Variances, Incentives, and SFAS 151

By Timothy B. Biggart and Thomas A. Carnes

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In October 2002, FASB and the International Accounting Standards Board (IASB) issued the Norwalk Agreement, pledging that the two groups would seek convergence in their accounting standards. The goal was “to improve the comparability of cross-border financial reporting by working … toward development of a single set of high-quality accounting standards.”

FASB describes SFAS 151 as one example where the two boards see an opportunity to improve standards by eliminating certain narrow differences. In this case, FASB changed its standard [found in Accounting Research Bulletin (ARB) 43, No. 4] to adopt the language of the international standard. The adoption was uncontroversial; FASB received only 26 comment letters and did not hold a public hearing on the proposal.

‘Abnormal’ Inventory Costs

The change centers on the term “abnormal” as it applies to idle-facility expense, freight, handling costs, and wasted material. ARB 43 stated that “under some circumstances” such charges might be so abnormal that they should be treated as current-period expenses. If such circumstances were not met, or the charges were not “so abnormal,” these charges typically would be included in fixed overhead and recognized as part of cost of goods sold when the related inventory is sold. Standards-setters were concerned that firms might apply the U.S. standard and the international standard inconsistently, even though both attempted to ensure the same outcome.

This concern led to SFAS 151. Required for all inventory costs incurred during fiscal years beginning after June 15, 2005, it states that “unallocated overheads are recognized as an expense in the period in which they are incurred,” and that abnormal freight, handling costs, and wasted materials must be treated as “current period charges rather than as a portion of the inventory cost.” The standard also requires that “the allocation of fixed production overheads to the costs of conversion is based on the normal capacity of the production facilities.”

Neither ARB 43 nor SFAS 151 provides explicit guidance as to the form of the current period expense. Customary usage of “period cost” refers to those operating expenses recorded on the income statement below gross margin. Based on the use of that phrase, the unallocated overhead expense would be recorded with selling and administrative expenses. The cost principle of inventory valuation, however, explicitly identifies manufacturing overhead as an inventory cost. Thus, it could be argued that the unallocated overhead expense should be added to cost of goods sold, above gross margin. Of course, location of the expense within the income statement does not affect net income, but it does affect gross margin and gross margin percentage.

Although the issue of how to treat abnormal inventory costs and where they fit on the income statement existed before SFAS 151, the requirements of the new standard can help illuminate the complexities of this issue. Closer examination is needed into what normal capacity should be, and the role played by variances and incentives.

Normal Capacity

One question the standard leads to is the definition of normal capacity. Businesses incur fixed manufacturing costs to acquire a certain throughput capacity. The acquisition of plant, equipment, and supervision enables a company to produce a certain level of output. In one sense, that normal capacity could be modeled as the practical physical output capacity of a facility. The definition of practical capacity usually is the maximum efficient output level, or around 85% of the absolute maximum output level. If a company used practical capacity as normal capacity, any time it produced at levels lower than full production, it would have to recognize its unallocated overhead expenses as current-period costs.

FASB recognized this potential problem and took steps to address it. SFAS 151 considers normal capacity as a range, not as a single point. It describes normal capacity as a range of production levels expected to be achieved over multiple periods or seasons, and it adds that variation in production levels across periods is expected and determines the range of normal capacity. It also states that business- and industry-specific factors will affect the range of normal capacity. On that basis, FASB is using a definition of normal capacity close to the definition used in standard normal costing, which considers budgeted (planned) production to be normal capacity and uses it as the denominator in the fixed manufacturing overhead allocation rate. Such a system allocates fixed overhead based on what a company plans to produce for the period. In this case, an existing flexible budgeting system variance, the fixed manufacturing overhead production volume variance (when unfavorable), would measure the unallocated overhead expenses SFAS 151 requires to be recognized as current-period costs.

Fixed Manufacturing Overhead Production Volume Variance

Cost analysts and management accountants long ago recognized the major differences between the measurement and management of fixed overhead costs and of variable costs. By definition, if it requires fixed capacity costing $1,000 to produce 100 units, the total fixed cost of that capacity remains $1,000 if only 80 units are produced. If production volume decreases, however, the cost per unit increases, as shown in Exhibit 1.

