Accounting for Manufactured Inventory: Cost Classification Under GAAP

Avoiding inventory cost misclassification under GAAP

Accounting for manufactured inventory under generally accepted accounting principles (“GAAP”) is complex, given the variety of direct and indirect costs, and missteps can lead to significant reporting errors. Properly distinguishing between costs that must be capitalized into inventory and those that must be expensed as incurred is essential for accurate financial reporting. Misclassification of costs can lead to significant financial misstatements. This article clarifies the distinction between these two types of costs and their impact on inventory valuation.

Inventoriable costs under GAAP

Costs necessary for the production of inventory, such as raw materials, labor, and other expenditures, must be capitalized as part of inventory. The following costs meet these criteria:

Direct costs

• Direct Materials: These are the raw materials that physically become part of the product. Examples include clay for bricks, wood for furniture, and leather for shoes. These costs are traceable to the final product.
• Direct Labor: This represents the compensation and related benefits of employees directly involved in the production process. Workers such as assembly line operators, machinists, and fabricators fall into this category.

Indirect costs

• Indirect labor: This represents the compensation and related benefits of employees who support production but do not directly work on the product (supervisors, maintenance, quality control).
• Manufacturing Overhead: These are indirect costs that support the manufacturing process but cannot be traced directly to a specific product or job. While not directly tied to any one item, these costs are essential for overall production. Examples include rent, utilities, depreciation of production equipment, production-related insurance (e.g., factory property coverage), property taxes, and supplies. A portion or all these costs should be allocated based on their usage in the production process.

After capitalization, GAAP requires inventory to be measured at the lower of cost or net realizable value, ensuring that reported inventory reflects its recoverable amount. This valuation rule prevents overstating inventory and ensures compliance with GAAP reporting standards.

Period costs under GAAP

While many costs must be recorded in inventory, others must be excluded and/or expensed in the period incurred. These non-inventoriable costs do not support the production of goods or the manufacturing process. Some common examples include:

• Selling, General, and Administrative Costs: These costs, such as office salaries, sales commissions, advertising expenses, and administrative costs, are not tied to the manufacturing process and, therefore, are not capitalized into inventory.
• Interest: Interest is generally expensed as incurred under Accounting Standards Codification (“ASC”) 835-20, except for qualifying self-constructed assets or custom-built items intended for sale that require a long production period (e.g., ships or aircraft). Routine manufactured inventory does not qualify.
• Abnormal Waste, Scrap Defectives, and Spoilage: The key word is abnormal, as these items must be expensed as incurred. Normal waste, scrap and spoilage (recurring aspects of the manufacturing process) can be capitalized into inventory. Examples of abnormal waste include avoidable damage, defective, or unusable materials resulting from human error, while normal waste includes unavoidable material loss, scrap, or spoilage during processing.
• Research and Development Costs: These are costs incurred during the process of designing and developing new products or processes. Under ASC 730, research and development costs are generally expensed as incurred. Even when certain development costs have future benefit and qualify for capitalization under other guidance (such as software development or fixed asset construction), they are not included in inventory.

Why proper classification matters

Properly distinguishing between costs that must be capitalized into inventory and those that must be expensed as incurred is essential to accurately reporting inventory valuation for manufacturers. By following established accounting principles, manufacturers ensure compliance with industry standards, ultimately delivering financial statements that reflect true business performance.

How we can help

At Keiter, we specialize in the complexities of inventory cost allocation and are committed to advising our clients on how to apply these principles. Our team of specialists can provide insights and support for your inventory accounting needs.

For further assistance or tailored guidance, please contact your Keiter Opportunity Advisor | Email | 804.747.0000

Resources and further reading:

For full guidance, visit the Financial Accounting Standards Board (FASB) ASC and review these key sections:

• ASC 330 – Inventory
  • 330-10-30-1: Inventory measured at cost
  • 330-10-30-3: Conversion costs (direct labor and overhead)
  • 330-10-35-1B: Lower of cost or net realizable value
• ASC 835 – Interest
  • 835-20-15-5, 15-6: Interest capitalization for qualifying assets
• ASC 730 – Research and Development
  • 730-10-25-2: R&D costs expensed as incurred