Inventory

Some companies perform services for which they bill their clients while other companies purchase goods with the intent of reselling them (hopefully at a higher price) to their customers. In this chapter, we will cover inventory and how to determine its cost.

Inventory is all the goods that a company purchases with the intent of reselling them. From an accounting standpoint, the system has to know the selling price and the cost of each item that was purchased. The difference is the gross profit, as shown by this simple formula:

Selling price - Cost of the item = Gross profit

The selling price is easy; the invoice to the customer will show that. However, the cost of the item requires some special handling to ensure that the proper cost is reflected on the books.

Four Ways to Compute Cost

The cost of an item consists of two main components: the actual price and the acquisition cost (i.e., what it cost to get the physical item into your inventory, including costs such as delivery charges, shipping insurance, and tracking costs). The actual price and the acquisition cost are both included in the cost of the inventory item.

There are four methods which an accounting system can use to compute the cost of the item that was sold to the customer. Each method has its benefits and drawbacks as we will see in this section.

Specific Identification

From a computation point of view, Specific Identification is easy. You know the exact item that was sold and you know the matching purchase order. Large-ticket items such as cars or jewelry are typically calculated this way. This technique works when there is a manageable number of items sold and the actual items sold can be identified. For example:

Sticker price of car $ - Dealer invoice $ = Gross profit on the car

An inventory system that uses “specific ID” must provide a serial number or some other identifier, and the costs and selling information are grouped by that identifying number. It requires a more detailed record-keeping since costs are tied to a single inventory item but it provides the most accurate cost and profit calculations.

First-In, First-Out

A second approach is called First-In, First-Out (FIFO) which stands for when the first item into an inventory is also the first item sold. However, this is an accounting approach, not necessarily a physical approach. For example, if we were selling gasoline, the gasoline could be stored in a tank.

Assuming the valves to extract the gasoline are located at the bottom of the tank, then physically, the inventory would be extracted at FIFO. The first gallons of gasoline placed into the tank will be the first gallons extracted.

Since the tank was filled with gasoline purchased at different times, the cost of the gasoline in the tank would vary. If gas prices are rising, the gas at the bottom of the tank has the lowest price and the gas at the top has the highest prices. So, as a simple example, let’s assume the gas was purchased in five lots at the prices shown below:

If we now sell 15,000 gallons of gas at $3.50 per gallon, we need to determine our cost of those gallons. Using the FIFO method, our cost would computed as follows:

• 5,000 gallons at $2.18 = $10,900
• 6,500 gallons at $2.35 = $15,175
• 3,500 gallons at $2.50 = $ 8,750
• Total cost of gas sold = $34,825

Selling price = $52,500 - Cost $34,825 = Gross profit of $17,675

Even if our gasoline was extracted from the top of the tank (meaning, the last items in were physically sold first), we can still use the FIFO method to compute our cost. In a period of rising prices, the FIFO method will maximize our gross profit (and increase our tax burden).

Last-In, First-Out

The Last-In, First-Out method (LIFO) operates by using the same structure as FIFO but the costs are computed in reverse. That is, the newest items purchased are assumed to be the first items sold. For example, imagine a mulch farm where new mulch purchases are added to the top of the pile. When customer purchases mulch, the top layer is used (i.e., the last items purchased). However, the accounting method used does not have to agree with the physical way the inventory is processed.

Using our gasoline purchases example again, let’s see the impact of using LIFO when someone purchases 15,000 gallons of gasoline at $3.50 per gallon:

• 3,750 gallons at $2.90 = $10,875.00
• 2,500 gallons at $2.60 = $ 6,500.00
• 4,000 gallons at $2.50 = $10,000.00
• 4,750 gallons at $2.35 = $11,162.50
• Total cost of gas sold = $38,537.50

Selling price of = $52,500 - Cost of $38,537.50 = Gross profit of $ 13,962.50

As the example shows, by using the LIFO method, our profits decrease since we are selling the highest price items first. Of course, in the case of a supply shortage, we can create scenarios in which the items left in inventory (i.e., the first ones ever purchased), if sold, would result in a larger profit. The longer items stay in inventory, the lower the value of inventory will be. Gas prices in the mid-1990s were approximately $1.50 per gallon. If we ever actually sold the gas from those inventory layers, the profits would rise when, more than likely, the actual cost of the gas was much higher than the $1.50 per gallon cost still on the books.

Comparison between LIFO/FIFO Methods

The choice of LIFO/FIFO has an impact on profitability, taxes, and value of the remaining inventory. During a period of rising prices, the chart below illustrates the differences:

If prices to purchase inventory are falling, the chart is reversed.

Average Cost

The Average Cost method takes the weighted average of all of the purchases and computes the average cost per unit. This cost is then multiplied by the units sold to get the cost of goods sold and the ending inventory balance. By using our example from above, we can compute our cost:

The average cost is:

• $53,550 / 21,750 = $2.46

To determine the cost of goods sold, we take the total amount of units sold (15,000) and multiple by $2.46, which is $36,391. The remaining inventory is 6,750 units at a cost of $16,619. By using this approach, pricing fluctuations are less likely to skew the cost of goods sold from our inventory.

