OCW041: Understanding Inventory

Nature of Inventory

Inventory represents finished and unfinished goods which have not yet been sold by a company.

Learning Objectives

Explain the purpose of inventory and how a company controls and reports it

Key Takeaways

Key Points

  • Inventories are maintained because time lags in moving goods to customers could put sales at risk.
  • Inventories are maintained as buffers to meet uncertainties in demand, supply and movements of goods.
  • There are four stages of inventory: raw material, work in progress, finished goods, and goods for resale.
  • Raw materials – materials and components scheduled for use in making a product. Work in process, WIP – materials and components that have began their transformation to finished goods. Finished goods – goods ready for sale to customers. Goods for resale – returned goods that are salable.
  • When a merchant buys goods from inventory, the value of the inventory account is reduced by the cost of goods sold. For commodity items that one cannot track individually, accountants must choose a method that fits the nature of the sale.
  • FIFO (first in-first out) regards the first unit that arrived in inventory as the first sold. LIFO (last in-first out) considers the last unit arriving in inventory as the first sold. Using LIFO accounting for inventory a company reports lower net income and book value, resulting in lower taxation.

Key Terms

  • inventory: A detailed list of all of the items on hand.
  • supply chain: A system of organizations, people, technology, activities, information and resources involved in moving a product or service from supplier to customer.
  • raw material: A material in its unprocessed, natural state considered usable for manufacture.

Definition of Inventory

Inventory represents finished and unfinished goods which have not yet been sold by a company.. Inventories are maintained as buffers to meet uncertainties in demand, supply, and movements of goods. These holdings are recorded in an accounting system.

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Inventory Template: Example of inventory template.

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Housing inventory growth in Phoenix: There was an interesting comment on the housing bubble blog listing “available inventory”, otherwise known as the number of houses currently for sale, in Phoenix. It listed the available inventory on a daily basis from 7/20/2006 to 5/9/2006 (up to the day it was posted! )Phoenix is one of the “hot” markets of the housing bubble, but certainly isn’t the top of the list. Inventory run ups like this are being seen nation wide, and are leading to price reductions (if the seller is smart) and long waits to sell as bubble flippers all try to cash out at once.

Basic Inventory Accounting

An organization’s inventory counts as a current asset on an organization’s balance sheet because the organization can, in principle, turn it into cash by selling it. However, it ties up money that could serve for other purposes and requires additional expense for its protection. Inventory may also cause significant tax expenses, depending on particular countries’ laws regarding depreciation of inventory, as in the case of Thor Power Tool Company v. Commissioner.

Inventory Systems

There are two principal systems for determining inventory quantities on hand: periodic and perpetual system.

The Periodic System

This system requires a physical count of goods on hand at the end of a period. A cost basis (i.e., FIFO, LIFO) is then applied to derive an inventory value. Because it is simple and requires records and adjustments mostly at the end of a period, it is widely used. It does lack some of the planning and control benefits of the perpetual system.

The Perpetual System

The perpetual system requires continuous recording of receipt and disbursement for every item of inventory. Most large manufacturing and merchandising companies use this system to ensure adequate supplies are on hand for production or sale, and to minimize costly machine shut-downs and customer complaints.

Inventory Costing

Inventory cost includes all expenditures relating to inventory acquisition, preparation, and readiness for sale, minus purchase discounts.

Rationale for Keeping Inventory:

  1. Time – The time lags present in the supply chain, from supplier to user at every stage, requires that you maintain certain amounts of inventory to use in this lead time. However, in practice, inventory is to be maintained for consumption during ‘variations in lead time’. Lead time itself can be addressed by ordering that many days in advance.
  2. Uncertainty – Inventories are maintained as buffers to meet uncertainties in demand, supply and movements of goods.
  3. Economies of scale – Ideal condition of “one unit at a time at a place where a user needs it, when he needs it” principle tends to incur lots of costs in terms of logistics. So bulk buying, movement and storing brings in economies of scale, thus inventory.

