Week 5 Lecture Notes
Accounting for Inventory
Introduction to Inventory
Inventory (or stock) is the term used for goods bought or manufactured for resale but
which are as yet unsold. Inventory enables the timing difference between production
capacity and customer demand to be smoothed. The value of inventory according to
AASB102 Inventories is the lower of cost and net realisable value.
The cost of inventory includes all costs of purchase, conversion (i.e. manufacture) and
other costs incurred in bringing the inventory to its present location and condition.
Costs of purchase therefore include import duties and transportation, less any rebates
or discounts. Costs of conversion include direct labour and an allocation of both fixed
and variable production overheads (overheads are covered in chapter 13, weeks 7 &
8). Special methods of calculating inventory value apply to construction contracts,
agriculture and commodities trading.
As students would have learned in financial accounting (see Chapter 6 of the text) the
matching principle requires that business adjusts for changes in inventory in its
Income Statement (the ‘cost of goods sold’) and in its Balance Sheet (inventory is a
current asset).
The cost of goods sold is calculated as shown in the following example:
$
Opening inventory (at beginning of period)
12,000
Plus purchases (or cost of manufacture)
32,000
= Stock available for sale
44,000
Less closing inventory (at end of period)
10,000
= Cost of goods sold
34,000
For a retailer, inventory is the cost of goods bought for resale. For a manufacturer,
there are three different types of inventory
 Raw materials
 Work in progress
 Finished goods
Manufacturing firms purchase raw materials (unprocessed goods) and undertake the
conversion process through the application of labour, machinery and know-how to
manufacture finished goods. The finished goods are then available to be sold to
customers. Work-in-progress consists of goods that have begun but have not yet
completed the conversion process.
Flow of costs
Figures 1 and 2 show in diagram form the flow of costs from purchasing to sales for a
retail organisation (Figure 1) and for a manufacturer (Figure 2).
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Figure 1: The flow of costs in purchasing
Inventory Finished Goods
Increases inventory
Cost of sales
Purchases
Sales
Decreases inventory
Increases cost of sales
Figure 2: The flow of costs in manufacturing
Inventory
Raw materials
Purchases
Increases inventory
Issued to production
Decreases inventory
Inventory
Work in progress
Cost of sales
Increases inventory
Production labour
Increases inventory
Production overhead
Increases inventory
Completed production
Decreases inventory
Sales of finished goods
Inventory
Finished goods
Increases inventory
Decreases inventory
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Increases
cost of sales
Figure 3: The flow of costs in backflush costing
Inventory
Raw materials
Purchases
Increases inventory
Completed production
Decreases inventory
Inventory
Finished goods
Cost of sales
Increases inventory
Conversion costs
Increases inventory
Sales of finished goods
Decreases inventory
Increases cost of sales
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Cost formulas for inventory
Inventory valuation is important as the determination of the cost of inventory affects
both:
 Cost of sales in the Income Statement, and
 The inventory valuation in the Balance Sheet.
The valuation of inventory is therefore an important link between financial accounting
and management accounting.
The cost of inventory items that are not interchangeable or are segregated for specific
projects are assigned by the specific identification of their individual costs. So for
example, a component purchased for a specific job with a cost of $600 but unused,
would be valued at $600.
However, if inventory items are similar and cannot be differentiated, costs are
assigned by using either the weighted average cost or first-in, first-out (FIFO)
methods. The last-in, first-out (LIFO) method, common in the United States, is not
acceptable in Australia or the UK.
Inventory valuation under Weighted Average method
Under the weighted average method, the cost of each item is determined from the
weighted average of the cost of similar items at the beginning of a period and the cost
of similar items purchased or produced during the period.
A product is purchased on three separate occasions:
Units Unit price
Total cost
5,000 $1.20
$6,000
2,000 $1.25
$2,500
3,000 $1.27
$3,810
10,000
$12,310

Calculate the cost of 6,000 units sold and the value of inventory using the
weighted average method.
The weighted average cost is $12,310/10,000 or $1.231 per unit. The cost of goods
sold is 6,000 @ $1.231 = $7,386
The value of inventory is 4,000 @ $1.231 = $4,924
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Inventory valuation under FIFO
FIFO assumes that items of inventory purchased or produced first are sold first, so
that those remaining in inventory are those most recently purchased or produced.
