You may have heard the "in-stock" thrown around before, but what does it mean? To answer this question and learn more about how your company accounts for inventory correctly, we’ve created a quick guide on the best methods! Accounting can impact many aspects of the business - such as cash flow or cost/profit ratio- making sure everything gets recorded correctly should always be the top priority when managing any warehousing environment, even though there's plenty to consider.
Several common challenges can arise when trying to value inventory properly. First, there can be disagreements about what costs should be included in the valuation. Second, valuing inventory can be difficult when there are many different types of inventory items. Third, accounting for changes in inventory levels can be complex. Finally, estimating future demand for inventory can be tricky.
Working closely with accounting and inventory experts can often overcome these challenges. By valuing inventory properly, companies can ensure that their financial statements are accurate and that they are not overpaying taxes on their inventory.
Table of Contents
Fundamentals of Inventory
Overview: What is inventory accounting?
Accounting for Inventory
What Is Inventory Costing?
Types of Inventory Costs
Four Basic Inventory Valuation Methods
The Key to Using Inventory Cost Accounting Methods in Your Business
Additional Inventory Issues
Inventory Accounting- Stay Aware of Mistakes is the Key to Preventing Them
BUY THE BOOK HERE: Inventory Accounting- Comprehensive Practitioners Guide: What Every Management Accounting Professional Must Know About Inventory Accounting
Fundamentals of Inventory
1.0
Inventory is a collection of a company's economic goods at a particular moment. The purpose of the inventory is to mitigate the risk of the company being unable to meet customer demand.
Companies must manage their inventory using accounting principles to make sound decisions about what, when, and how much to order. Merchandise sold], but also the cost of the merchandise purchased [COGS]. From an accounting standpoint, there are two types of inventory:
1] Merchandising inventory, which is found in businesses that sell physical products, and
2] Manufacturing inventory is found in businesses that produce physical products.
The Cost of Goods Sold [COGS] calculation for a merchandising business is relatively straightforward: Beginning Inventory + Purchases – Ending Inventory = COGS.
For a manufacturing business, however, the calculation is more complicated because there are different types of manufacturing inventory: Raw materials, work-in-process [WIP], and finished goods.
Therefore, the formula for COGS for a manufacturing business becomes Beginning Finished Goods Inventory + Cost of Goods Manufactured – Ending Finished Goods Inventory = COGS.
In any merchandising company, inventory is a crucial asset. This includes the beginning inventory plus any purchases made throughout the period. When the company sells a product, they lose a piece of its inventory. Goods available for sale refer to the total cost of all the company's inventory at any time. This includes beginning inventory and any inventory purchased throughout the period. These goods were sold to customers or are still in inventory at the end.
The cost of goods sold is a crucial expense on the income statement, as it shows how much inventory has been sold and lost throughout a given period. Understanding and managing inventory is crucial for any merchandising company to succeed.
Inventory costing is a complex topic, but businesses must understand their different methods. The four specific costing methods are identification, first-in, first-out, last-in, first-out, and weighted-average cost. Each method has its strengths and weaknesses, and businesses should carefully consider which will work best.
The specific identification method is the most accurate, but it can be challenging to track individual items. The first-in, first-out method is simple to understand and implement but may not accurately reflect the actual inventory cost. The last-in, first-out method is the opposite of the first-in, first-out method, which may be more accurate in some cases. The weighted-average cost method is a compromise between the other methods, and it may be the best option for businesses that want a balance between accuracy and simplicity.
A company's cost allocation process represents management's chosen method for expensing product costs, based strictly on estimates of the flow of inventory costs, which is unrelated to the actual flow of the physical inventory. Using a cost allocation strategy eliminates the need for often cost-prohibitive individual tracking of costs of each specific inventory item, for which purchase prices may vary significantly.
In this chapter, you will be provided with some background concepts and explanations of terms associated with inventory, as well as a basic demonstration of each of the four allocation methods. The four methods are specific identification, first in, first out [FIFO], last in, first out [LIFO], and weighted average.
Each method has benefits and drawbacks that must be considered when choosing which method best suits the inventory needs of a company. After reading this chapter, you should thoroughly understand the basics of inventory costing.
Overview: What is inventory accounting?
2.0
Inventory accounting is the process of valuing stock inventory for resale. The main goal of inventory accounting is to ensure that all inventory is correctly accounted for, following Generally Accepted Accounting Principles [GAAP].GAAP requires that inventory be recorded using cost or market value methods. To ensure that all inventory is properly accounted for, businesses must maintain accurate inventory purchases and turnover records. By tracking these metrics, businesses can make informed decisions about their inventory management and ensure that they comply with GAAP requirements.
Inventory can be a complicated topic for small businesses. Inventory is considered a current asset, so it is not depreciated. Inventory costs must be carefully tracked to ensure accurate financial reporting. If you only sold a single item, inventory accounting would be simple. Still, you likely have multiple items in inventory and need to account for each of those items separately. While this is not difficult, you can quickly incur complications when inventory costs vary.
For example, if you purchase some inventory at the total price and then receive a discount on subsequent purchases, you need to account for the different costs of goods sold [COGS]. This can become complicated quickly, so it’s essential to have a sound accounting system in place to track your inventory accurately.
