Inflation's Demise:Overhead Cost Control
Overhead costs are distorted immediately, and dramatically, by surplus capacity. Labor-intensive producers can adjust fairly rapidly through labor-force reductions, but capital-intensive producers cannot. Liquidating properties or fixed assets can eliminate the cost of persistent surplus capacity, but the assets may be difficult or impossible to sell. Manufacturers can be expected to implement a variety of short- to medium-term accounting tactics and longer-term financial tactics in order to minimize the adverse consequences.
Tactical accounting changes can be anticipated in the areas of fixed asset accounting, overhead cost allocation and inventory valuation. Possible financial tactics include restructuring of operations to minimize fixed costs, asset liquidation and, worst case, asset write-offs.
Fixed overhead costs are typically governed by original acquisition costs and pre-determined amortization schedules. The periodic amortization cost thus accrued is divided by production volumes to determine overhead costs per unit. Excess capacity drives these costs up as ever-smaller production volumes absorb constant amortization costs. In markets experiencing falling prices, real overhead costs will constantly increase over the long run because deflation increases the purchasing power of the original investment.
Businesses tend to amortize their fixed assets as rapidly as allowed during periods of inflation and high capacity utilization. This minimizes short-term tax liabilities by reducing pre-tax profits, and reflects the tendency of equipment to wear-out faster the more it is used. But businesses competing in markets characterized by stable or falling prices can be expected to lengthen the amortization schedules of their existing fixed assets as much as allowed, because equipment is not being utilized as much and because there are smaller pre-tax profits to shelter. This tactic has the salutary effect of reducing overhead cost per unit, reducing cost of sales, boosting short-term profits and strengthening the balance sheet, thereby improving apparent business performance. Many of today's fixed asset accounting and cost-allocation systems, however, lack the flexibility to implement such changes quickly. Strong demand for flexible replacement systems can therefore be anticipated.
Related inventory valuations and the resulting cost of sales per unit will be affected, too. During inflationary periods, businesses tend to maximize cost of sales as much as allowed, chiefly to minimize pre-tax profits and the value-added tax base. In the future, however, financial controllers will be pressured to change their inventory valuation methods by whatever means necessary, and allowable, to minimize cost of sales, in order to further boost short-term profits and strengthen the balance sheet. As with fixed assets, many of today's inventory management systems lack such flexibility. Replacement systems will be needed to the extent that surplus inventories are being cleared in the short- to medium-term, and to whatever extent a minimum inventory investment is required to operate the business over the long run.
During inflationary times, automation of plant, warehouse and office operations became an important tactic for minimizing ever-increasing labor costs. Capital resources could be substituted for labor, and written-off in constant, periodic amounts that declined in real value over time as inflation eroded the purchasing power of money.
Tactical accounting changes can be anticipated in the areas of fixed asset accounting, overhead cost allocation and inventory valuation. Possible financial tactics include restructuring of operations to minimize fixed costs, asset liquidation and, worst case, asset write-offs.
Fixed overhead costs are typically governed by original acquisition costs and pre-determined amortization schedules. The periodic amortization cost thus accrued is divided by production volumes to determine overhead costs per unit. Excess capacity drives these costs up as ever-smaller production volumes absorb constant amortization costs. In markets experiencing falling prices, real overhead costs will constantly increase over the long run because deflation increases the purchasing power of the original investment.
Businesses tend to amortize their fixed assets as rapidly as allowed during periods of inflation and high capacity utilization. This minimizes short-term tax liabilities by reducing pre-tax profits, and reflects the tendency of equipment to wear-out faster the more it is used. But businesses competing in markets characterized by stable or falling prices can be expected to lengthen the amortization schedules of their existing fixed assets as much as allowed, because equipment is not being utilized as much and because there are smaller pre-tax profits to shelter. This tactic has the salutary effect of reducing overhead cost per unit, reducing cost of sales, boosting short-term profits and strengthening the balance sheet, thereby improving apparent business performance. Many of today's fixed asset accounting and cost-allocation systems, however, lack the flexibility to implement such changes quickly. Strong demand for flexible replacement systems can therefore be anticipated.
Related inventory valuations and the resulting cost of sales per unit will be affected, too. During inflationary periods, businesses tend to maximize cost of sales as much as allowed, chiefly to minimize pre-tax profits and the value-added tax base. In the future, however, financial controllers will be pressured to change their inventory valuation methods by whatever means necessary, and allowable, to minimize cost of sales, in order to further boost short-term profits and strengthen the balance sheet. As with fixed assets, many of today's inventory management systems lack such flexibility. Replacement systems will be needed to the extent that surplus inventories are being cleared in the short- to medium-term, and to whatever extent a minimum inventory investment is required to operate the business over the long run.
During inflationary times, automation of plant, warehouse and office operations became an important tactic for minimizing ever-increasing labor costs. Capital resources could be substituted for labor, and written-off in constant, periodic amounts that declined in real value over time as inflation eroded the purchasing power of money.
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