What is Work-in-progress financing ?

Work-in-progress (WIP) financing is an essential tool that is generally specific to the manufacturing and construction industry.

In this type of financing, the lender provides funding for raw materials, labor costs and overhead costs that a business might have incurred during the production process before the final product is sold.

In other words, WIP financing aims to provide businesses with cash flow to cover the cost of production.

It is also known as production financing and helps businesses to continue their operations without having to wait for their customers to make payments.

Example of WIP Financing?

To help in understand WIP financing better, here is an example: Let’s assume that Ted Ltd. manufactures kitchen cabinets and recently received a big order with a total of $300,000.

It will cost Ted Corp. $100,000 for the wood, $30,000 for other raw materials and an additional $20,000 for payroll.

The grand total to fulfill the order will be $150,000.

However, Ted Corp. only has around $50,000 in cash available to pay for all the costs, leaving them with a shortage of $100,000. To finish the order on time without compromising the quality, Ted Corp. opts for WIP financing from a financial institution.

The financial institution provides the business with the remaining $100,000 to finish the order and deliver the kitchen cabinets on time.

Once the order is complete and Ted Corp. gets paid $300,000, they can repay the loan they have taken from the financial institution.

How Does WIP Financing Work?

WIP financing is often available for businesses that are well-established and have other receivables. Which means it is not typically available for startup companies.

For the approval of the WIP financing application, the financial institution will review the outstanding purchase order or any other documentation from the business’ customer, access the costs associated with producing the project and compare it to the purchase order (PO).

Then, they determine the amount required to complete the order and then use the information to perform basic financial analysis of the overall business to approve the application.

Here’s how WIP financing typically works in the U.S:

1. Assessment of the Project

The financial institution assesses the project to determine the amount of financing a business requires to complete the project.

It also assesses the likelihood of whether the project will be completed on time and within the stipulated budget.

2. Advance Payment

After the assessment, the financial institution provides the business with advance payment.

The advance amount is based on a percentage of the project's total cost. This funding will help the business to purchase raw materials, pay labor costs and cover other overhead expenses.

3. Progress Tracking

The financial institution or the lender will then keep a close eye on the project's progress to ensure that everything is going according to plan.

This includes regular visits, detailed progress reports and regular communication with the business owner.

4. Repayment

Once the project is complete, the business will sell the finished product and use the payment from the customer to repay the WIP financing along with any interest and fees owed.

5. Continuation of Funding

However, in case the project takes longer than expected or incurs additional costs, the financial institution may provide the business with more funding to cover these expenses.

WIP financing provides a reliable source of funding to the business for the entire duration of the project.

What Problems Does WIP Financing Solve?

The main problem that work-in-progress financing solves is cash flow constraints for businesses involved in manufacturing, construction, fabrication and more.

These businesses get projects that require a significant amount of upfront capital that they use for raw materials, labor costs and overhead expenses. However, the payment from the customer is not received until the project is completed.

This puts a strain on the business’ cash flow and limits its ability to complete the project.

The funding provided by WIP financing helps businesses to cover these costs and allows them to continue their operations and complete their projects without having to wait for their customers to make the payments.

This helps to reduce the risk of delays or cancellations that are caused due to lack of funds, which, in turn, helps the business from a negative reputation in the market.

Moreover, WIP financing also helps free up capital that would otherwise be tied up in a specific project. This allows businesses to use the funding for other purposes.

How can WIP Financing Be Used with Other Types of Financing?

In the U.S, WIP financing can be used along with other types of financing to provide businesses with a more structured and comprehensive financing solution for their projects.

Some of the ways that WIP financing can be used with other types of financing include:

1. Line of Credit

Businesses may use a line of credit to provide additional financing for their projects if they believe that WIP financing may not be sufficient.

By using this financing option, businesses can ensure that their projects are completed within the time given and the allocated budget.

2. Equipment Financing

Businesses in manufacturing can opt for equipment financing to purchase the necessary machinery and equipment.

In this case, WIP financing can be used to cover the costs of labor, raw materials and overhead expenses, whereas equipment financing can cover the cost of machinery and equipment required to complete the project.

3. Commercial Real Estate Financing

Businesses that have multiple construction projects can use commercial real estate financing to purchase the land on which the project will be built.

Here, WIP financing can help fund construction costs, whereas commercial real estate financing can cover the cost of land used for construction.

By combining WIP financing with other types of financing, businesses can easily and better manage the costs and risks associated with the projects.

It also increases the chances of the project’s success.

Advantages of WIP Financing

Using WIP financing offers multiple advantages to businesses that opt for it, such as:

1. Improved Cash Flow

WIP financing helps businesses by providing them with the necessary funds to cover the costs of overhead expenses, labor costs and raw materials that will be needed during the production process.

This, in turn, will improve the cash flow and allow businesses to complete their projects without waiting for their customers to pay.

2. Increased Flexibility

This type of funding allows businesses to manage their finances better and make decisions based on the needs of their projects.

The businesses have flexibility and control over their finances rather than being constrained by limited funds.

3. Access to Additional Funding

In some cases, WIP financing can also provide businesses with additional funding that they might not have been able to secure otherwise.

This increases the chances of the project being successful.

4. Lower Costs

Compared to other types of financing, such as traditional bank loans, WIP financing can be less expensive.

This is because it is based on the value of the projects and the likelihood of their success rather than the business' creditworthiness.

5. Reduced Risks

With WIP financing, projects are less likely to get delayed or canceled due to a lack of funding, which could have a negative impact on the business’ reputation and hold in the market.

Is WIP Credit Or Debit?

The impact of work-in-progress (WIP) on a business’ financial statements depends on the recorded transactions.

Generally, the cost of labor, raw materials and overhead expenses that go into WIP during the production process would be reflected as debit entries in the business’ general ledger.

