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(In times of economic distress and reduction in consumer spending. find out more. businesses always look for ways to increase profits. in c   . It is. crucial for investors who are analyzing stocks to understand how inventory is valued. inventory represents a large (if not the largest) portion of assets and. therefore."  Email Article Print Feedback Reprints Share ÷  Stocks Are you one of those investors who doesn't look at how a company accounts for its inventory? For many companies. as such. makes up an important part of the balance sheet.

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The following equation expresses how a company's inventory is determined: Beginning Inventory + Net Purchases .c  # Inventory is defined as assets that are intended for sale.Cost of Goods Sold (COGS) = Ending . are in process of being produced for sale or are to be used in producing goods.

There are three inventory-costing methods that are widely used by both public and private companies: p? . Inventory In other words. and the result is what remains. income statement and statement of cash flow. ]$X c  # The accounting method that a company decides to use to determine the costs of inventory can directly impact the balance sheet. you take what the company has in the beginning. add what it has purchased. subtract what's been sold.

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FIFO states that if the bakery sold 200 loaves on Wednesday.  (FIFO) This method assumes that the first unit making its way into inventory is the first sold. The $1. p?  c  . For example.25 each. let's say that a bakery produces 200 loaves of bread on Monday at a cost of $1 each. the COGS is $1 per loaf (recorded on the income statement) because that was the cost of each of the first loaves in inventory. and 200 more on Tuesday at $1.25 loaves would be allocated to ending inventory (appears on the balance sheet).

see  . p?   This method is quite straightforward. while ending inventory appears on the balance sheet under current assets. therefore. (For more insight. the same bakery would assign $1. is left over at the end of the accounting period. An important point in the examples above is that COGS appears on the income statement.25 per loaf to COGS.125 per unit. it takes the weighted average of all units available for sale during the accounting period and then uses that average cost to determine the value of COGS and ending inventory. while the remaining $1 loaves would be used to calculate the value of inventory at the end of the period. For the 200 loaves sold on Wednesday.  (LIFO) This method assumes that the last unit making its way into inventory is sold first. In our bakery example. The older inventory. calculated as [(200 x $1) + (200 x $1. the average cost for inventory would be $1.25)]/400.

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prices tend to rise. and FIFO. When prices are stable. our bakery would be able to produce all of its loafs of bread at $1. If prices are rising. then all three of the inventory valuation methods would produce the exact same results.c  c # If inflation were nonexistent. but it also increases net income because inventory that might be several years old is used . Over the long term. Unfortunately. which means the choice of accounting method can dramatically affect valuation ratios. LIFO and average cost would give us a cost of $1 per loaf. each of the accounting methods produce the following results: p? FIFO gives us a better indication of the value of ending inventory (on the balance sheet). the world is more complicated.

perhaps. but remember that it also has the potential to increase the amount of taxes that a company must pay. it then must also use LIFO when it reports financial results to shareholders. which results in lower taxes when prices are increasing. Increasing net income sounds good. If a company uses LIFO valuation when it files taxes. then the complete opposite of the above is true. LIFO results in lower net income because cost of goods sold is higher. earnings per share. p? LIFO isn't a good indicator of ending inventory value because the leftover inventory might be extremely old and. This results in a valuation that is much lower than today's prices.) One thing to keep in mind is that companies are prevented from getting the best of both worlds. in c   . This lowers net income and. (Note: if prices are decreasing. for any reason. p? Average cost produces results that fall somewhere between FIFO and LIFO. (Cash-value life insurance has always provided consumers with a tax-free avenue of growth within the policy that could be accessed at any time. Find out more. ultimately. to value the cost of goods sold. obsolete.

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) =   Let's examine the inventory of Cory's Tequila Co. (CTC) to see how the different inventory valuation methods can affect the financial analysis of a company. %  c  &  ' %  ( . !"     #.

000 $10 $10.000 $12 $12..000 units purchased at $8 each (a total of 4.000 $15 $15.000 March 1.000 units) c   ..000 * +. Beginning Inventory = 1.&   ) *   January 1.000 February 1.

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012.000 Beginning Inventory 8.000 8.000 8.000 Ending Inventory (appears on B/S) 8.000 15.250 '  .000 37.  $60.000 $60.000 11.000 $60.000 Purchases 37.000 37.

.000 $30. 15627. 12.000 $33.000 10.000 4c  15+...750 Expenses 10..  ..  $ 3 $37.000 10.

in order to find out what COGS is.000 units .000 units left)  What we are doing here is figuring out the ending inventory.000 units sold = 1.3.000 units left for ending inventory: (4.Ending Inventory = Cost of Goods Sold c = . All we've done is rearrange the above equation into the following: Beginning Inventory + Net Purchases . the results of which depend on the accounting method. ëNote: All calculations assume that there are 1.

" 1.000 units X $8 each = $8.000 c  / ""$   .

