If you are operating a business that sells physical goods and requires accounting for inventory, you’re probably wondering how best to record your inventory figures. After all, your net income will be impacted by the costs included and the inventory valuation method that you choose.
What is included in the cost of inventory?
The cost of an inventory is not simply the price that you purchased the item at. Inventory costs can include other costs that are associated with purchasing the product, such as transport and conversion.
Other costs include: import duties, transport fees, handling and a deduction based off trade discounts, rebates and price reduction.
The expenses involved in conversion refers to the costs that are incurred when bringing the inventory to its current condition and ready for sale. There are two main types of costs: fixed and variable. The variable expenses include those that are directly correlated with the production of the goods, such as direct labor and materials. Fixed expenses stay the same, whether a small or a large quantity of goods are produced. These include utilities, production manager salaries, property taxes of the factory, and equipment depreciation.
The fixed overhead expenses associated with the production of inventory are allocated amongst each unit. The important part of overhead cost allocation is that there is a rational and logical manner upon which these expenses are divided. For instance, overhead costs could be allocated for units according to the ratio of direct labor hours used for each type of product. Or, they could be allocated according to the raw materials costs associated with each good, for instance.
You may choose to include small parts and servicing equipment in the inventory category on the balance sheet and expense them as used in the income statement. However, if they are large equipment or spare parts, they may need to be classified under property, plant and equipment instead.
Expenses that are related to inventory, but not to its production, should not be included in inventory costs. Instead, they should be categorized separately as expenses on the income statement. Such costs include storage, selling costs and abnormal amounts of materials, labor and other such production expenses that have been wasted.
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Inventory Valuation Methods
When choosing which method to use, it is best to consider your business needs and which method makes the most sense. Accounting for inventory should be done so that they most closely match the costs and revenues that you incur in your business.
The following are the different valuation methods, with a description on their usage.
The specific item inventory valuation refers to recording inventory by each individual item. For instance, let’s say you run a business selling motorcycles. If you sell a motorcycle costing $28,000, you would decrease the inventory asset in the balance sheet by this amount and record it under cost of goods sold (COGS). The specific item method is best used for items that are large and vary in price. Under International Financial Reporting Standards (IFRS), you are required to use this method if you are selling products that are unique to one another and not interchangeable.
Like its name denotes, average cost is determined by the average cost of your inventory goods. One price point is used to account for various items that are moving in and out of your business. There are two types of systems to calculate average cost: the periodic system and perpetual system.
The periodic cost is calculated only at certain periods in time when a physical inventory count is performed. The equation is: beginning inventory cost+total current period purchase costs, divided by the number of units in beginning inventory and units purchased during the period. It is the weighted average unit cost used to allocate costs to inventory at the end of the period and COGS.
The perpetual cost is calculated every time a unit is sold. The average unit cost is “moving”, or computed to create a new average cost after each product is sold. Businesses that use the perpetual system likely have an information technology system to aid in accounting for inventory levels.
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First In First Out (FIFO)
Using this method, the cost of goods sold is calculated under the assumption that the beginning inventory and oldest purchases are sold first. The ending inventory is calculated using the more recent purchases. This method can impact the inventory amount on the balance sheet and COGS on the income statement. If the prices of inventory are rising, the amount of COGS is lower, resulting in a higher net income. The inventory on the balance statement is higher to reflect the prices of more recent purchases. The opposite is true for prices of inventory that are dropping.
Last In First Out (LIFO)
Unlike FIFO, LIFO is calculated under the assumption that the most recent purchases were sold first. The ending inventory is calculated using the oldest units on hand. LIFO has the opposite effect on the financial statements as FIFO. When the prices of inventory are rising, COGS is higher, which lowers net income. The inventory on the balance sheet is lower to reflect the prices of older purchases. The opposite is true when inventory prices are rising.
Unfortunately, this method not permitted as per IFRS. It is seen as a method of adjusting net income, since COGS changes according to whether a company uses FIFO or LIFO. LIFO is also not permitted for income tax purposes.
Lower of Cost and Net Realizable Value (NRV)
Under this valuation method, you determine the cost of your inventory by recording it at the lower of either its cost or its net realizable value. Net realizable value is the estimated selling price in the ordinary course of business, minus the estimated expenses of completion and estimated expenses needed in order to make the sale. In order to use net realizable value, you must assess items individually, or assess a group of similar items. The value of the items should be reassessed every reporting period. A write down will be reverse in the period if the net realizable value of the item increases.
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