Inventory Section 1 Retail versus Manufacturing The retailer has inventory costs, selling costs and administrative costs. The same is true for a manufacturer. Remember the inventory that we purchase? When we sell it we convert it to the expense cost of goods sold. Manufacturing companies too have inventory costs; these costs are accumulated into inventory accounts and transferred to finished goods when they are completed (product costs). They also have selling and administrative costs (period costs). These are costs that happen outside of the factory where they manufacture their product and are the same as for a retailer. Product costs—any cost that includes the word factory or manufacturing in it. Ask yourself: Where does this cost happen, if I closed down my factory and just started buying what I sell, would this cost go away? If the answer is yes, it is a product cost. Period costs—any cost that happens in the store or the office. oSelling expenses—those costs that happen in the store. (ie. sales salaries expense, depreciation on store equipment, store supplies expense). oAdministrative expenses—those costs that happen in the office. (ie. office salaries expense, depreciation on office equipment, office supplies expense). Inventory accounts A manufacturing firm uses three different inventory accounts. These would all appear on their balance sheet or in a supporting schedule somewhere in their annual report. These would be considered a current asset just like the one inventory account is for a retail business. Raw materials—these are the materials that come from the suppliers. They are stored in a warehouse or supply room until someone needs them to complete a job. If I were making tables, this would be the wood, screws, nails, stain, sandpaper, etc. that I needed in order to make the tables. Work in Process (WIP)—this is where the costs of production are accumulated. Finished Goods—this is the account that we transferred our finished items to. This is like the inventory account for a retailer in that this is the account that converts to cost of goods sold when we make a sale. We can apply the same inventory systems to expense these off that a retailer uses. This course does not cover manufacturing systems. These methods are covered in Cost accounting. We will cover the inventory systems used by retailers in this course. However, once the inventory is complete and in finished goods, the same costing methods covered in this class can apply to this inventory. The cost concept states that when we purchase inventory, we record it at what it actually cost us. This may be different than the price listed in the catalog or on our purchase order. We always list all purchases (inventory is not an exception) at what they actually cost us. This may include shipping costs if we are responsible for them and insurance costs. The price that we pay to get the purchase to us is part of the price of whatever it is that we bought. Insurance during transit also increases the price that we pay for inventory.
These costs must be recorded when we gain ownership of them. Remember from Accounting 1 that the fob terms determine when ownership changes. This is the point that we should record the purchase. When the terms are fob shipping point and we are the buyer, we own the merchandise from the shipping point on and so must record the purchase before we actually receive the product. Inventory is not reported on the income statement because it is a current asset. So we show it on the balance sheet. We may see inventory on the income statement if we use a periodic inventory system because we need those numbers to calculate the Cost of Goods Sold (COGS). We will talk more about this later. Inventory costing The cost of inventory can be calculated several different ways according to GAAP. The method chosen can impact the income of the company because the amount of inventory carried on the balance sheet has a direct impact on the expense related to the cost of merchandise sold on the income statement. For example: If the merchandise available for sale is: 1,000 and the ending inventory is:350 then the cost of merchandise sold is:650 Merchandise available for sale minus the ending inventory is how we determine the COMS. What we could have sold minus what we didn't sell equals what we did sell. But under different costing systems the ending inventory amount will change, therefore; If the merchandise available for sale is: 1,000 and the ending inventory is:300 then the cost of merchandise sold is:700 The higher the cost of merchandise sold, the lower the Net Income. COMS is an expense and so it reduces Net Income. Reducing the Net Income also reduces the taxes that we have to pay on Net Income; therefore, companies sometimes want to reduce their net income in order to reduce their tax burden. Costing methods There are several different methods that companies can use according to GAAP to report the cost of what they sell and therefore the value of their ending inventory. Specific identification-Companies can use this method if they can identify exactly which item they sold. This would work well for car dealerships and companies that sell custom made items. This does not work well for grocery stores or most retail stores because it is difficult to determine exactly which can of corn they sold. Most companies use a cost flow system to determine the cost of what they sell. These cost flow systems do not have anything to do with the actual physical flow of the inventory. They simply assign costs to the items sold based on the method chosen. It may or may not relate to the actual physical item sold. There are three basic types of these: First in-First out (FIFO)-this system assumes that the first items purchased are the first items sold. This is the most popular costing system. Last in-First out (LIFO)-this system assumes that the last items purchased are the first items sold. This system will probably not be allowed for use by publicly traded companies under new accounting laws that will be taking place in the next few years. We still teach it because private companies will still be able to use it. Average cost-this system determines the average cost of an item over the period and uses that amount to determine COMS and the ending inventory.
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