Chapter 9: Inventories
Raw materials and consumables
Finished goods
Work in Progress
Variants of valuation at historical cost
other valuation rules
1
Characteristics of Inventories
z
z
z
belong to current assets
kept in stock either to be sold to customers or to be
consumed by activities of the accounting entity
Retailer, wholesaler
Œ
z
merchandise inventory
Manufacturer
Œ
finished goods
Πwork in progress: goods not yet ready for sale
Πraw materials and purchased parts
z
optimal level of inventory
Œ
trade-off between holding costs, ordering cost, service
level, customer satisfaction, smooth production
2
The relative importance of inventories
Inventory / Total assets
Inventory / Current assets
Manufacturing
General Electric (Manufacturer)
Chevron (Oil drilling and refining)
0,02
0,03
0,07
0,13
Retail
Supervalu (Grocery retail)
Tommy Hilfiger (Clothing retail)
0,23
0,09
0,68
0,26
Internet
Yahoo (Internet search engine)
Cisco (Internet systems)
0,00
0,04
0,00
0,11
General services
SBC Communications
(Telecommunications services)
Wendy's (Restaurant services)
0,00
0,00
0,02
0,13
Financial services
Bank of America (Banking services)
Merril Lynch (Investment services)
0,00
0,00
0,00
0,00
3
The Inventory Balance Equation
z
Value of inventory at time t
= Initial inventory + inflows – outflows up to t
Œ
initial inventory: from past period; zero at start of business
• depends on valuation method used for inflows and outflows
Πinflows: valued at cost
• same as for fixed assets: „all costs incurred in order to bring
the inventories to their present location and condition“
Πoutflows: different approaches
• direct identification
• assumed order of depletion
• averaging
• determine market value of ending inventory and apply
balance equation
4
Importance of Inventory Valuation
z
z
z
inventory valuation affects the income statement
and the balance sheet
impact on ratios used in financial statement analysis
The Gross Profit Equation:
Gross profit = Sales Revenue
– purchases
+ ending inventory
– beginning inventory
z
Effect of inventory valuation on gross profit:
Œ
closing inventory understated (overstated)
Î gross profit for the period understated (overstated)
Πopening inventory understated (overstated)
Î gross profit for the period overstated (understated).
5
counterbalancing effect of valuation error
"correct closing inventory"
2003
2004
Sales for the period
Opening inventory
Purchases
less Closing inventory
Cost of sales
Gross profit
3.500
2.900
200
3.000
300
300
2.200
250
2.900
600
2.250
650
"closing inventory overstated"
2003
2004
Sales for the period
Opening inventory
Purchases
less Closing inventory
Cost of sales
Gross profit
3.500
2.900
200
3.000
450
450
2.200
250
2.750
750
2.400
500
overstating the
closing
inventory
results in a
higher profit in
2003,
... and a lower
profit in 2004.
... but total
profits over both
years are the
same!
Although total profit are equal, the trend of performance is reversed!
6
Inventory Control
z
Perpetual System
Œ
continuous record of changes
Πinventory account contains purchases and sales
Πclosing inventory as a residual
Πsupplementary occasional (physical) counts
z
Periodic System
Œ
Œ
Œ
Œ
Œ
physical counting and recording of inventory periodically
count taken near the end of a company‘s fiscal year
separate purchases account may be used
figure for usage during the year as residual
(used by businesses that sell inexpensive goods, e.g. fabric
store)
7
Perpetual Inventory System
Periodic Inventory System
1. Beginning inventory, 100 units at € 12
The inventory account shows the inventory
on hand at € 1.200.
The inventory account shows the inventory
on hand at € 1.200.
2. Purchase of 1.200 units at € 12
Inventory
Accounts Payable
14.400
14.400
14.400
Purchases
Accounts Payable
15.000
15.000
Accounts Receivable
Sales
14.400
3. Sale of 1.000 units at € 15
Accounts Receivable
Sales
Cost of Goods Sold
Inventory
15.000
12.000
15.000
No entry
12.000
4. End-of-period entries for inventory accounts, 300 units at € 12
No entry necessary; Inventory account has balance
of € 3.600
(Example adapted from Kieso/Weygandt)
Inventory (closing)
Cost of Goods Sold
Purchases
Inventory (opening)
3.600
12.000
14.400
1.200
Valuation: three decisions
1.
