Small Business Doctor

Companies need to keep some amount of inventory. When I go to a home repair supplier, I expect them to have the copper pipe I need in stock. When I go to my local bakery, I expect them to have the macarons I crave in stock. When I go to my local grocer, I expect them to have my local dairy’s milk in stock.

How much stock these retail stores should keep on hand is a question they need to answer well. Their customers rely on them to answer this question well. Similarly, their supplier vendors also need to answer this question well. In fact, all companies need to answer this question of how much inventory they should keep of each product.

Maintaining an inventory is an obvious need of any company. And yet, the devil is in the details. When accounting convention distorts the true answer, however, companies unfortunately pay real money through economic inefficiency. For small businesses, this cost can quickly become unbearable.

To see this play out, let’s examine operating expenses. Operating expenses are exactly what they appear to be. Operating expenses, sometimes known by the shorthand OpEx, are expenses incurred by a company’s normal day to day operations. Costs like rent, wages and office supplies are operating expenses.

Operating expenses appear on the income statement. Here’s an example.

In this income statement, the two lines below Gross Profit “Selling and Operating Expenses” and “General and Administrative Expenses” comprise “Total Operating Expenses.” Sometimes these two lines are combined as Selling, General and Administrative Expenses, and are otherwise known as SG&A.

In this example, total operating expenses are $10. However, while $10 is the correct GAAP answer, $10 likely understates total operating expenses for a company that makes things by a lot.

Where are the other operating expenses then? By GAAP rules, expenses that are actually operating expenses are obscured inside two other places in the financial statements.

The first place where these operating expenses in every way but name are concealed is inside the Cost of Goods Sold entry above Gross Profit. The second place where these operating expenses in every way but name are hidden is within Inventory on the balance sheet.

Inventory and Cost of Goods Sold are essentially the same thing at different stages in a company’s producing and selling process. Cookies that have been sold already are in the Cost of Goods Sold bucket while cookies that are sitting on the shelf, in the oven, as well as all the sugar and flour are all in the Inventory bucket.

Cost of Goods Sold, sometimes known as COGS or as Cost of Sales, should according to GAAP include only costs directly tied to the production of goods for sale. The same is true for the Inventory bucket.

Both Cost of Goods Sold and Inventory include direct materials, direct labor and manufacturing overhead. These are supposed to be the direct costs of producing the goods that were either purchased by customers during the period (COGS) or will be purchased by customers in a later period (Inventory).

Would this ordinary expense have been incurred by the company if no product was sold or produced during this period? If the answer is no, then this expense is part of the Cost of Goods Sold or Inventory. If the answer is yes, then it is an operating expense.

A Period Expense Disguised as an Asset

So, how do these two buckets include costs that are operating expenses in every way except by name? By including costs that are not directly variable to products being produced.

If a bakery produces 100 dozen cookies in a period, its direct materials like flour and sugar are directly variable to those cookies. If the bakery were to produce 200 dozen cookies, those direct materials would double. The same would be true for cookie boxes and all other direct materials.

Unless the bakery’s production employees are day laborers or perform piecework, however, these employees will still be paid their hourly wages even when their labor or lack thereof is not directly variable to the production of those cookies. The cake decorator will still be paid their wages even when there aren’t any cakes to be decorated. She will wait. Maybe she will clean something or serve a customer while waiting. Regardless, those wages are classified according to GAAP as direct labor that will increase the value of the bakery’s inventory.

The same is true for the bakery’s rent and utility payments for their baking space. These are classified as manufacturing overhead, and even when baking production has to stop or slow for whatever reason, these costs will continue to be applied to the production of goods for sale.

Unlike direct materials, the conversion costs of direct labor and manufacturing overhead are not in real life directly variable to the production of goods for sale. We don’t withhold pay and shutter production facilities directly in response to a production slowdown or stoppage.

Eventually we might need to layoff employees and downsize our production facilities, but we wouldn’t stop on a dime or even after a quarter in direct response to a slow down or stoppage the way that we would directly stop our utilization of direct materials in the same situation.

Instead, what is the most common management response to a slowdown in product sales? Inventory is built up to prevent idleness in the present and in the hope that future demand will soak it up.

This happens even though almost every piece of management advice over the past 50 years says that producing and holding inventory beyond what the company reasonably forecasts it will use is generally a bad idea. Inventory is inherently risky due to potential damage, spoilage, storage costs, obsolescence, and so on.