Inventory is a critical component of the cost of goods sold and the inventory valuation at the end of an accounting period. Proper inventory accounting helps ensure that your financial statements are accurate and up-to-date. Material and product purchases directly impact your income statement, while an increase in inventory levels will affect your balance sheet totals.
Therefore, keeping a close eye on inventory levels and ensuring that they are appropriately accounted for in your financial records is essential. By adequately tracking and accounting for inventory, you can avoid overstating or understating your costs and incomes, which can lead to serious financial problems down the road.
Inventory is a crucial component of any business, and understanding how to calculate the cost of goods sold is essential for maintaining accurate financial records. The cost of goods sold [COGS] represents the total value of the inventory sold during a particular period. To calculate COGS, you must take the beginning inventory value, add any new purchases, and subtract the ending inventory value.
For example, if your business starts the month of March with $5,250 in inventory and ends the month with $3,100 in inventory, your monthly COGS would be $6,250 [$5,250 + $4,100 - $3,100]. Knowing COGS is essential for businesses because it measures how efficiently they sell their inventory and generate revenue. It can also calculate other critical financial ratios, such as gross profit margin. Therefore, learning how to calculate COGS is essential for any business owner or manager.
At the end of every accounting period, businesses must determine the value of their inventory. This is known as inventory valuation. There are three main methods for inventory valuation: first in/first out [FIFO], last in/first out [LIFO], and weighted average. Each method has its advantages and disadvantages.
The FIFO method values inventory according to the order in which it was acquired. The most recent items acquired are assumed to be sold first. This is advantageous because it accurately represents the cost of goods sold. However, it can be disadvantageous because it doesn't consider market conditions.
The LIFO method values inventory according to the order in which it was acquired. The most recent items acquired are assumed to be sold first. This is advantageous because it takes into account market conditions. However, it can be disadvantageous because it doesn't accurately represent the cost of goods sold.
The weighted average method values inventory according to its average cost. This is advantageous because it provides a more accurate representation of the cost of goods sold than the FIFO or LIFO methods. However, it can be disadvantageous because it's more
Accounting for Inventory
3.0
Inventory is a current asset on the balance sheet, representing the raw materials, work-in-progress [WIP], and finished goods that a company has yet to sell. To account for inventory, businesses need to have a system in place to count and record changes in the value of their stock. This process is known as financial accounting for inventory, providing an accurate valuation of these assets.
Inventory accounting is vital in determining the value of stock items and ensuring that the correct item count is recorded. These figures are then used to calculate the costs of goods sold and the ending inventory value, which are crucial in assessing a company’s overall worth. Without accurate inventory accounting, it would not be easy to get an accurate picture of a business’s financial health.
As such, businesses need to ensure that they have a robust system in place for accounting for inventory. This will help them make better stock levels and pricing decisions, ultimately maximizing their profits.
As anyone who has ever run a business knows, keeping track of inventory is a critical task. After all, inventory represents the money a company has invested in its products, and ensuring that this investment is accounted for accurately is essential to sound financial management. However, inventory accounting can be a complicated and time-consuming process, partly because most companies offer a large variety of products for sale. This ongoing change process is further complicated because product purchases often occur irregularly and products are acquired for differing prices.
Additionally, inventory acquisitions are typically based on sales projections, which are always subject to some degree of uncertainty and can be pretty sporadic. Despite the challenges involved, proper inventory accounting is essential to the success of any business. By keeping a close eye on their inventory levels, businesses can ensure that they make sound investments and avoid potential financial pitfalls.
Merchandising companies must meticulously account for every individual product that they sell, equipping them with essential information, for decisions such as these:
What is the quantity of each product that is available to customers?
When should the inventory of each product item be replenished, and at what quantity?
How much should the company charge customers for each product to cover all costs plus the profit margin?
How much of the inventory cost should be allocated toward the units sold [cost of goods sold] during the period?
How much of the inventory cost should be allocated toward the remaining units [ending inventory] at the end of the period?
Is each product moving robustly, or have some individual inventory items’ activity decreased?
Are some inventory items obsolete?
A company's financial statements provide information about the company's revenues and expenses, as well as the company's assets and liabilities. The income statement, also known as the profit and loss statement, reports the company's revenue and expense items for a specific period. On the other hand, the balance sheet reports the company's assets and liabilities at a specific time.
The unsold inventory at the period end is an asset to the company and is therefore included in the company's financial statements on the balance sheet. Including unsold inventory in the financial statements gives investors and creditors an idea of the company's financial health. Knowing how much inventory a company has on hand can help them assess whether or not the company will be able to meet future demand.
The cost of inventory can be divided into two categories- the cost of goods sold and the cost of merchandise inventory. The cost of goods sold includes the total cost of all the inventory sold or removed during the period. On the other hand, the cost of merchandise inventory represents the total cost of all the remaining inventory at the period end. Together, these two categories represent the entirety of the inventory that a company has to work with during a given period. Therefore, businesses need to track the cost of goods sold and their merchandise inventory to get a complete picture of their inventory costs.
What Is Inventory Costing?
3.0
An essential part of any business is inventory control. This is the process of keeping track of a company's items in stock and ensuring that they have enough to meet customer demand while not tying up too much capital in unsold goods. A key element of inventory control is inventory costing. This is the process of assigning costs to the products a company has in stock. These costs can include the cost of the item itself and incidental costs such as storage, administration, and market fluctuation.
