As the cost of goods and services sold fluctuates, a company needs an accounting system that can keep track of products sold, the price of those products sold, and the cost to sell those products. In fact, recording and reporting the costs of doing business are the most important and fundamental functions of a working accounting system.
Purchasing Goods to Sell
Purchasing a product to resell and purchasing materials to supply a service are both examples of the cost of goods sold. This is a critical area that needs to be monitored by appropriate accounting procedures, as the original cost of a product to be sold helps determine the price of a product to the end consumer.
When a company purchases a product or material to sell, this is an expense that is recorded in an inventory asset account. An inventory asset account is exactly what its name describes: a listing of inventory, materials, or products the company has purchased to later sell as a whole or part of a product or service. When this expense is recorded in the inventory asset account, another entry will be made to either credit cash or credit accounts payable for this cost, as you would expect in the double-entry method of accounting.
Identified Cost of Inventory
It is important to be able to identify the value of a company's inventory at any given time, which is defined as the cost of inventory on hand. This cost is determined by what the company paid for the remaining inventory in stock, not what its marketable value is. Identifying the cost of inventory is an assumption that is made if you use the first in, first out method of business flow.
First In, First Out (FIFO)
First in, first out is a process that describes how a company acquires its materials to later resell to customers. In a nutshell, FIFO means that a company first purchases its inventory for a price and then later sells that inventory to the end consumer. The company tries to sell the old inventory before selling the newer inventory to the consumer. If a company cannot sell inventory, then that inventory is discarded. At any time, you can assume that a company's most up-to-date product would be in inventory behind older inventory as it tries to sell its older inventory first.
The FIFO method is used to determine the cost of goods sold. Everything is best understood through an example:
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Given the above entries, create a FIFO chart representing cost of goods sold:
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Date |
Quantity |
Item Cost |
Total AP |
Cost of Goods Sold |
Cumulative |
|
4/1 |
800 |
0.75 |
600.00 |
800 units |
|
|
4/8 |
1200 |
0.80 |
960.00 |
2000 units |
|
|
4/12 |
2800 |
0.83 |
2324.00 |
4800 units |
|
|
4/14 |
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|
0.84 |
1848.00 |
7000 units |
|
|
4/16 |
-800 |
0.75 |
600.00 |
6200 units |
|
|
4/16 |
-700 |
0.80 |
560.00 |
5500 units |
|
|
4/20 |
-500 |
0.80 |
400.00 |
5000 units |
|
|
4/20 |
-2500 |
0.83 |
2075.00 |
2500 units |
|
|
Total |
- |
- |
5732.00 |
3635.00 |
2500 units |
As you can see from the above illustration, as goods are sold, the first items purchased in the inventory are the first items that are sent out to customers, remaining true to the FIFO method of processing inventory. In the above example, we have 2,500 units left in inventory; and of those 2,500 units. 2,200 units were purchased at 84 cents a unit, and a remaining 300 units were purchased at 83 cents a unit.
Now, you could go crazy and try to itemize each individual purchase and sale and add them all up; however, it would be fine to journalize a summary of inventory purchased. In other words, you could journalize the above transaction as $5,732.00 to purchase 7,000 units for the month of April.
Last In, First Out (LIFO)
Last in, first out (LIFO) is also a method used to determine cost of goods in relation to inventory. This may seem like an odd method of determining cost of goods, but in fact, it is viable. Basically, instead of the first items purchased being the first sold, the items that come in last are immediately sold to customers. In theory, using the above example, as we replenish our inventory we may never use the original 800 units purchased. That is why some people refer to this method as FINO, or first in, never out.
Average Cost
Merchandising companies, as well as other forms of enterprises, deal with a collection of goods. This entire supply of goods is commonly referred to as an inventory.
Inventories, therefore, represent items that, either purchased or produced, are not immediately consumed. Inclusive within the inventory are goods that are being manufactured, as well as those that are already for sale.
Inventory usually takes into account goods that are in the process of being made and goods that are finished and ready for sale. Collectively, the type of goods made available for sale by a merchandising company is referred to as "merchandise inventory."
Upon receipt, items in inventory are initially recorded as an asset until made available for consumption or sale, at which time they are expensed. A "threshold" is the minimum amount of an item that must be on hand in order for it to be recorded as an asset.
