Chapter 8 Inventories and Cost of Goods Sold

Using a Cost Flow Assumption Specific Identification FIFO LIFO Average Cost The importance of time when working with inventory methods Estimating Inventory Inventory Turnover How Turnover relates to Gross Profit Inventory Management - a delicate balance Chapter 8 Manufacturing companies have three types of inventory: materials, work in process and finished goods. Retailers have one inventory: merchandise. In all cases, inventory is something the company will re-sell to someone else. Inventory cost is an asset until it is sold; after merchandise is sold, the cost becomes an expense, called Cost of Goods Sold (COGS). A journal entry transfers costs from the Balance Sheet to the Income Statement. Chapter 8 focuses on inventories of merchandise, those inventories held by retailers for sale to their customers. This would include grocery stores, clothing stores, in fact all the stores you would visit in the mall, or shop at on a regular basis, are retailers. That covers a large and broad group of businesses. There are several important points, or events, in the life on an inventory item. The company must first order and buy the item. It then holds the item on a shelf or warehouse, until a customer wants to but the item. Once the item is sold, the cost is transferred to COGS. So the three important times in an item's life are buying, holding and selling. Let's think for a moment about a hypothetical inventory item, we'll call it Item X. If you buy, hold and sell Item X all in the same year, say 2002, the entire transaction relating to Item X will be a completed and realized transaction. If the customer has paid for Item X there will be absolutely no accounting left to do, except show the sale and related COGS on the 2002 Income Statement. Nothing about Item X will affect the company in the future. Everything about Item X relates only to the past. If Item X costs you $40, and you sell it for $65, you made a Gross Profit on the item of $25. Income Statement 2002 Selling Price of Item X Less: Cost of Item X Gross Profit from selling Item X $ 65.00 40.00 $25.00

This is the information that will be included in the 2002 Income Statement. Nothing will be left on the Balance Sheet. Now let's think for a moment about Item Z. Assume you buy Item Z for late in 2002, and you are still holding it. There will be no sale to report, so the cost will remain on the Balance Sheet. If Item Z cost $50 that is the amount that will be shown on the Balance Sheet. Balance Sheet Dec. 31, 2002 Inventory at December 31, 2002 Cost of Item Z $50.00

If Item Z is sold in 2003, the cost will flow to the Income Statement for 2003, and the gross profit will be reported on that income statement. Inventory Valuation In the example above, you determined a value for Item Z at the end of the year. It is important for companies to count the physical inventory at the end of the year (Chapter 6). They must also place a dollar value on that inventory. The inventory value will be reported on the Balance Sheet at the end of the year. It is also important to know the correct value of merchandise sold. That is the cost used to determine Gross Profit. Without enough Gross Profit a company can't pay it's operating expenses, such as salaries and wages, rent and utilities, etc. We will discuss Gross Profit a little more later in this section. There are four methods commonly used to calculate a value for ending inventory. A company should select and use the method that best matches their merchandise and how it is sold. 4 methods of inventory valuation Inventory method Specific Identification How it works the cost of each individual inventory item is tracked separately; the exact cost of each item is used in the value of ending inventory When used auto sales, gems and jewelry, works of art, unique, one of a kind items eggs, milk, meat, produce; this is the default flow assumption, unless a different method is specified clothing, seasonal items; a highly specialized method of retail inventory lumber, nails, nuts and bolts (simple average); gasoline (moving average)

First In, First Out cost of earliest purchases flow to COGS; we assume (FIFO) that the items remaining at the end are the last ones bought in the year Last In, First Out cost of last purchases flow to COGS; we assume that (LIFO) the items remaining at the end are the earliest ones bought in the year Average Cost cost of items bought are averaged across the year; the average cost is used at the end of the year; a moving weighted average is sometimes used

Using a Cost Flow Assumption • • • • must meet cost-benefit rule accounts for quantities of homogeneous products matches the physical flow of goods can be used with either Periodic or Perpetual costing system

