Work in process (WIP) is a common term in manufacturing, often tossed around loosely. WIP is sometimes used interchangeably with “work in progress.” However, WIP has a specific meaning in an accounting context. While work in progress focuses on milestones, WIP aligns more with production efficiency and inventory management.
It’s generally better to reserve the term “work in progress” for longer-term or larger-scale projects or engagement-based work, while applying WIP to goods with relatively short production cycles. Indeed, WIP can be a valuable indicator of your manufacturing company’s financial and operational health.
WIP financial indicators
WIP generally refers to partially finished goods, usually mass-produced and standardized items, that are on the way toward completion. For accounting purposes, it encompasses the costs of the three components used thus far in the manufacturing process: raw materials, labor and overhead. WIP doesn’t include raw materials on the factory floor waiting to be used. It also doesn’t include the projected value of the future finished goods.
A different percentage is used to calculate the amount of costs allocated for each component. The percentage used for raw materials, for example, will be higher than for labor because you must incur the costs for materials before you can deploy labor to work on them.
Overhead costs include rent or mortgage payments, equipment maintenance, employee benefits, insurance, utilities, and depreciation. These costs are typically allocated based on the amount of related labor hours or machine hours compared with a manufacturer’s total labor hours or machine hours.
WIP is similar to job costing, frequently used for custom manufacturing or when manufacturing discrete batches. In those circumstances, you can track the costs for specific jobs or projects, making job costing more precise than WIP.
WIP operational indicators
WIP can help manufacturers identify the need to optimize production processes, reduce cycle time or improve inventory management. A high WIP may indicate inefficiencies in terms of both production processes and finances. That’s because WIP comes with storage costs, diverting money that could otherwise be invested elsewhere.
The good news is that you may be able to reduce your WIP. You could, for example, adopt just-in-time production, identify and address bottlenecks in the process, or upgrade your equipment.
Accounting for WIP
WIP appears on your balance sheet as a current asset, as part of inventory. When goods are finished and sellable, they’re transferred from WIP to the finished goods account, which also is part of inventory. Eventually, what started as WIP will land in your costs of goods sold.
Most manufacturers aim to reduce the amount of WIP on their balance sheets as much as possible before their financial statements are prepared. This allows them to avoid the hassle of estimating the percentages of completion. It’s generally easier to account for finished goods than WIP. As an added perk, minimizing WIP may cut your storage costs and trim the odds of obsolescence.
It’s important to adjust your WIP appropriately so that your reported assets and earnings accurately represent your operations for the associated reporting period. Adjustments are especially critical for manufacturers with longer production cycles. In such cycles, the costs for all three WIP components can fluctuate. Supply chain disruptions or labor shortages, for example, could increase your costs over time. You also may need to adjust for:
- Equipment or machinery breakdowns,
- The implementation of technological advances, or
- Variations in demand that result in larger or smaller production numbers.
If you don’t adjust for these changes, your reported cost of goods sold may be off. This inaccuracy, in turn, could affect vital financial metrics such as inventory turnover and days in inventory.
Keep your eye on WIP
Failing to monitor your manufacturing company’s WIP can have negative financial and operational outcomes. Staying on top of WIP can help you maximize production efficiencies, better manage your costs and, ultimately, improve your profitability. Contact us with questions.
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