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Chapter 9: Inventories

Raw materials and consumablesFinished goods

Work in ProgressVariants of valuation at historical cost

other valuation rules

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Characteristics of Inventories

belong to current assetskept in stock either to be sold to customers or to beconsumed by activities of the accounting entityRetailer, wholesaler

merchandise inventoryManufacturer

finished goodswork in progress: goods not yet ready for saleraw materials and purchased parts

optimal level of inventorytrade-off between holding costs, ordering cost, servicelevel, customer satisfaction, smooth production

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Inventory / Total assets Inventory / Current assets

Manufacturing General Electric (Manufacturer) 0,02 0,07 Chevron (Oil drilling and refining) 0,03 0,13

Retail Supervalu (Grocery retail) 0,23 0,68 Tommy Hilfiger (Clothing retail) 0,09 0,26

Internet Yahoo (Internet search engine) 0,00 0,00 Cisco (Internet systems) 0,04 0,11

General services SBC Communications 0,00 0,00 (Telecommunications services) Wendy's (Restaurant services) 0,02 0,13

Financial services Bank of America (Banking services) 0,00 0,00 Merril Lynch (Investment services) 0,00 0,00

The relative importance of inventories

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The Inventory Balance Equation

Value of inventory at time t= Initial inventory + inflows – outflows up to t

initial inventory: from past period; zero at start of business• depends on valuation method used for inflows and outflows

inflows: valued at cost• same as for fixed assets: „all costs incurred in order to bring

the inventories to their present location and condition“outflows: different approaches• direct identification• assumed order of depletion• averaging

determine market value of ending inventory and applybalance equation

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Importance of Inventory Valuation

inventory valuation affects the income statementand the balance sheetimpact on ratios used in financial statement analysisThe Gross Profit Equation:

Gross profit = Sales Revenue-( beginning inventory+purchases– ending inventory)

Effect of inventory valuation on gross profit:closing inventory understated (overstated)

gross profit for the period understated (overstated)opening inventory understated (overstated)

gross profit for the period overstated (understated).

COGS⎪⎪⎩

⎪⎪⎨

⎧

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counterbalancing effect of valuation error

"correct closing inventory" 2003 2004

Sales for the period 3.500 2.900Opening inventory 200 300Purchases 3.000 2.200less Closing inventory 300 250Cost of sales 2.900 2.250Gross profit 600 650

"closing inventory overstated" 2003 2004

Sales for the period 3.500 2.900Opening inventory 200 450Purchases 3.000 2.200less Closing inventory 450 250Cost of sales 2.750 2.400Gross profit 750 500

overstating theclosinginventoryresults in a higher profit in 2003,

... and a lowerprofit in 2004.

... but total profits over bothyears are thesame!

Although total profit are equal, the trend of performance is reversed!

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Inventory Control

Perpetual Systemcontinuous record of changesinventory account contains purchases and salesclosing inventory as a residualsupplementary occasional (physical) counts

Periodic Systemphysical counting and recording of inventory periodicallycount taken near the end of a company‘s fiscal yearseparate purchases account may be usedfigure for usage during the year as residual(used by businesses that sell inexpensive goods, e.g. fabricstore)

Perpetual Inventory System Periodic Inventory System

1. Beginning inventory, 100 units at € 12

The inventory account shows the inventory The inventory account shows the inventoryon hand at € 1.200. on hand at € 1.200.

2. Purchase of 1.200 units at € 12

Inventory 14.400 Purchases 14.400 Accounts Payable 14.400 Accounts Payable 14.400

3. Sale of 1.000 units at € 15

Accounts Receivable 15.000 Accounts Receivable 15.000 Sales 15.000 Sales 15.000

Cost of Goods Sold 12.000 No entry Inventory 12.000

4. End-of-period entries for inventory accounts, 300 units at € 12

No entry necessary; Inventory account has balance Inventory (closing) 3.600 of € 3.600 Cost of Goods Sold 12.000

Purchases 14.400(Example adapted from Kieso/Weygandt) Inventory (opening) 1.200

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Valuation: three decisions

1. What physical goods are to be included in inventory?

2. What costs are to be included in inventory?3. What cost flow assumption should be

adopted?

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1. Inventory: attribution to accounting entity

Rule: Goods should be included in the inventory of the party

who has legal title to it.important for goods in transit and consigned goods

Goods in transitLegal title determined by the terms of sale.• FOB (free on board) shipping point: Ownership of the goods

passes to the buyer when the public carrier accepts thegoods from the seller.

• FOB destination: Legal title to the goods remains with theseller until the goods reach the buyer.

Consigned goodsGoods included in the inventory of the consignor, not in thatof the consignee.

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2. Inventory Costs

... is the purchase price plus any chargesincurred bringing the inventory to its existingcondition.

production overhead IS included.

period costs are NOT included.

Overhead costs should be included only accordingto capacity utilization

do not capitalize cost of idle capacity

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Inventory valuation – an example

Candy Inc. spent the fourth quarter of its fiscal yearproducing candy for easter. 2.000 batches wereproduced at labor cost of € 20 per batch and € 150 for material per batch.

