Inventory Methods and Issues

There are four basic issues concerning inventory.

  1. The costs included in the acquisition cost
  2. The valuation basis used for items in inventory.
  3. The frequency with which inventory computations occur, perpetual or periodic.
  4. The cost flow assumption used to trace the movement of costs into and out of inventory, which doesn't necessarily represent physical flow of inventory.

Acquisition Cost

The acquisition cost of inventory includes those costs that are necessary to bring the inventory to a condition that is sellable. For instance the cost might include the additional finishing touchs to make the product presentable to the buyer. The extent to which these additional costs are incurred depends a great deal on the type of firm.

A merchandising firm might buy the inventory ready for resale but will incur freight and other shipping costs to transfer the product from the manufacturer to bring the goods to the point of sale. Additional costs maybe incurred for unpacking or marking prices on the goods. In some situations the ability to track the cost of unpacking and pricing inventory may be more than the benefits of knowing the specific cost per inventory item. In this case the costs of unpacking and pricing may be assigned to the general expenses of the period rather than inventory costs. The acquisition cost of inventory is also adjusted for any purchase discounts or purchase returns. For accounting purposes the word purchase refers to goods received by the firm, not the act of ordering goods from the supplier.

A manufacturing firm also deals with the freight and shipping costs that the merchandising firm deals with as well as the other costs referred to above. However, the inventory cost reported by the manufacturing firm includes the cost of converting the raw materials to finished goods. The cost of goods sold for a manufacturing firm include all the costs of a merchandising firm plus the conversion costs of goods sold during the period. The manufacturing firm indicates the extent to which its inventory costs are progressing through three inventory accounts, raw materials, work-in process, and finished goods. The last account represents those inventory items that have been converted to saleable form but remain unsold at the end of the period. The items in this account have been assigned all costs. Raw materials and work-in-process are accounts that track the costs of conversion to saleable form.

A service organization furnishes intangible services but may have inventories of items necessary to complete their services or inventories of of unbilled costs or jobs in progress. Unbilled costs or jobs in progress are intangible inventories that track the progress of the service provider with regard to each client. Plumbers and Carpenters may have materials inventory to indicate what materials the provider has on hand at the end of the period that has yet to be used to provide the client services. Service organizations do not have a finished goods inventory.

Valuation Basis

The general principle of inventory valuation is that inventory is reported on the balance sheet at the lower of its cost or its market value. In most situations the inventory will be reported at its cost, however, inventory may be reduced below cost when there is evidence that the value of the items, when sold, will be less than the cost. This may occur because of obsolesence, deterioration, or significant price changes. Unfortunately the actual market value of inventory items is not necessarily easily obtainable. The FASB states that this estimate of market value should be the current replacement cost of the item. In other words, the amount that it would cost to currently manufacture or purchase the inventory item. The FASB has placed upper and lower bounds on the definition of "market". Market should not be higher than the estimated selling price less the costs associated with the sale (net realizable value) and should not be lower than the net realizable value less the normal profit margin. Thus, inventory is reported at historical cost if that is the lowest amount and at the next lowest of either current replacement cost, net realizable value (ceiling), or net realizable value minus profit margin (floor).

Perpetual versus Periodic Inventory

In each accounting period we must be able to define or determine the cost of goods sold during the period. To do that we must know beginning inventory, the amount of purchases, and the ending inventory amounts. The cost of goods is by definition the beginning inventory plus purchases minus ending inventory. How ending inventory is determined is the choice between periodic or perpetual inventory methods.

The terms periodic and perpetual imply a time frame for determining the amount of ending inventory. In one sense the titles are descriptive. Under the periodic method we periodically determine the amount of goods remaining in inventory where periodic is defined once every accounting period and usually at the end of the accounting period. When that number is determined it is used as the beginning inventory number for the next period. Thus, inventory balances are only determined periodically. The perpetual method provides estimates of ending inventory continuously. As items leave inventory and are sold inventory is updated to indicate the on hand unsold product. However, the perpetual inventory method is not a physical check of the inventory amount but a recording of changes in inventory when each sales transaction occurs. To actually determine the physical inventory on hand the firm must, at the end of the accounting period, take inventory just as is done using the periodic method. The difference is that the perpetual method provides an estimated ending inventory number that allows completion of the financial statements without taking a physical inventory.

