INVENTORY

Inventory are stock, goods, merchandise. It's those assets, those products, those things of value, that you either buy from another or make yourself, that you then sell on to someone else (at a higher price than what it cost you to buy or make the inventory).

Inventory are classified as current assets, as the business intends to sell them (and usually does) within a year from the date that it is listed on the balance sheet.

Examples of Inventory

Here are some examples of inventory:

1) Joe Superathlete Shoes sells Adidas and Nike shoes. Guess what? Those are both inventory for his business because they are bought from the manufacturers of the shoes and are sold to the public at a higher amount, resulting in a profit for the business.

2) Morgan Used Cars sells used cars. Are these inventory? Well, usually motor vehicles would fall under non-current assets in our balance sheet. However, in this particular case, the business intends to sell them as part of their regular business operations (they definitely intend to sell them in less than a year), and so these cars are classified as "inventory" under the category of "current assets."

The FIFO method, LIFO method and Weighted Average Cost method are three ways of valuing your inventory. In this lesson we're going to look at all three methods with examples.

At the end of each period (month or year) one should do a physical inventory count to determine the number of inventory on hand.

Then you need to place a value on the goods. One would think this would be easy - the value of the goods is simply how much they originally cost. Unfortunately there is a bit more to it than just this.

There are three methods used when valuing the goods that you have on hand at the end of the period.

The following example will illustrate this:

Cindy Sheppard runs a candy shop. She enters into the following transactions during July:

July 1 Purchases 1,200 lollypops at $1 each.

July 13 Purchases 500 lollypops at $1.20 each.

July 14 Sells 700 lollypops at $2 each.

First of all, how many lollypops does she have at the end of the month?

Answer:

1,200 + 500 – 700 = 1,000 lollypops

Now, there are three ways that Ms. Sheppard could value her closing stock...

1. The First-In-First-Out Method (FIFO)

This method assumes that the first inventories bought are the first ones to be sold, and that inventories bought later are sold later.

The value of our closing inventories in this example would be calculated as follows:

Using the First-In-First-Out method, our closing inventory comes to $1,100. This equates to a cost of $1.10 per lollypop ($1,100/1,000 lollypops).

It is very common to use the FIFO method if one trades in foodstuffs and other goods that have a limited shelf life, because the oldest goods need to be sold before they pass their sell-by date.

Thus the first-in-first-out method is probably the most commonly used method in small business. Well, probably...

2. The Last-In-First-Out Method (LIFO)

This method assumes that the last inventories bought are the first ones to be sold, and that inventories bought first are sold last.

The value of our closing inventories in this example would be calculated as follows:

Using the Last-In-First-Out method, our closing inventory comes to $1,000. This equates to a cost of $1.00 per lollypop ($1,000/1,000 lollypops).

The LIFO method is commonly used in the U.S.A.

3. The Weighted Average Cost Method

This method assumes that we sell all our inventories simultaneously.

The weighted average cost method is most commonly used in manufacturing businesses where inventories are piled or mixed together and cannot be differentiated, such as chemicals, oils, etc. Chemicals bought two months ago cannot be differentiated from those bought yesterday, as they are all mixed together.

So we work out an average cost for all chemicals that we have in our possession. The method specifically involves working out an average cost per unit at each point in time after a purchase.

In our example above (assuming the weighted average cost method was allowed for valuing the lollypops), the value of our closing inventories would be calculated as follows:

Using the weighted average cost method, our closing inventory amounts to $1,059. This equates to a cost of $1.06 per lollypop ($1,059/1,000 lollypops).

Oddly enough, the LIFO method is the preferred inventory valuation method in the United States but is disallowed in non-US countries. The FIFO method and the weighted average cost method are used in non-US countries. In recent years there have been calls for the standardization of accounting rules throughout the world, and talk specifically about disallowing LIFO in the US (or making the rest of the world follow the LIFO system). As of this writing the matter has not been resolved and the differences in inventory valuation still exist.

Sales, Cost of Goods Sold

and Gross Profit

We mentioned previously how a trading business differs from a service business: whereas a service business provides a service, such as accounting, medical or repair work, a trading business trades in inventory (it buys goods at a low price and sells it at a higher price).

A trading business will also differ from a service business in terms of its income and expenses – i.e. the way a profit is made: whereas a service business renders services, a trading business makes sales.

The income statement for a trading business will thus look slightly different to the income statement of a service business (check out the lesson on the income statement to review what it looks like for a service business).

Left is the income statement for a trading business:

The first section of the income statement for a trading business describes the core activities of a trading business, i.e. the buying and selling:

Sales: Sales are the full income for the year for selling goods.

Cost of goods sold: This refers to the cost of all the goods that we sold this year. It is also known as cost of sales. Cost of goods sold is an expense charged against sales to work out a gross profit (see definition below). So, for example, we may have sold 100 units this year at $4 each, and these 100 units that we sold cost us $3 each originally. So our sales would be $400 and our cost of the goods we sold (cost of sales) would amount to $300. This would result in a gross profit of $100 (sales minus cost of sales). Cost of goods sold is not the same as purchases, as you will see from our examples below.

Gross profit: An initial profit on the product we are selling, before deducting general business expenses.

Perpetual and Periodic Inventory

Inventory records are kept using either one of the following systems:

a. Perpetual Inventory System

Perpetual means continuous. This is a system where a business keeps continuous, moment-to-moment records of the number, value and type of inventories that it has at the business.

A computerized accounting system – where each item of inventory is linked to the electronic accounting records – creates a perpetual system. Products that have barcodes are automatically recorded as having been sold at tills in a supermarket when they are ‘swiped.’ Inventory levels are automatically decreased as soon as the invoice has been entered and completed at the till.

b. Periodic Inventory System

Where one does periodic inventory counts (such as once a month, or at the beginning and end of each year), and does not have an accurate record of the inventories in between these points – well, this is a periodic system.

This system does not keep continuous, moment-to-moment records of inventories.

Accurate records are only kept periodically – meaning, at certain points in time – in this case, when the actual counts are done.

Many small businesses still only have a periodic system of inventory.

Report abuse