Companies use inventory costing to understand their merchandise's actual cost clearly and to ensure they are pricing their goods correctly. Generally accepted accounting principles [GAAP] provide standardized rules for inventory costing to ensure that companies do not overstate their expenses. By understanding and adequately applying inventory costing methods, businesses can better control their inventory levels and keep their finances healthy.
Inventory management is a critical component of supply chain management, as it helps ensure that businesses have the right products to meet customer demand. By keeping track of inventory levels and turnover rates, businesses can avoid the costly mistake of overstocking or understocking their shelves.
Additionally, proper inventory control can help businesses maximize their profits by ensuring they carry the right mix of products. By understanding the needs of their customers and matching those needs with available inventory, businesses can optimize their stock levels and minimize waste. In today's competitive marketplace, efficient inventory management is essential to ensuring that businesses can meet the demands of their customers.
There are several approaches to cost accounting. These include:
Standard costing
Lean accounting
Activity-based
Throughput
Marginal costing
Inventory Accounting- Standard costing
3.1
By far still the most popular, Standard costing is a tool that can be used to manage and control costs. Setting a standard for each production element makes it possible to track actual costs against the standards and take corrective action if necessary. Standard costing can also be used to create budgets and to evaluate the performance of managers and employees. While standard costing has its advantages, it is essential to remember that it is only one tool among many and should not be used in isolation. Standard costing can be a valuable tool for cost management when appropriately used.
Inventory Accounting- Lean accounting
3.2
In business, "lean" refers to principles emphasizing efficiency and waste reduction. In lean accounting, these principles are applied to financial decision-making. The goal is to provide accurate and timely information that can be used to inform operational decisions. This approach can be contrasted with traditional accounting, which often focuses on historical data and compliance with generally accepted accounting principles [GAAP].
Lean accounting provides decision-makers with the information they need to choose where to allocate resources. This can help businesses to achieve their objectives more efficiently and effectively. While lean accounting is still evolving, it has the potential to revolutionize the way businesses make financial decisions.
Inventory Accounting- Activity-based costing
3.3
Activity-based costing [ABC] is an accounting method that assigns costs to Activities rather than products. Products are then costed as a combination of the Activities they require. This approach can provide more accurate product costing since it considers all the costs associated with producing a product, not just the direct costs.
In addition, activity-based costing can help identify areas where improvements can be made to reduce costs. For example, if the cost of producing a product is high because it requires a large number of activities, ABC can help identify which activities are most costly and where improvements can be made. As a result, activity-based costing is a powerful tool for managing costs and improving productivity.
Inventory Accounting- Throughput cost accounting
3.4
Throughput cost accounting [TCA] is a system used to trace and absorb all costs incurred in bringing a product or service to market. It is based on the theory of constraints [TOC], which posits that any system is limited by its weakest link or constraint. In business terms, organizations must identify and address their crucial bottleneck processes to improve overall performance. TCA is designed to help organizations do just that by tracing all costs associated with the bottleneck process and then using those costs to calculate a "throughput price." Organizations can make more informed decisions about allocating resources and optimizing their operations by understanding the total cost of their key processes. This, in turn, can lead to improved profitability and competitiveness.
Inventory Accounting- Marginal costing
3.5
To allocate finite resources efficiently and effectively, businesses need an accurate idea of the cost of producing each output unit. This information can set prices, decide what products to produce, and how to best use resources. Marginal costing is a tool that can be used to calculate the cost of producing one additional unit of output. The marginal cost is the increase in total cost that results from producing one additional unit of output. It includes all the additional costs incurred due to the increased production, such as the cost of raw materials, labor, and overhead. By understanding marginal costing, businesses can make informed decisions about pricing, product mix, and resource allocation.
Choosing the suitable valuation methodology
Types of Inventory Costs
4.0
Inventoriable Costs
4.1
Inventoriable costs are part of the total cost of a product. These include raw materials, labor, manufacturing overhead, freight-in, certain administrative costs, and storage. Accountants usually record inventoriable costs as assets on the balance sheet, which are then charged as expenses and moved to the costs of goods sold in the income statement.
For example, if a company buys raw materials to make a product, the cost of those materials is an inventoriable cost. When the company uses the raw materials in production, it includes the cost of the raw materials in the cost of goods sold. This way, inventoriable costs are eventually recorded as expenses in the income statement. This gives investors and managers a better sense of the cost of producing a product.
In any business, it is essential to keep track of costs to make informed decisions about where to allocate resources. For accountants, one of the critical considerations in determining which costs are considered inventoriable. In other words, which costs can be directly linked to the production of goods or services?
There is no one-size-fits-all answer to this question, as the answer will vary depending on the industry. However, some common categories of expenses are typically considered inventoriable. These include ordering costs, holding costs, and administrative costs.
Ordering costs are those associated with the procurement of goods or services. This can include the payroll and benefits for the procurement department and activities such as the pre-qualification of suppliers. Holding costs are what companies pay to store goods they have not yet sold. These can be included in the overhead cost center. Administrative costs are also typically considered inventoriable. These are the business's costs, such as rent, utilities, and insurance.
By considering these various expense categories, accountants can better understand which costs are inventoriable and should be taken into account when making decisions about resource allocation.