2.
3.
What physical goods are to be included in
inventory?
What costs are to be included in inventory?
What cost flow assumption should be
adopted?
9
1. Inventory: attribution to accounting entity
z
Rule: Goods should be included in the inventory of
the party
who has legal title to it.
Œ
z
Goods in transit
Œ
z
important for goods in transit and consigned goods
Legal 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 the
goods from the seller.
• FOB destination: Legal title to the goods remains with the
seller until the goods reach the buyer.
Consigned goods
Œ
Goods included in the inventory of the consignor, not in that
of the consignee.
10
2. Inventory Costs
z
... is the purchase price plus any charges
incurred bringing the inventory to its existing
condition.
z
production overhead IS included.
z
period costs are NOT included.
z
Overhead costs should be included only according
to capacity utilization
Πdo not capitalize cost of idle capacity
11
Inventory valuation – an example
z
Candy Inc. spent the fourth quarter of its fiscal year
producing candy for easter. 2.000 batches were
produced at labor cost of
€ 20 per batch and € 150 for material per batch.
direct cost
z
Other cost in that quarter:
Œ
Œ
Œ
Œ
Œ
Œ
Œ
€ 20.000 – salary for production supervisors
€ 28.000 – depreciation of production facilities
manufacturing
€ 2.000 – setup cost
overhead
€ 11.250 – salary of factory manager
€ 68.750 – various manufacturing overhead
€ 250.000 – cost of headquarters
administrative
€ 40.000 – salary of sales representatives overhead
selling
overhead
12
Multi-product case
z
Overhead needs to be allocated to different products
Œ
z
matter of cost accounting
usual method
Œ
choose an allocation base e.g. direct cost or direct labor
hrs.
Πcalculate the overhead rate per unit of the allocation base
Πmultiply units of allocation base in product times overhead
rate
z
activity-based costing
Œ
determine the total cost of each activity in the firm
Œ determine a „cost driver“ as an allocation base for the cost
of each activity
Πdetermine the cost driver rate for each activity
Πallocate activity cost according to usage by the product
13
The inventory is to be valued as follows:
z
Provided regular capacity is 2000 batches
Œ
Œ
Œ
Œ
Œ
Direct cost:
Manufacturing overhead:
Administrative overhead:
Selling overhead:
Total:
Î Value of inventory:
z
€ 170
€ 65 ( 130.000 / 2.000 )
----€ 235 per batch
€ 470.000
Assume regular capacity is 2500 batches
Œ
Œ
Œ
Œ
Œ
Direct cost:
Manufacturing overhead:
Administrative overhead:
Selling overhead:
Total:
Î Value of inventory:
€ 170
€ 52 ( 130.000 / 2.500 )
----€ 222 per batch
€ 444.000
14
3. Cost flow assumptions for inventory
valuation
z
z
distinguishable items are purchased and sold Æ
required to monitor actual goods flow and record
corresponding costs
identical items of merchandise (at different prices)
purchased and sold
Œ
usually impractical to monitor actual goods flow and record
corresponding costs
assumption about cost flow
Œ
Specific Identification
ΠAverage Cost
ΠFirst-In, First-Out
ΠLast-In, First-Out
Cost flow assumptions
15
Inventory valuation – applying different
methods
z
We use the following data to calculate inventory,
cost of sales, and gross profit for the different
methods:
Purchase of
Sale of
8 units @ € 2,50
(March)
4 units @ € 3,00
(April)
4 units @ € 4,00
(June)
2 units @ € 5,00
(May)
16
Specific Identification
z
items purchased and sold must be distinguishable
problem of allocating overhead costs to inventory
possibility of income manipulation
z
for the example:
z
z
Œ
cost of goods sold either 5.00 or 6.00 depending on whether
items out of March‘s or April‘s purchase were used.
