Chapter Eight: Inventory
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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. Managerial accounting courses cover the specifics of accounting for manufactured inventory. This book will focus on the general principles of inventory accounting that are applicable to most enterprises.
Recall from the merchandising chapter the discussion of freight charges. In that chapter, F.O.B. terms were introduced, and the focus was on which party would bear the cost of freight. But, F.O.B. terms also 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. In the diagram, the buyer or seller shown in green would "inventory" the goods in transit.
Another inventory-related problem area pertains to goods on consignment. Consigned goods describe products that are in the physical custody of one party, but actually belong to another party. 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.
The consignor is the party holding legal ownership/title to the consigned goods. Consigned goods should be included in the inventory of the consignor.
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 resold to an end customer. For example, auto parts manufacturers produce many types of parts that are very specialized and expensive. 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. As a result, the parts manufacturer may consign their inventory to auto parts retailers.
Conceptually, it is fairly simple to understand the accounting for consigned goods. Practically, there is a significant record keeping 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). When the consignee sells 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 an accounting system capable of identifying consigned units, tracking their movement, and knowing when they are actually sold.
The value of a company's shares of stock often moves significantly with information about earnings. Why begin a discussion of inventory with this observation? The reason is that inventory measurement bears directly on the determination of income! The slightest adjustment to inventory will cause a corresponding change in an entity's reported income.
Recall from earlier chapters this basic formulation:
Notice that the goods available for sale are "allocated" to ending inventory and cost of goods sold. In the graphic, the inventory appears as physical units. But, in a company's accounting records, this flow must be translated into units of money. The following graphic illustrates this allocation process.
Observe that if $1 less is allocated to ending inventory, then $1 more flows 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. Thus, 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:
In earlier chapters, the assigned cost of inventory was always given. Not much was said about how that cost was determined. To now delve deeper, consider a general rule: Inventory should include all costs that are "ordinary and necessary" to put the goods "in place" and "in condition" for 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 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 solidify this point, consider a simple example. Mueller Hardware has a nail storage barrel. The barrel was filled three times. The first filling consisted of 100 pounds costing $1.01 per pound. The second filling consisted of 80 pounds costing $1.10 per pound. The final restocking was 90 pounds at $1.30 per pound. The barrel was never allowed to empty completely and customers have picked all around in the barrel as they bought nails. It is hard to say exactly which nails are "physically" still in the barrel. As one might expect, some of the nails are probably from the first filling, some from the second, and some from the final. At the end of the accounting period, Mueller weighs the barrel and decides that 120 pounds of nails are on hand. What is the cost of the ending inventory? Remember, this question bears directly on the determination of income!
To deal with this very common accounting question, a company must adopt an inventory costing method (and that method must be applied consistently from year to year). The methods from which to choose are varied, generally consisting of one of the following:
- First-in, first-out (FIFO)
- Last-in, first-out (LIFO)
Each of these methods entails certain cost-flow assumptions. Importantly, the assumptions bear no relation to the physical flow of goods; they are merely used to assign costs to inventory units. (Note: FIFO and LIFO are pronounced with a long "i" and long "o" vowel sound.) Another method that will be discussed shortly is the specific identification method. As its name suggests, the specific identification method does not depend on a cost flow assumption.
With first-in, first-out, the oldest cost (i.e., the first in) is matched against revenue and assigned to cost of goods sold. Conversely, the most recent purchases are assigned to units in ending inventory. For Mueller's nails the FIFO calculations would look like this:
The weighted-average method relies on average unit cost to calculate cost of units sold and ending inventory. Average cost is determined by dividing total cost of goods available for sale by total units available for sale. Mueller Hardware paid $306 for 270 pounds, producing an average cost of $1.13333 per pound ($306/270). The ending inventory consisted of 120 pounds, or $136 (120 X $1.13333 average price per pound). The cost of goods sold was $170 (150 pounds X $1.13333 average price per pound):
Examine each of the following comparative illustrations noting how the cost of beginning inventory and purchases flow to ending inventory and cost of goods sold.
Accountants usually adopt the FIFO, LIFO, or Weighted-Average cost flow assumption. The actual physical flow of the inventory may or may not bear a resemblance to the adopted cost flow assumption. In the following illustration, assume that Gonzales Chemical Company had a beginning inventory balance that consisted of 4,000 units costing $12 per unit. Purchases and sales are shown in the schedule. Assume that Gonzales conducted a physical count of inventory and confirmed that 5,000 units were actually on hand at the end of the year.