Any business needs certain functions fulfilled to run smoothly. For example, someone needs to be in charge of the company's finances, and someone else needs to handle inventory. These are both essential functions, but they come with associated costs.
These are administrative costs, which can include wages and benefits for the employees who fulfill these roles. Administrative costs are often associated with the accounting department but can also be spread across several departments. Regardless of where they come from, administrative costs are an essential part of business and must be accounted for.
Inventory Holding Cost
4.2
Inventory carrying costs are one of the most critical and often overlooked expenses for businesses that maintain inventory. The costs associated with storing unsold inventory can add up quickly, eating into profits and putting a strain on cash flow. In addition to the direct costs of storage, inventory carrying costs include the opportunity cost of capital tied up in unsold stock. As a result, effective inventory management is essential for maximizing profits and minimizing holding costs. While there is no one-size-fits-all solution, businesses can use various techniques to reduce their inventory carrying costs. These may include Just-In-Time [JIT] ordering, Vendor Managed Inventory [VMI] arrangements, or using electronic data interchange [EDI] to streamline communication with suppliers. By carefully managing their inventory, businesses can minimize their holding costs and maximize their profits.
The cost of inventory can be divided into two categories: the cost of storage and the cost of handling. The storage cost is the ongoing expense of keeping the inventory safe and secure, including utility costs, insurance, and staff. The cost of handling is the expense of physically putting the inventory into storage and taking it out again when needed, which requires maintenance, handling equipment, and security.
One final cost that businesses must consider is obsolescence when stock becomes outdated or no longer helpful.
Businesses must dispose of the inventory at a reduced cost or even give it away for free. Storage, handling, and obsolescence—can add up quickly, especially when you factor in capital costs like interest fees. But by understanding the different costs associated with inventory, businesses can make more informed decisions about how much to keep on hand.
Inventory Carrying Cost Formula
4.3
The most common way to calculate inventory carrying costs is by using a percentage of the inventory value. However, this method can be inaccurate, as it doesn't consider all available holding costs. A more accurate way to calculate inventory carrying costs is to add up all known holding costs and divide the sum by the inventory value.
This will give you a percentage that can be used for future reference. By using this method, you can be sure that you are taking into account all of the necessary costs associated with your inventory, ensuring that you don't overspend in the future.
As an exercise, companies should itemize their specific costs. Inventory carrying costs should include:
Cost of capital
Costs of freight
Storage costs
Labor costs
Cost of insurance and replacement
Opportunity costs
Any obsolete, dead, or stolen stock
Different industries have standard estimates for this calculation, such as 2% for storage costs and 15% for capital costs. Companies do not include these costs in inventory accounts but expense them as they incur them. Considering these costs is essential to ensure profit margins are sufficient to cover them.
For example, a company with a 10% profit margin would need to sell its products for 10% more to cover the storage cost. Similarly, a company with a 20% profit margin would need to sell its products for 25% more to cover the cost of capital. By considering these costs, companies can price their products more accurately and ensure they make a sufficient profit.
Inventory Cost Formula
4.4
Why is the inventory cost formula essential? The inventory cost formula is important because it directly affects the company’s profit. This formula uses the beginning inventory value, ending inventory value, and purchase costs over the period. Calculate inventory cost by adding the beginning inventory to inventory purchases and subtracting the ending inventory. In other words, this formula provides a way to track how much a company spends on inventory over a set period.
This information is then used to help make decisions about purchasing and pricing in the future. Without this formula, it would be not easy to accurately assess the actual inventory cost and make informed decisions about managing it best. The inventory cost formula ensures businesses operate as efficiently and profitably as possible.
For example, the company values inventory at the start of the period at $50,000. It purchases $15,000 over the period. The value of the inventory at the end of the period is $25,000. The inventory cost for that period is [$50,000 + $15,000] – $25,000 = $40,000.
This basic formula considers all the inventoriable costs required to get and keep items for sale and bears on income determination. Any adjustment to inventory causes changes in the reported income.
Standard Cost Inventory
4.5
Standard costing is an essential tool that helps companies budget, manage, and control costs. Standard cost inventory is based on historical data and represents operations under normal circumstances. Variances occur when there is a difference between the standard and actual costs. When negative variances occur, management must take action to improve operations and potentially make changes to the standard cost. Using standard costing, companies can better control their costs and ensure that they operate efficiently.
Companies that use standard costing systems usually produce variance reports to show the standard's and actual costs' differences. In the manufacturing environment, the materials price variance is the difference between the budgeted and actual cost for materials. The formula for materials price variance is the following:
For example, a manufacturing company of automotive parts budgets $348,500 [standard cost] for 20,500 [standard quantity] of the primary material for its popular high-performance oil filters for the year.
The standard price per unit is $17. If only 18,000 filters are produced during the year due to lower than expected demand, then a materials quantity variance of -2,500 [-18,000 actual quantity - 20,500 standard quantity] exists if the company paid $355,000 for the 18,000 units of material used during the year, a materials price variance of $6,500 [$355,000 - $348,500].
The total materials cost variance would be $4,000 [[$355,000 actual cost - $348,500 standard cost] - [-2,500 unfavorable quantity variance]]. If this is a favorable materials price variance and an unfavorable quantity variance, then management would want to investigate why
Using the formula, the materials price variance = [$19 – $17] x 20,500 = $41,000.
