Basics of Inventories

CFA Level 1 - Assets

INVENTORIES - BASICS

Inventory Processing Systems

Inventory-processing systems relate to the timing of the assessment of inventory. They can be valued on a continuous basis (physical count of inventory will be done after each sale) or periodically (physical count of inventory will be done at the end of each period). For most businesses, continuous revaluation of their inventory is too expensive and generates little value. As a result, most companies evaluate their inventory periodically.

The inventory-costing methods used relate to the way management has decided to evaluate the cost of their inventory, for example, specific identification, average cost, first in first out (FIFO), or last in first out (LIFO). The costing method will have an impact on the estimated value of the inventory on hand and the estimated cost of goods sold (COGS) reported on the income statement.

The valuation method is the process by which the inventory is valued. GAAP requires inventory to be valued at the lower of cost to market (LCM) valuation. Market valuation is defined as replacement cost. The choices made by management with the inventory- processing systems, the inventory-costing method and the valuation method used will affect what is reported on a company's balance sheet, net income statement (profits) and cash flow statement. All these choices should be driven by the application of the matching principle. Unfortunately, these choices are sometimes driven by the owner/management tax implications (usually among private companies), or by the intention to artificially increase a company's profitability (usually among public companies).   

Inventory Cost
Inventory cost is the net invoice price (less discounts) plus any freight and transit insurance plus taxes and tariffs. Inventory includes not only inventory on hand but also inventory in transit. Furthermore, inventory does not have to be a finished product to the included.The cost of inventory can be calculated based on:

1) the specific identification method,
2) the average-cost method,
3) first in, first out (FIFO),
and 4) last in, first out (LIFO)

GAAP allows management to use four methods to evaluate inventory. We will use the following example to illustrate each of these methods.

Example: Company ABC purchased these items in May, and sold item 102 and 103 for a total of $300:

 

1) The Specific-identification Inventory Method

Under this inventory method each unit purchased for resale is identified and accounted for by its invoice. Companies that use this method carry a small number of units.

Cost of goods sold: $75 (ID: 102 and 103)
Ending inventory: $55 (ID: 101 and 104)
Gross profit: $300-$75 = $225

2) Average-cost Method
Under this inventory method the units in inventory are considered as a whole and their cost is averaged out. Companies that use this method carry a large number of units.

Total cost: $130
Average cost: $33 per unit (total cost / total number of units)
Cost of goods sold: $66 ($33*2 units sold)
Ending inventory: $66 ($33*2 units left)
Gross profit: $300-$66 = $234

3) First-in, First-out (FIFO)
Under this inventory method the units that were first purchased are assumed to be sold first.

Cost of goods sold: $65 (ID: 101 and 102)
Ending inventory: $65 (ID: 103 and 104)
Gross profit: $300-$65= $235

4) Last-in, First-out (LIFO)
 Under this inventory method the units that were last purchased are assumed to be sold first.

Cost of goods sold: $65 (ID: 103 and 104)
Ending inventory: $65 (ID: 101 and 102)
Gross profit: $300-$65 = $235

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