MODULE: Quick Food Service Operations

Chapter 5: Accounting and Finance Inventory in Quick Food Service

Operation
Learning Objective:
 Discuss the process of accounting and finance inventory in Quick Food
Service Operation
 Cite the important of accounting and finance Inventory in Quick Food
Service.
 Assess the students at the end of the lesson

Inventory Accounting
What Is Inventory Accounting?
Inventory accounting is the body of accounting that deals with valuing and
accounting for changes in inventoried assets.
A company's inventory typically involves goods in three stages of
production: raw goods, in-progress goods, and finished goods that are ready for
sale. Inventory accounting will assign values to the items in each of these three
processes and record them as company assets. Assets are goods that will likely
be of future value to the company, so they need to be accurately valued in order
for the company to have a precise valuation.
https://www.investopedia.com/terms/i/inventoryaccounting.asp#:~:text=Inventory%20accounting%20is%20the%20bod
y,that%20are%20ready%20for%20sale.

KEY TAKEAWAYS

 Inventory accounting determines the specific value of assets at certain

stages in their development and production.
 This accounting method ensures an accurate representation of the value
of all assets, company-wide.
 Careful examination by a company of these values could lead to increased
profit margins at each stage of the product.
Inventory items at any of the three production stages can change in value.
Changes in value can occur for a number of reasons including depreciation,
deterioration, obsolescence, change in customer taste, increased demand,
decreased market supply, and so on. An accurate inventory accounting system
will keep track of these changes to inventory goods at all three production stages
and adjust company asset values and the costs associated with the inventory
accordingly.

How Inventory Accounting Works

GAAP requires inventory to be properly accounted for according to a very
particular set of standards, to limit the potential of overstating profit by
understating inventory value. Profit is revenue minus costs. Revenue is
generated by selling inventory. If the inventory value (or cost) is understated,
then the profit associated with the sale of the inventory may be overstated. That
can potentially inflate the company's valuation.

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The other item the GAAP rules guard against is the potential for a company to
overstate its value by overstating the value of inventory. Since inventory is an
asset, it affects the overall value of the company. A company which is
manufacturing or selling an outdated item might see a decrease in the value of its
inventory. Unless this is accurately captured in the company financials, the value
of the company's assets and thus the company itself might be inflated.

Advantages of Inventory Accounting

The main advantage of inventory accounting is to have an accurate

representation of the company's financial health. However, there are some
additional advantages to keeping track of the value of items through their
respective production stages. Namely, inventory accounting allows businesses to
assess where they may be able to increase profit margins on a product at a
particular place in that product's cycle.

This can be seen most prominently in products that require exceptional time or
expense in secondary stages of production. Items such as pharmaceuticals,
machinery, and technology are three products that require large amounts of
expense after their initial designing. By evaluating the value of the product at a
certain stage⁠—such as clinical trials or transportation of the product⁠—a company
can adjust the variables at that stage to keep the product value the same while
increasing their profit margins by decreasing expenses.
https://www.investopedia.com/terms/i/inventoryaccounting.asp#:~:text=Inventory%20accounting%20is%20the%20body,th
at%20are%20ready%20for%20sale.
What Is Inventory Valuation and why is it important?

Inventory valuation is the monetary amount associated with the goods in the
inventory at the end of an accounting period. The valuation is based on the costs
incurred to acquire the inventory and get it ready for sale.

Inventories are the largest current business assets. Inventory valuation allows
you to evaluate your Cost of Goods Sold (COGS) and, ultimately, your
profitability. The most widely used methods for valuation are FIFO (first-in, first-
out), LIFO (last-in, first-out) and WAC (weighted average cost).

What this article covers:

 What Are the Objectives of Inventory Valuation?

 How Inventory Is Valued
 Which Inventory Valuation Method Is Best

What Are the Objectives of Inventory Valuation?

Inventory refers to the goods meant for sale or unsold goods. In manufacturing, it
includes raw materials, semi-finished and finished goods. Inventory valuation is
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 MODULE: Quick Food Service Operations
done at the end of every financial year to calculate the cost of goods sold and the
cost of the unsold inventory.

This is crucial as the excess or shortage of inventory affects the production and
profitability of a business.

DETERMINE THE GROSS INCOME

Inventory is used to find the gross profit, which is the excess of sales over cost of
goods sold. To determine the gross profit or the trading profit, the cost of goods
sold is matched with the revenue of the accounting period.