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" 1.000 c  / ""$ .000 units X $15 each = $15.

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000 x 10) + (1.25 each = $11.000 x 15)]/4000 units = $11.000 x 8) + (1. " [(1.25 per unit 1.000 units X $11.250 ""$ ! ) !.000 x 12) + c  / (1.

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000 Each inventory valuation method causes the various ratios to produce significantly different results (excluding the effects of income taxes):  .  & Using the information above.000 inventory) Current liabilities $40. Let's assume the following: Assets (not including inventory) $150.000 Current assets (not including $100.000 Total liabilities $50. we can calculate various performance and leverage ratios.

78 Inventory Turnover 7.30 0.7 2.0 5. c  c   " Debt-to-Asset 0.5 4.31 Working Capital 2.88 2.3 Gross Profit Margin 38% 50% 44% .32 0.

see the  .To learn more about each ratio listed above.

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you will be better able to compare companies within the same industry. inventory analysis can have a big effect on the bottom line. a company probably won't publish its entire inventory situation in its financial statements. however. By learning how these differences work. . Companies are required. to state in the notes to financial statements what inventory system they use.   . Unfortunately. As you can see from the ratio results.

check out its inventory. it might reveal more than you thought." This means that if inventory values were to plummet. Many companies will also state that they use the "lower of cost or market. LIFO or average cost. Next time you're valuing a company. Understanding inventory calculation might seem overwhelming. their valuations would represent the market value (or replacement cost) instead of FIFO. but it's something you need to be aware of. ? ?à   à ???  ? ? .

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total assets.    When ending inventory is incorrect. the cost of merchandise sold and net income will also be incorrect on the income statement. and owner's equity. The inventory accounting involves two major aspects: p? o? ?? ? . the following balances of the balance sheet will also be incorrect as a result: merchandise inventory. When ending inventory is incorrect.

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 ??? The following methods are the most commonly used for inventory valuation by companies: p? ÷  ÷  ÷ ÷ .

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   The two most widely used inventory accounting systems are the periodic and the perpetual. p? °e e .

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The most commonly used inventory costing methods under a periodic system are: [? . In order to determine the cost of goods sold. a physical inventory must be taken. The periodic system records only revenue each time a sale is made.

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The FIFO method bases its cost flow on the chronological order purchases are made.? ? These methods produce different results because their flow of costs are based upon different assumptions. while the LIFO method bases it cost flow in a reverse chronological order. The average cost method produces a cost flow based on a weighted average of unit costs. 6 c  .

and inventory on hand.    The perpetual inventory system requires that a separate inventory ledger be maintained for each good. unit cost. Inventory ledgers provide detailed information on purchases. and total cost. cost of goods sold. Each column gives information on quantity. The most commonly used inventory costing methods under a perpetual system are [? .

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the Inventory Shortages account should be debited. 6   .e. When the average cost method is used. an average unit cost of each good is calculated each time a purchase is made. and physical inventories can be easily compared. it aids in the management of proper inventory levels. The advantages of the perpetual inventory system is a high degree of control.In the FIFO and LIFO method. each purchase record is kept with its purchase prices. a missing or stolen good) is discovered. Whenever a shortage (i. Every piece sold is subtracted from each purchase record until no qty is left and the next purchase record is considered.

By recording the cost of goods sold for each sale. 6    . In Perpetual Inventory System there must be actual facts and figures. To record purchases. the perpetual system requires an extra entry to debit the Cost of goods sold and credit Merchandise Inventory.  There are fundamental differences for accounting and reporting merchandise inventory transactions under the periodic and perpetual inventory systems. To record sales. both of which the periodic inventory system requires. the perpetual inventory system alleviated the need for adjusting entries and calculation of the goods sold at the end of a financial period. the periodic system debits the Purchases account while the perpetual system debits the Merchandise Inventory account.

The net realizable value is the estimated selling price less any expense incurred to dispose of the good. This method allows declines in inventory value to be offset against income of the period. the lower of cost or market method of valuation is recommended.     Under certain circumstances. 6      . they should be recorded at net realizable value. When goods are damaged or obsolete. and can only be sold for below purchase prices. valuation of inventory based on cost is impractical. If the market price of a good drops below the purchase price.

Two very popular methods are 1). it is necessary to estimate the inventory cost. and 2). In certain business operations.gross profit (or gross margin) method.retail inventory method. The retail inventory method uses a cost to retail price ratio. taking a physical inventory is impossible or impractical. The physical inventory is . In such a situation.

and the ending inventory is estimated by adding cost of goods sold to goods available for sale. sales minus cost of goods sold divided by sales). ? .valued at retail.e. and it is multiplied by the cost ratio (or percentage) to determine the estimated cost of the ending inventory. The gross profit method uses the previous years average gross profit margin (i. Current year gross profit is estimated by multiplying current year sales by that gross profit margin. the current year cost of goods sold is estimated by subtracting the gross profit from sales.