Other Cost Considerations

We touched, in general, on how to cost the items placed in inventory. Any cost of acquiring the object is added to the cost. Any trade discounts are subtracted from the cost. If a company takes a cash discount for early payment of the invoice, they have the option to reduce costs by that amount, or they can include those discounts in the income section. However, the company must be consistent with their treatment of these cash discounts.

Uniform Capitalization (UNICAP)

Uniform Capitalization (UNICAP) is a method that the IRS requires for allocating additional costs to the inventory. Generally speaking, smaller companies (e.g., those with less than 10 million in gross sales over a three-year period) are exempt. In addition, companies who are allowed to use the Cash Basis for tax reporting are also exempt.

The concept behind UNICAP is to allocate additional costs (that might be treated as expenses) into the inventory valuation. There are two main categories: Indirect Costs and Service Costs.

Indirect Costs

Indirect Costs include things such as rental of storage space, utilities, and insurance, etc. For a car dealer, these costs might include rental of the lot on which the cars are stored, and insurance on those cars while stored on the lot, etc. For a retailer, the costs could include store rental, and labor to staff the store, etc.

Service Costs

Service Costs are administrative overhead such as management, human resources, and security. A portion of these costs must be allocated to the inventory valuation as well.

For small businesses, these costs are generally written as expenses and deducted during the current year. For larger businesses, particularly in an inventory that takes longer than a year to sell, UNICAP provides a method to allocate those costs more closely to the inventory in the period in which it sells.

Taxes

The IRS allows you to use any of the four general methods for computing inventory; however, they recommend certain inventory valuation methods based upon the type of business. The IRS will also consider a request to change methods but they will compute the tax impact of such a change before allowing it.

Manufacturing

In a manufacturing business, there are multiple inventories depending on where the product is at the time the report is prepared. A business can use any of the costing methods to evaluate inventory as it moves between various categories.

Raw Materials

Raw Materials are the starting point of material that will, through some sort of manufacturing process, become finished products to sell. In the case of a refinery, for example, the crude oil is the raw material that will eventually be processed to produce fuel.

The cost of the raw material should include any shipping or freight charges involved in getting the material to the physical location. Another factor to consider is spoilage of raw materials, particularly if demand slows or other problems prevent production from occurring. If spoilage occurs, you can create a journal entry to expense the cost and reduce the inventory lost due to spoilage:

When raw materials begin to get used in the manufacturing process, they enter the next type of inventory: Work in Process. This involves a journal entry to move the inventory between phases:

Note that, when this journal entry is made, expense and overhead costs are usually recorded as well to reflect the cost of working on the material. Also note that some manufacturing processes produce scrap (i.e., raw materials that cannot be used for some reason in the work process). In such cases, you can expense the scrap material rather than move the entire amount to Work in Process:

Work in Process

Work in Process is the inventory that has entered the production process but has not yet been completed. If production is very short, a business can move the raw material directly to finished goods. But if the production cycle takes longer than an accounting period, there is likely to be some in-between inventory.

The journal entry to move the inventory from Work in Process to Finished Goods is as follows:

If products get lost or damaged between the two steps, the business can record an expense entry to handle the loss. Typically, there will also be other journal entries to allocate direct and overhead costs to the proper expense accounts to reflect the completion of the manufacturing process.

Finished Goods

Once the process is completed, the Finished Goods inventory contains the actual product that will be sold to the customer. The cost passed on the customer will be the cost of the raw materials and some costs associated with the manufacturing process. Costs associated with moving the inventory from vendors to raw materials are typically included in the inventory layer. The costs, if any, to move raw materials to processing and to move products to finished goods should also be included in the inventory layer.

Inventory Ratios

Businesses must carefully manage inventory levels. Too much inventory can create loss or spoilage, incur holding costs, and represents money tied up that could be used elsewhere in the business. However, being out of stock could result in the loss of customers.

The Inventory Turnover ratio is a commonly used ratio to indicate how often inventory is turned over in a given period. Basically, the number tells you how many times inventory was “sold out” during the period. There is no good or bad number; the turnover ratio needs to be compared to standards and other companies within the industry. For example, in the automobile industry, Inventory Turnover ratios are typically between five and ten times, yearly.

To compute Inventory turnover, use the following formula:

Cost of Goods Sold/Average Inventory

Inventory is often the largest asset on the balance sheet. If it takes too long to sell (i.e., turn to cash), costs for holding the inventory pile up. In general, the larger the turnover number, the better. For some products, it might take over a year to sell the inventory (such as exotic cars) while other products (such as baked goods or apparel) would expect a much higher turnover.

Summary

Inventory is typically purchased or assembled over a period of time, making computing the cost of items sold more complicated but important for matching those costs to revenue. The various inventory “costing: techniques attempt to match costs and revenue based upon the most appropriate model for the business. A business generally chooses a model and uses it throughout the life of the business, adhering to the consistency and comparability principles of accounting.