Understand insufficient quantity on a production order

An insufficient quantity occurs when a production order requires more of an inventory item to satisfy its bill of materials than the business owns. Such a situation might arise for many reasons, including:

  • A business follows a just-in-time purchasing policy, buying raw materials only after production orders requiring them are issued.
  • Suppliers deliver new inventory prior to sending a sales invoice (which is entered by the business as a purchase invoice). In this situation, the inventory may be on hand in the warehouse but not yet technically owned by the business, because the purchase has not been recorded.

Insufficient quantities cause accounting problems, because the cost of inventory items not yet owned is unknown. (Quoted or expected prices do not count.) Therefore, the true cost of the production order’s finished item(s) is also unknown. In turn, the cost of sales for sold items is unknown and profit is miscalculated.

Note
In the long run, after all inventory replenishment is recorded, overall profit could be correctly calculated. However, costs of individual production orders and sales, and profits for interim periods could still be incorrect.

Manager avoids these problems by determining when quantities of inventory items are insufficient for production orders and actively controlling allocation of costs to the right accounts at appropriate times. Fortunately, you do not need to do anything. Everything is automatic.

Note
Nothing about insufficient quantities or Manager’s treatment of them controls or prevents actual production. They only affect when and how costs are distributed to finished items and eventually to the cost of goods sold. If required materials are physically available in inventory, production can occur, regardless of whether their purchase has been recorded, they are needed for other production orders, or their reception has been recorded by goods receipts.

Problems caused by insufficient quantities

To explain concepts behind insufficient quantities, this Guide uses a very simple example. Imagine a business with two inventory items, both with starting quantities of zero:

  • Leather, a raw material
  • Handbag, a finished item

A customer buys a handbag on June 24, 2020. We record the sale with a sales invoice on that day at a price of 100:

Before we can deliver the handbag to our customer, we need leather to produce it. We do not have leather in stock, so we order it from our leather supplier. Our leather supplier will deliver the required leather the next day, June 25, 2020, but will invoice us at the end of the month.

Once we have the leather on hand, even though we do not yet legally own it, we create a production order on June 25, 2020 to take 5 units of leather to produce 1 unit of handbag:

Finally, on June 30, 2020 our leather supplier gives as a purchase invoice for 20 covering our purchase of 5 units of leather:

Absent Manager’s insufficient quantity process, this sequence of transactions would end up showing a value of 20 for inventory on hand even though the quantity of everything on hand is zero:

That would occur because, when the production order was created on June 25, 2020, it created 1 handbag with a cost of 0 because the cost of leather became known only at the end of the month when we entered the purchase invoice from our leather supplier. But by that time, the handbag had been sold and delivered, so the purchase cost of leather was transferred directly to handbags, of which none existed. This sequence also would distort the Inventory Profit Margin report, because no cost is being allocated to the sale (as the cost of the leather became known several days after the sale). Profit margin for this sale would incorrectly show 100%:

In normal production and sales environments, idiosyncrasies like this could easily be overlooked, buried by other transactions.

Solving the problem

To solve this problem, Manager does not “produce” finished items until all input items are fully costed.

Note
In the context of this Guide, the term produce means to account for the production of finished inventory items, including their proper costs. As mentioned in a Note above, production orders do not actually control manufacturing activity.

For example, if your production order has 5 input items and even one is of insufficient quantity, the output item is not costed and added to inventory until there is sufficient quantity of all input items. This means once the finished item is finally produced, the full cost is known and subsequent sales of this item will correctly record the cost of goods sold. We will return to our example of leather and handbag to see this concept at work.

When the production order is entered on June 25, 2020, leather has been ordered and delivered, but not yet purchased. So from an accounting perspective, its cost is unknown. In the Production Orders tab, Manager shows Status of the production order to be Insufficient Qty:

Insufficient Qty means the production order has one or more items on its bill of materials for which the business does not own the required quantity. (Remember, ownership is conveyed by a purchase invoice or payment.) In this case, we have insufficient quantity because we are using 5 units of leather which we did not purchase yet. We will own these 5 units of leather once the purchase invoice from our leather supplier is entered on June 30, 2020. Once that leather is purchased, production order status will automatically switch from Insufficient Qty to Complete:

Status being Complete triggers addition of the finished inventory item to inventory on the date the production order is fulfilled, not on the date the production order is created. This is important because, on the date the production order is created (June 25, 2020), the cost of leather is not known yet. It becomes known on June 30, 2020. So the finished handbag is added to inventory on June 30, 2020 with its full cost.

Because there was a sale entered on June 24, 2020 to remove one handbag, the handbag can finally be removed from inventory on June 30, 2020, along with its full cost:

As a consequence, the Inventory Profit Margin report is correct, too:

The Production in progress account

Now, the example above is trivial because the production order required 5 units of leather and none was in inventory. Let’s look at a situation where a production order requires the same 5 units of leather, but we already have 2 units of leather in inventory:

After the production order is created, the Inventory Items screen shows this:

Qty on hand for leather is reduced by 5 and total cost changes from 8.00 to 0.00. But inventory costs cannot simply disappear. In this case, the value of 2 units of leather is transferred to an account named Production in progress:

Production in progress is an asset control account added to your chart of accounts automatically when your first production order is created. Partial costs are temporarily accumulated there for production orders with insufficent quantity. When the production order collects sufficient quantities for all inventory items on the bill of materials, the cost is transferred to Inventory on hand. If you have no production orders with insufficent quantity, the balance of Production in progress will always be zero.

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