What is Inventory?
Inventory is an asset that is:
- Held for sale in the ordinary course of business;
- In the process of production of such sale;
- In the form of materials or supplies to be consumed in the production process or in the rendering of the services.
Inventory is recorded either at cost or net realisable value, whichever is lower.
Here, Net Realisable Value means the value obtained on the sale of asset less costs incurred for making such a sale. And Cost of inventory includes:
- purchase cost
- conversion cost and
- costs associated with bringing the inventory in current state and location.
Cost of Purchase
Cost of purchase not only includes the purchase price of the goods bought. It also includes the costs that are directly associated with the acquisition of goods. For example purchase price, taxes, duties, freight inwards and other direct costs all form part of the purchase cost. However, there are certain items that are deducted from the above costs while calculating the cost of purchase. These include trade discounts, duty drawbacks, rebates etc.
Cost of Conversion
Conversion cost of inventories include costs directly associated with converting raw materials into finished goods. For example direct labor. These costs are bifurcated into fixed and variable costs of production.
Now, fixed costs are the indirect costs that do not change with the change in the level of output. For example depreciation, management and administration expense, factory building maintenance etc. On the other hand, variable production costs are the costs that vary with the volume of output. For example cost of indirect materials.
These are the costs that help in bringing the inventories to their current condition and location. For example transportation charges.
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There were rumors about Nordstrom planning to sell its business in the year 2001. Norstrom is one of the oldest and largest specialty retailers in the world. The rumors were based on the fact that the departmental chain had been downsizing its growth plans on the back of falling sales. The reasons for Nordstrom’s poor performance was its ignorance of the changing dynamics of the retailing industry.
Nordstrom was criticized for not investing in technology to improve its inventory management or merchandizing practices. The retailer kept on focusing on achieving excellence at customer service to lure more customers. And did not adopt ace supply chain management practices to gain competitive advantage in the retail industry. Further, cost control was another important aspect to stay competitive given thin margins.
Finally, Nordstrom’s management realized in 2001 its poor performance was a result of ignoring modern inventory management practices. Thus, the retailer implemented Perpetual Inventory System in 2002. And the effect of implementing such a system was seen in company’s healthy results in the second quarter of 2002. Thus, such an instance gave respite to Nordstrom’s shareholders.
So, we can say that effective inventory management helps in maintaining right balance of stock. Furthermore, it gives a better understanding of what is selling and what isn’t. Additionally, such an inventory control helps in providing better customer service.
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Types of Companies For Inventory Accounting
The concept of Inventory accounting and cost of sales can be understood with respect of three types of companies. These include merchandising, manufacturing and service companies.
1. Merchandising Companies
These are the companies that sell goods in nearly the same form in which they acquire them. Retail stores, wholesalers, distributors and similar other companies selling tangible goods are examples of merchandising companies. Now, the cost of sales for merchandising companies is as follows:
Cost of Sales = Cost of Acquisition + Cost incurred in making the goods ready for sale
The above equation does not include cost of manufacture. This is because the merchandising companies do not change the physical form of goods.
So, inventory appearing on the balance sheet of a merchandising company reflects the cost of goods acquired in place of Cost of Goods Sold (COGS).
2. Manufacturing Companies
Manufacturing companies are the companies that convert raw materials into finished goods. Therefore, cost of sales for such companies comprises of:
- raw material cost
- conversion cost and
- cost of goods sold
These companies have mainly three types of inventory accounts: raw material, work-in-process and finished goods.
3. Service Companies
Service organizations sell intangible services over tangible goods. Examples of services include hospitals and healthcare organizations, banks and financial institutions, hotels etc. These organizations may have material inventories and work-in-process inventories but do not have finished goods inventory.
For instance, in case of a contractor offering plumbing service, pipes and fittings makeup for the material inventory. Likewise, professional service firms like accounting, consulting etc. may have job-in-progress inventory. Such inventory includes costs that have been incurred on behalf of the client but have not yet been claimed.