Specific Identification The Specific Identification method assumes that each inventory item is special enough, unique enough, and costly enough to merit tracking one at a time. But does that apply to each and every item? What about a ream (500 sheets) of typing paper. Is it necessary to place a value on each and every sheet of paper? Most business would answer "No" to that question. The cost of keeping that much detailed information would exceed the usefulness, or benefit, of the information. We call that the cost-benefit rule. The cost of an accounting system (or any other venture) should be outweighed by the benefits, or it is not cost-effective to follow that course of action. For most companies, the Specific Identification method is far too costly and the additional information that could be gained is of little value. Most companies use a cost flow assumption. This simply means that the flow of inventory follows a certain pattern. Companies will buy merchandise in a manner consistent with the merchandise itself.

FIFO For instance, a grocery store will buy only the amount of milk it can sell in a week. Because milk spoils quickly, the store will buy small amounts each week, and make sure the milk it has for sale is the freshest milk available. Further, one gallon of milk is basically the same as the next gallon (with only minor differences). We say that milk is a homogeneous product. All the milk can be viewed as a single product group, that follows an almost identical weekly sales and spoilage pattern. The grocery will use a flow assumption to value its milk inventory at the end of the year. They will use FIFO, assuming that the milk on hand is the last milk that was bought during the year. The LIFO method would assume that the milk bought in the first week of the year is the same milk on the shelf at the end of the year. Obviously year old milk will probably be coagulated into a solid, stinking block of green muck. So we know that LIFO would be an incorrect flow assumption for milk. So when will the LIFO assumption will be valid? LIFO Let's now picture a clothing store. There are basically 4 clothing seasons: Winter, Spring, Summer and Autumn. There is a line of clothing for each season. Further, clothing styles change each year. Except for a few items (socks, handkerchiefs, belts) customers will prefer to buy this year's fashions, rather than last year's fashions. Here's how that works into the LIFO method. At the end of the year the clothing store looks at its merchandise. If their year ends in December, they have Winter clothes in the show room. But when they look in the storage room, most of the clothes there are from earlier seasons that year. So Last In, First Out means, the most current seasons clothes (Last In) are the ones that people want now (First Out). After all, you wouldn't be buying last summer's clothes in the middle of winter, would you? Most people will wait until the following year and buy clothes in style in the coming summer. Average Cost Some merchandise is nearly identical and is carried in large quantities, like lumber, nails, nuts and bolts or gasoline. If you have a tank on gasoline with say 50 gallons in it, and you add 200 more gallons, you can't separate the first 50 gallons out from the rest of it. It all just becomes on take with 250 gallons of gasoline in it. So companies use the average cost method to account for things like this. If you run a gas station, your costs will change every week. You will always have some left in the tank from the week before, and the delivery truck will dump more gas in your tank at this week's prices. Gas stations use a moving average method - they take the moving average from last week, and calculate a new moving average after adding this weeks batch of gasoline to the tank. So a moving average updates the cost frequently, and applies that particular average cost to that week's gasoline sales. Next week they will calculate a new moving average and apply it to next week's gasoline sales, etc. At one time my office was next to a company that sold nuts, bolts, screws, nails, washers and other types of small hardware items. They bought directly from the manufacturers, mostly foreign. Their goods came packed in small wooden barrels. Believe me, a small wooden barrel full of nails is heavy! They repackaged the items into small plastic bags for resale to stores, and ultimately to end consumers. They had a very sophisticated set of scales that would accurately weigh out the pieces into the desired quantity. For instance ,they could weigh out 10 flat washers accurately, and drop them into a small plastic bag. It was much quicker and easier than counting pieces manually. How do you think they counted and valued their ending inventory? They weighted all the opened containers (no need to weigh a full, unopened one), and used their cost per pound, to calculate the value of their ending inventory. This may seem a bit unconventional, but it is a very good method, and entirely acceptable. Some bulk products and how they might be measured for average costing:

