My company bought production tools and manufacturing equipment that could handle monthly capacity of 8,000 units. We capitalized that tooling and equipment on the balance sheet as fixed assets (PP&E). We are only producing and selling 1,000 units a month. We are amortizing the capitalized PP&E on straight line basis over the expected life of the assets (28 months). The large amortization expense, relative to the low level of revenue is generating an acrrual-based gross profit that is NEGATIVE. What is the usual accounting treatment? 1) do we continue amortizing the PP&E and generating negative Gross Profit? 2) do we write off some of the PP&E now and just keep the PP&E that we think is needed for the remainder of the product life, or 3) do we book some of the amortization to COGS for the portion of PP&E that is used in production, and book the rest of the amortization each month to Opex ?
Amortization of Manufacturing Equipment
Answers
Generalized answer...
1. Unclear what you mean by negative gross profit because of the amortization. Gross Profit should NOT include your PP&E amortization. GP should just be Revenue minus COGS (where COGS are costs directly identifiable to the sold items).....meaning the amortization should be in OPEX.
2. "PP&E that is used in production" --> You might want to rethink (or revisit) the classification. If it is "consumable" meaning consumption is relative to production, then it should be in COGS (materials). If not, it stays on PP&E.
3. Not sure about the specific type of machinery but you may also want to revisit the 28 month life and increase the period (if it applies). A lower monthly amortization amount to "soften" it's effect on bottom line.
The negative profit figures are NOT directly caused by the amortization. It is caused by the low revenue (production) as compared to its capability. (for lack of a better analogy right now, you bought a bus for 2 people) I would stay with the 28 month straight line amortization and figure out how to increase production/sales/revenue or make use of the PP&E's IDLEtime.
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thanks. To clarify the PP&E is TOOLING, MANUFACTURING EQUIPMENT that is used for injection molding plastic parts, stamping metal parts and testing the product on the assembly lines. Doesn't that amortization go into COGS as OCOGS ? If I classify that amortization as Opex, would it go in Engineering or G&A opex?
It is hard to say with certainty as each case/use is different....but the principles I laid out in my earlier response will still apply.
MY (emphasis) reading is that you capitalized tooling supplies instead of inventory or mold tools. This may be the reason you call it "amortization"? If it is tooling supplies (i.e. not capitalized), then you dont have to technically amortize it (I know, semantics), but as COGS added to the cost to the product (over the unit capacity of the mold). You may look at it this way, you are "consuming" the mold's capacity/life based on projected total units or you may look at it as "materials". This may also be the reason why you have a 28 month "amortization" basis instead of an 8,000 unit basis. At least for the molds.
Again, as an emphasis, the COGS in this case (as you say, "amortization) is applied to units sold/revenue and should NOT pull down your GP. The other equipment depreciation amortization (those that you can't directly identify with the product units) is below the GP. If you have a separate Engineering section for this...then it can be also be classified there instead of G&A (examples for this would be improvements to your workshop/factory building).
As a P.S., I read my response and even I got slightly confused. LOL Let me know if you need me to reclarify.
It sounds like you are using the wrong divisor for amortization. The molds don't die in 28 months, but they won't really last past the 8000th unit produced.
So by assigning a value based on production, the per unit basis remains constant, the total amortization at the end of life is the same but the distribution hanged from month to month.
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Yeah! What he said! lol
Your question would be covered pretty thoroughly in a cost accounting text under "absorption costing" and "Activity Based Costing", but I'll see if I can give you a short-ish answer here. Absorption costing demands that Manufacturing OH costs (including equipment depreciation) be absorbed into the cost of the product/inventory, and that it consequently be expensed as COGS only when the product is eventually sold. Until then, your equipment depreciation becomes part of the inventoriable cost of each product. Normally, in absorption/ABC costing, you'd debit your mfg equipment depreciation to a "cost pool" (of the same name) and then allocate it to each product via an allocation rate-per-unit as each product is completed. You stated that your equipment had an 8,000 unit per month capacity and a 28 month life, which adds up to a productive life of 224,000 units of production. The "allocation rate" for depreciation of this equipment would then be [cost-salvage] / 224,000. So if your machine cost $168K (net of salvage), your allocation rate would be $.75 per unit (168/224). You stated an issue with your production lagging behind equipment capacity of 8K units/month, and the related issue of over-depreciating the equipment and causing reporting issues. As stated by Steven Bragg (a co-author of GAAP), "Under the units of production method, the amount of depreciation charged to expense varies in direct proportion to the amount of asset usage. Thus, a business may charge more depreciation in periods when there is more asset usage, and less depreciation in periods when there is less usage. It is the most accurate method for charging depreciation, since this method links closely to the wear and tear on assets." Hence, you should abandon the straight line method and use the "units of production method" of deprecation for this equipment. Record (debit) the depreciation to the equipment depreciation cost pool, then allocate to each product on a per unit basis using your predetermined allocation rate. I hope that helps.