What happens when for whatever reason my inventory stockpile is now worth less than its historical cost of production or is even maybe now outright worthless due to the market? The accountant makes a one-time inventory write-down or a complete write-off. That’s not the behavior of a reliable asset. Your cash asset is not subject to a write-down or a write-off like that. Neither is your delivery truck, real estate or production equipment.

That is why direct labor and manufacturing overhead are in real life operating expenses in every way except name. These real life operating expenses are obscured by GAAP accounting inside the asset Inventory. Direct labor and manufacturing overhead are in real life a deferred operating expense disguised as an asset.

This accounting rule is also a violation of GAAP’s conservatism principle. All estimated losses should be recognized and recorded before they occur, while estimated gains should not be recorded. This approach is to ensure that financial statements do not overstate assets or income. And yet, this simple demonstration shows both an overstating of assets and of income due to classifying conversion costs as inventory assets instead of as period expenses.

This is an accounting farce that adversely affects company decision makers and the users of company financial statements. There is no good reason for this distortion to persist, and this distortion is particularly harmful to small businesses.

What Are the Effects of This Cost Accounting Distortion?

The GAAP-required accounting treatment of direct labor and manufacturing overhead costs as components of the asset Inventory instead of as the period-specific operating expenses they are in real life produces at least the following six distortions.

Incentivizes inventory increases and disincentivizes inventory draw downs

To better see these distortions, suppose that Company A uses standard accounting and adds direct labor and manufacturing overhead to value its inventory while Company B does not. Company B expenses them in the period they occurred as SG&A expenses. The sales and expenses of each company are identical. Every operation, literally everything they do, everything is identical. Economically, they are the same entity. The only difference is in the accounting treatment of conversion costs, which are direct labor and manufacturing overhead.

If the only difference is the accounting treatment of direct labor and manufacturing overhead, then why does Company B have $400 of expenses and Company A have $325? Look at their respective balance sheets.

The $75 difference in expenses between the two companies is inside the balance sheet asset of Inventory as Conversion Costs. This has the effect of boosting both assets and of course equity for Company A.

So, a company that shifts conversion costs onto their valuation of inventory will have a higher net income and greater asset valuations than a company that does not. These effects of boosting profitability and company valuation will persist and accumulate during every period during which inventory grows. Furthermore, these boosting effects will scale with the amount of inventory produced during a period.

Which company is more likely to get a bank loan? Which company is more likely to attract investors? Remember, the only difference is in the accounting. The only difference is in how the same information is classified and presented. As a result of this single difference, Company A appears, according to the accounting, to be a much better company than Company B even though they are exactly the same.

The opposite effects happen, however, during periods in which inventory is reduced. Suppose that Year 2 was a booming one for sales. It was double Year 1, and all of the inventory was drawn down.

As can be seen, using up all of the prior year’s inventory exactly reversed the profitability and net asset valuations from the prior year. Now their situations are reversed. Company B is now more profitable than Company A. Its balance sheet accounts during Year 2 also increased by more than Company A.

And yet, both companies now have the same balance sheet at the end of Year 2. Even though both companies were exactly the same, their profitability and net assets appeared significantly differently until the end. This effect was entirely due to a difference in accounting practice.

This demonstrates that, all things held equal, this accounting treatment incentivizes company managers at Company A to avoid drawing down their inventory. Similarly, they are also always, all things held equal, incentivized to have excess production capacity so that they can grow inventory. If Company A had not drawn down or devalued its inventory, it would have still appeared to be more profitable and more valuable than Company B even though they are otherwise identical companies.

Distorts management decision-making

This also demonstrates that this accounting rule also distorts sound management decision-making, because there is no rational economic reason for increasing production capacity in this demonstration. Doing so would make Company A in reality less economically efficient than Company B. Doing so would simply add costs with no real economic benefit.

This effects of this distortion are particularly pernicious for small business managers, because for most small businesses, cash is at a premium. Being incentivized to increase costs for no good financial reason other than to make artificial accounting numbers look better risks the survival of the small business.

Remember, in real life the existence of finished goods inventory inside of a company by definition means that there is no consumer demand for those products at their sale price at this time. If there were, they would be sold. So ask yourself “Why should these products currently be valued at this price when there is no demand for them at this price?”. A direct materials valuation of inventory is closer to a scrap value floor for these goods that is more consistent with other GAAP accounting treatments.

A small practical example of the pernicious effects of this distortion would be to decide to purchase the piece of equipment that works with larger batch sizes rather than the smaller one. This distortion makes it seem like not only are there no real downsides to overproduction, but the cost per unit would often be lower with bigger equipment. However, if as is often the case, there is little demand for that overproduction and bigger equipment is more costly to acquire, maintain and operate, this decision bias can be very harmful to a small business.

