The transformation has to be measured
A trading business buys something and sells it, so its cost is knowable. A manufacturer converts inputs into something different, and the cost of the output has to be constructed rather than observed.
Raw materials, direct labour and production overheads all have to be attributed to what was made, across three inventory stages, with a defensible basis at each. And because production volumes fluctuate, the same factory can produce the same item at materially different apparent costs in different months — which is either meaningful information or an artefact of the costing method, depending entirely on how the method was designed.
The decisions involved are made once, usually at commissioning, often by whoever configured the system. They then govern the accounts for years, and they are almost never revisited even when the product mix has changed completely.
When this applies to you
Manufacturers and processors across food, building materials, packaging, chemicals, plastics, metals and light engineering. Assembly operations. Businesses with meaningful work in progress and substantial plant.
Particularly manufacturers whose production volumes vary, manufacturers with multiple product lines sharing a facility, and businesses that have added products or capacity without revisiting how costs are absorbed.
How the engagement runs
The work breaks into stages, and each one has to close before the next starts:
- Design or review the costing system — standard or actual costing, and how variances are calculated, analysed and treated.
- Set the overhead absorption basis against normal capacity rather than actual output, and test it annually.
- Build the bill of materials and routing so product cost is constructed from data rather than estimated.
- Value work in progress by stage on a measurable basis.
- Maintain the fixed asset register with component accounting and depreciation policy by class.
- Verify inventory across all three stages — raw materials, WIP and finished goods are three distinct counting problems.
- Test net realisable value, since absorbed cost can exceed what the product will sell for.
- Handle corporate tax and VAT, including capital asset treatment and any customs or excise interaction.
Variance analysis as management information
In a standard costing system, variances are where the operational information lives — and most manufacturers post them without analysing them, which discards the entire benefit:
- Material price variance — paid more or less than standard. A purchasing question
- Material usage variance — used more or less than the bill of materials specifies. A production or quality question
- Labour rate variance — a wage or mix question
- Labour efficiency variance — a productivity, training or maintenance question
- Overhead expenditure variance — spent more or less than budgeted on fixed overheads
- Overhead volume variance — produced more or less than normal capacity, which is capacity utilisation rather than efficiency
Each points at a different person and a different remedy. A manufacturer reporting a single unexplained cost variance knows only that something moved; one reporting these six knows what and roughly why, which is the difference between a number and a decision.
When absorbed cost exceeds what the product sells for
Inventory is carried at the lower of cost and net realisable value. In a manufacturer, absorbed cost can drift above realisable value for reasons that have nothing to do with the market.
Running below normal capacity inflates absorbed cost per unit, if the absorption basis was set on actual output rather than normal capacity. Input prices rise faster than selling prices can follow. A product line is superseded but the finished goods remain. Each produces inventory carried above what it will actually fetch.
The write-down is unwelcome and it is not optional. And because the businesses most likely to be carrying overvalued inventory are those running below capacity, the write-down tends to arrive in exactly the period that can least absorb it. Which is the argument for testing net realisable value routinely rather than at the year end — a problem identified in month four can still be traded out of; one identified in month twelve is simply reported.
What we see go wrong most often
Where businesses get caught:
- Absorbing overhead on actual output rather than normal capacity, inflating cost in a quiet period.
- Administration and selling costs absorbed into inventory, overstating assets and profit.
- Work in progress estimated rather than measured by stage.
- Variances posted without analysis, discarding the system’s most useful output.
- Absorption basis never revisited after the product mix changed.
- Net realisable value never tested, carrying inventory above what it will fetch.
- Repairs and capital improvements treated inconsistently, depending on what the year needs.
- No component accounting on major assets with parts of different lives.
Deadlines that apply
The absorption basis should be reviewed at least annually and whenever product mix or capacity changes materially — which for most manufacturers is more often than the basis actually gets reviewed.
Variance analysis is monthly. Net realisable value testing should be routine rather than a year-end exercise. Inventory verification should cover all three stages, at year end at minimum and cycled where volumes justify it. Corporate tax follows at 30 September 2026 for a December year end.
What lands on your desk
- A costing system with the absorption basis documented and tested against capacity
- Product cost built from bill of materials and routing
- Work in progress valued by stage on a measurable basis
- Six-variance analysis reported monthly with commentary
- Fixed asset register with component accounting
- Inventory verified across all three stages
- Net realisable value testing as a routine control
- Financial statements, audit file and corporate tax return
What we need from you
The list is short and you will have most of it already:
- Production volumes, capacity and output by product
- Current costing system and absorption basis
- Bill of materials and routing data
- Fixed asset register with acquisition dates and costs
- Inventory listings for raw materials, WIP and finished goods
- Factory overhead costs including utilities and maintenance
- Selling prices by product, for the net realisable value test
- Prior year financial statements
What it costs
Bookkeeping is priced on transaction volume. The costing system design or review is a one-off fixed fee and is where the value concentrates — it determines inventory value and reported margin in every subsequent period, and for most manufacturers it has not been examined since commissioning.
Inventory verification is quoted per count and is more involved than for a trading business, because work in progress must be assessed rather than counted.
Related
Frequently Asked Questions
What should be included in the cost of manufactured inventory?
Direct materials, direct labour and production overheads absorbed on a proper basis. Administration and selling costs do not belong there. Including them overstates both assets and profit, and it is a common finding in manufacturers without a formal costing policy.
Should overhead be absorbed on actual output?
No — on normal capacity. Absorbing on actual output means a quiet month inflates unit cost and carries that inflated figure into inventory. Unabsorbed overhead in a low-output period is expensed, because it belongs to idle capacity rather than to product.
How should work in progress be valued?
By stage of completion, on a measurable basis: materials issued plus labour and overhead absorbed to that point. Estimating it leaves the largest judgement in the accounts unsupported, and it is the first thing an auditor tests in a manufacturing business.
What is a volume variance and why does it matter?
The difference arising from producing more or less than normal capacity. It is a capacity utilisation measure rather than an efficiency one, and confusing the two leads businesses to chase productivity when the actual issue is that the factory is running below the volume its cost base was built for.
When should we write inventory down?
Whenever absorbed cost exceeds net realisable value — and it should be tested routinely rather than at year end. Manufacturers running below capacity are the most likely to be carrying overvalued inventory, which means the write-down tends to arrive in the period least able to absorb it.
Repairs or capital improvement?
An overhaul that extends an asset’s life is capital; routine maintenance is expense. What matters is a documented basis applied consistently rather than a judgement that follows what the year needs — it will be tested by an auditor, and taxable income starts from accounting income.
Our absorption basis was set when the factory opened. Does that matter?
Almost certainly. Product mix, volumes and the cost base will all have changed since, and an absorption basis that no longer reflects the factory produces an inventory value and a margin that are both wrong, in the same direction, every period. It is worth reviewing annually.
If the answer is when the factory opened, both your inventory value and your margin are probably wrong — consistently, and in the same direction.
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Last reviewed 27 July 2026. Rates, thresholds and deadlines change — the e-invoicing provider deadline has already moved once. Confirm current requirements with the Federal Tax Authority before acting, or ask us to check your position.