Assets - Basics of Inventories

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

Effects of Misstated Inventory


Related Articles
  1. Fundamental Analysis

    Inventory Valuation For Investors: FIFO And LIFO

    We go over these methods of calculating this component of the balance sheet, and how the choice affects the bottom line.
  2. Professionals

    Inventory Analysis

    CFA Level 1 - Inventory Analysis. Learn how to calculate ending inventory balances and how unstable price environments cause costing methods to yield different results.
  3. Investing Basics

    How to Analyze a Company's Inventory

    Discover how to analyze a company's inventory by understanding different types of inventory and doing a quantitative and qualitative assessment of inventory.
  4. Investing

    Days Sales of Inventory

    Days Sales of Inventory, also called Days Inventory Outstanding, is a key financial measurement of a company's performance pertaining to inventory management. In simple terms, it tells how many ...
  5. Economics

    Explaining Carrying Cost of Inventory

    The carrying cost of inventory is the cost a business pays for holding goods in stock.
  6. Economics

    How to Calculate Average Inventory

    Average inventory is the median value of an inventory at a specific time period.
  7. Economics

    What is Involved in Inventory Management?

    Inventory management refers to the theories, functions and management skills involved in controlling an inventory.
  8. Fundamental Analysis

    Understanding Periodic Vs. Perpetual Inventory

    An overview of the two primary inventory accounting systems.
  9. Professionals

    Causes of Decline in LIFO Reserve

    CFA Level 1 - Causes of Decline in LIFO Reserve. Learn why a company's LIFO reserves might decline. Describes "LIFO liquidation" and its effects on profitability and COGS.
  10. Fundamental Analysis

    Reading The Inventory Turnover

    Inventory turnover is a ratio that shows how quickly a company uses up its supply of goods over a given time frame. Inventory turnover may be calculated as the market value of sales divided by ...
RELATED TERMS
  1. Highest In, First Out - HIFO

    In accounting, an inventory distribution method in which the ...
  2. Lower of Cost and Market Method

    A requirement of GAAP in the United States that inventory be ...
  3. Ending Inventory

    The value of goods available for sale at the end of the accounting ...
  4. Average Inventory

    A calculation comparing the value or number of a particular good ...
  5. Periodic Inventory

    A method of inventory valuation for financial reporting purposes ...
  6. Average Age Of Inventory

    The average number of days it takes for a firm to sell to consumers ...
RELATED FAQS
  1. How do you analyze inventory on the balance sheet?

    Learn how to analyze inventory using financial statements and footnotes by doing ratio analysis and performing qualitative ... Read Answer >>
  2. Why should investors care about the Days Sales of Inventory (DSI)?

    Learn about days sales of inventory and what it measures; understand why an investor would want to know a company's days ... Read Answer >>
  3. Why is it sometimes better to use an average inventory figure when calculating the ...

    For a couple of key reasons, average inventory can be a better and more accurate measure when calculating the inventory turnover ... Read Answer >>
  4. What are the generally accepted accounting principles for inventory reserves?

    As with most matters related to generally accepted accounting principles (GAAP), accountants assigned with the task of applying ... Read Answer >>
  5. What is the formula for calculating inventory turnover?

    Learn about the inventory turnover ratio, how it is calculated and what this efficiency metric tells businesses about their ... Read Answer >>
  6. How do I calculate the inventory turnover ratio?

    The inventory turnover ratio is a key measure for evaluating how efficient management is at managing company inventory and ... Read Answer >>
Hot Definitions
  1. Law Of Demand

    A microeconomic law that states that, all other factors being equal, as the price of a good or service increases, consumer ...
  2. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  3. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  4. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  5. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  6. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
Trading Center