Chapter 9: Inventories Raw materials and consumables Finished goods Work in Progress Variants of valuation at historical cost other valuation rules 1
Characteristics of Inventories belong to current assets kept in stock either to be sold to customers or to be consumed by activities of the accounting entity Retailer, wholesaler merchandise inventory Manufacturer finished goods work in progress: goods not yet ready for sale raw materials and purchased parts optimal level of inventory trade-off between holding costs, ordering cost, service level, customer satisfaction, smooth production 2
The relative importance of inventories Inventory / Total assets Inventory / Current assets Manufacturing General Electric (Manufacturer) 0,02 0,07 Chevron (Oil drilling and refining) 0,03 0,13 Retail Supervalu (Grocery retail) 0,23 0,68 Tommy Hilfiger (Clothing retail) 0,09 0,26 Internet Yahoo (Internet search engine) 0,00 0,00 Cisco (Internet systems) 0,04 0,11 General services SBC Communications 0,00 0,00 (Telecommunications services) Wendy's (Restaurant services) 0,02 0,13 Financial services Bank of America (Banking services) 0,00 0,00 Merril Lynch (Investment services) 0,00 0,00 3
The Inventory Balance Equation Value of inventory at time t = Initial inventory + inflows outflows up to t initial inventory: from past period; zero at start of business depends on valuation method used for inflows and outflows inflows: valued at cost same as for fixed assets: all costs incurred in order to bring the inventories to their present location and condition outflows: different approaches direct identification assumed order of depletion averaging determine market value of ending inventory and apply balance equation 4
Importance of Inventory Valuation inventory valuation affects the income statement and the balance sheet impact on ratios used in financial statement analysis The Gross Profit Equation: Gross profit = Sales Revenue purchases + ending inventory beginning inventory Effect of inventory valuation on gross profit: closing inventory understated (overstated) gross profit for the period understated (overstated) opening inventory understated (overstated) gross profit for the period overstated (understated). 5
counterbalancing effect of valuation error "correct closing inventory" 2003 2004 Sales for the period 3.500 2.900 Opening inventory 200 300 Purchases 3.000 2.200 less Closing inventory 300 250 Cost of sales 2.900 2.250 Gross profit 600 650 overstating the closing inventory results in a higher profit in 2003, "closing inventory overstated" 2003 2004 Sales for the period 3.500 2.900 Opening inventory 200 450 Purchases 3.000 2.200 less Closing inventory 450 250 Cost of sales 2.750 2.400 Gross profit 750 500... and a lower profit in 2004.... but total profits over both years are the same! Although total profit are equal, the trend of performance is reversed! 6
Inventory Control Perpetual System continuous record of changes inventory account contains purchases and sales closing inventory as a residual supplementary occasional (physical) counts Periodic System physical counting and recording of inventory periodically count taken near the end of a company s fiscal year separate purchases account may be used figure for usage during the year as residual (used by businesses that sell inexpensive goods, e.g. fabric store) 7
Perpetual Inventory System Periodic Inventory System 1. Beginning inventory, 100 units at 12 The inventory account shows the inventory The inventory account shows the inventory on hand at 1.200. on hand at 1.200. 2. Purchase of 1.200 units at 12 Inventory 14.400 Purchases 14.400 Accounts Payable 14.400 Accounts Payable 14.400 3. Sale of 1.000 units at 15 Accounts Receivable 15.000 Accounts Receivable 15.000 Sales 15.000 Sales 15.000 Cost of Goods Sold 12.000 No entry Inventory 12.000 4. End-of-period entries for inventory accounts, 300 units at 12 No entry necessary; Inventory account has balance Inventory (closing) 3.600 of 3.600 Cost of Goods Sold 12.000 Purchases 14.400 (Example adapted from Kieso/Weygandt) Inventory (opening) 1.200
Valuation: three decisions 1. What physical goods are to be included in inventory? 2. What costs are to be included in inventory? 3. What cost flow assumption should be adopted? 9
1. Inventory: attribution to accounting entity Rule: Goods should be included in the inventory of the party who has legal title to it. important for goods in transit and consigned goods Goods in transit Legal title determined by the terms of sale. FOB (free on board) shipping point: Ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller. FOB destination: Legal title to the goods remains with the seller until the goods reach the buyer. Consigned goods Goods included in the inventory of the consignor, not in that of the consignee. 10
2. Inventory Costs... is the purchase price plus any charges incurred bringing the inventory to its existing condition. production overhead IS included. period costs are NOT included. Overhead costs should be included only according to capacity utilization do not capitalize cost of idle capacity 11
