Inventory Types: Merchandising, Manufacturing

Definition and Classification of Inventory

• Inventories are assets held for sale or used/consumed in producing goods for sale.
• Inventories are divided into merchandising, manufacturing and supply inventories.

Merchandising Inventory

• Merchandising inventory includes items readily available for sale to customers.
• These items are owned by the company and ready for sale
• Merchandisers use a single classification: merchandise inventory.

Manufacturing Inventory

• Manufacturers use three inventory accounts: raw materials, work in process, and finished goods.
• Raw materials inventory includes the cost of goods on hand not yet in production, like wood or steel, which can be traced to the end product.
• Work in process inventory includes the cost of raw materials for partially processed units, plus direct labor and overhead costs.
• Finished goods inventory includes costs for completed but unsold units at the end of the fiscal period.

Supplies Inventory

• Merchandising and Manufacturing Companies may use a Supplies Inventory account.
• Items in this account include stationary, cleaning supplies, etc, used in production but not the primary materials being sold/processed.

Perpetual Inventory System

• Continuously tracks changes in the Inventory account.
• Records purchases and sales of goods directly to the Inventory account as they occur.
• Purchases of merchandise/raw materials are debited to Inventory.
• Freight-in debited to Inventory.
• Purchase returns/allowances and purchase discounts are credited to Inventory.
• Cost of goods sold is recorded at each sale by debiting Cost of Goods Sold and crediting Inventory.
• A subsidiary ledger shows quantity and cost of each inventory type.
• This system provides a continuous record of balances in both the Inventory and Cost of Goods Sold accounts.

Periodic Inventory System

• Quantity of inventory is determined periodically.
• Records all acquisitions of inventory by debiting the Purchases account.
• Adds the total in the Purchases account to the beginning inventory cost to determine total goods available for sale during the period.
• To compute the cost of goods sold, the ending inventory is subtracted from the cost of goods available for sale
• Under this system, cost of goods sold depends on a physical count of ending inventory.
• Companies take a physical inventory at least once a year.

Adjustments for Perpetual Inventory System

• An adjustment is needed If there’s a difference between the perpetual inventory balance and the physical count.
• Inventory Over and Short adjusts Cost of Goods Sold and represents normal and expected discrepancies from shrinkage, breakage, shoplifting, or incorrect recordkeeping.
• Inventory Over and Short might be reported in the "Other income and expense" section of the income statement.

Effects of Inventory Error on Financial Statements

Impact on Current Year's Income Statement

Impact on Subsequent Year's Balance Sheet

Determining Inventory Quantities

• All companies need to determine inventory quantities at the end of an accounting period, regardless of inventory system.
• Companies using a perpetual system take physical inventory to check accuracy and find any losses.
• Companies using a periodic system use physical inventory to determine inventory on hand, and the cost of goods sold.
• Determining inventory quantities requires a physical count and determining ownership of goods.
• Physical inventory involves counting, weighing, or measuring each inventory type on hand.
• Inventory counts are more accurate when goods are not being sold/received.
• Companies often take inventory during slow business hours.
• Determining what inventory a company owns is a challenge when computing inventory quantities.
• It involves determining if all items included belong to the company and if the company owns any goods not included in the count.

Goods in Transit

• Goods in transit are a complication of determining ownership.
• Goods in transit should be included in the inventory of the company that has legal title.
• Legal title is determined by the terms of the sale, i.e FOB Shipping and FOB destination
• Inventory quantities may be miscounted if ignored.
• Inaccurate inventory counts affect the balance sheet and the cost of goods sold calculation.

Consigned Goods

• Consigned goods are goods held by one party that are owned by another party to try and sell them for a fee without taking ownership of the goods.
• If an inventory count were taken, the car would not be included in the dealer's inventory.

Basic Issues on Inventory Valuation

• Goods sold/used rarely match goods bought/produced, causing inventory increases/decreases.
• Companies must allocate the cost of goods available for sale between sold/used goods and goods still on hand.
• Cost of goods available for sale/use is the sum of beginning inventory cost and the cost of goods acquired/produced.
• Cost of goods sold is the difference is the cost of goods available for sale less the cost of goods on hand at the end of the period.
• Valuing inventories requires determining physical goods to include, relevant costs (product vs. period), and the cost flow assumption.

