INVENTORY Accounting ASW Summer 2005

Two Inventory Issues Manufacturing accounting –what if you make inventory rather than buying? Inventory cost flow assumptions –how do you know which units you sold?

Manufacturing Accounting How do we value inventory/CGS for a manufacturing firm? Should include all costs of acquiring the product and making it ready for sale

Overview of Manufacturing Firm Period costs - Selling, general and administrative, etc. Production costs

Period Costs Examples - corporate headquarters - marketing, advertising - finance, interest - research and development Generate period costs charged to expense - just as in a merchandising firm

Product Costs Identify all relevant costs of “acquiring” –Direct labor labor costs which can be linked to specific product typically costs of employees working directly on that product assigned based on actual labor used

Direct materials –materials costs which can be linked to products –typically major components of the product –assigned based on actual materials used

Overhead--can’t be linked to products –indirect labor e.g., janitorial, supervisor –indirect materials e.g., supplies, small components –overhead e.g., depr., rent, utilities on production facilities –allocate based on “drivers” e.g., direct labor, direct materials

Are these product or period costs? Cutting-machine operator Factory janitor Factory payroll clerks Factory superintendent General office secretary Guards at the factory gate Inspectors in a factory Factory maintenance workers Factory security guards General office clerks President of the firm Sales manager Raw materials receiving room workers Sweepers who clean a retail store Traveling salespersons

Physical flow Raw materials into warehouse Materials and labor on plant floor Finished product to warehouse Shipped out when sold

Cost allocation Cost of materials inputs into raw material inventory when acquired Cost of materials, labor & overhead into work in process inventory as produced Total cost incurred into finished goods inventory when completed Total cost into cost of goods sold at sale

Inventory Accounting Inventory xx Cash xx Cost of Goods Sold xx Inventory xx Issue: How do you know which inventory you sold?

Inventory Cost Systems Perpetual inventory system –Implicitly assumed so far –Keep track of invent. cost and units continuously –Often impractical and unnecessarily expensive –Rare in practice (except with unique items)

Periodic inventory system –keeps track of beginning inventory & purchases –uses ending balance in inventory to infer cost of goods sold –most common approach

Inventory Equations Problem 7.29 Beg. Inv. + Purchases = Cost of Goods Available for Sale $0 + $24,384 = $24,384 0 Units + 10,700 units = 10,700 units available CGAS - Ending Inventory = Cost of Goods Sold $24,384 - Ending Inventory = Cost of Goods Sold 10, ,500 = 7,200 units sold How to infer what products were sold? - only important if prices are changing - typically make an assumption

Ways to measure cost flows Specific identification - identify specific item being sold - accurately measures cost - cumbersome and expensive Cost flow assumption - need not mirror actual flows - all three are common in practice

Cost flow assumptions First In, First Out (FIFO) –assumes first ones purchased were first sold –generally matches costs and unit flows –high net income and inventory balances if prices are increasing

Last In, First Out (LIFO) –assumes last ones purchased were first sold –poor matching of costs and unit flows –low net income and inventory balances if prices are increasing –required in US for financial reporting if used for tax –rare outside the US –exception to general rule that financial reporting does not need to match tax

Weighted average –assumes inventory sold was purchased at average cost –generally good matching of costs and unit flows –net income and inventory balances between LIFO and FIFO (most similar to FIFO)