Inventories and Cost of Goods Sold (1)

Manufacturing companies have three types of inventory: materials, work in process and finished goods. Retailers have one inventory: merchandise. In all cases, inventory is something the company will re-sell to someone else. Inventory cost is an asset until it is sold; after merchandise is sold, the cost becomes an expense, called Cost of Goods Sold (COGS). A journal entry transfers costs from the Balance Sheet to the Income Statement.

There are several important points, or events, in the life on an inventory item. The company must first order and buy the item. It then holds the item on a shelf or warehouse, until a customer wants to but the item. Once the item is sold, the cost is transferred to COGS. So the three important times in an item's life are buying, holding and selling.

Let's think for a moment about a hypothetical inventory item, we'll call it Item X. If you buy, hold and sell Item X all in the same year, say 2002, the entire transaction relating to Item X will be a completed and realized transaction. If the customer has paid for Item X there will be absolutely no accounting left to do, except show the sale and related COGS on the 2002 Income Statement. Nothing about Item X will affect the company in the future. Everything about Item X relates only to the past.

If Item X costs you $40, and you sell it for $65, you made a Gross Profit on the item of $25.

Income Statement 2002

Selling Price of Item X	$ 65.00
Less: Cost of Item X	40.00
Gross Profit from selling Item X	$25.00

This is the information that will be included in the 2002 Income Statement. Nothing will be left on the Balance Sheet.

Now let's think for a moment about Item Z. Assume you buy Item Z for late in 2002, and you are still holding it. There will be no sale to report, so the cost will remain on the Balance Sheet. If Item Z cost $50 that is the amount that will be shown on the Balance Sheet.

Balance Sheet Dec. 31, 2002

Inventory at December 31, 2002
Cost of Item Z	$50.00

If Item Z is sold in 2003, the cost will flow to the Income Statement for 2003, and the gross profit will be reported on that income statement.

Inventory Valuation
In the example above, you determined a value for Item Z at the end of the year. It is important for companies to count the physical inventory at the end of the year (Chapter 6). They must also place a dollar value on that inventory. The inventory value will be reported on the Balance Sheet at the end of the year.

It is also important to know the correct value of merchandise sold. That is the cost used to determine Gross Profit. Without enough Gross Profit a company can't pay it's operating expenses, such as salaries and wages, rent and utilities, etc. We will discuss Gross Profit a little more later in this section.

There are four methods commonly used to calculate a value for ending inventory. A company should select and use the method that best matches their merchandise and how it is sold.

4 methods of inventory valuation

Inventory method	How it works	When used
Specific Identification	the cost of each individual inventory item is tracked separately; the exact cost of each item is used in the value of ending inventory	auto sales, gems and jewelry, works of art, unique, one of a kind items
First In, First Out (FIFO)	cost of earliest purchases flow to COGS; we assume that the items remaining at the end are the last ones bought in the year	eggs, milk, meat, produce; this is the default flow assumption, unless a different method is specified
Last In, First Out (LIFO)	cost of last purchases flow to COGS; we assume that the items remaining at the end are the earliest ones bought in the year	clothing, seasonal items; a highly specialized method of retail inventory
Average Cost	cost of items bought are averaged across the year; the average cost is used at the end of the year; a moving weighted average is sometimes used	lumber, nails, nuts and bolts (simple average); gasoline (moving average)

Using a Cost Flow Assumption

• must meet cost-benefit rule
• accounts for quantities of homogeneous products
• matches the physical flow of goods
• can be used with either Periodic or Perpetual costing system

Specific Identification
The Specific Identification method assumes that each inventory item is special enough, unique enough, and costly enough to merit tracking one at a time. But does that apply to each and every item? What about a ream (500 sheets) of typing paper. Is it necessary to place a value on each and every sheet of paper?

Most business would answer "No" to that question. The cost of keeping that much detailed information would exceed the usefulness, or benefit, of the information. We call that the cost-benefit rule. The cost of an accounting system (or any other venture) should be outweighed by the benefits, or it is not cost-effective to follow that course of action.

For most companies, the Specific Identification method is far too costly and the additional information that could be gained is of little value. Most companies use a cost flow assumption. This simply means that the flow of inventory follows a certain pattern. Companies will buy merchandise in a manner consistent with the merchandise itself.