Push Down Accounting

And finance Allah Shmoop What is work in process from

a cost accounting perspective Aren't people you make a little

side money selling homemade tea cozies shaped like Nobel Prize

winning economist Milton Friedman This guy also used to be

a runway model is your best seller But you also

do some brisk business in Friedrich Hayek as well To

make them you need some fabric some insulating foam some

thread some buttons for the eyes some yarn for the

air though you don't need much yarn there for Friedman

Those items represent your raw materials In accounting terms They

are called your direct materials When you're done you've got

your completed cozies You post them on your website and

you wait for orders to come in in accounting Speak

Those are your finished goods But what about when they

are You know in between what they called when you're

just doing the cutting or the working or the sewing

and they're not done yet Well the cozies Yeah they're

partially good or partially finished They're not fully finished goods

but you've done some work on them They're too far

along to reuse the raw materials somewhere else You kind

of committed that raw material to that finished product You

can't just list these products either as direct materials anymore

They're just kind of like used up raw materials in

the process of being done right And that's why they're

called a work in process magic Well you take a

bunch of fabric cut it in the shape of Robert

Shiller so on one of the eyes and then you

get a call from your mother You know she just

got an email from your Uncle Harry begging her to

send in money again Trouble is well your uncle Harry

died in two thousand twelve so you rush over to

your mom's before she can Long into her PayPal account

And well meanwhile you've got half of Robert Shiller just

sitting there on your kitchen table It's not direct materials

anymore It's been cut in half sewn in semi used

But it's not finished goods either No one's going to

buy a half finished Robert Shiller So how do you

classify that Cozy Yeah it's a work in process or

work in progress Spork Whip w Well this partly done

situation is common in business Manufacturing processes can involve a

large number of steps and can require large amount of

time tio go from beginning to end In the build

a lot of dough gets tied up in work in

process at a large manufacturer If you constrain line the

waste well then it can save you a ton of

capital costs and businesses Do periodic inventory counts Toe optimize

all this They count up their direct materials and record

how much of them are still waiting to get used

to just sitting around They're costing rent money for the

capital that was deployed to build them thereby um the

value of that material then gets listed in the firm's

financial statements and those amounts add up like think about

a major truck maker with a billion two hundred million

dollars worth of partially made trucks lots of expensive steel

parts lots of electronics lots of tires and plastic parts

all waiting to get you know put together So then

there are finished good and they can be shipped off

to a you know dealership or car A van near

you will think about the financing on that amount of

money The truck payers paying seven percent a year on

the one point two billion dollars in inventory capital that

it's holding at any given time Well that's eighty five

million dollars or about a third of the company's earnings

Seven percent on a billion to is a lot of

money for a low profit margin carmaker So then applying

proper accounting practices the business tallies the amount of finished

goods it has sitting in its warehouse just like it

did with direct materials inventory The firm then calculates the

value of its finished goods or its final product That

figure then gets listed in the firm's financial statements as

well as inventory But the inventory isn't done yet There's

one more step work in process has to be actually

counted and then added to the inventory value with work

in process stages a sensitive part of the whole shebang

Once the products are finished you can then sell the

inventory You can't sell it until they're done If the

business hits a rough patch or has to liquidate itself

like it's going bankrupt And just as the cell for

parts well the finished products can get sold for cash

even if prices have to get cut dramatically Those finished

product still have value the work in process not so

much like you can think about a ninety eight percent

finished car that just needs a waxing Yeah you could

probably auction that for a modest discount But a half

built car you know Good luck with that Well a

similar story happens with just raw materials like Think about

it in practice here a truck maker with a warehouse

full of tires can extract some value by liquidating the

unused tires But once they're on a truck and they've

been driven around for eighteen miles testing things well they

can't really be returned to the tire maker or sold

us anything close to newly priced tires So if you

have a truck that's half made tyres installed but the

vehicle isn't roadworthy doesn't have bumpers or you know a

streaming music service already set up in it Well then

you don't have a truck you Khun Cell and you

don't have parts that you Khun Cell or return It's

pretty much the worst of both worlds like un Miley

Cyrus While tracking work in process figures allow the company

to give a complete financial picture of its inventory Yeah

partially done stuff and fully done stuff and you kind

of add the two values together So what happens Well

you stop your mom from sending money to the fake

Uncle Harry turned out the call was a prince of

Nigeria sort of thing She is so happy you saved

her from getting scammed She offers to invest in your

cozy business at a very high valuation to you Then

you use the money to build the factory and hire

some employees Now you make ten thousand cozies a month

You buy one hundred fifty thousand dollars of raw materials

get started on your expanded cozy business Your workers start

making little Paul Krugman's and Gary Beckers each cozy cell

for fifteen bucks After three months it's time to put

together a financial statements for your first quarter of operation

Well what happens It was part of the process You

conduct an inventory taking time It's been three months and

you've made thirty thousand total cozies Now there's five thousand

dollars worth of materials in your store rooms just sitting

there Meanwhile you've sold twenty five thousand cozies over that

three months The quarter there earning total revenue from sales

of three hundred seventy five thousand dollars Meanwhile there are

five thousand finished cozies sitting in the warehouse ready to

sell the value of those cozy stands at seventy five

grand That's five thousand cozies times the fifteen dollars sale

price for each That's net in sales to you and

you're carrying your inventory at the price that it's expected

to sell for And that's a controversial that might be

a high price to carry that But you have so

many advanced orders coming it's probably fair accounting to hold

them there because you know there are more or less

spoken foreign soon out the door Anyway that seventy five

thousand dollars figure well it goes into the financial statements

seventy five grand worth of finished inventory Well what else

is going on here You also find that five hundred

cozies are in process works in process at the time

you calculate the value of the inventory you're holding on

the balance sheet So on average there about a half

done So at the close of your period this quarter

you've got net two hundred fifty cozy equivalents in your

W inventory Their value goes on the books as thirty

seven hundred fifty bucks in the work in process inventory

right Because they're half done or half the sale price

that they would be a tte the goose step seventy

five hundred bucks price So that's five hundred cozies half

finished giving you two hundred fifty net finished cozy equivalence

Each one value fifteen dollars So two hundred fifty times

fifteen is Yeah three seven five zero for the inventory

reckoning And that's it That's how you do your books

You got your finished inventory You're partially finished inventory or

inventory in process Your total him up And that's the

total value of your inventory Yes and Milton Friedman would

be so proud Or at least Uncle Harry Wood Oh