This increases not only the business’ assets but also the WIP account balance.

However, once the WIP is completed and added to the finished goods inventory, the cost of it is transferred from the WIP account to the finished goods inventory account.

This transfer is recorded as a credit to the WIP account and a debit to the finished goods inventory account.

When the finished products are sold, the cost of products is recognized as the cost of products sold. So, it is recorded as a debit to the cost of goods sold account and credit to the finished goods inventory account.

What is the Difference Between WIP and Accrued Income?

Both work-in-progress and accrued income are two completely different financial concepts that highlight different aspects of a business’ operations.

To start with, WIP refers to partially completed or unfinished products that are still in the production process and yet to be sold/shipped to customers.

In comparison, accrued income refers to the revenue that is earned but not yet received or recorded in a business’ financial statements.

WIP is considered to be a type of raw material or finished goods inventory and is generally included in the business’ balance sheet as a current asset.

On the other hand, accrued income is seen in a business’ financial statements as a liability, as the business has a legal obligation to deliver the products or services and recognize the revenue at a later date.

To summarize, WIP represents the costs associated with producing unfinished products, while accrued income represents the revenue that has been earned by the business but not yet received.

However, both of these concepts are necessary to understand a business’ financial position and performance.

How to Account for WIP Inventory?

It is important to accurately track and account for WIP as it represents a significant portion of a business’ assets and also affects its financial statements as well as profitability.

The ways in which WIP inventory is accounted for are as follows:

1. Recording Costs

As the production process goes underway, the costs associated with the production work-in-progress, such as labor costs, overhead expenses and cost of raw materials, are recorded in the business’ ledger.

This is done by a job cost accounting system.

2. Valuing WIP

The value of the WIP is calculated by adding the costs it has incurred in the production process, which it currently is at.

This value is then added to the business’ balance sheet as a current asset.

3. Transferring Costs

When the WIP is completed and added to the finished goods inventory, the cost of the WIP is transferred from the WIP account to the finished goods inventory account.

This transfer is considered to be a credit for the WIP account and a debit to the finished goods inventory account.

4. Recognizing Revenue

Once the finished products are sold, the cost of the products is considered to be the cost of goods sold expense.

It is also recorded as a debit to the cost of goods sold account and a credit to the finished goods inventory account.

The gross profit is the difference between the cost of goods sold and the sales price.

Which Industries can Get WIP Financing?

Here are some of the industries that can get easy access to WIP financing:

1. Manufacturing

Businesses belonging to the manufacturing industry, such as producers of electronics, textiles, machinery and others, more often than not, have large amounts of WIP and may require funding to cover the costs of production.

2. Construction

The construction industry may also opt for WIP financing as their projects can take several months or even years to complete.

3. Agriculture

Farmers and ranchers may use WIP financing for the production of crops and livestock. This can take up to several months to mature and be market ready.

4. Mining

As for the mining industry, businesses in this industry might require WIP financing to cover the costs of exploring, developing and extracting minerals.

Their projects can also go on for several months or years.

5. Energy

Businesses in the energy industry, such as oil and gas producers, may use WIP financing for the production of energy resources.

Apart from these, it is important to note that any business that offers products or services that take long to complete and are subject to cost fluctuations may opt for WIP financing.

FAQs

1. How is WIP Taxed?

In the U.S, the work-in-progress inventory is taxed in the same manner as other types of inventory.

The taxation of WIP is determined by the specific tax laws and regulations in the jurisdiction in which the business is located as well as on the type of business entity, such as sole proprietorship, partnership, corporation and more.

Generally, businesses that have a WIP inventory are required to pay taxes on the value of their WIP, based on the relevant laws and regulations.

However, when the finished products are sold, businesses are required to pay taxes on the difference between the cost of goods sold and the sales price.

Also, note that the tax treatment of WIP can vary from jurisdiction to jurisdiction. Businesses should consult a tax professional or accountant to understand the specific tax implications of holding WIP inventory.

2. Does WIP financing Include Overheads?

Yes, the value of WIP inventory generally does include overhead costs in addition to raw materials and direct labor costs.

Overhead expenses are indirect costs that are closely related to the production of the WIP, such as rent, insurance, utilities and other indirect costs that cannot be directly traced to the production of specific goods.

To accurately value the WIP funds and to determine the cost of goods sold when the WIP becomes the finished goods inventory, it is important to include overhead costs.

However, do note that the specific treatment of overhead costs in WIP accounting may vary depending on the business’ accounting policies and the jurisdiction where it is located.

Businesses should consult a financial advisor or a professional accountant for guidance on the proper treatment of overhead costs in WIP accounting.

3. How Does WIP financing Affect Profit?

The value of WIP inventory can have a significant impact on a business’ profitability as it affects the cost of goods sold, gross profit margin, working capital and inventory valuation.

It is crucial for businesses to accurately track and value their WIP inventory to ensure that their financial statements accurately reflect their financial performance.

4. Is WIP Considered Inventory?

In simple terms, yes. Work-in-progress (WIP) is considered inventory in the United States. WIP refers to partially finished or unfinished products that are still in the production process and have yet to be sold/shipped to the customers.

Hence, it is considered to be a type of raw material or finished goods inventory. It is typically included in a business’ balance sheet as current assets.

5. Does WIP Have Depreciation?

Generally, WIP does not have depreciation. Depreciation is a method of allocating the cost of tangible assets over their useful life.

It is used to recognize the decline in the value of those assets due to reasons such as wear and tear, obsolescence and other factors.

WIP is not considered to be a tangible asset as it has not yet been completed and does not provide any future economic benefits.

The costs associated with WIP, such as labor costs, direct materials and overhead expenses, are capitalized as a part of the finished product’s cost and considered an expense when the product is sold.