As a CPA, I have spent a career applying Generally Accepted Accounting Principles to employers and clients of all sizes. Quite
some time ago I realized that to be really good, companies needed to utilize three sets of books: one to operate the company
with, one for the bank (GAAP) and one for the tax man. Nothing unscrupulous here, because all the books need to reconcile.
But they have different objectives and will yield different results.
One of the purposes of GAAP, and a cornerstone for accountants, is matching revenues and expenses. To accomplish this, there
are very complex formulas to choose from to put overhead costs into inventory to be expensed when the product is sold. So for
a product that takes three months to build we are to believe that heat, lights, and administrative expenses for those three months
slide up from the Income Statement and sit on the Balance Sheet in Inventory until the product is sold. Now it is true that those
costs were incurred while that product was being made, but did they add value to inventory? I think not.
In fact, it is easy to argue that the value of inventory goes down as the part gets made. How so? Think about it. A sheet of
stainless steel has a published per pound value and can be resold at very close to the purchased cost. Once that sheet is cut, its
value per pound goes down, because it will need special handling that a full sheet would not. Then the piece gets bent, has
another piece welded to it, parts that are not stainless steel get attached. So labor and materials are added, but if the part had to
be liquidated in that state, the value may actually be declining due to the labor needed to disassemble before the scrap value can
be realized.
In the Theory of Constraints as developed by Eliyahu Goldratt, costing is done as close to cash basis as possible. Pure Theory of
Constraints followers do not include Inventory on a balance sheet at all. I am not quite that rigid, but there is no place for
overhead in inventory on the operating statement. You should never incentivize managers to make inventory, which is what
taking costs out of the Income Statement and holding them in inventory does.
The problem is this: GAAP does not follow the laws of Cash. The laws of Cash include:
Cash is Neutral. It does not know where it came from and 1. it will go wherever you send it.
2. Spending cash on something that will get sold to someone else multiplies its worth.
3. Spending cash on something that expires like electricity or taxes doe s not add value to a product.
4. Lazy cash (old receivables, obsolete inventory, unused assets) tend to decrease in value over time.
Finally, one law of cash we can all agree on: Cash: More is Better!