THE COSTS
INVENTORY

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        THE COMPONENTS OF INVENTORY

        You have already seen that inventory for a merchandising business consists of the goods available for resale to customers.  However, retailers are not the only businesses that maintain inventory.  Manufacturers also have inventories related to the goods they produce.  Goods completed and awaiting sale are termed "finished goods" inventory.  A manufacturer may also have "work in process" inventory consisting of goods being manufactured but not yet completed.  And, a third category of inventory is "raw material," consisting of goods to be used in the manufacture of products.  Inventories are typically classified as current assets on the balance sheet.  A substantial portion of the managerial accounting deal with issues relating to accounting for costs of manufactured inventory.  For now, we will focus on general principles of inventory accounting that are applicable to most all enterprises.

        DETERMINING WHICH GOODS TO INCLUDE IN INVENTORY:

        The F.O.B. terms determine when goods are (or are not) included in inventory.  Technically, goods in transit belong to the party holding legal ownership.  Ownership depends on the F.O.B. terms.  Goods sold F.O.B. destination do not belong to the purchaser until they arrive at their final destination.  Goods sold F.O.B. shipping point become property of the purchaser once shipped by the seller.  Therefore, when determining the amount of inventory owned at year end, goods in transit must be considered in light of the F.O.B. terms.  In the case of F.O.B. shipping point, for instance, a buyer would need to include as inventory the goods that are being transported but not yet received.  The diagram at right is meant to show who includes goods in transit, with ownership shifting at the F.O.B. point noted with a "flag."

    FOB

        Another problem area pertains to goods on consignment.  Consigned goods describe products that are in the custody of one party, but belong to another.  Thus, the party holding physical possession is not the legal owner. The person with physical possession is known as the consignee.  The consignee is responsible for taking care of the goods and trying to sell them to an end customer.  In essence, the consignee is acting as a sales agent. The consignor is the party holding legal ownership/title to the consigned goods in inventory.  Because consigned goods belong to the consignor, they should be included in the inventory of the consignor -- not the consignee!

    Consignment

        Consignments arise when the owner desires to place inventory in the hands of a sales agent, but the sales agent does not want to pay for those goods unless the agent is able to sell them to an end customer.  For example, auto parts manufacturers may produce many types of parts that are very specialized and expensive, such as braking systems.  A retail auto parts store may not be able to afford to stock every variety.  In addition, there is the real risk of ending up with numerous obsolete units.  But, the manufacturer desperately needs these units in the retail channel -- when brakes fail, customers will go to the source that can provide an immediate solution.  As a result, the manufacturer may consign the units to auto parts retailers.
       
      Conceptually, it is fairly simple to understand the accounting for consigned goods.  Practically, they pose a recordkeeping challenge.  When examining a company's inventory on hand, special care must be taken to identify both goods consigned out to others (which are to be included in inventory) and goods consigned in (which are not to be included in inventory).  Obviously, if the consignee does sell the consigned goods to an end user, the consignee would keep a portion of the sales price, and remit the balance to the consignor.  All of this activity requires a good accounting system to be able to identify which units are consigned, track their movement, and know when they are actually sold or returned.

        INVENTORY AND ITS IMPORTANCE TO INCOME MEASUREMENT

         Even a casual observer of the stock markets will note that stock values often move significantly on information about a company's earnings.  Now, you may be wondering why a discussion of inventory would begin with this observation.  The reason is that inventory measurement bears directly on the determination of income! 