product gasoline, oil, milk, orange juice crude oil natural gas nails, nuts and bolts wheat, oats, corn, other grains electric, telephone or TV cable gallon, liter barrel


cubic yard, cubic meter pound, kilo bushel foot, meter

The importance of time when working with inventory methods When it comes to inventory values, time is of the essence. That's a legal term, and means that time is more than just important, it is essential. You can't sell something you don't have, right? You can sell only what you have on hand in your inventory. Once an item is sold we have to determine how much cost to transfer from the Inventory account to the COGS account. Using the Periodic system If you use a Periodic inventory system, you value your inventory only once a year - at the end of the year! So the job is fairly easy, and you should have little problem making the calculation. You apply a cost flow assumption once at the end of the year, and it pertains only to the physical merchandise still on hand at the end of the year. It doesn't matter when sales take place, or when inventory is purchased. We ignore all that when we use the Periodic system. All we have to care about is what inventory is on hand at the end of the year.

Using the Perpetual System If you use the Perpetual system you have to track each and every purchase and sale of inventory. Time is definitely of the essence. We will use a cost flow and apply it continuously, updating the Sales, Inventory and COGS accounts daily, as merchandise is purchased and sold. This can be a daunting task, and usually is done by sophisticated and expensive computerized systems. When you go to a grocery or department store, notice that all the products have a bar code, which is scanned by an electronic cash register. All the merchandise is scanned into the the computer inventory records when it arrives at the store, and is scanned out as it is sold. The inventory records are continuously updated, along with the inventory value. The type of system a company uses will depend on how much it can afford to spend. Obviously, not all companies can or need to spend $50,000 to $100,000 for each scanning cash register, plus the cost of the computer and software itself. Installing such a system can easily cost $1 million or more per store. That's a high price tag, so most companies use a Periodic system, and update their inventory only once a year. Estimating Inventory Let's say a company uses the Periodic system. In the middle of the year they go to the bank seeking a loan for expansion. The banker asks to see a set of financial statements. Taking a complete physical inventory can be a huge, time-consuming task. The company may simply not have time to drop everything and take a physical inventory at this time. Do they have any options? In fact, they do. They can estimate the inventory on hand. They can reconstruct the inventory based on their purchase and sales records for the year to date. There are a couple of methods used to do this. They are both similar. The Gross Profit method is one method. The store needs to know it's gross profit rate or cost ratio (the inverse of gross profit rate). They start with the beginning inventory balance, add purchases, and deduct for sales made using the cost ratio. The result is an estimate of the merchandise on hand.

This method is especially useful when there has been a loss due to theft, fire, flood and so forth. The Gross Profit or Retail methods can be used to substantiate an insurance claim for loss in these situations. Inventory Turnover Inventory turnover is not some sort of exotic pastry. It also does not mean we physically pick up our inventory and turn it over or upside down. Having dispensed with those misconceptions, just what is inventory turnover? Each time you sell your entire inventory, you are said to have "turned" or "turned over" your inventory. We measure this as the number of times per year that this happens. We also measure it in a dollar amount, not by the actual physical objects. A store might have a year-old can of "Uncle Simon's Nasty Stuff That Only Your Aunt Ethel Will Eat". Not selling that can will have not effect on inventory turnover, in the larger sense of the word. [Managers are definitely interested in micro-inventory management: looking at the sales pattern of individual items. Walmart has been an aggressive pioneer in this area. Right now we are dealing with macro-inventory management: looking at the dollar value of the entire inventory, taken as a whole.] Earlier I discussed how a grocery store stocks milk. The buy enough for one week. There are 52 weeks in a year, so we would expect their inventory turnover, for milk, to be roughly 52. We usually calculate this using dollars, rather than tracking actual cartons of milk.