Stages of Inventory:

  1. Raw materials – materials and components scheduled for use in making a product.
  2. Work in process, WIP – materials and components that have began their transformation to finished goods.
  3. Finished goods – goods ready for sale to customers.
  4. Goods for resale – returned goods that are salable.

Categories of Goods Included in Inventory

Most manufacturing organizations usually divide their “goods for sale” inventory into raw materials, work in process, and finished goods.

Learning Objectives

Distinguish between the raw materials, work in process, finished goods and goods for resale

Key Takeaways

Key Points

  • Raw materials – Materials and components scheduled for use in making a product.
  • Work in process /progress (WIP) – Materials and components that have began their transformation to finished goods.
  • Finished goods – Goods ready for sale to customers.
  • Goods for resale – Returned goods that are salable.
  • Distressed inventory is inventory for which the potential to be sold at a normal cost has passed or will soon pass.
  • Inventory credit refers to the use of stock, or inventory, as collateral to raise finance.

Key Terms

  • work in progress: A portion of inventory that represents goods which are no longer salable as raw materials, but not yet salable as finished goods.
  • Work in process: a company’s partially finished goods waiting for completion and eventual sale or the value of these items
  • Finished goods: Goods that are completed, from a manufacturing standpoint, but not yet sold or distributed to the end-user.
  • finished goods inventory: the amount of completed products not yet sold or distributed to the end-user
  • raw materials: A raw material is the basic material from which a product is manufactured or made.

Categories of Goods

While the reasons for holding stock were covered earlier, most manufacturing organizations usually divide their “goods for sale” inventory into several categories:

  • Raw materials – Materials and components scheduled for use in making a product.
  • Work in process or work in progress (WIP) – Materials and components that have began their transformation to finished goods.
  • Finished goods – Goods ready for sale to customers.
  • Goods for resale – Returned goods that are salable.

Raw Materials

A raw material is the basic material from which a product is manufactured or made. For example, the term is used to denote material that came from nature and is in an unprocessed or minimally processed state. Latex, iron ore, logs, crude oil, and salt water are examples of raw materials.

Work in Process (WIP)

WIP, or in-process inventory, includes unfinished items for products in a production process. These items are not yet completed, and are just being fabricated, waiting in a queue for further processing, or in a buffer storage. The term is used in production and supply chain management.

Optimal production management aims to minimize work in process. Work in process requires storage space, represents bound capital not available for investment, and carries an inherent risk of earlier expiration of the shelf life of the products. A queue leading to a production step shows that the step is well buffered for shortage in supplies from preceding steps, but may also indicate insufficient capacity to process the output from these preceding steps.

Finished Goods

Goods that are completed (manufactured) but not yet sold or distributed to the end-user.

Goods for resale

Returned goods that are salable. This is not always included in the “goods for sale” inventory; that depends on the preference of the company.

Example

A canned food manufacturer’s materials inventory includes the ingredients needed to form the foods to be canned, empty cans and their lids (or coils of steel or aluminum for constructing those components), labels, and anything else (solder, glue, etc.) that will form part of a finished can. The firm’s work in process includes those materials from the time of release to the work floor until they become complete and ready for sale to wholesale or retail customers. This may be vats of prepared food, filled cans not yet labeled, or sub-assemblies of food components. It may also include finished cans that are not yet packaged into cartons or pallets. The manufacturer’s finished good inventory consists of all the filled and labeled cans of food in its warehouse that it has manufactured and wishes to sell to food distributors (wholesalers), to grocery stores (retailers), and even perhaps to consumers through arrangements like factory stores and outlet centers.

Components of Inventory Cost

The cost of goods produced in the business should include all costs of production: parts, labor, and overhead.

Learning Objectives

Identify the components used to calculate the cost of goods sold

Key Takeaways

Key Points

  • Labor costs include direct labor and indirect labor. Direct labor costs are the wages paid to those employees who spend all their time working directly on the product being manufactured. Indirect labor costs are the wages paid to other factory employees involved in production.
  • Overhead costs (costs incurred at the plant or organization level) are often allocated to sets of produced goods based on the ratio of labor hours or costs or the ratio of materials used for producing the set of goods.
  • Most businesses make more than one of a particular item. Thus, costs are incurred for multiple items rather than a particular item sold. Parts and raw materials are often tracked to particular sets (e.g., batches or production runs) of goods, then allocated to each item.