Cost of Ending Inventory
4.6
The cost of ending inventory is the value of what is leftover in stock and available for sale at the end of a period. The basic calculation for ending inventory is the beginning inventory plus any purchases minus the cost of goods sold.
The cost of ending inventory can change based on the cost flow assumption the company chooses to use. The goods that companies sell first and their relative costs when purchased affect the cost of what is leftover in inventory, as make the assumptions behind any estimates. Many businesses must carefully manage their ending inventory levels, as too much-ending inventory can tie up working capital unnecessarily.
A basic example of calculating ending inventory is for Goods, Ltd. This company started its production month with a beginning inventory of $100,000. It purchased $25,000 worth of inventory during the month and sold $75,000 worth of inventory that same month. Therefore, its ending inventory for that month would be calculated as $100,000 + $25,000 - $75,000, or $50,000. If Goods Ltd used different cost flow assumptions, such as FIFO or LIFO, its ending inventory figure could be different. Therefore, businesses must carefully consider which cost flow assumption makes the most sense for them when
Inventory Accounting- RM, WIP, FG
4.7
The cost of manufacturing inventory can be split into three categories: raw materials, work in progress [WIP], and finished goods. Raw material costs are typically lower than those for completed products, but there's no strict rule about which type should carry less expense; it depends on how much time each item spends before being sold to customers or destroyed because they're not needed anymore.
For example, if a company sells products with a long shelf life, the raw materials for those products will likely make up a more significant percentage of the total manufacturing cost than those with a shorter shelf life. Similarly, if a company manufactures products prone to obsolescence, the finished goods will make up a more significant percentage of the total manufacturing cost. Understanding which inventory items fall into which category can help a company manage its manufacturing costs more effectively.
The accounting equation that divides up these different kinds is R + M - W, where r stands for revenue from sales/discontinued operations plus related tax expenses. At the same time, m represents Minutes consumed by machines operating during the production process, i.e., measure input. The objective is to ascertain break-even output levels so that there is no loss, but the average profit earned. The equation can also be rearranged to show how many units must be sold at a specific price to achieve the desired profit. The variable costs included in the minutes consumed calculation are labor, energy, and other variable inputs like materials.
If we let y represent output [measured in minutes], then the break-even output is given by: y = fixed costs/[price-variable cost per unit]. It is straightforward to see that if the average variable cost decreases, other things remain the same, the break-even output increases, and vice versa. Also, if the selling price decreases, all else being equal, more units must be sold to reach the exact profitability level, and hence, the break-even output will increase. If both selling price and variable cost per unit fall, then the expansion of output necessary to achieve any given level of profitability will be greater than would be
Four Basic Inventory Valuation Methods
5.0
The following dataset will be used to demonstrate the application and analysis of the four inventory accounting methods.
Company: Spy Who Loves You Corporation
Product: Global Positioning System [GPS] Tracking Device
Description: The product in question is a real-time GPS tracking device that has seen a surge in demand in recent months. The device is designed for individuals who wish to monitor the whereabouts of others. It is explicitly marketed to parents of middle school and high school students as a safety measure. The product's appeal lies in its ability to provide parents with peace of mind by keeping them apprised of their child’s location while also freeing up the student from having to check in constantly.
With demand for the product currently outstripping supply, the selling price has escalated rapidly. Despite the cost, the product remains in high demand due to the peace of mind it provides parents. As such, the current trend will likely continue into the foreseeable future.
Specific Identification Method
5.1
The specific identification method is an inventory costing method used to track the actual cost of the sold item. This method is generally used only on expensive items that are highly customized or inherently distinctive. The specific identification method is too cumbersome for goods of large quantity, especially if there are no significant feature differences in the various inventory items of each product type.
However, this method is helpful for demonstration, assuming that the company sold one specific identifiable unit, purchased in the second lot of products, at $27.
Three separate lots of goods are purchased:
Figure 2.76 By: Rice University Source: Openstax CC BY-NC-SA 4.0
First-in, First-out [FIFO] Method
5.2
The first-in, first-out method [FIFO] is an inventory accounting technique that assumes that the earliest purchased items are the ones sold first. This method is used to track the costs of inventory and determine the cost of goods sold. Under FIFO, the oldest inventory items are assumed to be sold first, and the newest items are assumed to remain in inventory at the end of the accounting period.
While this method may not accurately reflect the physical flow of inventory, it can provide a more accurate picture of the costs associated with a sale. As a result, FIFO is a commonly used method for inventory valuation.
Three separate lots of goods are purchased:
Figure 2.77 By: Rice University Source: Openstax CC BY-NC-SA 4.0
Last-in, First-out [LIFO] Method
5.3
The last-in, first-out method [LIFO] records costs relating to a sale as if the latest purchased item would be sold first. As a result, the earliest acquisitions would be the items that remain in inventory at the end of the period.
Three separate lots of goods are purchased:
Figure 2.78 By: Rice University Source: Openstax CC BY-NC-SA 4.0
Weighted-Average Cost Method
5.4
The weighted-average cost method calculates the average cost of all units of each inventory item. The average is obtained by multiplying the number of units by the cost paid per unit for each lot of goods, then adding the calculated total value of all lots together, and finally dividing the total cost by the total number of units for that product. As a caveat relating to the average cost method, note that a new average cost must be calculated after every change in inventory to reassess the per-unit weighted-average value of the goods.
