Notes

Controlling inventory quality, quantities, and cost are key to maintaining gross profit margin. Finally, selecting appropriate accounting methods for inventory can have a dramatic effect on the amount a company pays in income taxes.

The cost and quality of inventory are concerns faced by all modern manufacturers and merchandisers and so we turn our attention to cost of goods sold (cost of sales, cost of products sold) on the income statement and inventory on the balance sheet. The primary goals of inventory management are to have sufficient quantities of high-quality inventory available to serve customers' needs while minimizing the costs of carrying inventory. Purchasing or producing too few units of a hot-selling item causes stock-outs, which mean lost sales revenue and decreases in customer satisfaction. Conversely, purchasing too many units of a slow-selling item increases storage costs as well as interest costs on short-term borrowings used to finance the purchases. It may even lead to losses if the merchandise cannot be sold at normal prices.

Inventory is tangible property that is held for sale in the normal course of business or used to produce goods or services for sale. The types of inventory normally held depend on the characteristics of the business.

• Merchandise inventory, goods (or merchandise) held for resale in the normal course of business. The goods usually are acquired in a finished condition and are ready for sale without further processing.
• Raw Materials Inventory, items acquired for processing into finished goods. These items are included in raw materials inventory until they are used, at which point they become part of work in process inventory.
• Work In Process Inventory, goods in the process of being manufactured but not yet complete. When completed, work in process inventory becomes finished goods inventory.
• Finished Goods Inventory, manufactured goods that are complete and ready for sale.

Costs included in Inventory Purchases Goods in inventory are initially recorded at cost. Inventory cost includes the sum of the costs incurred in bringing an article to usable or salable condition and location. In general, the company should cease accumulating purchase costs when the raw material are ready for use or when the merchandise inventory is ready for shipment.

Flow of Inventory Costs When merchandise is purchased, the merchandise inventory account is increased. When the goods are sold, cost of goods sold is increased and merchandise inventory is decreased.

The flow of inventory costs in manufacturing environment is more complex. First, raw materials must be purchased. When they are used, the cost of these materials is removed from the raw materials inventory and added to the work in process inventory. Two other components of manufacturing cost, direct labor and factory overhead, are also added to the work in process inventory when they are used. Direct Labor cost represents the earnings of employees who work directly on the products being manufactured. Factory Overhead costs include all other manufacturing costs. When the product is completed and ready for sale, the related amounts in work in process inventory are transferred to finished goods inventory. When the finished goods are sold, cost of goods sold increases, and finished goods inventory decreases.

Cost of Goods Sold Equation Cost of Good Sold (CGS) expense is directly related to sales revenue. Sales Revenue during an accounting period is the number of units sold multiplied by the sales price. Cost of goods sold is the same number of units multiplied by their unit costs.

Every company starts each accounting period with a stock of inventory called Beginning Inventory (BI). During the accounting period, new Purchaes (P) are added to inventory. The sum of the two amounts is the Goods Available for Sale during that period. What remains unsold at the end of the period becomes Ending Invntory (EI) on the balance sheet. The portion of goods available for sale that is sold becomes Cost of Goods Sold on the income statement. The relationships between these various inventory amounts are brought together in the Cost of Goods Sold Equation:

BI + P - EI = CGS

Perpetual and Periodic Inventory System The amount of purchases for the period is always accumulated in the accounting system. The amount of cost of goods sold and ending inventory can be determined by using one of two different inventory systems: perpetual or periodic.

In a Perpetual Inventory System, purchase transactions are recorded directly in an inventory account. When each sale is recorded, a companion cost of goods sold entry is made, decreasing inventory and recording cost of goods sold.

Under the Periodic Inventory System, no up-to-date record of inventory is maintained during the year. An actual physical count of the goods remaining on hand is required at the end of each period. The primary disadvantage of a periodic inventory system is the lack of inventory information. Managers are not informed about low or excess stock situations.

Inventory Costing Methods

• Specific Identification Method, the cost of each item sold is individually identified and recorded as cost of goods sold. This method requires keeping track of the purchase cost of each item. The specific identification method is impractical when large quantities of similar items are stocked.

The choice of an inventory costing method is not based on the physical flow of goods on and off the shelves. That is why they are called cost flow assumptions.

• First-In, First-Out Method, frequently called FIFO, assumes that the earliest goods purchased (the first ones in) are the first goods sold, and the last goods purchased are left in ending inventory. FIFO allocates the oldest unit costs to cost of goods sold and the newest unit costs to ending inventory.
• Last-In, First-Out Method, frequently called LIFO, assumes that the most recently purchased goods (the last ones in) are sold first and the oldest units are left in ending inventory. LIFO allocates the newest unit costs to cost of goods sold and the oldest unit costs to ending inventory.
• Average Cost Method, uses the weighted average unit cost of the goods available for sale for both cost of goods and ending inventory.

Each of the four alternative inventory costing method is in conformity with GAAP and the tax law. To understand why managers choose different methods in different circumstances, we must first understand their effects on the income statement and balance sheet.

The weighted average cost method generally gives income and inventory amounts that are between the LIFO and FIFO extremes. When unit costs are rising, LIFO produces lower income and a lower inventory valuation than FIFO. When unit costs are declining, LIFO produces higher income and higher inventory valuation than FIFO.

Valuation at Lower of Cost or Market Inventories should be measured initially at their purchase cost in conformity with the cost principle. When the Net Realizable Value (sales price less cost to sell) of goods remaining in ending inventory falls below cost, these goods must be assigned a unit cost equal to their current estimated net realizable value. This rule is known as measuring inventories at the lowest of cost or market (LCM). This departure from the cost principle is based on the conservatism constraint, which requires special care to avoid overstating assets and income. Under LCM, companies recognize a "holding" loss in the period in which the net realizable value of an item drops, rather than in the period the item is sold. The holding loss is the difference between the purchase cost and the lower net realizable value. It is added to the cost of goods sold for the period.