Jason Day, financial controller for Nilstrom Industries, was reviewing production cost reports for the year. One type of costs in these reports continued to bother him—fixed manufacturing overhead such as rental cost of the companies’ factories, and some of the electricity and other utility costs. This total fixed manufacturing overhead cost had grown sharply in recent years and is now approaching 30% of total manufacturing cost.
There had been much internal debate as how to report this overhead cost, both internally and externally. The Vice President of Operations, Maria Crane, argued that the current approach to these costs of reporting them as a cost of production, just like direct materials and direct labour should continue. She therefore recommended that this cost be identified as manufacturing overhead and reported as part of inventory costs until sold – saying “I’m not a qualified accountant but from my MBA I remember that all manufacturing costs must go to inventory and be expensed only when sold. To be consistent, this approach also needs to be followed for internal reporting.”
Day, however, was unsure and thought that perhaps this cost should be reported as an expense of the current period – and that perhaps Maria Crane had a vested interest in not wishing to do so. He was also unsure why Maria had insisted on increasing production recently even though sales demand had fallen. Others argued that fixed manufacturing overhead be reported differently internally than externally. The president finally had to decide the issue and asked each executive to submit a formal opinion on the matter.
Required
Jason Day approaches you as a trusted advisor to draft some advice for him evaluating the arguments as to how the cost should be accounted for both externally in the financial statements and internally for performance evaluation purposes. He is also keen to understand if there could be any reason why Maria Crane chose to build up inventories. Discuss all relevant points of view, but come to a conclusion as to the most appropriate way to account for fixed manufacturing overhead costs.
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