Inventory valuation an example Candy Inc. spent the fourth quarter of its fiscal year producing candy for easter. 2.000 batches were produced at labor cost of 20 per batch and 150 for material per batch. Other cost in that quarter: 20.000 salary for production supervisors 28.000 depreciation of production facilities 2.000 setup cost 11.250 salary of factory manager 68.750 various manufacturing overhead 250.000 cost of headquarters 40.000 salary of sales representatives selling overhead direct cost manufacturing overhead administrative overhead 12
Multi-product case Overhead needs to be allocated to different products matter of cost accounting usual method choose an allocation base e.g. direct cost or direct labor hrs. calculate the overhead rate per unit of the allocation base multiply units of allocation base in product times overhead rate activity-based costing determine the total cost of each activity in the firm determine a cost driver as an allocation base for the cost of each activity determine the cost driver rate for each activity allocate activity cost according to usage by the product 13
The inventory is to be valued as follows: Provided regular capacity is 2000 batches Direct cost: 170 Manufacturing overhead: 65 ( 130.000 / 2.000 ) Administrative overhead: --- Selling overhead: --- Total: 235 per batch Value of inventory: 470.000 Assume regular capacity is 2500 batches Direct cost: 170 Manufacturing overhead: 52 ( 130.000 / 2.500 ) Administrative overhead: --- Selling overhead: --- Total: 222 per batch Value of inventory: 444.000 14
3. Cost flow assumptions for inventory valuation distinguishable items are purchased and sold required to monitor actual goods flow and record corresponding costs identical items of merchandise (at different prices) purchased and sold usually impractical to monitor actual goods flow and record corresponding costs assumption about cost flow Specific Identification Average Cost First-In, First-Out Last-In, First-Out Cost flow assumptions 15
Inventory valuation applying different methods We use the following data to calculate inventory, cost of sales, and gross profit for the different methods: Purchase of 8 units @ 2,50 (March) 4 units @ 3,00 (April) 4 units @ 4,00 (June) Sale of 2 units @ 5,00 (May) 16
Specific Identification items purchased and sold must be distinguishable problem of allocating overhead costs to inventory possibility of income manipulation for the example: cost of goods sold either 5.00 or 6.00 depending on whether items out of March s or April s purchase were used. 17
Inventory valued at average cost: Average Cost Inventory Inventory Cost of in numbers value Sales March 8 units @ 2,5 = 20 April 4 units @ 3 = 12 June 4 units @ 4 = 16 June end total 16 units @ 3 48 Sale of 2 items (May) - 2 units @ 3-6 6 Ending inventory 14 units @ 3 42 Cost of sales 6 units in inventory are valued at the average cost of the goods available for sale, i.e. total cost of inventory over number of items method easy to handle objective in nature, less room for manipulation 18
Inventory valued using FIFO First-In, First-Out Inventory Inventory Cost of (FIFO) in numbers value Sales March 8 units @ 2,5 = 20 April 4 units @ 3 = 12 June 4 units @ 4 = 16 June end total 16 48 Sale of 2 items (May) - 2 units @ 2,5 (March) = -5 5 Ending inventory 14 = 43 Cost of sales 5 cost of the first items purchased is assigned to the first items sold ending inventory valued at most recent cost disadvantage: old costs are matched with current revenues no manipulation of income figures 19
Inventory valued using LIFO Last-In, First-Out Inventory Inventory Cost of (LIFO) in numbers value Sales March 8 units @ 2,5 = 20 April 4 units @ 3 = 12 June 4 units @ 4 = 16 June end total 16 48 Sale of 2 units (May) - 2 @ 4 (June) = -8 8 Ending inventory 14 = 40 Cost of sales 8 cost of items purchased last is assigned to items sold first items from the earliest purchases rest in ending inventory advantage: most recent costs are matched with current revenues disadvantage: possible distortion of inventory figure (again) no manipulation of income figures? 20
Comparison of the effects on gross profit Average Cost Sales 10 Purchases 48 Closing Inventory 42 Cost of sales 6 Gross profit 4 FIFO Sales 10 Purchases 48 Closing Inventory 43 Cost of sales 5 Gross profit 5 LIFO Sales 10 Purchases 48 Closing Inventory 40 Cost of sales 8 Gross profit 2 Gross profit highest under FIFO and lowest under LIFO, (only in a period of rising prices. The reverse would be true if prices decline.) This year s closing inventory is next year s opening inventory! 21
Summary of Income Effects - When Inventory Costs (Prices) are Increasing Ending inventory, Averagegross profit, LIFO cost FIFO and net income Summary of Income Effects - When Inventory Costs (Prices) are Decreasing Ending inventory, Averagegross profit, LIFO cost FIFO and net income 22
