Some manufacturers have been known to intentionally misclassify their manufacturing overhead costs. They record a certain amount of manufacturing cost in marketing expense or general and administration expense that should have been recorded in their manufacturing overhead accounts. Therefore, the amount of the misclassified costs isn’t included in the calculation of product cost. The purpose is to maximize costs that are charged off immediately to expense in order to reduce the current taxable income of the business. By minimizing current taxable income, a business reduces its income tax for the current year, of course.
The Internal Revenue Code takes a special interest in the problem of manufacturing overhead cost classification. The experience of the IRS had been that many manufacturers were misclassifying some of their manufacturing overhead costs. Congress amended the tax law to remedy this tax-evasion technique. The income tax law now spells out in some detail particular costs that must be classified as manufacturing overhead costs and therefore capitalized. Capitalize means to record the cost in an inventory asset account by including the cost in the calculation of product cost. The cost of products held in inventory remains in the inventory asset account, and the cost is not charged to expense until the products are sold.
Through this post, I am going to demonstrate how a manufacturing cost could be misclassified and how it affects the profit. Enjoy!
What Cost to Be Classified as “Manufacturing Cost”
The following costs should definitely be classified as manufacturing costs:
- Production-line Employee Benefits costs;
- Rework, Scrap, and Spoilage costs;
- Quality Control costs; and
- Repairs and Maintenance [on production machinery and equipment].
Of course, you should classify depreciation of production machinery and equipment, as well as property taxes on the production plant (building and building and land improvements), as manufacturing overhead costs.
The Effect of Misclassified Manufacturing Costs
To illustrate the effects of misclassifying manufacturing costs, suppose that $960,000 of a company’s fixed manufacturing overhead costs had been recorded in general and administrative expenses. Have a look at the following profit and loss report:
Otherwise, other factors remain the same.
The next figure shows the effects of the misclassification error. Note the impact on the operating profit line, which generally approximates taxable income before the interest expense deduction:
[Note: As you probably know the income tax law has many special provisions that affect the actual taxable income of a business for a year, which we don’t discuss in this post]
In the above figure, the amount of general and administrative expenses is inflated $960,000 [from $1,420,000 [in the first figure] to $2,380,000 [in the second figure]].
Now, you may think that operating profit should be lower the same amount, or $960,000;
No, this isn’t the case.
Here is why:
The large part of the $960,000 misclassified fixed manufacturing overhead costs would be charged to cost of goods sold expense if it had been classified properly. The business sold 11,000 units of the 12,000 units it produced during the year, so 11/12 of its manufacturing overhead costs end up in cost of goods sold expense.
For the $960,000 of misclassified overhead costs, $880,000 would have been included in cost of goods sold expense if it had been classified properly:
$960,000 misclassified amount of manufacturing overhead cost × 11/12 ratio of units sold to units produced during period = $880,000 amount that would have been in cost of goods sold expense.
Therefore, the net effect on operating profit is only $80,000:
[$960,000 overstatement of general and administrative expenses minus $880,000 that would have been in cost of goods sold = $80,000 net decrease in profit].
Take notice of the manifold mischief that misclassifying manufacturing costs causes [see the second figure again]. Cost of goods sold expense is wrong, which means gross margin is wrong. And, of course, operating profit is wrong. The amount of manufacturing cost allocated to the increase in inventory is $80,000 too low. Operating profit, or taxable income before interest, is $80,000 less, which is the point of the misclassification. Therefore, income tax for the year is lower.
Warning: Intentionally misclassifying manufacturing overhead costs is viewed as cooking the books by professional accountants, and, more importantly, by the IRS. If you’re tempted to misclassify your manufacturing costs, don’t forget that the IRS may select your business to audit and discover that you’ve committed accounting fraud.
Although it would be rather unusual, a manufacturer could feasibly begin and end the year with no inventory. In this atypical case, operating profit would be the same no matter how costs were classified — although for internal reports to managers, the proper classification of costs is always important.
Target sales prices are determined by marking up product cost a certain percent. Thus, managers should be very certain regarding whether the correct amount of manufacturing overhead costs are included in the calculation of product cost. If not, the markup percent should be adjusted because it would be based on an understated product cost. The better course of action is to properly classify manufacturing overhead costs in the first place.