Inventory 2

Let’s have a quick look at… …… what we have done in the previous class.

… are assets : Held for sale in the ordinary course of business. Held in the process of such sale. Being used in the production of goods to be sold. Held in the form of materials or supplies that will be consumed in the production process, or in rendering services. Packing material for packing goods to be sold. Spares used in case of fixed assets whose use is not regular. Inventory…

To be brief, inventory includes… Raw Material Work-in Progress Finished Goods Spares Consumables Packaging Material

Flows of Inventory …A Retailer or A merchandiser Merchandise Purchases Cost of Goods Sold Merchandise Inventory Merchandiser

Flows of Inventory …A Producer or A Manufacturer Direct Labour Factory Overhead Raw Materials Inventory Work in Process Inventory Finished Goods Inventory Cost of Goods Sold Manufacturer Raw Materials

Where cost flows of Inventory have impacts?

Balance Sheet… Raw Materials Work in Process Finished Goods Balance Sheet: Assets Side Manufacturing Overhead Labour

Profit and Loss Account … Profit and Loss Account: Expenses Side Opening Stock Purchases and Production and Conversions Expenses Closing Stock COST OF GOODS SOLD Raw Materials Work in Process Finished Goods Raw Materials Work in Process Finished Goods

Impact of Inventory Flow… Beginning Inventory Purchases for the Period Ending Inventory (Balance Sheet) Goods Available for Sale Cost of Goods Sold (Income Statement) + +

When to record Inventory in books of accounts?

The General Rule is … … purchases should be recorded by the buyer when the legal title to the goods passes to the buyer. But, in some cases, it is difficult to determine when the legal title is passed to the buyer?

Exception to the General Rule… Goods in transit Goods received on approval basis Consigned goods

Now, let’s proceed further… Any question?

First, let’s check the understanding of what all we discussed in the previous class… Indicate which of the following items will be typically reported as inventory in the financial statements. Goods out on consignment at another entity’s store. Goods sold on installment basis. Goods purchased f.o.b. shipping point that are in transit on the closing day of the balance sheet. Goods held on consignment from another business. Temporary investments in bonds that will be sold in the near future. Materials on hand not yet placed into production process by the closing date of the balance sheet. Goods sold f.o.b. destination that are in transit by the closing date of the balance sheet. Office supplies – stationery Goods sent to another business firm on approval basis. LEARNING BY TESTING

What costs to be included in inventory?

General Rule… The cost of inventories should comprise all costs of purchase , costs of conversion and other costs incurred in bringing the inventories to their present location and condition.

COSTS OF PURCHASE… It includes… Purchase Price Duties and taxes (other than those subsequently recoverable by the enterprise from the taxing authorities) Inward freight and Insurance for goods-in-transit Other expenditure directly attributable to the acquisition. Cost of purchases includes all those expenses that are incurred to bring the raw material at the desired location.

COSTS OF PURCHASE… What it does not include… Trade Discounts and rebates. Duty Drawbacks, Duties and taxes subsequently recoverable by a firm from the taxing authorities. Trade Discount Vs. Cash Discount

COSTS OF CONVERSION … It includes all those expenses that are incurred to convert raw material into work-in-progress and finally, into finished goods. Such a cost is generally called CONVERSION COST. Conversion Cost includes… Direct Labour Cost Indirect Labour Cost (Production) Other fixed production overheads – Fixed or Variable.

COSTS OF CONVERSION … Costs of Conversion do not include… Storage Costs , unless those costs are necessary in the production process prior to a further production stage. Administrative Overheads that do not contribute to bringing the inventories to their present location and condition. Selling and Distribution Costs .

OTHER COSTS … Other costs are included in the cost of inventories only to the extent that they are incurred in bringing the inventories to their present location and condition.

Testing Understanding … Suggest which of the following will not be considered for the inventory costs… Cost of Insurance of warehouse. Cost of Spares used in production process. Cash Discount. Transportation costs to bring goods to warehouse. Insurance of goods-in-transit. VAT paid on the purchase of raw material. Paid to workers for packing of goods. Expenses related to heating of factory. Salary paid to CEO of the firm. Cost of issuing cheques to the vendors.

