to Mr. Skaros

To: Production Manager, David Skaros

From: Accounting Department

Date: March 11, 2019

Subject: Ending Inventory related query

Mr. Skaros,

This is to explain to you the reasons for not maintaining enough inventory to meet demands.

Obsolete Inventory

Overstocking on products runs the risk of the product becoming obsolete. This is true especially in technology sectors such as smartphones and televisions, but no industry is exempt. Even the latest kid’s game craze might inspire you to place a large order. If the buzz dissipates quickly and kids aren’t looking for the game, you’ll be left holding a lot of inventory you can’t move.

Storage Capacity and Fees

Storage capacity and the related storage fees are a concern for companies holding more inventory than is needed. It takes space and resources to hold inventory. Companies lose profit by paying labor for maintaining the storage space, organizing the stock and transporting the stock from one place to another. Companies that rent storage space lose additional profit by paying rental fees to store unused stock.

Storage Costs

The more substance you have, the more space you need. Commercial space is leased per square foot. Consider the costs to store excess inventory compared to the savings on wholesale orders. It also costs to do more inventory control and audits, potentially requiring additional manpower to work the warehouse. The calculation of the cost to store inventory should be based on the incremental annual costs or the company’s opportunity costs. In other words, if a business has a large amount of cash, no debt, and a warehouse that is half empty, its costs to store inventory will be relatively low. Another company with little cash, much debt, and little available storage space will have relatively high costs of storing inventory.

Perishable Products

Overstocking perishable items often results in the items sitting in storage past the recommended “use by” date. For example, food businesses cannot sell out-of-date products because of the risk to the health and safety of customers. In these cases, overstocking results in items that must be thrown out, meaning they are a total loss.

Discounts

A business owner who overstocks often finds himself in the position of needing to sell the inventory at deeply discounted prices in order to clear up space for new inventory. By selling the discounted stock the business suffers low margins and profits.

Potential Insurance Costs and Loss

Insurance costs go up with larger storage areas and larger inventory values. This factor needs to be considered and compared to wholesale savings. If there is a fire, theft or another natural disaster, not only will the business be recuperating, it will need to pay higher premiums as insurance rates go up. Insurance companies offer different options when you purchase an insurance policy. The more coverage you get, or the more comprehensive coverage you choose, the higher your insurance premium may be.

Tying Up Capital

When you have excess inventory, you pay for the order, the storage, and insurance. You can’t get around this. For businesses that are working with small margins and on tight monthly budgets, this can hamper business development decisions because they don’t have cash on hand. A common generality is that 80% of demand will be generated by 20% of items. Prioritize that 20% to the top of your list, always checking to make sure that inventory is in stock and reordered frequently.

Business owners might examine the disadvantages pertinent to the business and then decide whether carrying excess inventory makes sense. It is up to each business owner to review the financial health of his company. Inventory is one key factor in that. All of these elements mean that you are able to plan and strategize. This is critical to developing and maintaining relationships with investors, who want to see that you have specific plans for your operations.