Lesson 5: Inventory. 5.1 Introduction. 5.2 Manufacturer or Retailer?

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1 Lesson 5: Inventory 5.1 Introduction Whether it is a brick and mortar or digital store, for many businesses, inventory management is a key cog of their operations. Managing inventory is an important key to running a successful business. First off companies have to stock the right amount to reach a medium between having enough inventory to satisfy customers and having too much inventory and not enough customers. Furthermore, inventory often has a certain shelf life. For groceries stores, spoilage is a risk that must be accounted for when determining how much to stock. Likewise, for technology or clothing retailers, obsolescence is a risk as technology is always improving and fashion is always changing. Thus, there is a variety of factors and planning involved in dealing with inventory. Having an accounting system that properly values inventory and properly tracks sales and purchases is the first step towards proper inventory management. If you run a company with inventory, you have to make two key decisions. First off, you must pick a system, either perpetual or periodic. Second, you have to pick a method LIFO, FIFO, or Weighted Average. 5.2 Manufacturer or Retailer? A company that makes inventory and then sells it to other companies is the manufacturer. A company that buys finished goods from another company (manufacturer) is a retailer. It is important to know the distinction between these two as there are slight differences in how these companies manage inventory. A retailer will only have one component of inventory. Journal entries to record this are straight forward. For example, say a retailer purchases 10,000 worth of goods: Inventory 10,000 Cash 10,000 On the other hand, a manufacturer will have three components of inventory: Raw Materials o Basic building blocks from which goods and finished products are made. For example, raw materials inventory for a furniture manufacturer would include wood, while a window manufacturer would have sheets of glass.

2 Works-in-Process o Materials that have begun to be manufactured into finished goods, but haven t been finalized. Essentially, these are goods that are in progress, but have not been completed. Finished Goods o The final product of manufacturing. Finished goods are held in inventory until sold. The journal entry for recording the purchase of raw materials is rather straightforward. Say you purchased $1,000 worth of wood by paying cash. The journal entry to record this would be: Raw Materials 1,000 Cash 1,000 Once the production process begins, the wood will be transferred to works-in-process. Keep in mind that depending on how fast the production process is, some or all of the raw materials may be used at once. For simplicity purposes, we will assume all the raw materials are used. The journal entry will be as follows: Works-in -Process 1,000 Raw Materials 1,000 Works-in-process includes not only raw materials (direct and indirect), but also, direct labor and overhead. Direct materials include what we touched on above. These are the materials that are the core components of finished goods. Direct labor is the costs incurred by workers doing the core work of the business. For example, in a manufacturing company, direct labor is attributed to the employees physically operating equipment and making the finished goods. Overhead, however, is slightly more complicated. Overhead includes both indirect materials and labor. Indirect materials are materials that facilitate the process of making inventory but are too small to keep track of. These include oil used for machines, chemical cleaning products, and other miscellaneous items. Indirect labor include the wages of anyone not working in the factory, but still contribute to the production of the product. A prime example is janitorial staff. Overhead also includes all other indirect costs such as utilities, rent, property taxes, legal fees, depreciation, etc. A good rule of thumb to determine overhead is if the cost is related or incurred in the production factory and the cost is not direct labor or direct materials, it will generally be