Number of Days in Inventory is the concept expressed in number of days. It tells us how many days, on average, inventory stays on a shelf before it is sold. Since there are 365 days in a year, we can divide 365 by the inventory turnover rate and get the number of days in inventory. 365 / 52 = 7 (rounded) or roughly 1 week There are 52 weeks in the year, and the store wants to stock enough for 1 week at a time. Their weekly milk inventory is sold 52 times a year (turnover), or once every 7 days (days in inventory). Let's look at a table and see some typical correlation's. Notice the inverse relationship between turnover rate and days in inventory. As one goes up, the other goes down. Turnover Rate 52 12 6 4 2 1 Days in Inventory 7 30.4 60.8 91.25 182.5 365 Frequency weekly monthly 2 months quarter (3 months) half year one year

What I'm hoping you'll get from this is a little common sense. Eggs would not have a turnover rate of 4. Perishable items will have a high turnover rate and low number of days in inventory. Automobiles, diamond rings, and works of art would probably not have a turnover rate of 52. It can take much longer to sell these expensive items. They will have a low turnover rate, and a high number of days in inventory. How Turnover relates to Gross Profit Profits depend on several things. One of the most important is the relationship between turnover and gross profit. Higher turnover brings greater profit. Lets look at a simple example.

A store buys Item X for $20, and sells it for $30. The Gross Profit from each item is $10.

Annual Turnover Rate 1

Sales 30


GP 10

2 4

60 120

40 80

20 40

Guess what, we can just multiply the annual turnover rate and the GP per unit ($10). That would be an easier calculation!

Annual Turnover Rate 1 2 4 6 12 52

$GP x TO Rate $10 x 1 $10 x 2 $10 x 4 $10 x 6 $10 x 12 $10 x 52

Total $GP $10 $20 $40 $60 $120 $520

If you sell 1 unit per year, you will only make $10 per year. If you sell 1 unit per week you make $520 per year. Which is better? (I sincerely hope you chose $520 per year. If not, please consult a physician. You may need professional help.) Turnover is essential to profits. Higher turnover = higher profits. Let's look at an example Jim buys pocket knives from the manufacturers and resells them on e-bay. He buys by the case and pays $5 for each knife. At the both the start and end of the year he had 30 knives on hand (to make this example a little easier). Jim bought and sold 800 knives during the year. He had 32 knives on hand at the start and end of the year, so his average inventory is 32 (32+32/2 = 32).

Cost Component COGS @ $5 Avg Inventory @ $5 Results Turnover rate Days in inventory

Units 800 32 $4000 / $160 = 365 / 25 =

$ Cost $ 4,000 $ 160 25 14.6

What this is telling us: His average inventory was 32 knives last year. He sells 32 knives every 25 days. Each batch of 32 knives is in inventory 14.6 days. If he sells 800 knives every year, that's about 800 / 365 = 2.19 knives per day. This is consistent with our results. 32 knives / 14.6 days = 2.19 knives per day. He sells about 2 x 32 = 64 knives each month (avg 66.6 knives per month). Inventory Management - a delicate balance By now you should be seeing the correlation between Gross Profit and sales. No matter what your gross profit is, making more sales will always mean making more GP. Since each and every unit of product you sell earns you a GP, you will always do better selling more, rather than less. Inventory turnover is a measure of ow often your average inventory is sold. Since business managers have access to all the detailed operating information of their company, they can manage inventory on a product by product basis. They can effectively look at the turnover of a single product, and more accurately gauge their real average inventory held for that item. There is one very important thing that all businesses have to deal with: carrying the right amount of inventory - not too much, not too little. If you carry too little inventory you will lose sales, and that will reduce your GP. If you carry too much inventory the surplus will tie up your cash flow. You will have to warehouse, protect and insure the excess inventory. And you run a high risk of spoilage, obsolescence, theft and damage. A company will maximize its profits by carrying the correct amount of each item in its inventory. This amount is determined by careful analysis and tracking of customer's buying patters. Stores have to pay attention to the seasonal and cyclic buying trends their customers display. Effective inventory management requires both day-to-day attention, and ongoing analysis of customer preferences and buying habits.

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