Cost of goods sold = Opening stock + Purchases – Closing stock

The above equation shows that the inventory value affects the cost and thereby
the gross profit. For example, if the closing stock is overvalued, it will inflate the
current year’s profit and reduce profits for subsequent years.

ASCERTAIN THE FINANCIAL POSITION

Closing stock is shown as a current asset. The value of the closing stock on the
Balance Sheet determines the financial position of the business. Overvaluation or
undervaluation can give a misleading picture of the working capital position and
the overall financial position.

How Inventory Is Valued

The method for valuing inventory depends on how the stock is tracked by the
business over time. A business must value inventory at cost. Since inventory is
constantly being sold and restocked and its price is continually changing, the
business must make a cost flow assumption that it will use frequently.

There are four accepted methods of inventory valuation.

 Specific Identification
 First-In, First-Out (FIFO)
 Last-In, First-Out (LIFO)
 Weighted Average Cost
SPECIFIC IDENTIFICATION

Under this method, every item in your inventory is tracked from the time it is
stocked to when it is sold. It is usually used for large items that can be easily
identified and have widely different features and costs associated with these
features.

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The primary requirement of this method is that you should be able to track every
item individually with RFID tag, stamped receipt date or a serial number.

While this method introduces a high degree of accuracy to the valuation of

inventory, it is restricted to valuing rare, high-value items for which such
differentiation is needed.

FIRST-IN, FIRST-OUT (FIFO)

This method is based on the premise that the first inventory purchased is the first
to be sold. The remaining assets in inventory are matched to the assets that are
most recently purchased or produced.

It is one of the most common methods of inventory valuation used by businesses

as it is simple and easy to understand. During inflation, the FIFO method yields a
higher value of the ending inventory, lower cost of goods sold, and a higher gross
profit.

Unfortunately, the FIFO model fails to present an accurate depiction of the costs
when there is a rapid hike in prices. Also, unlike the LIFO method, it does not
offer any tax advantages.

LAST-IN, FIRST-OUT (LIFO)

Under this inventory valuation method, the assumption is that the newer
inventory is sold first while the older inventory remains in stock. This method is
hardly used by businesses since the older inventories are rarely sold and
gradually lose their value. This results in significant loss to the business.

The only reason to use LIFO is when businesses expect the inventory cost to
increase over time and lead to a price inflation. By moving high-cost inventories
to cost of goods sold, the reported profit levels businesses can be lowered. This
allows businesses to pay less tax.

WEIGHTED AVERAGE COST

Under the weighted average cost method, the weighted average is used to
determine the amount that goes into the cost of goods sold and inventory.
Weighted average cost per unit is calculated as follows:

Weighted Average Cost Per Unit = Total Cost of Goods in Inventory / Total
Units in Inventory

This method is commonly used to determine a cost for units that are
indistinguishable from one another and it is difficult to track the individual costs.

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Which Inventory Valuation Method Is Best

Choosing the right inventory valuation method is important as it has a direct

impact on the business’s profit margin. Your choice can lead to drastic
differences in the cost of goods sold, net income and ending inventory.

There are advantages and disadvantages of each method. For example, the
LIFO method will give you the lowest profit because the last inventory items
bought are usually the most expensive while the FIFO will give you the highest
profit as the first items in stock are usually the cheapest.

To assess the method which is best for you, you need to pay attention to
changes in the inventory costs.

 If the inventory costs are escalating or are likely to increase, LIFO costing
may be better. As higher cost items are considered sold, it results in higher
costs and lower profits.
 In case your inventory costs are falling, FIFO might be the best option for you.
 For a more accurate cost, use the FIFO method of inventory valuation as it
assumes the older items that are less costly are the ones sold first.

As a business owner, you need to analyze each method and apply the method
that reflects the periodic income accurately and suits your specific business
situation. The Financial Accounting Standards Board (FASB), in its Generally
Accepted Accounting Procedures, allows both FIFO and LIFO accounting.

It is also important to note businesses cannot switch from one method of

inventory valuation to another. If your business decides to change to LIFO
accounting from FIFO accounting, you must file Form 970 with the IRS.
https://www.freshbooks.com/hub/accounting/inventory-valuation

Accounting for inventory

How to Account for Inventory

The accounting for inventory involves determining the correct unit counts
comprising ending inventory, and then assigning a value to those units. The
resulting costs are then used to record an ending inventory value, as well as
to calculate the cost of goods sold for the reporting period.