The issue of Inventory System is … … should we record transactions related to inventory INSTANTANEOUSLY or PERIODICALLY ?

If we record transactions related to inventory INSTANTANEOUSLY , then we are using a System of Inventory which is known as … PERPETUAL INVENTORY SYSTEM

And, if we are recording transactions related to inventory periodically then, it is called … PERIODIC INVENTORY SYSTEM .

Overview of Perpetual and Periodic Systems Perpetual system Inventory records are updated whenever a purchase or a sale is made. Advances in information technology have made the cost of using this system practical. Periodic system Inventory records are not updated when a sale is made.

Perpetual Inventory System It is a method of recording changes in inventories on a continuous basis in the Inventory Account. It provides a continuous record of the balances in both Inventory Account and Cost of Goods Sold Account. The affordability of the computerized accounting software have made the perpetual system of inventory cost effective for many kind of businesses.

Periodic Inventory System Under this method, some changes in inventories are record on periodic basis and thus, inventory balances and the cost of goods sold can be determined only on period basis. It provides a continuous record of the balances in both Inventory Account and Cost of Goods Sold Account. The affordability of the computerized accounting software have made the perpetual system of inventory cost effective for many kind of businesses.

Taking a Physical Count of Inventory The actual quantity on hand is determined by taking a physical count in case of periodic inventory system and a cost is attached to the quantity counted . With a perpetual system, closing balance of inventory can be taken from the Inventory Account and a physical count can reveal inventory shrinkage or clerical error .

How to find the Value of Inventory ?

The issue of Inventory Valuation requires… … an assumption about the flow of inventory so that we can judge the flow of cost of inventory!!!

Remember… Flow of physical inventory is difficult to know and hence, there is a need of making an assumption about the physical movement of inventory . And, according to the physical movement assumption , cost flow is presumed . In real life, the actual physical flow of inventory and the cost flow assumption are quite different.

COST FLOW ASSUMPTIONS … Four assumptions are made with regard to inventory cost flow: Specific Identification, FIFO , LIFO , and Average Cost .

Cost Flow Assumption #1 : Specific Identification

Specific Identification… In it, identify the movement of each and every item! When you buy record an item, record it in Inventory Account as a distinct item. It requires that when an item is sold, charge it against revenue as C ost o f G oods S old ( COGS ).

Specific Identification… This method requires no assumption about the flow of inventory units. This method is used when items: … are unique. … can be directly identified with a specific purchase and its invoice. … are relatively small in number. … are easily distinguishable.

Where Specific Identification Method can be used? Examples: Automobiles, custom furniture, some types of jewelry, art.

Cost Flow Assumption #2 : FIFO – F ast I n, F irst O ut.

FIFO … F irst I n, F irst O ut . The assumption about the flow of inventory made under FIFO is … The items are sold/issued in the order they are acquired. It means that an item received FIRST will be sold/issued FIRST. It means that the oldest units are sold and the newest units remain in inventory.

FIFO … F irst I n, F irst O ut . When a Sale/an issue occurs: The earliest units purchased are charged to Cost of Goods Sold . The cost of the most recent purchases remain in inventory .

Cost Flow Assumption #3 : LIFO – L ast I n, F irst O ut.

LIFO … L ast I n, F irst O ut . The assumption about the flow of inventory made under LIFO is … The items are sold/issued in the reverse order they are acquired. It means that an item received LAST will be sold/issued FIRST. It means that the newest units are sold and the oldest units remain in inventory.

LIFO … L ast I n, F irst O ut . When a Sale/an issue occurs: The LATEST units purchased are charged to Cost of Goods Sold . The cost of the OLDEST units remain in inventory .

Cost Flow Assumption #4 : Average Cost

Average Cost Method… Under this method, no specific assumption is made about the flow of inventory made. Cost of Goods Sold/Issued is computed by multiplying the number of units sold/issued by the average cost per unit. Average Cost is computed for all inventory available for sale during the period. Average cost per unit Cost of goods available for sale Number of units available for sale =

Inventory 2

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