Based on the information in the schedule, Gonzales will report sales of $304,000. This amount is the result of selling 7,000 units at $22 ($154,000) and 6,000 units at $25 ($150,000). The dollar amount of sales will be reported in the income statement, along with cost of goods sold and gross profit. How much is cost of goods sold and gross profit? The answer will depend on the cost flow assumption.
If Gonzales uses FIFO, ending inventory, cost of goods sold, and the resulting financial statements are as follows:
If Gonzales uses LIFO, ending inventory, cost of goods sold, and the resulting financial statements are as follows:
These calculations support the following financial statement components.
The following table reveals that the amount of gross profit and ending inventory can appear quite different, depending on the inventory method selected:
The results above are consistent with a general rule that LIFO produces the lowest income (assuming rising prices, as was evident in the Gonzales example), FIFO the highest, and weighted average an amount in between. Because LIFO tends to depress profits, one may wonder why a company would select this option; the answer is sometimes driven by income tax considerations. Lower income produces a lower tax bill, thus companies will tend to prefer the LIFO choice. Usually, financial accounting methods do not have to conform to methods chosen for tax purposes. However, in the United States, LIFO "conformity rules" generally require that LIFO be used for financial reporting if it is used for tax purposes. In many countries LIFO is not permitted for tax or accounting purposes, and there is discussion about the USA perhaps adopting this global approach.
Accounting theorists may argue that financial statement presentations are enhanced by LIFO because it matches recently incurred costs with the recently generated revenues. Others maintain that FIFO is better because recent costs are reported in inventory on the balance sheet. Whichever method is used, it is important to note that the inventory method must be clearly communicated in the financial statements and related notes. LIFO companies frequently augment their reports with supplemental data about what inventory cost would be if FIFO were used instead. Consistency in method of application should be maintained. This does not mean that changes cannot occur; however, changes should only be made if financial reporting is deemed to be improved.
The specific identification method requires a business to identify each unit of merchandise with the unit's cost and retain that identification until the inventory is sold. Once a specific inventory item is sold, the cost of the unit is assigned to cost of goods sold. Specific identification requires tedious record keeping and is typically only used for inventories of uniquely identifiable goods that have a fairly high per-unit cost (e.g., automobiles, fine jewelry, and so forth).
To illustrate, assume Classic Cars began the year with 5 units in stock. Classic has a detailed list, by serial number, of each car and its cost. The aggregate cost of the cars is $125,000. During the year, 100 additional cars are acquired at an aggregate cost of $3,000,000. Each car is unique and had a different unit cost. The year ended with only 3 cars in inventory. Under specific identification, it would be necessary to examine the 3 cars, determine their serial numbers, and find the exact cost for each of those units. If that aggregated to $225,000, then ending inventory would be reported at that amount. One may further assume that the cost of the units sold is $2,900,000, which can be calculated as cost of goods available for sale minus ending inventory. The cost of goods sold could be verified by summing up the individual cost for each unit sold.
The preceding illustrations 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.
The following table reveals the FIFO application of the perpetual inventory system for Gonzales. Note that there is considerable detail in tracking inventory using a perpetual approach. 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. Observe that the financial statement results are the same as under the periodic FIFO approach introduced earlier. This is anticipated because the beginning inventory and early purchases are peeled away and charged to cost of goods sold in the same order, whether the associated calculations are done "as you go" (perpetual) or "at the end of the period" (periodic).
The table above provides information needed to record purchase and sale information. Specifically, Inventory is debited as purchases occur and credited as sales occur. The journal entries are below. The resulting ledger accounts and financial statements are shown below:
The following table, ledgers, and financial statements reveal the application of perpetual LIFO. Note that the results usually differ from the periodic LIFO approach. The journal entries are not repeated here but would be the same as with FIFO; only the amounts would change.
The average method can be applied on a perpetual basis, earning it the name moving average. This technique is involved, as a new average unit cost must be computed with each purchase transaction. The following table, ledgers, and financial statements reveal the application of moving average.
As with the periodic system, observe that the perpetual system also produced the lowest gross profit via LIFO, the highest with FIFO, and the moving-average fell in between.
Although every attempt is made to prepare and present financial data that are free from bias, accountants do employ a degree of conservatism. Conservatism dictates that accountants avoid overstatement of assets and income. Conversely, liabilities would tend to be presented at higher amounts in the face of uncertainty. This is not a hardened rule, just a general principle of measurement.
