Work in Process Inventory (WIP) – Definition and Formula
Every manufacturing company must deal with inventory. Those that do it thoroughly by properly accounting for Work in Process inventory are bound to have a competitive advantage over the others.
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And whether the counting and reconciling of inventory for raw materials or components versus finished goods is done manually on paper, on spreadsheets, or by using connected software platforms and scanners, the calculations are straightforward. Materials in, a calculated Bill of Materials and waste as a guide, and finished goods out should produce a correct starting and ending inventory.
What is Work-in-Process (WIP)?
WIP, or “Work in Progress” is a part of a company’s overall inventory that
While both raw materials and finished goods can be
Calculating Work in Process Inventory
As materials move from the warehouse to the production floor, labor is accrued at every move. This may include forklift operators as well as line operators, stagers, and finish labor. It will also include the labor required to transport and store the finished goods in the finished goods warehouse or dock.
In addition to direct labor, there are overhead costs as well. Overhead costs include items such as:
- Indirect labor
All direct and indirect costs must be added to the Work in Process to ensure accurate valuation. This requires an accurate Bill of Materials (BOM) that applies each line of direct and indirect costs in the right proportion and against the produced volume. If the BOMs are correct for all WIP within a factory, the estimated number may be considered a close enough estimate for accounting.
It is also possible to do a manual WIP count but the process is often labor-intensive and therefore expensive and reserved for yearend inventory valuations.
Read more about Applied Overhead vs. Actual Overhead.
Work in Process Accounting
Usually, a company takes a WIP count at an established accounting period. This may be monthly, quarterly, or yearly. The ending WIP count for the end of one period becomes the beginning WIP inventory for the next and again the raw materials and BOMs used should match the number of finished units completed.
The frequency and method of WIP count may also depend on the type of manufacturer. Private companies have fewer reporting requirements but must value certain things correctly for taxation purposes depending on the locality or country. On the other hand, public companies often have stricter and more detailed reporting guidelines in addition to taxation reporting.
Regardless of the type of company, all companies must produce the most accurate WIP count possible because,
The value should only include raw materials, overhead, and direct
You can use Work in Process Inventory to Calculate the Cost of Goods Manufactured.
Why Accurate Work in Process Accounting is Important
All companies are intensely focused on their cash flow statement and overall financial health. But while larger companies can absorb a few more errors due to scale and averaging, small to medium-sized companies often have little to no room for error. There are three important reasons why accurate WIP accounting is a must.
- Taxation – No one wants to be audited by their country’s tax service for inaccurate taxes. As a current asset, WIP is a taxable entity, and underestimating or inaccurate accounting can result in hefty fines. The opposite is also a danger as overestimating can make manufacturers responsible for higher taxes when they aren’t required.
- Cash Flow and Financing – Many companies use short-term financing, including WIP Inventory Financing, to address short-term cash flow issues. Requirements for this type of financing always include accurate WIP accounting and valuation and an incorrect valuation may lead to the discontinuation of the short-term financing agreement. Accurate values are also used when assessing a company’s health for a longer-term loan as well.
- Production Impact – Inaccurate WIP accounting can also lead to production errors. By overvaluing or undervaluing one segment of WIP, upstream processes may be triggered to make up a perceived loss or idled to allow a perceived overage to deplete. If the WIP calculation and valuation was wrong, the factory may become out of balance, impacting delivery schedules and leading to negative financial misfortunes from the reduction of future sales. Inaccurate accounting can also send the wrong demand signal to raw materials purchasing who will then overorder materials and tie up cash flow with overstock, or in underordering which drives up costs through equipment stoppage or through expediting of freight to bring in the required material once the error is discovered.
Correctly Managing WIP
Accurate WIP is an important part of any company’s total inventory. And keeping that inventory
The most effective solution for overall inventory management is software. Using an appropriately sized and customizable platform, factories can deploy an MRP system or manufacturing ERP solution that fits small to medium-sized companies with the same capabilities – and accuracies – found in large manufacturers of scale. These platforms not only allow accurate cost accounting but also include
There are several reasons why a factory manufacturing software can improve WIP accuracy and accounting:
- Even if a company has a small WIP footprint, and a short production cycle, manual and spreadsheet-based programs become unwieldy as the company grows.
- Human beings are prone to make mistakes, and mistakes in raw materials inventory (which may also be manual), or mistakes in BOM calculations will multiply the errors in WIP as the error echoes through the system. Most platforms integrate with modern RF scanning to ensure not only accurate counting and valuation but also to allow tracking so that inventory does not move from raw material to WIP too soon and so that WIP can be listed as a finished good in real-time and not unnecessarily tie up asset value in WIP.
- As an asset, inventory aided by software will help to properly value WIP as an asset reducing the chances of taxation dilemmas or cash flow issues. And as the software is tied into the MRP/ERP system.
As supply chains and manufacturing become more complex with the increase in globalization, factories are tasked with honing production and inventory accuracy across their enterprise to stay competitive. It no longer makes sense for small to medium companies to remain stuck in a manual, spreadsheet world.
Modern platforms not only allow tracking, accurate data and analysis, increased agility, and a high degree of customization. They also are on par in capabilities and functionality with larger MRP/ERP programs that can ties inventory, production, and finance together and prevent small and medium companies from finding themselves one bad WIP valuation away from disaster.
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