This laborious requirement might make use of the average method cost-prohibitive. However, suppose businesses can commit to constantly reassessing and recalculating their inventory averages using this method. In that case, they may find that it provides more accurate results than other methods that do not consider changes in inventory levels.
Three separate lots of goods are purchased:
Figure 2.79 By: Rice University Source: Openstax CC BY-NC-SA 4.0
The figure shows the different outcomes of using different methods to allocate costs. In this example, the sales price is not affected by the cost assumptions; only the cost amount varies, depending on the chosen method. The four methods shown in the figure produce different results, with the cost allocation method making a significant difference. Note that the sales price is not affected by the cost assumptions; only the cost amount varies, depending on which method is chosen.
Each method has advantages and disadvantages, and the best choice will depend on the situation. For example, if many products have similar production costs, then using a physical measure such as square footage may be more accurate than using a labor-based measure such as direct labor hours. Ultimately, the goal is to choose a method that best reflects the underlying production costs.
Figure 2.80 Comparison of the Four Costing Methods One unit sold for $36. Comparison of the Four Costing Methods. By: Rice University Source: Openstax CC BY-NC-SA 4.0
Costing disclosure requirements are essential for financial statement users to understand the methods a company uses to calculate the cost of its inventory and, ultimately, the costs of goods sold. Costing methodologies can significantly impact a company’s reported results of operations. As such, users of the financial statements must be aware of any changes in methodology that may have been made.
Generally, companies must disclose their costing methods in the notes to the financial statements. In addition, if a company changes its costing method, it must disclose the impact of the change on the reported results of operations. As a result, costing disclosures provide users of financial statements with important information about a company’s inventory cost calculation methods and any changes.
For tax purposes, the Internal Revenue Service [IRS] generally allows different methods of accounting treatment than for financial statement purposes. However, an exception prohibits using last in, first out [LIFO] inventory costing on the company tax return unless LIFO is also used for financial statement costing calculations. This exception is important because it can significantly impact a company's bottom line. While LIFO may be preferable for financial statement purposes, it may not be the best choice for tax purposes. As a result, companies should carefully consider all their options before choosing a method of inventory costing.
The Key to Using Inventory Cost Accounting Methods in Your Business
6.0
Understanding the different inventory cost accounting methods available is vital to making informed financial reporting decisions. The three most common methods are first-in, first-out [FIFO], last-in, first-out [LIFO], and weighted average cost [WAC]. Each method uses different assumptions about how the costs of goods flow through inventory, which can result in different valuations of ending inventory. As a result, the choice of method can significantly impact a company's financial statements.
When choosing an inventory costing method, businesses must consider several factors, including the type of goods they sell, their production process, and the desired effect on financial statements. For example, businesses that produce large quantities of homogeneous products may prefer FIFO methods because they more accurately reflect the physical flow of goods. Alternatively, businesses that sell rapidly changing products may prefer LIFO methods because they more accurately reflect current replacement costs. Ultimately, the goal is to choose a method that best aligns with the company's business model and provides valuable information for decision-making.
How to Choose an Inventory Cost Accounting Method
6.1
There are three main cost accounting methods- absorption costing, variable costing, and activity-based costing- and each method has different implications for a company's balance sheet and income statement. Companies need to understand how these methods would change their financial statements before choosing a method, as it can significantly impact taxes owed.
Additionally, once a company chooses a method, it is crucial to consistently use it yearly to present the fairest possible picture of the company's finances. Making a change mid-stream can be complicated and may require approval from the IRS. Most importantly, the sum of COGS and ending inventory equals the cost of goods available. With this understanding, companies can choose the cost accounting method that makes the most sense for their business.
Choosing the suitable accounting method for your inventory can significantly impact your bottom line. But with so many methods to choose from, it can be hard to know which one is right for your business. That's where your cost accountant comes in. They can look at your reconciled data and make a business recommendation about which method is best for your company. And because they're up-to-date on all the latest tax laws, they can also help you with tax planning throughout the year - instead of just once a year at tax time. So if you're not already working with a cost accountant, now is the time to start.
To choose the best inventory costing method, companies must weigh the advantages and disadvantages of each method. The three primary methods are WAC, LIFO, and FIFO. WAC, or weighted average cost, involves calculating the average cost of all inventory on hand and applying that cost to all units sold. This method is less subject to manipulation than LIFO or FIFO but can be less accurate if there are significant price fluctuations.
LIFO matches the most recent costs with current sales or last in, first out. This method results in lower taxes owing, as COGS is reported at lower values. However, LIFO can result in obsolete inventory being reported on the balance sheet. FIFO, or first in, first out, matches the oldest costs with current sales. This accurately represents COGS but can result in higher taxes owing. Companies must carefully consider all factors before choosing a costing method.
There are two central inventory systems that companies use, perpetual and periodic. The main difference between the two is when the calculations are done. In a perpetual system, the calculations are done after each sale. This results in a more consistent price over time. However, in a periodic system, the calculations are only done at the end of a period. This can cause prices to fluctuate more over time.
Each method will also change slightly based on whether the company uses a periodic or perpetual inventory system. For example, if a company uses the weighted average method in a perpetual system, it will produce a weighted average system for each sale. However, suppose they use the weighted average method in a periodic system. In that case, they will only perform the calculations at the end of a period, considering everything that happened.