Using the same information:
Units Unit price
5,000 $1.20
2,000 $1.25
3,000 $1.27
10,000

Total cost
$6,000
$2,500
$3,810
$12,310
Calculate the cost of 6,000 units sold and the value of inventory using the
FIFO method.
Under FIFO, the 6,000 units sold come first from the original 5,000 purchased, and
the balance of 1,000 from the second purchase of 2,000 units. The cost of goods sold
is therefore:
5,000 @ $1.20 = $6,000
and
1,000 @ $1.25 = 1,250
Total
= $7,250
The remaining inventory is the last purchased, i.e. 1,000 from the second purchase of
2,000 and 3,000 from the third purchase. The value of inventory is therefore:
1,000 @ $1.25 = $1,250
and
3,000 @ $1.27 = 3,810
Total
$5,060
Note that depending on the method used, the cost of sales (and therefore profit)
differs. If the 6,000 units were sold at a price of $2.00
 Under weighted average the gross profit would be $4,614 ($12,000 - $7,386).
 Under FIFO the gross profit would be $4,750 ($12,000 – $7,250).
Retail method
The retail method is used for the measurement of inventory cost for retail
organisations where there are large numbers of rapidly changing items with similar
margins. The retail method of inventory valuation determines the cost of inventory by
deducting an appropriate percentage profit margin from the sales value of inventory.
Net realisable value
Where the net realisable value is less than cost, this value should be used for
inventory valuation. The net realisable value is the proceeds of sale, less any costs of
disposal (e.g. transport, cleaning, etc.) The realisable value could be a discounted
sales value, trade-in value, scrap value, etc. which is lower than the cost of purchase
(or cost of production).
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Methods of costing inventory in manufacturing
There are different types of manufacturing and it is important to differentiate
alternative methods of production to which different methods apply for the calculation
of cost of sales and the value of inventory:
 Custom: Unique, custom products produced singly, e.g. a building.
 Batch: A quantity of the same goods produced at the same time (often called a
production run), e.g. textbooks.
 Continuous: Products produced in a continuous production process, e.g. oil and
chemicals, soft drinks, etc.
For custom and batch manufacture, costs are collected through a job costing system
that accumulates the cost of raw materials as they are issued to each job (either a
custom product or a batch of products) and the cost of time spent by different
categories of labour. To each of these costs overhead is allocated to cover the fixed
and variable manufacturing overheads that are not included in materials or labour
(overhead will be explained in Chapter 13). When a custom product is completed, the
accumulated cost of materials, labour and overhead is the cost of that custom product.
For each batch the total job cost is divided by the number of units produced (e.g. the
number of copies of the textbook) to give a cost per unit (i.e. cost per textbook).
For continuous manufacture a process costing system is used, under which costs are
collected over a period of time, together with a measure of the volume of production.
At the end of the accounting period, the total costs are divided by the volume
produced to give a cost per unit of volume. Under a process costing system, materials
are issued to production, but as labour hours cannot be allocated to continuously
produced products, conversion costs comprise the production labour and production
overhead. In process costing, equivalent units measure the resources used in
production relative to the resources necessary to complete all units.
Examples of job and process costing are in the next section. In both cases, two
important documents record the costs being incurred:
 Material issues: record the quantity of material issued from raw materials to
production.
 Timesheets: record the number of hours worked by production labour to
convert the raw material to finished goods.
Backflush costing
The introduction by many manufacturing companies of Just-in-Time (JIT) is intended
to bring components from suppliers to the assembly line as they are required for
production, rather than for the manufacturer to hold large quantities of raw materials
to meet future production requirements. JIT has resulted in a significant reduction in
inventories and so inventory valuation becomes less relevant.
Under traditional costing approaches, each material issues transaction is recorded
separately. Backflush costing aims to eliminate detailed transaction processing.
Rather than tracking each movement of materials, the output from the production
process determines (based on bills of materials and standard costs) the amount of
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materials to be transferred from raw materials to finished goods. Importantly, under
backflush costing there is no separate accounting for work in progress. The timing of
the recording of costs is based on a trigger point.
In its simplest version, backflush costing transfers the cost of materials from
suppliers, and conversion costs, to finished goods inventory when production of
finished goods is complete (the trigger point). In a modified version, trigger points
occur when raw materials are purchased and when finished goods are completed. The
modified version is shown in Figure 3.