3 overhead. Say for example, you incur indirect labor of $2,000. The journal entry would be: Works-in -Process 2,000 Salaries Payable 2,000 Allocating overhead is more complicated. Usually there is a pre-determined overhead rate that uses a base such as direct labor to estimate the amount of overhead for a certain period. For example, the rate is calculated by taking the total estimated overhead cost and divided by the total direct labor hours to get to costs per hour. To find the overhead incurred, we would multiply the rate by the actual amount of direct labors incurred. The technical aspect of this is beyond financial accounting; usually, this information is detailed in managerial accounting. However, for the purposes of this course, you only have to understand that overhead sometimes is allocated by a certain driver. The journal entry would be similar to the one above in debiting the overhead incurred to Works-in-Process. As Works-in-Process is completed, the amounts are transferred to finished goods. For example, say the final cost of inventory was $10,000. The journal entry would be as follows: Finished Goods 10,000 Works-in-Process 10, Inventory Systems There are two inventory systems a company can use to track inventory: the perpetual system and the periodic system. The key difference between the two systems is the timing in which Cost of Goods Sold and Inventory accounts are charged. The perpetual system updates these accounts continuously, while the periodic system updates only at the end of the period. As discussed above, the manufacturer has three classes of inventory while the retailer only has one. In our discussion of inventory systems, we will be taking the view of the manufacturer. A. Sale of Goods The periodic system will include only one entry for each sale and transaction. However, the perpetual system will include two entries for each sale.

4 Periodic System Cash Sales Revenue Perpetual System Cash Sales Revenue Cost of Goods Sold Inventory At the end of the period, however, the periodic system will require the second entry to reflect the cost of goods sold and reduction of inventory for the period as a whole. B. Purchases, Purchase Discounts, Freight-in (shipping), and Returns and Allowances Under the periodic system, you would record these items in their respective accounts: Periodic System: Purchases Purchases Cash Periodic System: Purchase Returns Cash Purchase Returns Periodic System: Freight In Freight In Cash At the end of a period, to arrive at Cost of Goods Sold, you would take the Beginning Inventory adjust it for the items above and subtract ending inventory. Below is an example of this schedule:

5 Periodic System: Cost of Goods Sold Account Beginning Inventory 10,000 Add Purchases 5,000 Add Freight In 100 Less Returns (500) Goods Available for Sale 14,600 Less Ending Inventory (4,600) Cost of Goods Sod 10,000 The perpetual system is much simpler. Under the perpetual system, the same entries above for purchase, purchase returns, and freight in are all booked to the Inventory account. The Cost of Goods Sold will not need to be calculated with a separate schedule. The amount will be readily apparent in the trial balance. Perpetual System: Purchases Inventory 5,000 Cash 5,000 Perpetual System: Purchase Returns Cash 500 Inventory 500 Perpetual System: Freight In Inventory 100 Cash Inventory Methods Establishing an inventory management method can help a company appropriately value its Costs of Goods Sold as well as the Ending Inventory on hand. In a business in which sales is largely correlated to the sale of inventory, having a detailed inventory valuation is crucial to success. There are three basic approaches to valuing inventory:

6 FIFO- First in, First Out LIFO- Last in, First Out Weighted Average- Average Cost However, depending on if your company is on the perpetual or periodic system, there are further variations to these three approaches: FIFO-Periodic FIFO- Perpetual LIFO- Periodic LIFO- Perpetual Weighted Average- Periodic Weighted Average- Perpetual Each one of these methods has slight differences from each other. In order to clearly demonstrate each of the differences, we will be using this set of data and applying it to each of the methods: 1/1/2013 Beginning Inventory 2, ,000 1/2/2013 Purchase 1, ,000 1/10/2013 Sale 500 1/15/2013 Sale 600 1/30/2013 Sale 1,000 Regardless of which method we use, there are certain facts that will be universal. First off, by totaling all sales, we can see that we have sold 2,100 units. If you total beginning inventory and purchases, you will see that for the month of January, the maximum number of units we can sell is 4,000 units. Thus, we should have an ending inventory of 1,900 units. Furthermore, the total amount of goods available for sales in dollars is $35,000. These numbers will hold true regardless of what method we use. 5.5 FIFO Periodic First in, First out assumes that inventory purchased or manufactured first is sold first and new inventory is sold second. Thus, your Cost of Goods Sold will be your older inventory, while your remaining Ending Inventory will be your newer inventory. Under a periodic system, dates do not matter. Using the numbers from above, you can see that you sold 2,100 units. Your cost of units sold will come from your oldest units; thus, first from your beginning inventory and then from your 1/2/2013 purchases until you have accumulated 2,100 units.