    Inventory

        Notice that the goods available for sale are "allocated" to ending inventory and cost of goods sold.  In the graphic, the units of inventory appear as physical units.  But, in a company's accounting records, this flow must be translated into units of money.  After all, the balance sheet expresses inventory in money, not units.  And, cost of goods sold on the income statement is also expressed in money:
    Standard Cost Flow Allocation
        This means that allocating $1 less of the total cost of goods available for sale into ending inventory will necessarily result in placing $1 more into cost of goods sold (and vice versa).  Further, as cost of goods sold is increased or decreased, there is an opposite effect on gross profit.  Remember, sales minus cost of goods sold equals gross profit.  As you can see, a critical factor in determining income is the allocation of the cost of goods available for sale between ending inventory and cost of goods sold:
    Allocation Impact

        DETERMINING THE COST OF ENDING INVENTORY:

        Inventory should include all costs that are "ordinary and necessary" to put the goods "in place" and "in condition" for their resale. This means that inventory cost would include the invoice price, freight-in, and similar items relating to the general rule.  Conversely, "carrying costs" like interest charges (if money was borrowed to buy the inventory), storage costs, and insurance on goods held awaiting sale would not be included in inventory accounts; instead those costs would be expensed as incurred.  Likewise, freight-out and sales commissions would be expensed as a selling cost rather than being included with inventory.
    Once the unit cost of inventory is determined via the preceding rules of logic, specific costing methods must be adopted.  In other words, each unit of inventory will not have the exact same cost, and an assumption must be implemented to maintain a systematic approach to assigning costs to units on hand (and to units sold). To see Costing Methods click here!

        PERPETUAL INVENTORY SYSTEMS

        All of the Costing Methods illustrated were based on the periodic inventory system.  In other words, the ending inventory was counted and costs were assigned only at the end of the period.  A more robust system is the perpetual system.  With a perpetual system, a running count of goods on hand is maintained at all times.  Modern information systems facilitate detailed perpetual cost tracking for those goods.

        PERPETUAL FIFO:  The following table reveals the application of the perpetual inventory system -- using a FIFO approach:

    Perpetual FiFo

        Two points come to mind when examining this table.  First, there is considerable detail in tracking inventory using a perpetual approach; thank goodness for computers.  Second, careful study is needed to discern exactly what is occurring on each date.  For example, look at April 17 and note that 3,000 units remain after selling 7,000 units.  This is determined by looking at the preceding balance data on March 5 (consisting of 10,000 total units (4,000 + 6,000)), and removing 7,000 units as follows: all of the 4,000 unit layer, and 3,000 of the 6,000 unit layer.  Remember, this is the FIFO application, so the layers are peeled away based on the chronological order of their creation.  In essence, each purchase and sale transaction impacts the residual composition of the layers associated with the item of inventory.  Realize that this type of data must be captured and maintained for each item of inventory if the perpetual system is to be utilized; a task that was virtually impossible before cost effective computer solutions became commonplace.  Today, the method is quite common, as it provides better "real-time" data needed to run a successful business.

        JOURNAL ENTRIES:  The table above provides information needed to record purchase and sale information.  Specifically, Inventory is debited as purchases occur and credited as sales occur.  Following are the entries:

    3-5-XX

    Inventory

     

    96,000

     
                Accounts Payable    

    96,000

      Purchased $96,000 of inventory on account (6,000 X $16)      
             
    4-17-XX

    Accounts Receivable

     

    154,000

     
                Sales    

    154,000

      Sold merchandise on account (7,000 X $22)      
             
    4-17-XX

    Cost of Goods Sold

     

    96,000

     
                Inventory    

    96,000

      To record the cost of merchandise sold ((4,000 X $12) + (3,000 X $16))      
             
    9-7-XX

    Inventory

     

    136,000

     
                Accounts Payable    

    136,000

      Purchased $136,000 of inventory on account (8,000 X $17)      
             
    11-11-XX

    Accounts Receivable

     

    150,000

     
                Sales    

    150,000

      Sold merchandise on account (6,000 X $25)      
             
    11-11-XX

    Cost of Goods Sold

     

    99,000

     
                Inventory    

    99,000

      To record the cost of merchandise sold ((3,000 X $16) + (3,000 X $17))      
             

        Let's see how these entries impact certain ledger accounts and the resulting financial statements:

    General Ledger

        If you are very perceptive, you will note that this is the same thing that resulted under the periodic FIFO approach introduced earlier.  So, another general observation is in order:  The FIFO method will produce the same financial statement results no matter whether it is applied on a periodic or perpetual basis.  This occurs because the beginning inventory and early purchases are peeled away and charged to cost of goods sold -- whether the associated calculations are done "as you go" (perpetual) or "at the end of the period" (periodic).