Job costing illustration
Helo Pty Ltd manufactures components for helicopters. It does so in batches of 100
components. Each batch requires 500 kgs of rolled and formed steel, which takes 15
hours of labour. During the course of a month, the following transactions take place:
Purchase of steel
1,000kgs @ $12/kg
Issue of steel to production 500 kgs
Direct labour to roll and form 500 kgs steel 15 hours @ $125/hour
Overhead allocated at completion of production of 100 components $2,000.
60 of the components manufactured in the batch were sold for $130 each.
At month end, 500 kgs of steel has been issued to production and 7 hours have been
worked. The job is incomplete.
 Calculate the value of work in progress at month end.
Work in progress will comprise
Materials: Steel 500 kgs @ $12/kg
Labour: 7 hours @ $125
Work in progress
$6,000
875
$6,875
After completion of the job, calculate:
 The unit cost of production
 The gross profit
 The value of inventory.
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The job cost for the production of a batch of 100 components is as follows:
Materials: Steel 500 kgs @ $12/kg
$6,000
Labour: 15 hours @ $125
1,875
Overhead
2,000
Total job cost
$9,875
Cost per component
$98.75 ($9,875/100)
The cost of sales of the 60 components sold is $5,925 (60 @ $98.75). The sales
income is $7,800 (60 @ $130) and the gross profit is $1,875.
The stock of finished goods is $3,950 (40 @ $98.75). The stock of raw materials is
the cost of 500 kgs of steel that has been purchased but remains unused at its purchase
cost of $12/kg, a value of $6,000.
Job costing and work in progress for services
Whilst inventory may be thought of as only relating to manufacturers and retailers, it
also relates to professional service firms. Accountants and lawyers are examples of
firms with large work in progress inventories covering work carried out on behalf of
clients but not yet invoiced.
PLC Accountants have been conducting ABC Limited’s audit. At month end 15
partner hours and 60 audit hours have been allocated to ABC’s work, which has not
been invoiced. The hourly cost rates used by PLC are $200/hour for partners and
$80/hour for managers.
 Calculate the work in progress for PLC at month end.
Work in progress:
15 partner hours @ $200
60 audit hours @ $80
Total
$3,000
4,800
$7,800
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Process costing illustration
Voxic Ltd manufactures lubricants. It does so in a continuous production process 24
hours per day, 7 days per week. During the course of a month, raw materials costing
$140,000 were purchased and 100,000 litres of lubricant were produced. Materials
issued to production cost $75,000 and conversion costs incurred were $55,000. 80,000
litres of lubricant were sold for $1.50/litre.
At the end of month, calculate:
 The unit cost of production
 The gross profit
 The value of inventory.
The cost of production for the month was $130,000 (materials $75,000 + conversion
$55,000). As 100,000 litres were produced, the cost per litre is $1.30
($130,000/100,000 litres).
The cost of sales for the 80,000 litres sold was $104,000 (80,000 @ $1.30). Sales
proceeds were $120,000 (80,000 @ $1.50) and gross profit was $16,000.
Finished goods inventory is $26,000 (20,000 litres unsold @ $1.30). Raw materials
inventory is valued at $65,000 ($140,000 purchased less $75,000 issued).
Process costing with partially completed units – weighted average method
Kazoo produced oils on a process basis during a month.
The opening work in progress was 7,000 units, consisting of materials $12,000 and
conversion costs $30,000.
12,000 units commenced production during the month.
The closing work in progress was 4,000 units, 75% complete.
The cost of materials issued to production during the month was $140,000.
The conversion costs for production during the month were $80,000.
Calculate:
 The number of units completed
 The equivalent units in WIP
 The cost per unit, using the weighted average method
 The cost of work in progress and finished goods at month end.
Note: In process costing examples, unless you are advised otherwise, materials are
assumed to be added at the beginning of the process, and conversion costs are added
uniformly throughout the process.
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Opening WIP
Units commenced
Closing WIP
Completed
Units
7,000
12,000
19,000
4,000
15,000
Cost per unit:
Opening
WIP $
Material
Conversion
Total
12,000
30,000
$42,000
Cost
for
month
$
140,000
80,000
Total $
152,000
110,000
$262,000
Completed
units
WIP
Equivalent
units
Total
equivalent
units
Cost per
equivalent
unit1 $
15,000
15,000
4,000
3,0002
19,000
18,000
$8.00
$6.11
$14.11
Work in progress:
Materials 4,000 @ $8
$32,000
Conversion 3,000 @ $6.111 $18,333
$50,333
Finished goods:
15,000 units @ $14.111
Total costs
$211,666
$262,000
Note: If a FIFO method of costing and inventory valuation is used, a variation to this
calculation is necessary. However, the FIFO method will not be examined in
AFX9550 for process costing with partially completed units.