Each method requires a different means of recording the flow of goods in and out of the firm. Under the periodic method an account called "Purchases" is used to record the additional inventory items purchased for sale during the period. In the perpetual system purchases of inventory during the period are recorded directly to the inventory account. For example,

 Periodic--Recording Inventory Purchase
for Cash

Purchases          $1,000 Cash              $1,000

Perpetual--Recording Inventory Purchase for Cash

Inventory         $1,000 Cash            $1,000

At the end of the accounting period the periodic method requires that the purchases account and the inventory account are closed to costs of sold and the ending inventory number from the physical inventory count be entered in the inventory account. Assume that the inventory account from the example above began at $500 and the ending inventory was found to be $750.
 Cost of Goods Sold
$500 Inventory                       $500

Cost of Goods Sold             $1,000 Purchases                 $1,000

Inventory                   $750 Cost of Goods Sold               $750

At this point you should be able to determine that cost of goods sold for this example must be $750 ($500+$1,000-$750 = $750).

Under the perpetual system cost of goods sold and inventory are adjusted at each sale.

 Perpetual--Record sale of
goods on account for $1,000 cost = $500

Accounts Receivable        $1,000 Sales                     $1,000

Cost of goods sold             $500 Inventory                $500
The accounts reflect the transactions for the period and Cost of Goods Sold can be used to complete the income statement for the period.

Cost Flow Assumptions

There are times when a firm can match the inventory item sold with a specific purchase (e.g., automobiles). In these cases the actual cost of the inventory item can be identified and the cost of goods sold accurately reflects the cost of sales. In other situations the physical flow of inventory makes specific identification impossible and the firm must rely on estimates of costs of goods sold that reflect assumptions made about cost flow not physical flow of goods. Even in situations where specific identification is possible the firm may choose to use a cost flow assumption to achieve some tax or financial presentation objective.

When making the decision about which cost flow assumption to choose we are implicitly deciding which number, inventory on the balance sheet, or cost of goods sold on the income statement, will reflect current costs of inventory or making a decision to present only average inventory cost values in both instances.

The cost flow assumption the generates current inventory costs on the balance sheet and outdated inventory costs on the income statement is FIFO (first in, first out) . Adopting FIFO assumes that the first inventory purchased is also the first inventory that leaves the store when units are sold. In practice it is very likely that FIFO is more representative of actual physical inventory flow than the other cost flow assumptions. Thus, regardless of whether prices are rising or falling the balance sheet inventory number reflects the inventory purchased or produced last. The income statement cost of goods sold reflects the inventory purchased or produced first. The cost flow assumption that generates current costs for cost of goods sold and outdated costs for inventory on the balance sheet is LIFO (last in, first out). Thus, regardless of whether prices are rising or falling the balance sheet inventory number will reflect the items purchased or produced first and the cost of goods sold number will reflect those items purchased or produced last. Finally, the cost flow assumption that presents average values for both the balance sheet and income statement inventory cost numbers is weighted average. The weighted average assumption weights inventory costs by the number of units acquired at a specific cost. The total inventory cost after weighting is divided by the total units in inventory and the average unit cost is assigned to both units that make up cost of goods sold and units that make up ending inventory.

Below is a sequence of inventory purchases and sales. Following the sequence is the determination of cost of goods sold under each of the assumptions.

Purchase Inventory 300 units at $6
Purchase Inventory 400 units at $7
Sell 300 units at $12
Purchase Inventory 200 units at $8
Sell 400 units at $12
Purchase Inventory 200 units at $5
Total Sales 700 units.  Assumption first units purchased are sold
Cost of Goods Sold = (300 x $6 + 400 x $7) = $4,600
Total Sales 700 units.  Assumption last unit purchased are sold
Cost of Goods Sold = (200 x $5 +200 x $8 + 300 x $7) = $4,700
Weighted Average
Total Sales 700 units.  Assume a weighted average cost per unit
Average Weighted Cost per unit = $7,200/1100 = $6.55
Cost of Goods Sold = $6.55 x 700 = $4,585 

Choosing a cost flow assumption affects the firm's reported net income for the period. FIFO will generally produce higher income numbers but higher tax bills, LIFO produces lower income numbers and a lower tax bill. The weighted average approach will generally produce numbers between LIFO and FIFO. The choice is LIFO for tax purposes requires firms to use LIFO for financial reporting purposes.

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Professor Omer