Product Costs

• Product costs "attach" to the inventory and are recorded in the Inventory account.
• Product costs connect with bringing goods to the buyer's place and converting to a salable condition.
• Charges include costs of purchase, conversion, and other costs to bring inventories to the point of sale.
• Cost of purchase: purchase price, import duties/taxes, transportation, and directly related handling costs.
• Conversion costs: direct materials, direct labor, and manufacturing overhead costs.
• "Other costs": costs to bring the inventory to present location and condition ready to sell.

Period Costs

• Period costs aren't directly related to the acquisition/production of goods, and are not part of inventory cost.
• Selling expenses and Interest Expenses are period costs.

Cost Flow Assumptions

• Specific identification may not be practical and other flow methods are permitted that assume flows of costs unrelated to goods.
• The two assumed cost flow methods are First-In, First-Out (FIFO) and average cost.

Specific Identification

• Calls for identifying each item sold and each item in inventory.
• Used only when practical to separate the purchases made.
• Used when handling a small number of costly, distinguishable items.

Average Cost

• Prices items in inventory on an average cost basis of all similar goods available during the period.
• The moving-average method is used with perpetual inventory records.
• Weigh-average method is used for the periodic inventory system.
• Average-cost methods are simple, objective, and less subject to income manipulation.
• Costing items on an average-price basis is most persuasive when dealing with similar inventory items.

First-In, First-Out (FIFO)

• It assumes a company uses goods in the order purchased.
• The first goods purchased are the first used/sold; remaining inventory represents most recent purchases.
• One objective is to approximate the physical flow of goods and closely approximates specific identification when physical flow is first-in, first-out.
• FIFO prevents manipulation of income because the company cannot pick a certain cost to charge to expense.
• The ending inventory is close to current cost and it approximates replacement cost when price changes have not occurred since the most recent purchases.
• FIFO fails to match current costs against current revenues, possibly distorting gross profit and net income.

Lower-Of-Cost or Net Realizable Value Rule

• Inventories are recorded at their cost.
• If inventory declines in value below its original cost or damaged goods, the company should write down the inventory to net realizable value to report this loss.
• A company abandons the historical cost principle when the future utility (revenue-producing ability ) of the asset drops below its original cost.
• Net realizable value (NRV) is the net amount expected to realize from the sale of inventory.
• The market value of inventory item - Costs to complete and sell goods = Net realizable value

Estimating Inventory Costs

• Companies estimate inventories due to circumstances such as casualty from fire, flood, or earthquake or if managers want monthly or quarterly statements, but a physical inventory is taken only annually.
• Estimating inventories occurs primarily with a periodic inventory system.
• The two widely used methods of estimating inventories are the gross profit method and the retail inventory method.

Gross Profit Method

• Uses the estimated gross profit for the period to estimate the inventory at the end of the period.
• The gross profit is estimated from the preceding year, and adjusted for any current-period changes in the cost and sales prices.
• The following steps are needed:
• Determine the merchandise available for sale at cost.
• Determine the estimated gross profit by multiplying the net sales by the gross profit percentage.
• Determine the estimated cost of merchandise sold by deducting the estimated gross profit from the net sales.
• Estimate the ending inventory cost by deducting the estimated cost of merchandise sold from the merchandise available for sale.

Retail Method of Inventory Costing

• Requires costs and retail prices to be maintained for the merchandise available for sale.
• A ratio of cost to retail price is used to convert ending inventory at retail to estimate the ending inventory cost.
• The following steps are needed:
• Determine the total merchandise available for sale at cost and retail.
• Determine the ratio of the cost to retail of the merchandise available for sale.
• Determine the ending inventory at retail by deducting the net sales from the merchandise available for sale at retail.
• Estimate the ending inventory cost by multiplying the ending inventory at retail by the cost to retail ratio.

Control of Inventory

• The two primary objectives are safeguarding the inventory from damage or theft and reporting inventory in the financial statements.

Safeguarding Inventory

• Begins as soon as the inventory is ordered.
• Controls used for inventory include the purchase order, receiving report, and vendor's invoice.
• If discrepancies exist, they should be investigated and reconciled.
• Recording inventory using a perpetual inventory system provides effective control where the amount of inventory is always available in the subsidiary inventory ledger.
• Security measures to prevent damage and theft include storing inventory in restricted areas, locking high-priced inventory, two-way mirrors, cameras, security tags, and guards.