Chapter 8

Chapter 8: Inventories - Measurement

Inventory Overview

• Definition: Inventory refers to various forms of assets a company maintains to support its operational needs and sales objectives. Specifically, inventory comprises:

  • Goods a company intends to sell in the normal course of business, including both finished products and those in various stages of production.

  • Products currently being manufactured for future sale, highlighting the importance of inventory planning and management in aligning with market demand.

  • Goods that are currently utilized in the manufacturing process for eventual sale, indicating the role of inventory in production cycles.

• Cost of Goods Sold (COGS): This represents the total expense associated with inventory that has been sold over a particular period. COGS is crucial for measuring the actual cost of production and is typically reported on the income statement, impacting net income and financial ratios.

Types of Inventory

• Merchandising Inventory:

  • Purchased primarily in finished form from wholesalers or retailers, ready for resale.

  • The cost of merchandising inventory includes the purchase price plus any additional costs necessary to prepare goods for sale, such as shipping, handling, and storage costs, which are essential for accurate inventory valuation.

• Manufacturing Inventory:

  • Produced by a manufacturing company for sale to consumers or other businesses, which often involves more complex accounting than merchandising inventory.

  • Components include:

    • Raw Materials: The costs of components required for production (e.g., computer chips relevant in the electronics industry). Understanding raw material costs is vital for budgeting and forecasting production needs.

    • Work-in-Process (WIP): Costs related to products that are partially completed in manufacturing, which require tracking for efficiency and resource allocation.

    • Finished Goods: Completed products ready for sale, representing the endpoint of the manufacturing process.

Inventory Components for Manufacturers

• Inventory components for manufacturers are crucial for financial accuracy and include:

  • Cost of raw materials purchased, which affects pricing strategy and profit margins.

  • Costs associated with direct labor consumed in production, necessary for calculating total production costs and setting labor budgets.

  • Manufacturing overhead costs, which include all indirect costs related to production (e.g., utilities, depreciation on machinery), highlighting the importance of proper overhead allocation for profitability analysis.

  • Examples: Computer chips and memory modules in the electronics sector serve as primary components that can fluctuate in cost due to market conditions.

Inventory Disclosure Example: Intel Corporation

• Disclosure of inventory categories for Intel as of December 30, 2017:

  • Raw materials: $1,098 million

  • Work-in-process: $3,893 million

  • Finished goods: $1,992 million

  • Total Inventories: $6,983 million

• This level of detail showcases the significance of inventory management for large corporations in understanding their supply chain and operational efficiency.

Inventory Cost Flow for Manufacturing Companies

• Key stages in the monetary flow of inventory include:

  1. Raw materials purchases

  2. Raw materials used: Integral to assessing material usage efficiencies.

  3. Direct labor incurred: Essential for determining labor cost effectiveness in the production process.

  4. Manufacturing overhead: Important for overall production cost management.

5. Work in process: Tracking intermediates helps identify bottlenecks.

6. Finished goods: Indicates readiness for sales to consumers.

7. Cost of goods sold: Used to determine gross profit and assess operational success.

Inventory Systems

• Perpetual Inventory System:

  • Continuously updates inventory accounts with each transaction. This system is essential for real-time inventory management and decision-making.

  • Allows management to instantly know inventory on hand and sales made, aiding in optimal order management and inventory turnover rates.

  • Example Transaction: Lothridge Wholesale Beverage Company

    • Start of 2021 Inventory: $120,000

    • Purchases: $600,000

    • Sales: $820,000 (COGS: $540,000)

    • Conclusion: Ending inventory reported as $180,000 at year-end after all adjustments.

• Perpetual System Accounting Entries:

  • Records transactions as follows:

    • Debit Accounts Receivable, Credit Sales Revenue during sales to accurately recognize revenue.

    • Debit COGS, Credit Inventory for sold goods, ensuring timely tracking of inventory costs.

    • Adjustments are recorded for cost of inventory with every purchase, offering precise financial accountability.

• Periodic Inventory System:

  • Adjusts inventory balances and COGS at the end of the reporting period, affecting the accuracy of financial reporting.

  • The periodic method involves temporary accounts for merchandise purchases, returns, discounts, and freight, central to maintaining accurate accounting records.

  • Example: Lothridge’s transactions in a periodic context yield an ending inventory of $180,000 after physical count verification.

Sales Returns and Consignment Goods

• Merchandise returned by customers impacts inventory positively, increasing usable stock, and COGS negatively, which decreases profitability in the short term.

• Goods on consignment include products shipped to a reseller but remain in the consignor's inventory until sold, requiring careful tracking for liability and ownership.

Cost of Inventory Adjustments

Includes direct costs incurred to acquire and prepare inventory for sale, such as:

• Freight charges: Critical for understanding total landed costs.

• Insurance: Protects asset values against unexpected losses.

• Unloading and preparing for sale costs: Often overlooked but essential in determining overall inventory expenses.

Purchase Returns and Discounts

• Returns reduce purchases and account payable balances in perpetual systems, affecting net purchases and cash flow projections.

• Discounts: Reductions offered if payment is made within a specified timeframe, recorded either at gross or net amounts, impacting financial planning and cash management strategies.

Cost Flow Assumptions in Inventory

Methods to determine which units are sold:

• FIFO (First-in, First-out): The first goods purchased are sold first, beneficial in times of rising prices as it preserves profits.

• LIFO (Last-in, First-out): The last goods purchased are sold first, useful for tax benefits but can distort earnings in financial reporting due to inventory valuation.

• Average Cost: A mix of costs for goods sold, providing a middle-ground approach for inventory valuation.

Inventory Effects on Financial Statements

Cost flow methods can significantly influence net income and tax liability, especially during periods of fluctuating prices, necessitating strategic management of inventory practices.

Factors Influencing Inventory Method Choice

Choices are influenced by:

• Financial reporting requirements: Different methods can impact how financial health is perceived.

• Internal management needs: Efficient inventory flow aids in production planning and meeting consumer demand.

• Tax optimization: The cost flow assumption chosen can help in minimizing tax liabilities.

LIFO Reserves and Liquidation

• LIFO may have associated reserves indicating the difference in financial reporting between LIFO and other methods, affecting analysts' perceptions of financial stability.

• LIFO Liquidations: May occur producing higher net income during periods when older, cheaper inventory is sold at current prices, impacting cash flow and reported profitability.

International Financial Reporting Standards vs GAAP

• LIFO is acceptable under U.S. GAAP but not under IFRS, thus companies must disclose their inventory valuation methods, emphasizing the need for international compliance and consistency in financial reporting practices.