7 FIFO Periodic Cost of Goods Sold 1/1/2013 Beginning Inventory 2, ,000 1/2/2013 Purchase Total Cost of Goods Sold 2,100 20,800 On the other hand, your ending inventory will consist of the units that haven t been sold: FIFO Periodic Ending Inventory 1/1/2013 Beginning Inventory /2/2013 Purchase ,200 Total Ending Inventory 1,900 14,200 To double check our work, you can see that the total number of units sold (2,100) and units in ending inventory (1,900) tie to our numbers above. Also, the total value of goods sold and ending inventory equate to $35, LIFO Periodic This method is the exact opposite of FIFO Periodic. LIFO assumes the products that are made last or purchased last are sold first. Thus, Cost of Goods Sold will be your newer inventory, while your Ending Inventory will be your older ones. Once again, as this is under the periodic system, dates do not matter. You simply count from the newest purchased inventory (1/23/2013 purchase batch) until you reach 2,100 units. LIFO Periodic Cost of Goods Sold 1/1/2013 Beginning Inventory ,000 1/2/2013 Purchase 1, ,000 Total Cost of Goods Sold 2,100 16,000 The Ending Inventory would be the units left on hand. As the 1/2/2013 and 1/23/2013 purchases have all been sold, your remaining Ending Inventory comes from your Beginning Inventory.

8 LIFO Periodic Ending Inventory 1/1/2013 Beginning Inventory 1, ,000 Total Ending Inventory 1,900 19,000 Once again, to double check our numbers total units sold and units remaining total to 4,000. Furthermore, total dollar value of these two is at $35, Weighted Average - Periodic Weighted Average Periodic calculates a dollar per unit and applies this rate to the number of units sold and units remaining in inventory. This is done by totaling total units in dollars available for sale and dividing by total units available for sale. Weighted Average Periodic 1/1/2013 Beginning Inventory 2, ,000 1/2/2013 Purchase 1, ,000 Total 4,000 35,000 Weighted Average Price = 35,000/4,000= 8.75 As you can see, the weighted average price per unit is $8.75. Finding the Cost of Goods Sold and Ending Inventory is now fairly straight forward. Cost of Goods Sold- 2,100 Units * $8.75/unit = $18,375 Ending Inventory- 1,900 Units * $8.75/unit = $16,625 Once again total units sold and units in inventory total to 4,000 units and total dollar value equals to $35, FIFO Perpetual Under a perpetual system, the inventory account is constantly changing. Unlike the periodic system, dates do matter as goods can only be sold if there are goods physically available. Overall, the overarching concept stays the same, but a perpetual system requires slightly more work.

9 Using the facts illustrated in 5.3, the first step is to clearly illustrate what goods you have on hand and at what date: Goods on Hand 1/1/2013 Beginning Inventory 2, ,000 1/2/2013 Purchase 1, ,000 Starting with the 1/10/2013 sale of 500 units, the Cost of Goods Sold will come from Beginning Inventory: FIFO Perpetual Cost of Goods Sold 1/10/2013 Sale ,000 Ending Inventory minus the 1/10/2013 sale would be as follows: Good Available After 1/10/Sale 1/1/2013 Beginning Inventory 1, ,000 1/2/2013 Purchase 1, ,000 For presentation purposes, we have included the 1/23/2013 purchase as part of goods available for sale. Note that the goods purchased at 1/23/2013 are not available for sale until after 1/23/2013. If you don t have the inventory, you can t sell it! This is strictly for presentation purposes for you to get a better picture of the flow of inventory for the month of January as a whole. You will this same presentation for the rest of the sales in this lesson. Next, we would layer on the 1/15/2013 sale of 600 units and once again this would come from beginning inventory. FIFO Perpetual Cost of Goods Sold 1/10/2013 Sale ,000 1/15/2013 Sale ,000 With 1,100 of 2,000 of Beginning Inventory sold, Ending Inventory minus the 1/15/2013 sale would be as follows:

10 Good Available After 1/15/Sale 1/1/2013 Beginning Inventory ,000 1/2/2013 Purchase 1, ,000 Next we would layer on the 1/30/2013 sale of 1,000 goods. 900 units would come from Beginning Inventory while 1,000 units would come from the 1/2/2013 batch. FIFO Perpetual Cost of Goods Sold 1/10/2013 Sale ,000 1/15/2013 Sale ,000 1/30/2013 Sale , Total Cost of Goods Sold 2,100 20,800 Ending Inventory minus the 1/30/2013 sale would be as follows: Good Available After 1/30/Sale 1/1/2013 Beginning Inventory /2/2013 Purchase ,200 Total Ending Inventory 1,900 14,200 In summary, total value of Cost of Goods for January would be $20,800 while Ending Inventory would be $14,200 for a total of $35,000. Furthermore, total units sold and units in ending inventory total to 4,000 units. You may have noticed FIFO Perpetual is exactly the same as FIFO Periodic. This is not a coincidence and will always hold true.

11 5.9 LIFO Perpetual Even though FIFO Periodic and Perpetual will always have the same amounts for Cost of Goods Sold and Ending Inventory, this is not the case for LIFO Periodic and Perpetual. Conceptually, LIFO Perpetual similar to FIFO Perpetual; instead of the oldest goods, the newest goods would be sold first. Once again we start by clearly analyzing what goods we have on hand and at what date: Goods on Hand 1/1/2013 Beginning Inventory 2, ,000 1/2/2013 Purchase 1, ,000 Starting with the first sale on 1/10/2013 of 500 units, these units would come out from the newest batch of inventory, the 1/2/2013 batch. LIFO Perpetual Cost of Goods Sold 1/10/2013 Sale ,000 Ending Inventory minus the 1/10/2013 Sale would be as follows: Good Available After 1/10/Sale 1/1/2013 Beginning Inventory 2, ,000 1/2/2013 Purchase ,000 Once again it is important to note that the goods from the 1/23/3013 batch are not available until 1/23/2013. It is there just for presentation purposes. Next we would layer on the 1/15/2013 sale of 600 units. Once again this would first come from the newest batch, 1/2/2013. However, there are only 500 units available thus the excess 100 units would come from Beginning Inventory. LIFO Perpetual Cost of Goods Sold 1/10/2013 Sale ,000 1/15/2013 Sale ,000 1/15/2013 Sale ,000

12 Ending Inventory after the 1/15/2013 sale would be as follows: Good Available After 1/15 Sale 1/1/2013 Beginning Inventory 1, ,000 1/2/2013 Purchase Lastly, we would layer on the 1/30/2013 sale of 1,000 units. This would come from the newest batch, 1/23/2013 purchase. LIFO Perpetual Cost of Goods Sold 1/10/2013 Sale ,000 1/15/2013 Sale ,000 1/15/2013 Sale ,000 1/30/2013 Sale 1, ,000 Total Cost of Goods Sold 2,100 16,000 Ending Inventory after the 1/30/2013 sale would be as follows: Good Available After 1/30 Sale 1/1/2013 Beginning Inventory 1, ,000 1/2/2013 Purchase /23/2013 Purchase Total Ending Inventory 1,900 19,000 Once again we can verify that that total Cost of Goods Sold and Ending Inventory equal 4,000 units, while the total dollar amounts equal $35, Weighted Average Perpetual The last method of valuing inventory, although conceptually no different, is the most labor intensive. This method uses a weighted average rate to value inventory. As inventory on hand is always changing, a new rate is calculated every time a purchase is made. The first step is to calculate the weighted average cost per unit for beginning inventory:

13 Weighted Average Perpetual Goods on Hand WA Cost/ Unit 1/1/2013 Beginning Inventory 2, , Notice there is now an additional column for Weighted Cost / Unit. This calculation is done by taking the total and dividing it by units (20,000/2,000=10). The next transaction is a purchase on 1/2/2013. We layer this purchase on and recalculate the weighted average cost per unit. Weighted Average Perpetual Goods on Hand WA Cost/ Unit 1 /1 /201 3 Beginning Inv entory 2, , /2/201 3 Purchase 1, ,000 Total 3,000 28, The next transaction we have is a sale on 1/10/2013 of 500 units. The Cost of Goods sold would be valued at the latest weighted average cost per unit of $9.33. We now start a list of Cost of Goods Sold: Weighted Average Perpetual Cost of Goods Sold 1 /1 0/201 3 Sale ,665 Goods available after the 1/10/2013 sale will be as follows: Weighted Average Perpetual Goods on Hand WA Cost/ Unit 1 /1 0/201 3 Total on Hand 2, , The next transaction is another sale on 1/15/2013 of 600 units. Without a new purchase, the cost per unit will remain the same at $9.33. We update our Cost of Goods Sold as well as Goods on Hand: Weighted Average Perpetual Cost of Goods Sold 1 /1 0/201 3 Sale ,665 1 /1 5/201 3 Sale ,598 Total 1,100 10,263 Weighted Average Perpetual Goods on Hand WA Cost/ Unit 1 /1 5/201 3 Total on Hand 1, ,

14 The next transaction is a purchase of 1,000 units on 1/23/2013. As with all purchases, this will require a recalculation of weighted average cost per unit. In this case, the new weighted average cost per unit at 1/23/2013 is $8.53. Weighted Average Perpetual Goods on Hand WA Cost/ Unit 1 /1 5/201 3 Total on Hand 1, , /23/201 3 Purchase 1, ,000 T ot a l 2,900 24, Once again, we have another sale at 1/30/2013 of 1,000 units. These will be sold at the new weighted average rate of $8.53. Weighted Average Perpetual Cost of Goods Sold 1 /1 0/201 3 Sale ,665 1 /1 5/201 3 Sale ,598 1 /3 0/201 3 Sale 1, ,53 0 Total 2,100 18,7 93 Lastly, we have to update our schedule of goods on hand; these will be valued at the newest weighted average cost rate: Weighted Average Perpetual Goods on Hand WA Cost/ Unit 1 /30/201 3 Total on Hand 1, , Once again we can see that total Ending Inventory and total Cost of Goods sold add up to 4,000 units and $35,000 in value Lower of Cost of Market Now that you have a general idea of how to value inventory, we will incorporate another small wrinkle. Financial Accounting rules deem that inventory must be carried at lower of cost or market. You have already learned how to determine cost, but how do you determine market value? There are three concepts in market value:

15 Replacement Costs- this is the cost to replace assets of same or equal value. This information is readily available and does not require further calculations. Net Realizable Value- estimated selling price minus completion and selling costs Net Realizable Value Less Profit Margin- This is the Net Realizable value less a specified profit margin To see how these concepts relate to each other we will use the following set of data as an example: Item Replacement Cost Net Realizable Value Net Realizable Value Less Profit Margin Inv entory Inv entory Inv entory To determine market value, you take the middle number of the three. For example, Inventory 1 will have a market value of 6.00, Inventory 2 a market value of 8.00, and Inventory 3, a market value of Item Replacement Cost Net Realizable Value Net Realizable Value Less Profit Margin Market Value Cost Inv entory Inv entory Inv entory Now that you have determined the market value, the last step is to compare it to the cost. As the rule is lower of cost or market, you simply take the lower one. Thus, the inventory will be valued as follows: Item Carrying Basis Inv entory Inv entory Inv entory As you can see, Inventory 3 was adjusted to the market value of Assuming you have 500 units of Inventory 3 on hand, to reflect this reduction in basis, you would book the following entry:

16 Cost of Goods Sold Inv entory Inventory management is a rather technical aspect of accounting. The good news is there is a variety of software that automates much of these calculations. However, like other concepts, it is important for you to build a strong technical understanding of these concepts rather than merely rely on software.

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