Key Terms

  • raw materials: A raw material is the basic material from which a product is manufactured or made.
  • labor: Effort expended on a particular task; toil, work.
  • overhead: Any cost or expenditure (monetary, time, effort or otherwise) incurred in a project or activity, that does not directly contribute to the progress or outcome of the project or activity.

Cost of Goods

The cost of goods produced in the business should include all costs of production. The key components of cost generally include:

  • Parts, raw materials and supplies used,
  • Labor, including associated costs such as payroll taxes and benefits, and
  • Overhead of the business allocable to production.

Most businesses make more than one of a particular item. Thus, costs are incurred for multiple items rather than a particular item sold. Determining how much of each of these components to allocate to particular goods requires either tracking the particular costs or making some allocations of costs.

Parts and Raw Materials

Parts and raw materials are often tracked to particular sets (e.g., batches or production runs) of goods, then allocated to each item.

Labor

Labor costs include direct labor and indirect labor. Direct labor costs are the wages paid to those employees who spend all their time working directly on the product being manufactured. Indirect labor costs are the wages paid to other factory employees involved in production. Costs of payroll taxes and fringe benefits are generally included in labor costs, but may be treated as overhead costs. Labor costs may be allocated to an item or set of items based on timekeeping records.

Overhead Costs

Determining overhead costs often involves making assumptions about what costs should be associated with production activities and what costs should be associated with other activities. Traditional cost accounting methods attempt to make these assumptions based on past experience and management judgment as to factual relationships. Activity based costing attempts to allocate costs based on those factors that drive the business to incur the costs.

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Accounting cycle: Image of the accounting cycle

Overhead costs are often allocated to sets of produced goods based on the ratio of labor hours or costs or the ratio of materials used for producing the set of goods. Overhead costs may be referred to as factory overhead or factory burden for those costs incurred at the plant level or overall burden for those costs incurred at the organization level. Where labor hours are used, a burden rate or overhead cost per hour of labor may be added along with labor costs. Other methods may be used to associate overhead costs with particular goods produced. Overhead rates may be standard rates, in which case there may be variances, or may be adjusted for each set of goods produced.

Variable Production Overheads

Variable production overheads are allocated to units produced based on actual use of production facilities. Fixed production overheads are often allocated based on normal capacities or expected production. More or fewer goods may be produced than expected when developing cost assumptions (like burden rates). These differences in production levels often result in too much or too little cost being assigned to the goods produced. This also gives rise to variances.

Example

Jane owns a business that resells machines. At the start of 2009, she has no machines or parts on hand. She buys machines [latex]A[/latex] and [latex]B[/latex] for $10 each, and later buys machines [latex]C[/latex] and [latex]D[/latex] for $12 each. All the machines are the same, but they have serial numbers. Jane sells machines [latex]A[/latex] and [latex]C[/latex] for $20 each. Her cost of goods sold depends on her inventory method. Under specific identification, the cost of goods sold is:

[latex]$10+$12=$22[/latex]

which is the particular costs of machines [latex]A[/latex] and [latex]C[/latex]. If she uses FIFO, her costs are:

[latex]$10+$10=$20[/latex]

If she uses average cost, her costs are:

[latex]dfrac{$10+$10+$12+$12}{$4} cdot $2=$22[/latex]

If she uses LIFO, her costs are:

[latex]$12+$12=$24[/latex]

Thus, her profit for accounting and tax purposes may be $20, $18, or $16, depending on her inventory method.

Flow of Inventory Costs

Accounting techniques are used to manage assumptions of cost flows related to inventory and stock repurchases.

