Inventories represent one of the most important elements of a business. Much of a company’s resources is invested in this asset, which is usually its chief source of revenue. In recent years, accountants have given much consideration to the primary inventory problems of
(1) determining quantity and
(2) determining dollar value, which are discussed here and in the following two sections.
Classes of Inventories
In a merchandising business at the retail or wholesale level, inventories consist of goods held for sale in the same form as purchased and are designated merchandise inventory. A manufacturing business, in contrast, has several. types of inventories: finished goods, goods in process, and raw materials.
Finished Goods: Finished goods are completed products awaiting sale. All costs (i.e., those for raw materials, direct labor and manufacturing overhead) have been incurred. Finished parts of assemblies purchased or produced for use in the completed product, however, are classified as raw materials.
Goods in Process: Goods in process or work in process consists of partly completed goods. Generally, the cost of raw material, direct labor and manufacturing overhead applied to date can be identified and included in the cost of goods in process.
Raw Materials: Raw materials may be obtained directly from natural resources or from production. Thus, they may be produced by the company manufacturing the finished product or purchased as the finished product of another company. Raw materials cost includes the purchase price, freight, receiving, storage and/or other charges necessary to make the finished goods ready for use{ Factory supplies are auxiliary materials that do not become an integral part of the finished product, such as cleaning supplies, lubricating oils, and fuels.
Inventory Systems
The two principal systems for determining the inventory quantities on hand are the periodic system and the perpetual system. Both systems may be used simultaneously by companies with different classes of inventory.
The Periodic System: This system requires a physical count of goods on hand at the end of the period. A cost basis (i.e., FIFO, LIFO, etc.) is then applied to derive an inventory value. This system is widely used because it is simple and requires records and computations primarily only at the end of the period. It is not as useful as the perpetual system, however, in the planning and control of inventories.
The Perpetual System: This system calls for a continuous record of receipt and disbursement for every item of inventory. Physical counts of the quantities on hand are usually made at least once a year and reconciled to the perpetual records. Most large manufacturing and merchandising companies use the perpetual system to provide continuous control over the quantities and the investment in inventory. Adequate supplies are assured for production or sale and costly machine shut-downs and customer complaints are minimized.
Inventory Costing
Inventory cost includes all expenditures relating to inventory acquisition, preparation and readiness for sale. Any purchase discounts are treated as reductions in the cost of inventory. Accounting for inventory costs for goods in process and finished goods can be best accomplished by means of a good cost accounting system, a topic which will be treated in depth in later volumes of this series.
In a manufacturing company, the two primary methods for accumulating costs are (1) by job order and (2) by process or operation.
Job Order Cost System: This system is generally used by companies which manufacture a number of different products in limited quantities. The costs for each job are accumulated separately on a job order cost record and are included in goods in process until the job is completed. The completed job and its associated costs are considered finished goods until the job is sold. Examples of companies using job order cost systems are printing shops and construction companies.
Process Cost System: This system is used where large amounts of similar units are produced on an assembly-line basis. The controlling factor is the cost center or department. Costs of raw material, direct labor, and manufacturing overhead are accumulated by cost center rather than by individual job. The unit cost is obtained by dividing total costs by the quantity produced for the week, month, etc. Examples of companies using process cost systems are steel mills, paper companies, and other large-volume enterprises.
Special Inventory Items
While most items are included in inventory when received, the technical procedure is to recognize purchases when ownership changes or title passes. There are cases, however, where the legal rule must be modified because of special circumstances, some of which are described below.
Goods in Transit: Most goods are shipped f.o.b. shipping point, which means that title passes to the buyer when the goods are loaded on the carrier. When goods are shipped f.o.b destination, title does not pass until the shipment reaches its destination.
Goods on Consignment: When goods are shipped to dealers on consignnment, title does not change until the goods are sold by the consignee. Such goods are reported as inventory of the consignor (shipper) until the goods are sold and cash or an account receivable is obtained. The inventory cost includes all handling and shipping costs incurred in transferring the goods to the consignee.
Segregated Goods: When goods are produced on special order, title may pass at the time goods are segregated. At this point the vendor recognizes a sale and the goods are deducted from inventory. The purchaser records a purchase and an inventory increase when notice of segregation is received from the vendor.
Installment and Conditional Sales: In these cases, even though the buyer receives the merchandise, the seller retains title until the full sales price has been received. Technically, the seller should show goods transferred as inventory with an offset for the equity the buyer has built up through payments. Where the possibility of default is negligible, the seller usually waives his right and permits title to pass. However, there is usually a right to repossession of the product if the contract is not completed.
Cost Flow Methods
Since it is likely that during a specified time period a given item may be purchased at a variety of prices, it is necessary to determine which costs relate to units remaining in inventory and which costs relate to units sold. The concept of a cost flow refers to the entire flow of costs through the system, from purchase or production of goods to their sale. It does not involve the physical flow of goods, Because the value assigned to inventory has a direct effect on net income for both the current and subsequent accounting period, the objective in selecting a cost flow method is the matching of appropriate costs with revenue.
The main cost flow methods are: first-in, first-out (FIFO), last-in, first-out (LIFO), weighted average, and specific identification. They all resolve the basic costing problem: What is the combination of costs in the units on hand, and in the units shipped out?