17
Inventory valued at average cost:
Average Cost
March
z
z
z
Inventory
in numbers
Inventory
value
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
Ending inventory
Cost of sales
14 units @ 3
42
Cost of
Sales
6
6
units in inventory are valued at the average cost of the goods available
for sale, i.e. total cost of inventory over number of items
method easy to handle
objective in nature, less room for manipulation
18
Inventory valued using FIFO
First-In, First-Out
(FIFO)
March
=
20
April
4 units @ 3
=
12
June
4 units @ 4
=
16
Sale of 2 items (May)
Ending inventory
Cost of sales
z
z
z
Inventory
value
8 units @ 2,5
June end total
z
Inventory
in numbers
16
- 2 units @ 2,5 (March)
14
Cost of
Sales
48
=
-5
=
43
cost of the first items purchased is assigned to the first items sold
ending inventory valued at most recent cost
disadvantage: „old“ costs are matched with current revenues
no manipulation of income figures
5
5
19
Inventory valued using LIFO
Last-In, First-Out
(LIFO)
March
=
20
April
4 units @ 3
=
12
June
4 units @ 4
=
16
Sale of 2 units (May)
Ending inventory
Cost of sales
z
z
z
z
Inventory
value
8 units @ 2,5
June end total
z
Inventory
in numbers
16
-2@4
14
Cost of
Sales
48
(June)
=
-8
=
40
cost of items purchased last is assigned to items sold first
items from the earliest purchases rest in ending inventory
advantage: most recent costs are matched with current revenues
disadvantage: possible distortion of inventory figure
(again) no manipulation of income figures?
8
8
20
Comparison of the effects on gross profit
Average Cost
Sales
Purchases
Closing Inventory
Cost of sales
10
48
42
Gross profit
LIFO
Sales
Purchases
Closing Inventory
Cost of sales
Gross profit
FIFO
Sales
6
Purchases
Closing Inventory
Cost of sales
4
Gross profit
10
48
40
8
2
10
48
43
5
5
Gross profit highest under FIFO and
lowest under LIFO, (only in a period of
rising prices. The reverse would be true
if prices decline.)
This year‘s closing inventory is next
year‘s opening inventory!
21
Summary of Income Effects - When Inventory Costs (Prices) are Increasing
Ending
inventory,
gross profit,
and net income
LIFO
Averagecost
FIFO
Summary of Income Effects - When Inventory Costs (Prices) are Decreasing
Ending
inventory,
gross profit,
and net income
LIFO
Averagecost
FIFO
22
Impact of accounting principles on inventory
valuation
z
z
z
Consistency principle Æ stick to one method for
inventory valuation
Relevance, reliability Æ if valuation method is
changed, disclose that
Comparability
Æ if two companies use
different methods, effects of valuation methods need
to be determined for purposes of comparison
23
LIFO Liquidation
z
occurs if end-of-the-year balance falls short of the
beginning-of-the-year balance
z
disadvantage: you pay income taxes on the
difference between current cost and the old LIFO
costs
z
How to prevent LIFO liquidation ?
... make enough purchases prior to year end!
... or pool items of similar nature in one group (Æ
specific goods, pooled LIFO approach)
24
Example
z
In case 1, the inventory is liquidated (for whatever
reason) whereas in case 2 enough purchases were
made to keep the inventory at its beginning level:
Case 1
Sales for the period
Opening inventory
Purchases
less Closing inventory
Cost of sales
Gross profit
Case 2
18.000
2.000
10.000
0
18.000
2.000
14.000
2.000
12.000
6.000
14.000
4.000
25
Tax benefit of LIFO vs. use of LIFO
Use of various inventory methods
4%
20%
44%
FIFO
LIFO
Average
Other
32%
Source: Harrison/Horngren, p.276
26
Inventory valuation using lower of cost or
market rule
z
z
conservatism Æ valuation such that assets or
income figures are not overstated
if market value drops below acquisition price Æ
inventory valuation at market value
Œ
possible reasons why market value may be lower:
Πphysical deterioration
Πobsolescence
Πmarket downturn
z
departure from cost principle is justified (and
required!)