These basic inventory accounting activities are expanded upon in the

following bullet points:

 Determine ending unit counts. A company may use either a periodic or

perpetual inventory system to maintain its inventory records. A periodic

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system relies upon a physical count to determine the ending inventory
balance, while a perpetual system uses constant updates of the
inventory records to arrive at the same goal.
 Improve record accuracy. If a company uses the perpetual inventory
system to arrive at ending inventory balances, the accuracy of the
transactions is paramount.
 Conduct physical counts. If a company uses the periodic inventory
system to create ending inventory balances, the physical count must
be conducted correctly. This involves the completion of a specific
series of activities to improve the odds of counting all inventory items.
 Estimate ending inventory. There may be situations where it is not
possible to conduct a physical count to arrive at the ending inventory
balance. If so, the gross profit method or the retail inventory method
can be used to derive an approximate ending balance.
 Assign costs to inventory. The main role of the accountant on a
monthly basis is assigning costs to ending inventory unit counts. The
basic concept of cost layering, which involves tracking tranches of
inventory costs, involves the first in, first out (FIFO) layering system
and the last in, first out (LIFO) system. A different approach is the
assignment of a standard cost to each inventory item, rather than a
historical cost.
 Allocate inventory to overhead. The typical production facility has a
large amount of overhead costs, which must be allocated to the units
produced in a reporting period.

The preceding bullet points cover the essential accounting for the valuation of
inventory. In addition, it may be necessary to write down the inventory
values for obsolete inventory, or for spoilage or scrap, or because the
market value of some goods have declined below their cost. There may also
be issues with assigning costs to joint and by-product inventory items. We
expand upon these additional accounting activities in the following bullet
points:
 Write down obsolete inventory. There must be a system in place for
identifying obsolete inventory and writing down its associated cost.
 Review lower of cost or market. The accounting standards mandate
that the carrying amount of inventory items be written down to their
market values (subject to various limitations) if those market values
decline below cost.
 Account for spoilage, rework, and scrap. In any manufacturing
operation, there will inevitably be certain amounts of inventory
spoilage, as well as items that must be scrapped or reworked. There is
different accounting for normal and abnormal spoilage, the sale of
spoiled goods, rework, scrap, and related topics.
 Account for joint products and by-products. Some production
processes have split-off points at which multiple products are created.
The accountant must decide upon a standard method for assigning
product costs in these situations.
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 Disclosures. There are a small number of disclosures about inventory
that the accountant must include in the financial statements.
https://www.accountingtools.com/articles/accounting-for-inventory.html

Example of LIFO vs. FIFO

In the tables below, we use the inventory of a fictitious beverage producer called
ABC Bottling Company to see how the valuation methods can affect the outcome
of a company’s financial analysis.

The company made inventory purchases each month for Q1 for a total of 3,000
units. However, the company already had 1,000 units of older inventory that was
purchased at $8 each for an $8,000 valuation. In other words, the beginning
inventory was 4,000 units for the period.

The company sold 3,000 units in Q1, which left an ending inventory balance of
1,000 units or (4,000 units - 3,000 units sold = 1,000 units).

ABC CO. — MONTHLY INVENTORY PURCHASES

Month Units Purchased Cost / Each Value
Jan 1,000 $10 $10,000
Feb 1,000 $12 $12,000
Mar 1,000 $15 $15,000
3,000 = Total Purchased
ABC CO. — INCOME STATEMENT (SIMPLIFIED), JANUARY—MARCH
Item LIFO FIFO Average Cost
Sales = 3,000 units @ $20 each $60,000 $60,000 $60,000
Beginning Inventory 8,000 8,000 8,000
Purchases 37,000 37,000 37,000
Ending Inventory 8,000 15,000 11,250
COGS $37,000 $30,000 $33,750
Expenses 10,000 10,000 10,000
Net Income $13,000 $20,000 $16,250
COGS Valuation

 Under LIFO, COGS was valued at $37,000 because the 3,000 units that
were purchased most recently were used in the calculation or the January,
February, and March purchases ($10,000 + $12,000 + $15,000).
 Under FIFO, COGS was valued at $30,000 because FIFO uses the oldest
inventory first and then the January and February inventory purchases. In
other words, the 3,000 units comprised of (1,000 units for $8,000) + (1,000
units for $10,000 or Jan.) + (1,000 units for $12,000 or Feb.)
 The average cost method resulted in a valuation of $11,250 or (($8,000
+ $10,000 + $12,000 + $15,000) / 4).