1
2
Total cost divided by total equivalent units
4,000 units, 75% complete at end of month = 3,000 equivalent units
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Long term contract costing
Long term contract costing is a method of job costing that applies to large units that
are produced over a long period of time, e.g. construction projects. Because of the
length of time the contract takes to complete, it is necessary to apportion the profit
over several accounting periods. Although the goods that are the subject of the
contract have not been delivered, AASB111 Construction Contracts requires that
revenue and costs be allocated over the period in which the contract takes place (e.g.
the construction period). The stage of completion method is the most common method
to be applied to long term contracts. Under this method, profit recognised is the
proportion of work carried out, taking into account any known inequalities at the
various stages of the contract. The costs incurred in reaching the relevant stage of
completion are then matched with income. However, where the outcome of a contract
is not known with reasonable certainty, no profit should be reflected, although losses
should be recognised as soon as they are foreseen.
Long term contracts will frequently allow for progress payments to be made by a
customer at various stages of completion. For construction contracts, there will
typically be an architect’s certificate to support the stage of completion. Contracts
may also include a retention value, a proportion of the total contract price that is
retained by the customer and not paid until a specified period after the end of the
contract.
Macro Builders has entered into a 2 year contract to construct a building. The contract
price is $1.2 million, with an expected cost of construction of $1 million. After 1 year,
the following costs have been incurred:
Material delivered to site
$500,000
Salaries and wages paid
130,000
Overhead costs
170,000
The architect certifies the value of work completed to the contractual stage for a
progress payment as $600,000. Macro estimates that it will cost $250,000 to complete
the contract over and above the costs already incurred.
Calculate:
 The anticipated profit on the contract
 The amount of profit that can be considered to have been earned to date.
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Costs of construction:
Material delivered to site
Salaries and wages paid
Overhead costs
Less work not certified
Cost of work certified
Anticipated profit:
Cost of work certified
Work not certified
Estimated cost to complete
Contract price
Anticipated profit
$500,000
130,000
170,000
$800,000
200,000
$600,000
$600,000
200,000
250,000
1,050,000
1,200,000
$150,000
Expected cost of construction $1,000,000 (or $1,050,000)
Percentage complete 60% ($600,000/$1,000,000)
Take up profit of 60% of $150,000 = $90,000
Management accounting statements
The collection and analysis of financial data on manufacturing activities, adjusted by
the valuations of inventory for raw materials, work in progress and finished goods,
results in a manufacturing statement and cost of goods sold statement produced for
management accounting purposes.
Manufacturing statement
Direct material:
Raw material inventory at beginning of period
Purchases of raw materials
Raw material available for use
Less raw material inventory at end of period
Raw material usage in production
Direct labour
Manufacturing overhead:
Factory rental
Depreciation of plant & equipment
Light & power
Salaries & wages of indirect labour
Total manufacturing costs
Add work in progress inventory at beginning of
period
Less work in progress inventory at end of period
Cost of goods manufactured
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50,000
150,000
200,000
40,000
160,000
330,000
50,000
30,000
10,000
60,000
150,000
640,000
100,000
740,000
60,000
680,000
Cost of goods sold statement
Finished goods inventory at beginning of period
Cost of goods manufactured
Goods available for sale
Less finished goods inventory at end of period
Cost of goods sold
Income statement
Sales
Less cost of goods sold
Gross profit
Less selling and administrative expenses
Net profit
160,000
680,000
840,000
120,000
720,000
1,000,000
720,000
280,000
150,000
130,000
Included in the Notes to the Accounts would be a breakdown of the valuation of
inventory in the current assets section of the Balance Sheet. This would show:
Inventory raw materials
Inventory work in progress
Inventory finished goods
Total
40,000
60,000
120,000
220,000
Concluding comments
It is essential to value inventory for financial reporting purposes. However, as
chapters 10, 11 & 12 have shown, inventory costs may not be suitable for decision
making purposes. The assumptions and limitations of costs based on accounting
standards have to be understood and questioned in terms of their relevance for day to
day decision making.
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