Different Types Of Inventory Systems
There are three different types of inventory systems to accounts for inventory and cost of goods sold. These include:
- Periodic Inventory Method
- Perpetual Inventory Method
- Retail Method
1. Periodic Inventory Method
Under this method, ending inventory or the inventory on hand is determined by undertaking physical count of the inventory at specified periods. As per this method, all the purchases of inventory made during the accounting period are debited to the Purchases Account. Further, the purchases made during the period are added back to the beginning inventory in order to arrive at Cost of Goods Available for Sale. Thus, the ending inventory is deducted from the cost of goods available for sale to arrive at the Cost of Goods Sold during the period.
Therefore, a separate account is prepared for every element used to arrive at Cost of Goods Sold in this method. Say for instance the cost of ending inventory for a merchandising company is Rs 2,000. COGS is calculated by subtracting ending inventory from cost of goods available for sale.
As we can see, separate account is prepared for every component while calculating cost of goods sold under periodic inventory method. Thus, purchases account is prepared and the merchandise purchased is debited to this account.
Likewise, separate accounts are prepared for Purchases return, Freight-in and any other items involved in the calculation. Moreover, all these accounts are closed to Cost of Goods Sold at the end of the accounting period. The journal entries for the same are as follows:
Cost of Goods Sold Rs 4,000
To Merchandise Inventory Rs 4,000
Cost of Goods Sold Rs 7,400
Purchase Return Rs 200
To Purchases Rs 7,000
To Freight-In Rs 600
Merchandise Inventory Rs 2,000
To Cost of Goods Sold Rs 2,000
Income Summary Rs 9,400
To Cost of Goods Sold Rs 9,400
2. Perpetual Inventory Method
Under Perpetual Inventory System, the changes in inventory are recorded in the inventory account. This is unlike periodic inventory system, where every item in the cost of goods sold calculation is recorded in separate accounts. Items such as purchases and sales of goods are recorded directly in the inventory account as they occur.
Following are the salient accounting characteristics of perpetual inventory system:
- Merchandise purchases made for the purpose of resale or raw materials for production are debited to the Inventory account rather than purchases.
- Likewise items like Freight-in, Purchase returns, allowances and purchase discounts are too recorded in inventory account instead of separate accounts.
- For each sale made, the cost of goods sold is recognized by debiting cost of goods sold account and crediting inventory.
- Each item of inventory is recorded in the subsidiary ledger account. These subsidiary records exhibit cost and quantity of each type of inventory in hand. Furthermore, these records support the Merchandise Inventory Account which is the control account.
In this method, purchases are recorded directly in this subsidiary ledger account. This means merchandise inventory is debited directly to record these purchases . Whereas, accounts payable or cash accounts are credited against merchandise inventory.
Similarly, goods delivered to customers are also recorded in the ledger account. This means the Merchandise Inventory account gets credited directly. Whereas, Cost of Goods Sold is debited to offset the merchandise inventory.
So, we can say that the sum of balances for all the items is the ending inventory for the company. Journal entries for the transactions considered under Periodic Method are as follows:
Merchandise Inventory Rs 7,000
To Accounts Payable Rs 7,000
For Shipments to Customers
Cost of Goods Sold Rs 8,800
To Merchandise Inventory Rs 8,800
For Purchase Returns
Accounts Payable Rs 200
To Merchandise Inventory Rs 200
Cost of Goods Sold Rs 600
To Freight-In Rs 600
Income Summary Rs 9,400
To COGS Rs 9,400
3. Retail Method
There are some stores that do not use perpetual inventory records to manage and control inventory. However, such stores can still prepare accurate monthly income statements without taking a physical inventory. They need to use retail method of inventory.
Under this method, gross margin percentage of the goods available for sale is calculated. This is done by recording purchases both at its cost and retail selling price. Then, to find the approximate cost of goods sold, the complement of gross margin percentage is applied to sales for the month. Following illustration will help in explaining the concept.
As per the above table, the Gross Margin Percentage for the given period comes at (16,000-11,000)/16,000 = 31%. The complement of this is calculated as follows:
100% – 31% = 69%
If for instance, the sales for the month were Rs 13,000, then the cost of goods sold under this method is taken as 69% of this amount. That is 69% of 13,000 which is close to 8,970.