Similarly, LIFO [last in, first out] will produce different ending inventories and COGS for perpetual versus only yearly periodic systems. If companies apply LIFO in a perpetual system, they need to use special adjustments to take advantage of using the LIFO method for tax accounting.
Therefore, it is crucial to consider which inventory system will be used when choosing a valuation method.
Additional Inventory Issues
7.0
Other issues affecting inventory accounting include consignment sales, transportation and ownership issues, inventory estimation tools, and the effects of inflationary versus deflationary cycles on various methods.
Inventory Accounting- Consignment
7.1
Consignment sales involve the selling of goods on behalf of another party. The consignor retains ownership of the goods until they are sold, at which point the title passes to the buyer. Because the seller does not technically own the inventory, it is not included in their ending inventory balance. However, the seller may record an estimated value of the consignment inventory in their books. This can be tricky, as the estimates may not always match the actual sales prices.
In business, consigned goods are inventory items that belong to a third party but are displayed and sold by the company. The company does not own the consigned goods, and as such, they are not included on the company's balance sheet or in inventory calculations. The company's profit from consigned goods is typically limited to a percentage of the sales proceeds at the time of sale.
For example, if you sell your office and your current furniture doesn't match your new building, you may choose to dispose of the furniture by consigning it to a shop. The shop would keep a percentage of the sales revenue and pay you the remaining balance. In this example, assume that the shop will keep one-third of the sales proceeds and pay you the remaining two-thirds.
Consigning goods can be a beneficial arrangement for both parties involved. For the company, it allows them to sell merchandise without having to invest in inventory. And for the owner of the goods, it provides an opportunity to sell items without managing a retail operation. Of course, there are some risks involved - most notably, the possibility that unsold items will need to be returned - but overall, consignment can be a win-win situation for everyone
Estimating Inventory Costs: Gross Profit Method and Retail Inventory Method
7.2
Two methods commonly used to estimate inventory values are the gross profit method and the retail inventory method.
The gross profit method relies on estimations of the selling price and cost of goods sold. To calculate, you take the sales for a period and subtract the cost of goods sold during that period. This gives you the gross profit. From there, you take a percentage of the gross profit [usually 40-60%] to estimate the inventory value. While this method is quick and easy, it is also less accurate because it is based on estimates rather than actual figures.
The retail inventory method relies on estimating the ending inventory value and then working backward to calculate the cost of goods sold. You first need to estimate the ending inventory value by taking a physical count or using historical data. Once you estimate the ending inventory, you take the sales for some time and add any beginning inventory that was not sold during that period. This gives you the cost of goods available for sale. You subtract the ending inventory estimation from the cost of goods available for sale to get your estimated cost of goods sold.
Likewise, the retail inventory method estimates the cost of goods sold, much like the gross profit method does, but uses the retail value of the portions of inventory rather than the cost figures used in the gross profit method.
Inventory Accounting- Inflationary Versus Deflationary Cycles
7.3
Two types of economic cycles can affect businesses, inflationary and deflationary. Inflationary cycles are periods of rising prices, while deflationary cycles are periods of falling prices. Each type of cycle can affect a business's inventory differently.
In an inflationary cycle, the prices of goods rise. This means that the value of a company's inventory increases, even if the actual number of units doesn't change. This can lead to higher profits because the cost of goods sold will be lower than the current market price for those goods. However, it can also make it more challenging to manage cash flow because businesses may need to spend more money to replenish their inventory.
In a deflationary cycle, the prices of goods fall. This means that the value of a company's inventory decreases, even if the actual number of units doesn't change. This can lead to lower profits because the cost of goods sold will be higher than the current market price for those goods. However, it can also make it easier to manage cash flow because businesses will need to spend less money to replenish their inventory.
Each type of economic cycle can affect businesses depending on their particular situation.
Inventory Accounting- Transportation and ownership
7.4
Transportation and ownership issues can also affect inventory accounting. For example, who is responsible for the loss if goods are damaged in transit? And if goods are shipped on consignment, when does ownership transfer from the consignor to the consignee? Establishing clear policies and procedures can help to avoid misunderstandings and disputes down the line.
Inventory Accounting- Cost of Goods Sold Vs. Cost of Inventory
7.5
The two concepts are different in accounting because of when the costs are recognized. Companies valued inventory at its cost when the company acquired it. The company recognizes the inventory cost as an expense on its income statement only when the inventory is sold to customers. The timing of when these costs are recognized affects a company's reported profits.
If a company sold $100,000 of inventory it bought for $80,000, its COGS would be $80,000, and its reported profit would be $20,000. However, if the company had not yet sold the inventory, it would not have a COGS expense and would report the $80,000 as part of the inventory on its balance sheet. In this case, the company would report no profit because it has not yet sold its inventory to recognize revenue. When the costs are recognized, a company can manage its reported profits.
However, companies cannot simply choose to delay recognizing expenses to inflate their profits because there are Generally Accepted Accounting Principles [GAAP] that must be followed. Inventory costing is complex under GAAP because various methods companies can choose from having different implications on financial statements.