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Below are the Ending Inventory Valuations:

 Ending Inventory per LIFO: 1,000 units x $8 = $8,000. Remember that

the last units in (the newest ones) are sold first; therefore, we leave the
oldest units for ending inventory.
 Ending Inventory per FIFO: 1,000 units x $15 each
= $15,000. Remember that the first units in (the oldest ones) are sold first;
therefore, we leave the newest units for ending inventory.
 Ending Inventory per Average Cost: (1,000 x 8) + (1,000 x 10) + (1,000
x 12) + (1,000 x 15)] / 4000 units = $11.25 per unit; 1,000 units X $11.25
each = $11,250. Remember that we take a weighted average of all the
units in inventory.

LIFO or FIFO: It Really Does Matter

The difference between $8,000, $15,000 and $11,250 is considerable. In a
complete fundamental analysis of ABC Company, we could use these inventory
figures to calculate other metrics—factors that expose a company's current
financial health, and which enable us to make projections about its future, for
example. So, which inventory figure a company starts with when valuing its
inventory really does matter. And companies are required by law to state which
accounting method they used in their published financials.

Although the ABC Company example above is fairly straightforward, the subject
of inventory and whether to use LIFO, FIFO, or average cost can be complex.
Knowing how to manage inventory is a critical tool for companies, small or large;
as well as a major success factor for any business that holds inventory.
Managing inventory can help a company control and forecast its earnings.
Conversely, not knowing how to use inventory to its advantage, can prevent a
company from operating efficiently. For investors, inventory can be one of the
most important items to analyze because it can provide insight into what's
happening with a company's core business.

Compete Risk Free with $100,000 in Virtual Cash

https://www.investopedia.com/articles/02/060502.asp

Inventory an Asset or Liability?

Inventory appears on your balance sheet as an asset, or something you own. In
practical terms, however, inventory can be an asset or a liability, depending on
how much you have, which particular items you're stocking and how you use
them.
Tip

Inventory goes into your bookkeeping system as an asset, but in practical terms
it can be either an asset or a liability depending on the type of item and how you
manage it.
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Inventory as an Asset

Your balance sheet lists inventory as an asset, because you spend money on it
and it has value. Inventory is defined as anything that you will incorporate for
future use in your business operations. This definition covers items you have
bought for resale, such as pants and shirts for a clothing store. It also covers
parts you have on hand that will go into items you manufacture, such as wood
and screws, if you make furniture.

Finished items that you have not yet sold, count as inventory as well; for
example, furniture you have built or cakes you have baked. Supplies such as
paper clips, that you use to support business activities, instead of using than for
resale, also count as inventory, although they are not part of your cost of goods
sold.

Inventory as a Liability

Technically, inventory isn't a liability in the accounting sense that it represents

something you owe, but it can fit another definition of the word: a disadvantage
or drawback. Inventory becomes a problem when you have too much. If your
working capital is tied up in inventory that you won't need in the short term, you
may find yourself short on cash for expenditures that can't wait, such as rent or
payroll. If you have more inventory than you can reasonably store, you have to
deal with clutter that interferes with efficiency and costs you money in added
payroll.

Inventory can also be a liability, because consumer tastes change and it's
impossible to predict what your customers will be buying far into the future. If
you buy too much of what your clientele want right now, and then the demand
shifts, you may find yourself stuck with inventory that you're unable to sell.

Finding the Sweet Spot

The difference between inventory as an asset and inventory as a liability is a

matter of degree. Keep enough inventory that you won't run out, but no more
than you need. Develop relationships with suppliers who can get you what you
need quickly, so you can cut it close on ordering. This approach to managing
inventory is called "lean inventory," and it was spearheaded as an inventory
management philosophy by the Toyota company. It takes practice to have the
right amount on hand; inevitably, there will be times when you're caught short,
but lean inventory will save you money in the long term, by reducing waste and
by saving time.
https://smallbusiness.chron.com/difference-between-supplies-inventory-25895.html

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MODULE: Quick Food Service Operations
FIFO stands for “First-In, First-Out”. It is a method used for cost flow assumption
purposes in the cost of goods sold calculation. The FIFO method assumes that
the oldest products in a company’s inventory have been sold first. The costs paid
for those oldest products are the ones used in the calculation..

How Do You Calculate FIFO?