Increases volatility

An additional effect of this perverse incentive structure is to increase the riskiness and hence volatility of Company A’s reported earnings. If, as has been demonstrated, inventory conversion costs are really deferred operating expenses, then the longer these expenses are deferred, the more risky and volatile are reported earnings likely to be.

And this effect is also demonstrably true. Imagine if Company A had continued building its inventory during several years before an inventory draw down. The effects would have been even more pronounced. Counterintuitively, if that company experienced a record-breaking sales year with draw downs of a few years’ worth of inventory, it might actually result in a net loss according to this accounting rule. And this doesn’t only occur through sales. Inventories are routinely written down with little to no warning to the users of financial statements.

These write-downs and write-offs of inventory are often putatively due to factors like market forces beyond management’s ability to control or to foresee. The story is always the same. The company has an inventory of red shirts, but now the market prefers blue shirts. Write-down the red shirt inventory. Wise managers, however, should possess the foresight to shield their assets from such pernicious devaluations. If that’s not possible, then reconsider the value of said “assets,” as they may be more speculative than sound.

Other non-inventory assets like cash are indeed held to such standards. There is voluminous guidance and even a professional certification in managing the cash asset such that nothing including inflation can devalue this asset for a company. And yet, somehow, product inventories are incapable of being managed in such a way. Hmm.

Incentivizes eventual inventory dumping

The company may well be producing red shirts at a feverish pace for its inventory in the teeth of an evolving market trend towards blue shirts. And we would still value those red shirts in inventory at a minimum by their direct material and conversion costs as though the real world market did not exist. Even though the real world reality is that nobody is producing red shirts any longer, because their value is below their cost of production. The real world reality is that their red shirt inventory should be valued at a fraction of its cost and yet we will allow months or even years to pass before that reality is made manifest in that company’s financials through a write-down or a write-off of this inventory.

When that inventory is eventually written-down or written-off, it is often in the form of an inventory dump. The clothing industry is notorious for this. Inventory is moved through outlet stores and discount chains at massive price cuts from the valuations it previously held.

Instead of the market clearing through a gradual price discovery process, inventory is dumped in huge batches. For these huge batches of inventory to clear the market, prices need to be even lower than they would otherwise be. The reason inventory is dumped in huge batches has a lot to do with this accounting treatment for inventory.

Creates an artificial entry barrier to startups

Inventory dumping itself effectively creates an artificial barrier to entry for potential entrants to the industry. A startup that intends to compete on price or value must not only out compete the existing competition’s normal pricing but their massively discounted inventory dump pricing as well.

Anytime a market is flooded with goods that are priced artificially below their market price if there weren’t an inventory dump, whether it’s China or Nike doing it, it diminishes the opportunities for startups or small businesses to compete in that market. They are forced to compete in an unfair rigged market.

Diminishing Returns to Management

From an economics perspective, what this accounting treatment does, and to be clear again, this is longstanding and correct GAAP accounting, is it obscures the economic reality that there are diminishing returns to management. Placing operating expenses inside of inventory masks the ongoing inefficiencies of managing a large company.

The larger the company, the more complicated and complex is its management. This was proven by Nobel Prize-winning economist Ronald Coase decades ago. Production planning and product demand forecasting are notoriously challenging, and company management often gets these decisions wrong. If the consequence of these mistaken decisions is inventory growth, which on financial statements looks good and probably makes production supervisors look good, then there is no real incentive to make better decisions. Thus, the negative consequences of overproduction are obscured to management while those of underproduction, primarily foregone sales, are crystal clear. Better feedback would help management make better decisions.

It is of no surprise that cost accounting, from which this accounting practice derives, was invented by big inefficient corporations like General Motors. No sane sole proprietor or small partnership would ever be incentivized to make such a mistake as to confuse their strategic decision-making. They are too close and involved to not see this.

No. This accounting treatment favors large corporations with large production capacities. The purpose of a system is what it does. The purpose of adding conversion costs to inventory is to enable big companies with large production capabilities to appear more efficient at value creation than they actually are. All things equal, small companies can always be more agile and out compete any larger company on cost. This accounting practice obscures that reality by distorting and delaying the real costs of overproduction by the large companies that do this practice and must adhere to GAAP.