Inventory is a significant asset for many companies and is usually reported on the balance sheet at the paid cost. For manufacturers, the cost to produce the item is reported, which includes the costs of raw materials, labor, and overhead. Inventory can decrease for various reasons, such as selling products or using them in manufacturing. When this happens, the assets on the balance sheet also decrease.
Accountants also record changes in inventory as part of the cost of goods sold [COGS] on the income statement. In some cases, COGS is calculated by taking the beginning inventory and adding any purchases made during the period, then subtracting the ending inventory. This method provides valuable insights into a company's inventories and helps managers decide about ordering and pricing products.
Inventory Accounting- Stay Aware of Mistakes is the Key to Preventing Them
8.0
As the saying goes, "An ounce of prevention is worth a pound of cure." The same can be said of mistakes: Stay aware of the potential for mistakes, and you'll be in a much better position to prevent them. In the business world, nowhere is this more true than in the realm of inventory management. Proper inventory management is essential for any wholesale business, as it is a product that generates the revenue that keeps the business going.
But it can also be a cash drain. And tracking inventory is complicated, and errors are costly. The most common mistakes made in inventory management include: not correctly measuring inventory turns and other key metrics; not properly training employees on software and processes; poor planning due to improper forecasting; lack of automation like file exchanges and integrations in systems; inadequate or inaccurate inventory testing; and misstated ending inventory values. By being aware of these potential mistakes—and taking steps to prevent them—you can help ensure that your business runs smoothly and efficiently.
Inventory issues are a common reason for wholesaler losses, and the most common mistakes include:
1. Inventory turns and other key metrics aren’t adequately measured
2. Employees aren’t properly trained on software and processes
3. Forecasts aren’t properly made, resulting in poor planning
4. Systems lack automation like file exchanges and integrations
5. Inventory testing isn’t performed or isn’t accurate
6. Misstated ending inventory and its value
1. Inventory Accounting- Inventory turns and other key metrics aren’t adequately measured
Inventory management is critical to any business, but keeping track of all the moving parts can be difficult. There are many important metrics, such as inventory turns, sales volume, and margins. To correctly manage inventory, businesses should establish mandatory tracking procedures and review the data regularly. This will help identify slow-moving and fast-moving items so that resources can be directed accordingly.
For example, markdowns should be taken on slow-moving items to free up cash for faster-moving items. Additionally, businesses can use metrics like GMROI [gross margin return on investment] to make informed decisions about where to allocate their resources. By taking a proactive approach to inventory management, businesses can ensure that they are making the most of their resources.
2. Inventory Accounting- Employees aren’t adequately trained on software and processes
When it comes to inventory management, proper training is essential for employees. Software systems can be complex, and employees must know how to use them properly to avoid errors. If outsourcing your inventory management, closely examine the reporting capabilities of the company you are working with. Taking these precautions can help ensure that your inventory is well-managed and accurate.
3. Inventory Accounting- Forecasts aren’t properly made, resulting in poor planning
Forecasting can be tricky. You can make it a bit easier by segmenting your business. FOB overseas and POE-related inventory is pretty straightforward. Direct-to-consumer, FBA, and direct-to-store replenishment can be trickier. Segmenting your inventory and orders can make forecasting much easier and more accurate.
A few software programs can help you with this, but regardless of what you use, the key is to keep track of past performance and look for trends. This will allow you to predict future demand more accurately and avoid the costly mistakes of poor planning.
4. Inventory Accounting- Systems lack automation like file exchanges and integrations
Your business inventory system is your company's backbone, but it can be difficult to manage if it lacks automation. File exchanges for expected receiving, new items, and orders can help to improve accuracy and speed up order processing.
In addition, integrations with other platforms are critical for direct-to-consumer sales. For example, you can use UPS Worlships’s API to make sure small freight is really on the move and not just sitting on the warehouse floor, missing its delivery window, and then in need of being returned to inventory. With the right automation in place, your inventory system will be more efficient and easier to manage.
5. Inventory Accounting- Inventory testing isn’t performed or isn’t accurate
Depending on whether you discover lots of short shipments or lost freight, you may want to implement inventory testing. Performing a complete physical inventory is costly, time-consuming, and can disrupt shipping. Regularly you can select a small number of items and have the warehouse do a physical count. You must ensure all orders are processed when you reconcile their count with your system information. If you find a discrepancy between the two, it could indicate that your inventory levels are off, and you may want to investigate further. Testing your inventory regularly can help to ensure accuracy and prevent losses.
6. Inventory Accounting- Misstated ending inventory and its value
Getting your inventory figures right at the end of the year is essential because if they're wrong, they'll also be wrong at the start of the following year. That can lead to inaccurate profits and profit margins in your financial statements. So do a physical inventory at the end of the year, and if there are any differences from what's shown in your records, make an adjusting entry to correct it. That way, you'll better understand your profit margin when making decisions the following year.
7. Capitalizing cost variances into inventory and mistakingly carrying them into the next year
One of the challenges companies face when trying to manage inventory levels is capitalizing cost variances into inventory and then mistakenly carrying them into the following year. This can happen for several reasons, but often it's because the company doesn't have a sound system for tracking inventory levels and cost variances. As a result, they end up with too much inventory and have to write off the excess costs. In some cases, this can even lead to financial problems for the company.
To avoid this issue, it's crucial to have a system to track inventory levels and cost variances. This way, you can be sure that you're not over-capitalizing costs and carrying them into the following year.