The $2.50 increase in cost per unit is the cost of unused capacity. The production volume variance measures the total effect of that cost. It equals the total budgeted fixed overhead less the amount of fixed overhead applied at the actual level of output (e.g., the planned cost per unit multiplied by the actual units produced, as shown in Exhibit 2). When unfavorable, this variance is an assessment of the cost of failing to achieve the planned production. It represents unallocated overhead. Should the production level that has led to the variance be outside the range of expected variation in production (a determination that FASB says requires judgment), that amount is a current-period charge under SFAS 151. For reporting purposes, the variance ($200 in this case) cannot be reallocated to the actual units produced (and thus not recognized as an expense until the units are sold) because the standard specifies “the amount of fixed overhead allocated to each unit of production is not increased as a consequence of abnormally low production or idle plant.”

It is possible, of course, that actual production exceeds planned production (see Exhibit 3). If this occurs, the production volume variance is positive and fixed cost per unit will be less than budgeted. Positive production volume variances often affect internal performance appraisal, but SFAS 151 eliminates any effects they might have on the financial statements by requiring a decrease in the amount of fixed overhead allocated to each unit, thus ensuring inventories are not valued above cost. Such treatment is consistent with the general principle of not allowing the recognition of unrealized gains on inventory for external reporting purposes.

It is not necessary for the additional units to be sold, because the calculations are based on units produced. Managers can eliminate unfavorable production volume variances (or even create favorable variances) by increasing production during the year and storing the excess finished goods. SFAS 151 creates additional potential incentives to engage in “allocation management.” This incentive competes with other incentives concerning inventory management. The increase in inventory from excess production will adversely affect inventory turnover and inventory-to-sales ratios but could, if favorable production volume variances are created, increase gross margin percentage. Most important, continued overproduction could eventually lead to costly inventory write-downs if the market value of the inventory falls below cost.

Incentive Issues

A fundamental concern with any capacity-based fixed overhead allocation measurement is that it creates an incentive for production-level managers to control an unfavorable variance through excess production. If their compensation is based in part on such variances, production managers might increase production unnecessarily. This creates an internal agency problem, because a company’s best interests (avoiding the holding costs associated with overproduction, such as storage and potential obsolescence) may conflict with those of the production manager. One common way of mitigating this problem is to charge the purchasing department for such holding costs and create mutual monitoring incentives for purchasing managers and production managers (C.S. McWatters, D.C. Morse, and J.L. Zimmerman, Management Accounting, second edition, McGraw-Hill Irwin, New York, 2001).

SFAS 151, by recognizing unallocated overhead as an expense when incurred, formally links the allocation issue to the income statement. Because the allocations are based on production volumes rather than sales volumes, it is possible to increase production during the year to “use” the excess capacity. This eliminates the recognition of the expenses, or at least defers the recognition to a future period.

Although the problem of inventory buildups increasing current earnings at the expense of future earnings by absorbing overhead costs has been well documented, SFAS 151 may have the effect of increasing a company’s motivation to manipulate inventory. Because the change in wording from ARB 43 to SFAS 151 formalizes the link between any unused capacity and the income statement, businesses may be more reluctant to have unallocated overhead.

As a result, this change in accounting standard injects external-reporting concerns into production-level decisions. The change also potentially takes the internal agency problem outlined above and extends it beyond the entity, increasing the incentive, perhaps even increasing the necessity, for top management to become involved in such lower-level matters.

Upper-level management is much more concerned with net income than production-level management, as its job performance, in terms of both compensation and job retention, is typically linked to overall performance measures. If the potential effects of recognizing unallocated overhead as an expense would have a material effect upon a company’s net income, or upon a manager’s bonus, that manager must trade off inventory holding costs on the excess inventory against the perceived problem of reduced current period income. In many companies, production managers are not responsible for some holding costs. For example, the imputed financing cost may not even be calculated. If it is, it usually is not used in evaluating production-level management. Such holding costs on “excess” inventory appear not to meet the definition of costs that are included in current-period expenses, while the unallocated overhead that results if the excess inventory is not produced is included in current-period expenses—thus providing an additional incentive to produce excess inventory.

Significance for Financial Statement Users

The main purpose of standards such as SFAS 151 is to ensure that financial statements provide information useful to investors and creditors in their decision-making. Academic research is mixed regarding the signal that unexpected inventory growth sends to investors. There is evidence that increases in inventory that outpace increases in sales portend future bad news for a business, because it may indicate the company is stockpiling inventory, as outlined above, to switch current-period expenses into future periods. Such stockpiling cannot continue indefinitely. There is also evidence, however, that investors may generally consider growth in inventory a positive signal in that the company expects sales to increase in future periods and is stockpiling inventory to meet demand.

Many companies have already noted in their annual reports that they do not expect SFAS 151 to have a material effect on their financial statements. But if SFAS 151 results in some companies producing excess inventory and others increasing current-period expenses, it may be more difficult for investors to interpret the results of these firms’ financials.

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