To calculate COGS (Cost of Goods Sold) using the FIFO method, determine the
cost of your oldest inventory. Multiply that cost by the amount of inventory sold.

The “inventory sold” refers to the cost of purchased goods (with the intention of
reselling), or the cost of produced goods (which includes labor, material &
manufacturing overhead costs).

Keep in mind that the prices paid by a company for its inventory often fluctuate.
These fluctuating costs must be taken into account.

For instance, if a business sold 100 units of an item, and 75 units were originally
purchased by the company at $10.00 and 25 units were purchased at $15.00, it
cannot assign the $10.00 cost price to every unit sold. Only 75 units can be. The
remaining 25 items must be assigned to the higher price, the $15.00.

Lastly, the product needs to have been sold to be used in the equation. You
cannot apply unsold inventory to the cost of goods calculation.

What Are the Advantages of FIFO?

The FIFO method is considered to me a more trusted method than the LIFO
(“Last-In, First-Out”) method. You can read more about why FIFO is preferable
here.

The advantages to the FIFO method are as follows:

 The method is easy to understand, universally accepted and trusted.

 FIFO follows the natural flow of inventory (oldest products are sold first, with
accounting going by those costs first). This makes bookkeeping easier with
less chance of mistakes.
 Less waste (a company truly following the FIFO method will always be
moving out the oldest inventory first).
 Remaining products in inventory will be a better reflection of market value
(this is because products not sold have been built more recently).
 Higher profit.
 Financial statements are harder to manipulate.

The FIFO method gives a very accurate picture of a company’s finances. This
information helps a company plan for its future.
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What Are the Disadvantages of FIFO?

 The FIFO method can result in higher income tax for a business to pay,
because the gap between costs and profit is wider (than with LIFO).
 A company also needs to be careful with the FIFO method in that it is not
overstating profit. This can happen when product costs rise and those
later numbers are used in the cost of goods calculation, instead of the
actual costs.

FIFO EXAMPLE

Sal’s Sunglasses is a sunglass retailer located in Charleston, South Carolina. Sal

opened the store in September of last year. Right now, it is just the one location
but he may expand in the next couple of years depending on whether he can
make good money or not.

January has come along and Sal needs to calculate his cost of goods sold for the
previous year, which he will do using the FIFO method.

Here is what his inventory costs are:

Month Amount Price Paid

September 200 sunglasses $200.00 per

October 275 sunglasses $210.00 per
November 300 sunglasses $225.00 per
December 500 sunglasses $275.00 per

Sal sold 600 sunglasses during this time, out of his stock of 1275.

Going by the FIFO method, Sal needs to go by the older costs (of acquiring his
inventory) first.

Sal’s COGS calculation is as follows:

200 x $200.00 = $40,000.
275 x $210.00 = $57,750.
125 x $225.00 = $28,125.
COGS Total: $125,875.

Sal’s cost of goods sold is $125,875.

The remaining unsold 275 sunglasses will be accounted for in “inventory”.

Sal can use the cost of goods sold to help determine his profit.

Why Would You Use FIFO over LIFO?

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In the United States, a business has a choice of using either the FIFO (“First-In,
First Out”) method or LIFO (“Last-In, Last-Out”) method when calculating its cost
of goods sold. Both are legal although the LIFO method is often frowned upon
because bookkeeping is far more complex and the method is easy to manipulate.

Corporate taxes are cheaper for a company under the LIFO method because
LIFO allows a business to use its most recent product costs first. Typically these
costs have risen over time. Reduced profit may means tax breaks, however, it
may also make a company less attractive to investors.

The value of remaining inventory, assuming it is not-perishable, is also

understated with the LIFO method because the business is going by the older
costs to acquire or manufacture that product. That older inventory may, in fact,
stay on the books forever.

Investors and banking institutions value FIFO because it is a transparent method

of calculating cost of goods sold. It is also easier for management when it comes
to bookkeeping, because of its simplicity. It also means the company will be able
to declare more profit, making the business attractive to potential investors.
Lastly, a more accurate figure can be assigned to remaining inventory.

Outside the United States, many countries, such as Canada, India and Russia
are required to follow the rules set down by the IFRS (International Financial
Reporting Standards) Foundation. The IFRS provides a framework for globally
accepted accounting standards, among them is the requirements that all
companies calculate cost of goods sold using the FIFO method. As such, many
businesses, including those in the United States, make it a policy to go with
FIFO.

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