Other cost in that quarter:€ 20.000 – salary for production supervisors€ 28.000 – depreciation of production facilities€ 2.000 – setup cost€ 11.250 – salary of factory manager€ 68.750 – various manufacturing overhead€ 250.000 – cost of headquarters€ 40.000 – salary of sales representatives

direct cost

administrative overhead

sellingoverhead

manufacturingoverhead

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Multi-product case

Overhead needs to be allocated to different productsmatter of cost accounting

usual methodchoose an allocation base e.g. direct cost or direct laborhrs.calculate the overhead rate per unit of the allocation basemultiply units of allocation base in product times overheadrate

activity-based costingdetermine the total cost of each activity in the firmdetermine a „cost driver“ as an allocation base for the costof each activitydetermine the cost driver rate for each activityallocate activity cost according to usage by the product

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The inventory is to be valued as follows:

Provided regular capacity is 2000 batchesDirect cost: € 170Manufacturing overhead: € 65 ( 130.000 / 2.000 )Administrative overhead: ---Selling overhead: ---

Total: € 235 per batchValue of inventory: € 470.000

Assume regular capacity is 2500 batchesDirect cost: € 170Manufacturing overhead: € 52 ( 130.000 / 2.500 )Administrative overhead: ---Selling overhead: ---

Total: € 222 per batchValue of inventory: € 444.000

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3. Cost flow assumptions for inventoryvaluation

distinguishable items are purchased and soldrequired to monitor actual goods flow and recordcorresponding costsidentical items of merchandise (at different prices) purchased and sold

usually impractical to monitor actual goods flow and recordcorresponding costs

assumption about cost flowSpecific IdentificationAverage CostFirst-In, First-OutLast-In, First-Out

Cost flow assumptions

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Inventory valuation – applying different methods

We use the following data to calculate inventory, cost of sales, and gross profit for the different methods:

Purchase of 8 units @ € 2,50 (March)

Sale of 2 units @ € 5,00 (May)

4 units @ € 3,00 (April)

4 units @ € 4,00 (June)

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Specific Identification

items purchased and sold must be distinguishableproblem of allocating overhead costs to inventory

for the example:cost of goods sold either 5.00 or 6.00 depending on whetheritems out of March‘s or April‘s purchase were used.

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Inventory valued at average cost:

Average Cost Inventory Inventory Cost ofin numbers value Sales

March 8 units @ 2,5 = 20

April 4 units @ 3 = 12

June 4 units @ 4 = 16

June end total 16 units @ 3 48

Sale of 2 items (May) - 2 units @ 3 -6 6

Ending inventory 14 units @ 3 42 Cost of sales 6

units in inventory are valued at the average cost of the goods availablefor sale, i.e. total cost of inventory over number of itemsmethod easy to handleobjective in nature, less room for manipulation

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Inventory valued using FIFO

First-In, First-Out Inventory Inventory Cost of(FIFO) in numbers value Sales

March 8 units @ 2,5 = 20

April 4 units @ 3 = 12

June 4 units @ 4 = 16

June end total 16 48

Sale of 2 items (May) - 2 units @ 2,5 (March) = -5 5

Ending inventory 14 = 43 Cost of sales 5

cost of the first items purchased is assigned to the first items soldending inventory valued at most recent costdisadvantage: „old“ costs are matched with current revenuesno manipulation of income figures

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Inventory valued using LIFO

Last-In, First-Out Inventory Inventory Cost of(LIFO) in numbers value Sales

March 8 units @ 2,5 = 20

April 4 units @ 3 = 12

June 4 units @ 4 = 16

June end total 16 48

Sale of 2 units (May) - 2 @ 4 (June) = -8 8

Ending inventory 14 = 40 Cost of sales 8

cost of items purchased last is assigned to items sold firstitems from the earliest purchases rest in ending inventoryadvantage: most recent costs are matched with current revenuesdisadvantage: possible distortion of inventory figure(again) no manipulation of income figures?

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Comparison of the effects on gross profitAverage Cost

Sales 10

Purchases 48Closing Inventory 42Cost of sales 6

Gross profit 4

FIFOSales 10

Purchases 48Closing Inventory 43Cost of sales 5

Gross profit 5

LIFOSales 10

Purchases 48Closing Inventory 40Cost of sales 8

Gross profit 2

Gross profit highest under FIFO and lowest under LIFO, (only in a period of rising prices. The reverse would be trueif prices decline.)

This year‘s closing inventory is nextyear‘s opening inventory!

