What is Work in Process Inventory and How-to Calculate it (WIP) + Formula
Every manufacturing company follows three primary phases in the manufacturing process. First, there is the sourcing of requisite raw materials from suppliers. Naturally, the second step uses these raw materials in the production process, and the last step is marketing or selling the finished products.
It is imperative for any business to account for the products in the production process, just as it’s essential to account for raw materials and finished goods.
This article discusses how to calculate the in-process inventory, the costs associated with it, and exactly why you need to account for it.
What Exactly is Work In Process Inventory (WIP)?
Wikipedia describes work-in-process inventory as a company’s partially finished goods awaiting completion and sale. Generally, WIP, also known as in-process inventory, can be described as the goods that are still in the production process and yet to be completed for final sale.
WIP is calculated after a given period, either monthly, quarterly, or annually. Typically, the ending WIP for a given accounting period automatically translates into the beginning WIP for the next period.
The frequency of WIP reporting generally depends on the type of company involved. While public companies must adhere to strict reporting guidelines, private companies typically have fewer reporting requirements, though they are still obliged to value items for tax reasons.
It is important to note that WIP is considered a current asset since it is inventory meant to be converted into cash within a year. All companies must therefore ensure they value their WIP correctly, especially for taxation purposes.
Terms Relating To WIP
Calculating the cost of in-process inventory is relatively complicated compared to calculating the cost of finished goods. This can be attributed to the fact that for in-process inventory, there are numerous revolving components.
Below are several terms and calculations that you ought to understand before diving into calculating your WIP:
1. Beginning Inventory
As indicated earlier, the beginning WIP of a company is derived from the ending WIP inventory of the immediate previous WIP inventory.
To ensure an accurate valuation of a company’s in-process inventory, one must ensure all direct and indirect manufacturing costs are incorporated. This means that a company should have a detailed Bill of Materials (BOM) that indicates direct and indirect costs against their corresponding production volumes. The total manufacturing cost is calculated simply by adding raw materials, direct labor costs, and overheads. Overhead costs include things such as insurance, depreciation, and utilities.
Manufacturing Costs= raw materials+overheads+direct/indirect labour costs
3. Cost of Manufactured Goods (COGM)
These are the cumulative costs incurred in the production of the final product. To accurately determine your current WIP inventory value, you need to first determine the cost of manufactured goods. To determine your COGM, you will need to add your beginning WIP inventory with your total manufacturing costs and then subtract the ending inventory.
COGM= Beginning WIP Inventory+ Total Manufacturing Costs- Ending Inventory
With this in mind, we can now proceed to calculate your WIP Inventory.
Calculating Your Work-In-Process Inventory
To calculate your in-process inventory, the following WIP inventory formula is followed:
Ending WIP Inventory= Beginning WIP Inventory + Manufacturing Costs- Ending WIP Inventory
Work In-process Inventory Example
Assume Company A manufactures perfume. The last quarter-ending work in process inventory stands at $10,000. The manufacturing costs incurred in this quarter are $200,000, and the cost of manufactured goods is $100,000.
Let’s calculate Company A’s ending WIP inventory as per the formula;
Company A’s ending WIP inventory for this quarter is, therefore, $100,000.
Valuing your Work-In-Process Inventory:
Once you have determined your work-in-process inventory, the next important thing is to determine its value. It is important to select the appropriate inventory valuation method for your business.
Most companies generally lean towards the LIFO method to value their in-process inventory as it represents the current market value of goods used in production. The LIFO method also lessens a company’s tax burden as the cost of items bought in the recent past is generally higher.
On the other hand, the First In First Out (FIFO) method is more natural as a company tends to use raw materials as they come in. It is also considered more orderly as the order of receipt of materials is easily identifiable.
Analyzing your Work-In-Process Inventory
Any manufacturing company that is concerned with ensuring its production level is optimal will automatically have to ensure it keeps minimal WIP inventory levels. Why? Wouldn’t it be better to have high levels of WIP inventory, even for your balance sheet? While this could also be a good strategy, it may not be the best one yet, owing to the costs associated with WIP inventory or any inventory.
Keeping your WIP inventory low automatically translates into keeping the associated costs low as reasonably. Like any other inventory, WIP will require storage and the use of various other utilities to ensure it is well preserved as it awaits completion.
Some people consider not storing the WIP and keeping it on the assembly line instead. While this might solve your storage problem, it creates a backlog in the production line and may even create customer dissatisfaction if you cannot supply orders in time.
High levels of WIP inventory also imply that you have many costs tied to the inventory account. This means that for as long as these funds are tied up in the WIP, you cannot apply them for other business needs or even invest them until the WIP has been completed and sold.
