A principle for determining the correct capital costs of work-in-progress and inventory

In all production-inventory planning situations one of the major cost items to be considered is the capital cost for products in inventory and in the chain of process. In practical life as well as in theoretical models such costs are usually determined as a product value multiplied by an interest rate, where this value is computed on a cost-added basis: materials, labour, share of overheads, etc. In this paper we formulate models in which the physical production processes and their associated cash flow are analysed. By computing the present value of the cash flow as a function of characteristics of the production process, this value will also reflect a correct overall capital cost. Adjusting parameters of the physical process will then disclose what values to ascribe to products at different stages of production and assembly. It is shown that usual accounting principles often yield too conservative product values at early stages of production and that if percentage factors for covering overheads, etc., are to be used for evaluating work-in-progress, such factors should exceed the overall ratio between profits plus fixed overheads and variable costs.