Learning Objectives

Discuss how a company uses LIFO or FIFO to calculate the cost of inventory

Key Takeaways

Key Points

  • Accounting techniques are used to manage inventory and financial matters – how much money a company has tied up within inventory of produced goods, raw materials, parts, components, etc. These techniques manage assumptions of cost flows related to inventory and stock repurchases.
  • FIFO stands for first-in, first-out, meaning that the oldest inventory items are recorded as sold first, but do not necessarily mean that the exact oldest physical object has been tracked and sold.
  • LIFO stands for last-in first-out. The most recently produced items are recorded as sold first. Since the 1970’s, companies shifted towards the use of LIFO, which reduces their income taxes. The International Financial Reporting Standards banned using LIFO, so companies returned to FIFO.

Key Terms

  • LIFO: Last-in, first-out (accounting).
  • FIFO: First in, first out (accounting).
  • accounting: The development and use of a system for recording and analyzing the financial transactions and financial status of a business or other organization.

FIFO and LIFO methods are accounting techniques used in managing inventory and financial matters involving the amount of money a company has tied up within inventory of produced goods, raw materials, parts, components, or feed stocks. These methods are used to manage assumptions of cost flows related to inventory, stock repurchases (if purchased at different prices), and various other accounting purposes.

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Accounting Cycle: The accounting cycle (flows).

FIFO stands for first-in, first-out, meaning that the oldest inventory items recorded first are sold first, but does not necessarily mean that the exact oldest physical object has been tracked and sold.

  • An example of how to calculate the ending inventory balance of the period using FIFO — assume the following inventory is on hand and purchased on the following dates:
  • Inventory of Product X –
  • Purchase date: 10/1/12 — 10 units at a cost of USD 5
  • Purchase date: 10/5/12 — 5 units at a cost of USD 6
  • On 12/30/12, a sale of Product X is made for 11 units
  • When the sale is made, it is assumed that the 10 units purchased on 10/1/12 (the sale eliminates this inventory layer) and 1 unit purchased on 10/5/12 were sold
  • The ending inventory balance on 12/31/12, is 4 units at a cost of USD 6

LIFO stands for last-in, first-out, meaning that the most recently produced items are recorded as sold first. Since the 1970’s, some U.S. companies shifted towards the use of LIFO, which reduces their income taxes in times of inflation. However, with International Financial Reporting Standards banning the use of LIFO, more companies have gone back to FIFO. LIFO is only used in Japan and the United States.

  • An example of how to calculate the ending inventory balance of the period using LIFO — assume the following inventory is on hand and purchased on the following dates:
  • Inventory of Product X –
  • Purchase date: 10/1/12 — 10 units at a cost of USD 5
  • Purchase date: 10/5/12 — 5 units at a cost of USD 6
  • On 12/30/12, a sale of Product X is made for 11 units
  • When the sale is made, it is assumed that the 5 units purchased on 10/5/12 (the sale eliminates this inventory layer) and 6 units purchased on 10/1/12 were sold
  • The ending inventory balance on 12/31/12, is 4 units at a cost of USD 5

Differences between Inventory Costing Methods

The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the LIFO reserve. This reserve is essentially the amount by which an entity’s taxable income has been deferred by using the LIFO method.

Differences in Periods of Rising Prices (Inflation)

  • FIFO (+) Higher value of inventory (-) Lower cost of goods sold
  • LIFO (-) Lower value of inventory (+) Higher cost of goods sold

Differences in Periods of Falling Prices (Deflation)

  • FIFO (-) Lower value of inventory (+) Higher cost of goods sold
  • LIFO (+) Higher value on inventory (-) Lower cost on goods sold

Methods of Preparing Cash Flow Statements

  • The direct method of preparing a cash flow statement results in report that is easier to understand. It creates a cash flow statement report using major classes of gross cash receipts and payments.
  • The indirect method is almost universally used because FAS 95 requires a supplementary report similar to the indirect method if a company chooses to use the direct method. It uses net-income as a starting point, makes adjustments for all transactions for non-cash items, then adjusts from all cash-based transactions. An increase in an asset account is subtracted from net income. An increase in a liability account is added back to net income. This method converts accrual-basis net income (or loss) into cash flow by using a series of additions and deductions.


Source: Accounting