How Does WIP Inventory Affect My Business
You’re probably wondering why exactly I should use the WIP inventory method. What happens if I don’t? Does it have any impact on my business? Let’s find out. Below are several reasons why you ought to use the WIP inventory method.
- Production errors– if you use an incorrect system to account for your WIP, it is quite possible that you could wind up with production errors. How? Do you ask? If you overvalue or undervalue an aspect of your WIP, upstream processes could end up attempting to compensate for a perceived loss. You might end up either scaling down your production or ultimately overproducing. Further, a wrong WIP inventory is bound to influence key procurement decisions and sales and pricing strategies.
- Financing– companies with short-term cash flow issues tend to seek short-term financing solutions, such as WIP inventory financing. Lenders offering this type of funding require companies to provide accurate WIP inventory values, and incorrect values could lead to a lender terminating the financing agreement. Lenders also look out for precise WIP values to assess a company’s credit health when considering long-term financing solutions.
- Taxation– as indicated earlier, WIP is considered a current asset and is therefore subject to taxation. Undervaluing your WIP inventory can consequently lead to hefty fines from your tax authority. Conversely, overvaluing your WIP could result in paying higher taxes that aren’t the ideal requirement.
Work in Process v Work in Progress
These two terms are often used interchangeably, and you might therefore be wondering which refers to what and if there are indeed many differences between the two.
Below are some of the main differences between the two:
- While work in process is mainly used by manufacturing companies to refer to goods that are still in the process of being manufactured, work in progress is mainly used in the construction industry to describe ongoing construction projects.
- For work in process, the unfinished products being referred to are anticipated to be completed soon. For example, a bakery that has 20 cakes in production is a work in process. On the other hand, work in progress takes time and cannot be termed a current asset as it is not anticipated to be converted into cash soon. For example, a building expected to have 30 floors and has five floors currently complete is considered a work in progress.
- Work in progress is broader than work in process and can refer to renovation, work assignments, and services. Work in process is generally only used for products in the manufacturing process.
Advantages of Work In Process
On top of WIP inventory impacting your business, it also has numerous benefits attached to it, such as:
- As indicated earlier, WIP inventory is a current asset and needs to be valued for helping you access financing if need be.
- The tracking of WIP inventory also helps determine or identify any challenges in the production process, thus enabling them to be resolved faster.
- WIP inventory also helps companies ensure the flow of production remains uninterrupted. WIP is ignored; there may be an idle time in production as all inventories will be indicated as raw materials or finished products.
- WIP inventory helps a company meet the demand for its products as it helps ensure the production cycle remains uninterrupted.
- WIP inventory also helps in planning the production process and purchasing raw materials. WIP also helps ensure that no raw materials are left idle.
Disadvantages of Using WIP
- There is a risk of inventory becoming outdated, especially when the WIP inventory is more than what the market could demand, especially for companies dealing with seasonal goods. This is because it needs to be produced to meet anticipated demand. Continuous production of goods could lead to a pile-up of inventory.
- The valuing of WIP inventory tends to be a bit complex as one must understand precisely where the stock stands. E.g., the level of completion and the costs incurred on the same as at the end of the accounting period.
- Tracking inventory and ensuring the same is an additional expense for the business.
Managing Your WIP
Any business needs to adopt appropriate inventory management practices and ensure you have accurate WIP inventory values. At the inception stage, most companies prefer manual counting or spreadsheet-based inventory keeping due to the size of production and cost constraints. However, as a company grows, this method becomes both tedious and error-prone.
The best way to effectively manage your inventory is to use inventory management software such as EMERGE App. The software ensures that your inventory accounting is accurate and helps you track and manage it in a customizable manner
Below are several reasons why you ought to consider a digital solution such as EMERGE App for the management of your inventory:
- Even if you are beginning your company and your WIP footprint is still relatively small, manual inventory management and tracking systems are not sustainable in the long run
- Humans maintain manual systems, and systems run by humans are prone to error. Any errors made in manual inventory counting will be translated into your WIP inventory valuation and will result in inaccurate WIP values. A software system helps you avoid making errors and helps identify any discrepancies or errors faster and more efficiently.
- Because WIP inventory is an asset, a software inventory management system helps you value your inventory accurately, reducing the chances of run-ins with taxation authorities or cash flow issues.
Suppose you understand your WIP inventory and the impact it has on your business. In that case, you can make informed supply chain management decisions and come up with innovative ways to optimize your supply chain and garner more revenue from it.
Effectively managing your inventory is one of the critical steps that one must take to run a successful business. Be sure to partner with software service providers such as Emergeapp to help you achieve your inventory management goals.