With respect to inventories, "cost" refers to either the direct amount needed to acquire, develop, or construct inventories, or any costs directly attributable to the acquisition, development, or construction of a collection of merchandise.
Inventory Accounting: Out of Payables
The difference between businesses that deal in inventories and those that do not is that those with merchandise are unable to expense their items until they are "officially" sold.
During the interim, such items are accounted for within an inventory asset account. This means that these items come onto the ledger via way of payables. It is the responsibility of inventory accounting to get them out of payables.
There are different methods that accountants use to accomplish this task. Before the items are removed from payables, it is helpful to conduct an inventory processing wherein all items are accounted for based upon categorical checks.
While groupings can be set up according to any chosen system, some commonly used categories include purchased materials, inclusive of parts and materials; subassembly inventory, referring to semi-aligned parts and tools; and product inventory, inclusive of all end products.
In certain industries, there are many steps that go into formulating an end product. In these instances, it is possible to use what is known as a "percent completion" accounting method, wherein both materials and labor are associated with a particular job number.
Such items are then accounted for within an inventory account and periodically expensed based upon the percent of the job that is complete. The formula that explains this process is inventory/amount-cost of sales/amount. Once the job has been completed in its entirety and all of the costs for the job have been expensed, there should be nothing left sitting in inventory.
A Tale of Two Types of Inventory Accounting: Perpetual and Periodic
The two primary inventory accounting methods are perpetual and periodic.
Perpetual Inventory Method (PIM): This is an inventory accounting system whereby book inventory remains in continuous agreement with the amount of stock on hand, also called "continuous inventory." A daily record identifying both the dollar amount and the physical quantity of goods on hand, or inventory, is then reconciled against the actual physical counts conducted at intermittent intervals.
Periodic Inventory System: This is an inventory valuation method used in financial reporting in which a physical count of the inventory is performed at specific, set intervals. Basically, the periodic inventory method is only able to tally inventory counts at the following times: beginning of a period and when purchases are made. Initially, inventory items are recorded on the asset section of the balance sheet. Typically, small businesses use the periodic inventory system because it does not require bar codes and thus is more affordable than the PIM.
The most obvious distinction between PIM and the periodic inventory system is that in the former, the inventory account is adjusted continually throughout the accounting period, whereas in the latter, inventory transactions are recorded only periodically as opposed to continually.
Additional differences between the two types of inventory accounting methods include the following:
- PIM requires more record-keeping time.
- PIM currently is more prevalent because of the increased use of scanner devices, or bar codes.
- Even with employment of PIM, a periodic inventory count, typically conducted annually, is still necessary.
- The periodic inventory system cannot differentiate among goods sold and goods that are lost, destroyed, or stolen.
Inventory Valuations
When a business begins the process of taking inventory of the merchandise or items on hand, it can choose one of three methods in determining how to value the items:
1. Weighted average, also known as weighted cost: Weighted average takes the total cost of items within an inventory that are available for sale and divides that number by the total number of units available for sale. Most often, this average is computed at the close of an accounting period.
For example, let us say a business has five automobiles at $10,000 apiece and five automobiles at $20,000 apiece.
The weighted average method is then calculated in the following manner:
- Five automobiles at $10,000 each = $50,000
- Five automobiles at $20,000 each = $100,000
- Weighted average = $150,000 / 10 = $15,000
- $15,000 is the average cost of the 10 automobiles
2. FIFO: Quite literally, first in, first out is just that: The first automobiles received into inventory will be the first ones sold to customers. FIFO is based on the principle that most businesses tend to sell the first goods that come into inventory.
Yet, in truth, this concept applies better to perishable goods such as milk, eggs, etc., than non-perishable items like automobiles. The instances in which FIFO may apply to non-perishable items include the case of seasonal items that past a certain period may no longer be deemed as desirable.
3. LIFO: Again, this method follows a nearly literal translation of what the name implies; merchandise within this valuated category tends to adhere to the idea that the units most recently purchased will be the first units to be sold.
In the example of automobiles, the advantage of LIFO accounting is that typically the last ones purchased were acquired at the highest price. Thus, in attempting to sell the highest priced items first, a business is better able to reduce its short-term profit, thereby also significantly decreasing its associated tax costs.