27
„market value“
z
z
IFRS: market refers to net realizable value
US-GAAP
Œ
Œ
Retail business Æ market value refers to
purchasing the goods
Manufacturing business Æ market value refers to
reproducing the goods
„market“ means replacement costs !
Œ
Market Value – Upper and Lower Limits
• upper limit: Net realizable value
• lower limit: Net realizable value less a normal profit
margin
28
General rule of Lower of Cost or Market
(US-GAAP)
Ceiling
Net Realizable Value
Lower of
COST
or
MARKET
not more
than
Replacement Cost
Historical (purchase or
production) costs
not less
than
Net Realizable Value Less
Normal Profit Margin
Floor
29
How does the LCM-method under US-GAAP
work?
there are three valuation amounts from the market Æ the
middle value is called designated market value
z the designated market value is compared to cost
z the lower of the two amounts is used for inventory valuation
z
item historical
cost
1
2
3
4
5
6
7
I
37,00
84,00
21,00
112,00
56,00
30,00
46,00
replacement
cost
II
46,00
76,00
30,00
100,00
40,00
26,00
58,00
selling price
III
57,00
107,00
30,00
127,00
52,00
35,00
56,00
cost to
complete
net
realizable
value
(ceiling)
IV
III - IV = V
52,00
98,00
28,00
116,00
48,00
32,00
50,00
5,00
9,00
2,00
11,00
4,00
3,00
6,00
normal
profit
margin
net realizable
value less
normal profit
margin
(floor)
VI
V - VI = VII
12,00
40,00
18,00
80,00
6,00
22,00
18,00
98,00
4,00
44,00
4,00
28,00
7,00
43,00
designated
market
value
46,00
80,00
28,00
100,00
44,00
28,00
50,00
final
inventory
value
37,00
80,00
21,00
100,00
44,00
28,00
46,00
356,00 30
I
VII
I
II
VII
VII
I
Alternative applications of LCM
Lower of Cost or Market by:
historical
cost
designated
market value
individual
items
major
categories
total
inventory
Category A
item 1
item 2
item 3
total category A:
37,00
84,00
21,00
46,00
80,00
28,00
142,00
154,00
112,00
56,00
100,00
44,00
168,00
144,00
30,00
46,00
28,00
50,00
76,00
78,00
€ 386,00
€ 376,00
37,00
80,00
21,00
142,00
Category B
item 4
item 5
total category B:
100,00
44,00
144,00
Category C
item 6
item 7
total category C:
Total
28,00
46,00
76,00
€ 356,00
€ 362,00
€ 376,0031
Recording „market“ instead of cost
z
z
„market“ valuation lower than cost Æ writeoff becomes necessary
two methods – direct method vs. allowance method
z
direct method
- lower market valuation reflected in cost of goods sold
- no (separate) writeoff of inventory
z
indirect (allowance) method
- lower market valuation mirrored in contra asset account
- separate statement of loss due to market decline
Example – assume the
following inventory
valuations:
at cost
at market
opening inventory
€ 400.000
€ 420.000
closing inventory
€ 350.000
€ 300.000
32
Direct Method
Indirect Method
to close opening inventory
Cost of goods sold
(or Income summary)
Inventory
400.000
400.000
Cost of goods sold
(or Income summary)
Inventory
400.000
Inventory
Cost of goods sold
(or Income summary)
350.000
400.000
to record ending inventory
Inventory
Cost of goods sold
(or Income summary)
300.000
300.000
350.000
to write down inventory to market
no entry
Loss due to market
decline of inventory
Allowance to reduce
inventory to market
50.000
50.000
33
Financial ratios
z
key ratio: inventory turnover rate
Œ
similar to other asset turnover ratios
Sales revenue (or COGS) in year
Average inventories in year
z
Inventory turnover rate =
z
ratio differs between industries
indicator of increasing / decreasing demand
several reasons for rate changes possible, e.g.
z
z
Œ
build-up of inventory
Πjust-in-time production
34