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Summary of Income Effects - When Inventory Costs (Prices) are Increasing

Endinginventory, Average-gross profit, LIFO cost FIFOand net income

Summary of Income Effects - When Inventory Costs (Prices) are Decreasing

Endinginventory, Average-gross profit, LIFO cost FIFOand net income

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Impact of accounting principles on inventoryvaluation

Consistency principle stick to one method forinventory valuationRelevance, reliability if valuation method ischanged, disclose thatComparability if two companies use different methods, effects of valuation methods need to bedetermined for purposes of comparison

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LIFO Liquidation

occurs if end-of-the-year balance falls short of thebeginning-of-the-year balance

disadvantage: you pay income taxes on thedifference between current cost and the old LIFO costs

How to prevent LIFO liquidation ?... make enough purchases prior to year end! ... or pool items of similar nature in one group (

specific goods, pooled LIFO approach)

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Example

In case 1, the inventory is liquidated (for whateverreason) whereas in case 2 enough purchases weremade to keep the inventory at its beginning level:

Case 1 Case 2Sales for the period 18.000 18.000Opening inventory 2.000 2.000Purchases 10.000 14.000less Closing inventory 0 2.000Cost of sales 12.000 14.000Gross profit 6.000 4.000

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Tax benefit of LIFO vs. use of LIFO

Use of various inventory methods

44%

32%

20%4%

FIFOLIFOAverageOther

Source: Harrison/Horngren, p.276

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Inventory valuation using lower of cost ormarket rule

conservatism valuation such that assets orincome figures are not overstatedif market value drops below acquisition priceinventory valuation at market value

possible reasons why market value may be lower:physical deteriorationobsolescencemarket downturn

departure from cost principle is justified (and required!)

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„market value“

IFRS: market refers to net realizable valueUS-GAAP

Retail business market value refers to purchasing the goodsManufacturing business market value refers to reproducing the goods

„market“ means replacement costs !Market Value – Upper and Lower Limits• upper limit: Net realizable value• lower limit: Net realizable value less a normal profit

margin

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General rule of Lower of Cost or Market (US-GAAP)

Lower of COST or MARKET

Historical (purchase orproduction) costs

CeilingNet Realizable Value

not morethan

not lessthan

Net Realizable Value Less Normal Profit Margin

Floor

Replacement Cost

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How does the LCM-method under US-GAAP work?

there are three valuation amounts from the market themiddle value is called designated market valuethe designated market value is compared to costthe lower of the two amounts is used for inventory valuation

net realizableitem historical replacement selling price cost to net normal value less designated final

cost cost complete realizable profit normal profit market inventoryvalue margin margin value value

(ceiling) (floor)

I II III IV III - IV = V VI V - VI = VII1 37,00 46,00 57,00 5,00 52,00 12,00 40,00 46,00 37,00 I2 84,00 76,00 107,00 9,00 98,00 18,00 80,00 80,00 80,00 VII3 21,00 30,00 30,00 2,00 28,00 6,00 22,00 28,00 21,00 I4 112,00 100,00 127,00 11,00 116,00 18,00 98,00 100,00 100,00 II5 56,00 40,00 52,00 4,00 48,00 4,00 44,00 44,00 44,00 VII6 30,00 26,00 35,00 3,00 32,00 4,00 28,00 28,00 28,00 VII7 46,00 58,00 56,00 6,00 50,00 7,00 43,00 50,00 46,00 I

356,00

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Alternative applications of LCM

Lower of Cost or Market by:historical designated individual major total

cost market value items categories inventoryCategory A

item 1 37,00 46,00 37,00item 2 84,00 80,00 80,00item 3 21,00 28,00 21,00

total category A: 142,00 154,00 142,00

Category B

item 4 112,00 100,00 100,00item 5 56,00 44,00 44,00

total category B: 168,00 144,00 144,00

Category C

item 6 30,00 28,00 28,00item 7 46,00 50,00 46,00

total category C: 76,00 78,00 76,00

Total € 386,00 € 376,00 € 356,00 € 362,00 € 376,00

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Recording „market“ instead of cost„market“ valuation lower than cost writeoff becomes necessarytwo methods – direct method vs. allowance method

direct method- lower market valuation reflected in cost of goods sold- no (separate) writeoff of inventory

indirect (allowance) method- lower market valuation mirrored in contra asset account- separate statement of loss due to market decline

Example – assume thefollowing inventoryvaluations:

at cost at market

opening inventory € 400.000 € 420.000

closing inventory € 350.000 € 300.000

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Direct Method Indirect Method

to close opening inventory

Cost of goods sold 400.000 Cost of goods sold 400.000 (or Income summary) (or Income summary) Inventory 400.000 Inventory 400.000

to record ending inventory

Inventory 300.000 Inventory 350.000 Cost of goods sold 300.000 Cost of goods sold (or Income summary) (or Income summary) 350.000

to write down inventory to market

no entry Loss due to market 50.000 decline of inventory Allowance to reduce 50.000 inventory to market

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Financial ratios

key ratio: inventory turnover ratesimilar to other asset turnover ratios

Inventory turnover rate =

ratio differs between industriesindicator of increasing / decreasing demandseveral reasons for rate changes possible, e.g.

build-up of inventoryjust-in-time production

Sales revenue (or COGS) in yearAverage inventories in year