        PERPETUAL LIFO:  LIFO can also be applied on a perpetual basis.  This time, the results will not be the same as the periodic LIFO approach (because the "last-in" layers are constantly being peeled away, rather than waiting until the end of the period).  The following table reveals the application of a perpetual LIFO approach.  Study it carefully, this time noting that sales transactions result in a peeling away of the most recent purchase layers. The journal entries are not repeated here for the LIFO approach.  Do note, however, that the accounts would be the same (as with FIFO); only the amounts would change.

    Perpetual LiFo

    General Ledger LiFo

    MOVING AVERAGE:  The average method can also be applied on a perpetual basis, earning it the name "moving average" approach.  This technique is considerably more involved, as a new average unit cost must be computed with each purchase transaction.  For the last time, we will look at the Gonzales Chemical Company data:

    Perpetual Avg

        The resulting financial data using the moving-average approach are:

    GL Wa


        As with the periodic system, observe that the perpetual system produced the lowest gross profit via LIFO, the highest with FIFO, and the moving-average fell in between.

        INVENTORY MANAGEMENT

        The best run companies will minimize their investment in inventory.  Inventory is costly and involves the potential for loss and spoilage.  In the alternative, being out of stock may result in lost customers, so a delicate balance must be maintained.  Careful attention must be paid to the inventory levels.  One ratio that is often used to monitor inventory is the Inventory Turnover Ratio.  This ratio shows the number of times that a firm's inventory balance was turned ("sold") during a year.  It is calculated by dividing cost of sales by the average inventory level:

    Inventory Turnover Ratio = Cost of Goods Sold/Average Inventory


    If a company's average inventory was $1,000,000, and the annual cost of goods sold was $8,000,000, you would deduce that inventory turned over 8 times (approximately once every 45 days).  This could be good or bad depending on the particular business; if the company was a baker it would be very bad news, but a lumber yard might view this as good.  So, general assessments are not in order.  What is important is to monitor the turnover against other companies in the same line of business, and against prior years' results for the same company.  A declining turnover rate might indicate poor management, slow moving goods, or a worsening economy.  In making such comparisons and evaluations, you should now be clever enough to recognize that the choice of inventory method affects the reported amounts for cost of goods sold and average inventory.  As a result, the impacts of the inventory method in use must be considered in any analysis of inventory turnover ratios.

        INVENTORY ERRORS

        In the process of maintaining inventory records and the physical count of goods on hand, errors may occur.  It is quite easy to overlook goods on hand, count goods twice, or simply make mathematical mistakes.  Therefore, it is vital that accountants and business owners fully understand the effects of inventory errors and grasp the need to be careful to get these numbers as correct as possible.

    A general rule is that overstatements of ending inventory cause overstatements of income, while understatements of ending inventory cause understatements of income.  For instance, compare the following correct and incorrect scenario -- where the only difference is an overstatement of ending inventory by $1,000 (note that purchases were correctly recorded -- if they had not, the general rule of thumb would not hold):

    Overstate Error

        Had the above inventory error been an understatement ($3,000 instead of the correct $4,000), then the ripple effect would have caused an understatement of income by $1,000.

    Inventory errors tend to be counterbalancing.  That is, one year's ending inventory error becomes the next year's beginning inventory error. The general rule of thumb is that overstatements of beginning inventory cause that year's income to be understated, while understatements of beginning inventory cause overstatements of income.  Examine the following table where the only error relates to beginning inventory balances:

    Overstate Beggining Error

        Hence, if the above data related to two consecutive years, the total income would be correct  ($13,000 + $13,000 = $14,000 + $12,000).   However, the amount for each year is critically flawed.



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