Your local baker, farmer, professional or tradesman does not typically do this. They face no incentive to do this. Cash-based accounting does not distort economic reality like this. General Motors, Meta Inc. and their corporate peers, however, are absolutely incentivized to do this. And if this incentive structure and its effects were widely known, maybe it would not matter. But as a supporter of small businesses of all kinds, I need to educate the public on this accounting distortion to hopefully prevent yet another small business succumbing to the risks of believing that bigger is always better.

Promotes corporatism at the expense of capitalism

As capitalists, we all know that companies create value for society. This question for inventory valuation is when does that value creation occur?

I am not asking which stages of the value creation process contribute to that process. Nor am I asking which stages of the value creation are essential for a company. For most companies, value creation begins deep in their value chains.

Rather I am asking about the moment that company realizes the value of what it has produced. According to cost accounting this value is recognized by a company as its product is being produced. But in the real world of bank accounts and legally enforceable contracts, a company realizes the value of what it has produced when that product is exchanged for something of value, usually cash.

Suppose my company makes a hi-tech product that nobody wants to buy at any price equal to or greater than what it costs me to produce it. This scenario might seem far fetched, but this is not uncommon in the startup tech space. The market is telling me that my company has not produced something that the market assesses is worth what I could sell this thing for.

The beauty of a capitalist economy is that there is value in the free exchange of goods and services. The central planner does not decide this, and neither does a company. My company cannot dictate that someone else in the market buy this hi-tech product of ours even if we offer at our cost of production.

The value creation of capitalism lies in both free exchange and free entry. I have already briefly discussed above how valuing inventory is this manner artificially creates a barrier to entry for small firms. Here I am identifying how this accounting treatment of inventory artificially locates the value of an exchange within the company instead of within the marketplace.

It is through an economy’s free exchange that value is recognized and received by society. To place this immensely powerful value creation moment within the company rather than within the marketplace is to elevate the company above the marketplace. That is the essence of corporatism.

Corporatism is not capitalism. Corporatism is capitalism’s evil twin. Corporatism cannot survive within an economic system reliant on free entry and free exchange.

What is corporatism? Corporatism is what President Eisenhower called the military-industrial complex. Corporatism jacks up prices. It captures consumers. It favors regulations and laws favoring industry interests. Corporatism is all about bigger being better. Bigger barriers to entry to squash small competitors.

Corporatism is not inspired by Adam Smith and our American founders. Corporatism is inspired by Keynesian welfare politics and Fordist industrial organization with big corporations taking on quasi-public status in the economy, politics and in social issues. Sound familiar?

These big corporations need regulations that favor them so that they can keep new startup companies out of the marketplace. Why? Because the moment these small companies enter, they will outcompete these big businesses.

This accounting treatment of inventory is GAAP required accounting. It is an accounting regulation with massive implications. This accounting rule is a perfect example of large entrenched companies capturing public accounting regulations to benefit themselves at the expense of the small startup companies that would slay them in the absence of such regulations.

But this inventory is temporary and immaterial

Two rebuttals to this argument are some variation of the following:

• This is a temporary situation that will reverse itself next period or soon thereafter.
• This is not in practice used to materially alter a company’s financial position.

The response to these two points is to point to the years-long ongoing re-estimation of their computer server inventory’s useful life by Meta, Google and Microsoft, which was initially identified by Michael Burry of The Big Short fame. Since 2020, these corporations’ good faith estimates of their own servers’ lives keeps increasing. The effect of these ongoing re-estimates of their inventory’s useful life is to avoid devaluing that inventory and thereby to boost profits as shown in the demonstration above.

Hmm. Does anyone really think that there is some basis in material reality that somehow year after year pushes the useful life of these corporations’ computer servers out into the future? Do they have magic servers that somehow double their useful lives every five years? Of course not. The executives of these tech companies are neither dumb nor naive.

This is classic accounting manipulation to make these companies’ financial statements appear as good as possible to the investing public. To them, the inevitable draw down and/or devaluation of inventory should happen only at just the right time. This is all legal and GAAP compliant, which, dare I say, is a big part of the problem here.

Inventory valuation is, under this accounting rule, a manipulable variable for corporate management to manage the appearance of their company’s financial performance and position. If these huge corporations can brazenly manipulate their inventory valuation through the supposedly objective and irregular re-estimation process that literally needs to be publicly declared, how much more likely is it that large corporations manipulate their financial performance and position through the much more subtle, unannounced and frequently rewarded process of inventory overproduction?

This essay was, as I personally have been since my youth, inspired by the late Dr. Eliyahu Goldratt. In particular it was inspired by his paper on cost accounting.