Impact of accounting principles on inventory valuation Consistency principle stick to one method for inventory valuation Relevance, reliability if valuation method is changed, disclose that Comparability if two companies use different methods, effects of valuation methods need to be determined for purposes of comparison 23
LIFO Liquidation occurs if end-of-the-year balance falls short of the beginning-of-the-year balance disadvantage: you pay income taxes on the difference between current cost and the old LIFO costs How to prevent LIFO liquidation?... make enough purchases prior to year end!... or pool items of similar nature in one group ( specific goods, pooled LIFO approach) 24
Example In case 1, the inventory is liquidated (for whatever reason) whereas in case 2 enough purchases were made to keep the inventory at its beginning level: Case 1 Case 2 Sales for the period 18.000 18.000 Opening inventory 2.000 2.000 Purchases 10.000 14.000 less Closing inventory 0 2.000 Cost of sales 12.000 14.000 Gross profit 6.000 4.000 25
Tax benefit of LIFO vs. use of LIFO Use of various inventory methods 20% 4% 44% FIFO LIFO Average Other 32% Source: Harrison/Horngren, p.276 26
Inventory valuation using lower of cost or market rule conservatism valuation such that assets or income figures are not overstated if market value drops below acquisition price inventory valuation at market value possible reasons why market value may be lower: physical deterioration obsolescence market downturn departure from cost principle is justified (and required!) 27
market value IFRS: market refers to net realizable value US-GAAP Retail business market value refers to purchasing the goods Manufacturing business market value refers to reproducing the goods market means replacement costs! Market Value Upper and Lower Limits upper limit: Net realizable value lower limit: Net realizable value less a normal profit margin 28
General rule of Lower of Cost or Market (US-GAAP) Lower of COST or MARKET Historical (purchase or production) costs Ceiling Net Realizable Value not more than Replacement Cost not less than Net Realizable Value Less Normal Profit Margin Floor 29
How does the LCM-method under US-GAAP work? there are three valuation amounts from the market the middle value is called designated market value the designated market value is compared to cost the lower of the two amounts is used for inventory valuation net realizable item historical replacement selling price cost to net normal value less designated final cost cost complete realizable profit normal profit market inventory value margin margin value value (ceiling) (floor) I II III IV III - IV = V VI V - VI = VII 1 37,00 46,00 57,00 5,00 52,00 12,00 40,00 46,00 37,00 I 2 84,00 76,00 107,00 9,00 98,00 18,00 80,00 80,00 80,00 VII 3 21,00 30,00 30,00 2,00 28,00 6,00 22,00 28,00 21,00 I 4 112,00 100,00 127,00 11,00 116,00 18,00 98,00 100,00 100,00 II 5 56,00 40,00 52,00 4,00 48,00 4,00 44,00 44,00 44,00 VII 6 30,00 26,00 35,00 3,00 32,00 4,00 28,00 28,00 28,00 VII 7 46,00 58,00 56,00 6,00 50,00 7,00 43,00 50,00 46,00 I 356,0030
Alternative applications of LCM Category A Lower of Cost or Market by: historical designated individual major total cost market value items categories inventory item 1 37,00 46,00 37,00 item 2 84,00 80,00 80,00 item 3 21,00 28,00 21,00 total category A: 142,00 154,00 142,00 Category B item 4 112,00 100,00 100,00 item 5 56,00 44,00 44,00 total category B: 168,00 144,00 144,00 Category C item 6 30,00 28,00 28,00 item 7 46,00 50,00 46,00 total category C: 76,00 78,00 76,00 Total 386,00 376,00 356,00 362,00 376,0031
Recording market instead of cost market valuation lower than cost writeoff becomes necessary two methods direct method vs. allowance method direct method - lower market valuation reflected in cost of goods sold - no (separate) writeoff of inventory indirect (allowance) method - lower market valuation mirrored in contra asset account - separate statement of loss due to market decline Example assume the following inventory valuations: at cost at market opening inventory 400.000 420.000 closing inventory 350.000 300.000 32
Direct Method Indirect Method to close opening inventory Cost of goods sold 400.000 Cost of goods sold 400.000 (or Income summary) (or Income summary) Inventory 400.000 Inventory 400.000 to record ending inventory Inventory 300.000 Inventory 350.000 Cost of goods sold 300.000 Cost of goods sold (or Income summary) (or Income summary) 350.000 to write down inventory to market no entry Loss due to market 50.000 decline of inventory Allowance to reduce 50.000 inventory to market 33
Financial ratios key ratio: inventory turnover rate similar to other asset turnover ratios Inventory turnover rate = Sales revenue (or COGS) in year Average inventories in year ratio differs between industries indicator of increasing / decreasing demand several reasons for rate changes possible, e.g. build-up of inventory just-in-time production 34