In the case of inventory, a company may find itself holding inventory that has an uncertain future; meaning the company does not know if or when it will sell. Obsolescence, over supply, defects, major price declines, and similar problems can contribute to uncertainty about the "realization" (conversion to cash) for inventory items. Therefore, accountants evaluate inventory and employ lower of cost or market considerations. This simply means that if inventory is carried on the accounting records at greater than its market value, a write-down from the recorded cost to the lower market value would be made. In essence, the Inventory account would be credited, and a Loss for Decline in Market Value would be the offsetting debit. This debit would be reported in the income statement as a charge against (reduction in) income.
Market values are very subjective. In the case of inventory, applicable accounting rules define "market" as the replacement cost (not sales price!) of the goods. In other words, what would it cost for the company to acquire or reproduce the inventory?
However, the lower-of-cost-or-market rule can become complex because accounting rules specify that market not exceed a ceiling amount known as "net realizable value" (NRV = selling price minus completion and disposal costs). The reason is that "replacement cost" for some items can be very high even though there is no market in which to sell the item (e.g., out of date cell phones still in the inventory of a phone store). Such items are unlikely to produce much net value when sold. Therefore, "market" for purposes of the lower of cost or market test should not exceed the net realizable value. Additionally, the rules stipulate that "market" should not be less than a floor amount, which is the net realizable value less a normal profit margin. What arises then, is the following decision process:
Step 1: Determine market - Replacement cost, not to exceed the ceiling nor be less than the floor.
Step 2: Report inventory at the lower of its cost or market (as determined in step 1).
To illustrate, consider the following four different inventory items, and note that the "cost" is shaded in yellow and the appropriate "market value" is shaded in red. The reported value is in the final row, and corresponds to the lower of cost or market:
Despite the apparent focus on detail, it is noteworthy that the lower-of-cost-or-market adjustments can be made for each item in inventory, or for the aggregate of all the inventory. In the latter case, the good offsets the bad, and a write-down is only needed if the overall market is less than the overall cost. In any event, once a write-down is deemed necessary, the loss should be recognized in income and inventory should be reduced. Once reduced, the Inventory account becomes the new basis for valuation and reporting purposes going forward. Write-ups of previous write-downs for any recovery in value would not be permitted under United States GAAP.
The application of lower-of-cost-or-market principles varies under IFRS (international financial reporting standards). For instance, the concepts of "ceiling and floor" are usually not applicable. Instead, the international standards speak to net realizable value as the only benchmark for assessing market. Additionally, recoveries of previous write downs are recognized under IFRS.
Whether a company uses a periodic or perpetual inventory system, a physical count of goods on hand should occur from time to time. The quantities determined via the physical count are presumed to be correct, and any differences should result in an adjustment of the accounting records. Sometimes, however, a physical count may not be possible or is not cost effective, and estimates are employed.
One such estimation technique is the gross profit method. This method might be used to estimate inventory on hand for purposes of preparing monthly or quarterly financial statements, and certainly would come into play if a fire or other catastrophe destroyed the inventory. Very simply, a company's normal gross profit rate (i.e., gross profit as a percentage of sales) would be used to estimate the amount of gross profit and cost of sales. Assume that Tiki's inventory was destroyed by fire. Sales for the year, prior to the date of the fire were $1,000,000, and Tiki usually sells goods at a 40% gross profit rate. Therefore, Tiki can readily estimate that cost of goods sold was $600,000. Tiki's beginning of year inventory was $500,000, and $800,000 in purchases had occurred prior to the date of the fire. The inventory destroyed by fire can be estimated via the gross profit method, as shown.
A method that is widely used by merchandising firms to value or estimate ending inventory is the retail method. This method would only work where a category of inventory has a consistent mark-up. The cost-to-retail percentage is multiplied times ending inventory at retail. Ending inventory at retail can be determined by a physical count of goods on hand, at their retail value. Or, sales might be subtracted from goods available for sale at retail.
Crock Buster sells pots that cost $7.50 for $10. This yields a cost-to-retail percentage of 75%. The beginning inventory totaled $200,000 (at cost), purchases were $300,000 (at cost), and sales totaled $460,000 (at retail).
The only"givens"are highlighted in yellow. These three data points are manipulated by the cost-to-retail percentage to solve for ending inventory cost of $155,000. Be careful to note when the percentage factors are divided and when they are multiplied.
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, one 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, one must be clever enough to recognize that the choice of inventory method affects the results.
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. 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 this general rule is only valid when purchases are correctly recorded):
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, and vice versa. Examine the following table where the only error relates to beginning inventory balances:
Hence, if the above illustrations 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.