CHAPTER 8 CONTROL OF INVENTORY INTRODUCTION ------------ Control of inventory is a major management problem in most businesses. You should try to answer the following questions: 1. How does inventory effect the profits of a business? 2. How do we value our inventory? Which estimate method should we use? 3. What is the effect on inventory valuation, cost of goods sold and net profits of various inventory methods? 4. How do we make sure that our inventory is sold at the correct price? 5. How do we prevent theft of our inventory? 6. How do we determine the inventory price? COST OF GOODS SOLD ------------------ Inventory represents the cost of goods owned by a business for sale to customers. The cost of inventories must be matched against the revenues that they help produce. GOODS AVAILABLE FOR SALE consist of the beginning inventory and current net purchases. One of two things can happen to goods available to be sold: 1. they are sold or 2. they are not sold and remain in inventory. BEGINNING / INVENTORY SOLD- INVENTORY GOODS / COST OF GOODS SOLD AVAILABLE / + = FOR \ SALE \ INVENTORY NOT SOLD- NET \ ENDING INVENTORY PURCHASES As it can be seen, the cost of inventory (available for sale) is allocated between COST OF GOODS SOLD ( AN EXPENSE) and ENDING INVENTORY (an asset). The typical COST OF GOODS SOLD section of the income statement appears as follows: Cost of Goods Sold Beginning Inventory $ 10,000 Purchases $5,400 Less Returns & Allowances 400 ------ Net Purchases 5,000 ------- Goods Available for Sale 15,000 Less:Ending Inventory 3,000 ------- Cost of Goods Sold $ 12,000 This format also reveals another point. Whatever is not found in ending inventory is presumed to have been sold. Of course, this ignores the fact that other things can happen to inventory such as shrinkage, which refers to losses from activities such as shoplifting. COST FLOW ASSUMPTIONS --------------------- When goods are sold, the cost of the goods sold must eventually be identified and recorded. If the specific cost of goods can be identified (such as in high priced items-autos etc.), determining the cost of goods sold presents no major problem. However, specific identification is often not possible. For example, if a company makes several purchases of identical widgets during the year at different prices, it is unlikely that the costs of any single widget sold to a customer will be identifiable from the other identical widgets that remain in inventory. Accounting methods to attach costs to inventory items use cost flow assumptions, rather than the actual physical flow. Four alternative cost estimating methods are 1. first-in, first-out,2. last-in, first-out, 3. average cost, and 4. specific identification. PERIODIC INVENTORY SYSTEM ------------------------- The periodic inventory method involves taking a physical inventory count when you wish to prepare a financial statement. Let us assume the following information: ============================================================== Beginning inventory 100 $ 5.00 $ 500 Purchases Nov. 2 200 5.10 1020 Nov 10 100 5.20 520 Nov 15 300 5.30 1590 Nov 20 200 5.50 1100 Nov 30 400 6.00 2400 ---- ----- Goods Available for sale 1300 7130 Less Ending Inventory 500 ----- Items Sold 800 ============================================================= USING AVERAGE COST METHOD-PERIODIC SYSTEM ------------------------- Referring the example above, the average cost method would be calculated as follows: Cost of goods available for sale 7130 -------------------------------- = ------ = 5.4846 Units available for sale 1300 Thus the ENDING INVENTORY would be valued at: number of units in ending inventory X average cost per unit 500 X 5.4846 = 2742.32 AND the COST OF GOODS SOLD would be valued at: number of units sold X average cost per unit 800 X 5.4846 = 4387.68 NOTE that the ending inventory plus the cost of goods sold must equal the total cost of goods available for sale, OR an error has been made. 2742.32 + 4387.68 = 7130 THE FIRST-IN, FIRST-OUT METHOD OF ESTIMATING -PERIODIC SYSTEM -------------------------------------------- This method assumes that the units sold are the first units, that is, the beginning inventory plus the first purchases. Thus the ending inventory is the last units purchased. In the above example: THE UNITS SOLD ARE 800 UNITS AS FOLLOWS: Beginning inventory 100 5.00 500 purchases: Nov 2 200 5.10 1020 Nov 10 100 5.20 520 Nov 15 300 5.30 1590 Nov 20 100 5.50 550 ----- ----- 800 4180 Cost of Goods Sold ----- THE COST OF THE ENDING INVENTORY IS: Last purchases: Nov 20 100 5.50 550 Nov 30 400 6.00 2400 ---- ----- 500 2950 Cost of Ending Inventory ----- CHECK RESULTS Remember the Cost of Goods Sold plus the Ending Inventory must equal the total cost of goods available for sale. 4180 + 2950 = 7130 LAST-IN, FIRST-OUT METHOD OF ESTIMATING-PERIODIC SYSTEM -------------------------------------- This method of estimating the cost of goods sold and the ending inventory assumes that the first units sold will be the last units purchased. Using the same example above the results are: Cost of Goods Sold Nov 30 400 6.00 2400 Nov 20 200 5.50 1100 Nov 15 200 5.30 1060 ----- ----- 800 4560 Cost of goods sold ----- Cost of Ending Inventory Beginning inv. 100 5.00 500 Nov 2 200 5.10 1020 Nov 10 100 5.20 520 Nov 15 100 5.30 530 ---- ---- 500 2570 Cost of Ending ---- Inventory CHECK RESULTS 4560 + 2570 = 7130 COMPARING THE RESULTS OF THE VARIOUS METHODS -------------------------------------------- Cost of Goods sold Ending Inventory ------------------ -------------- Average cost 4388 2742 First-in,First-out 4180 2950 Last-in, First-out 4560 2570 It is important to understand that the Last-in, First-out method has provided the largest Cost of Goods Sold and as a result the smallest net profit. In a period of rising prices (as our example) the Last-in, First-out method will provide the highest Cost of Goods Sold and smallest net profit. In a period of declining prices the opposite will result, that is, the Last-in, First-out method will provide the lowest cost of goods sold and the highest net profit. PERPETUAL INVENTORY SYSTEM -------------------------- The PERIODIC INVENTORY METHOD ignores the dates of purchases and dates of sales and treats them as though the dates were the same. The PERPETUAL INVENTORY SYSTEM is a computerized system which immediately processes the transactions as they occur. Therefore the date of purchases and date of sales are taken into consideration. The method selected is calculated as of the date the transaction occurs . Note how this approach makes a real difference. Assume the same data as presented above but note the inclusion of the dates of the sales. THE AVERAGE COST METHOD-PERPETUAL SYSTEM ----------------------- ================================================================= Average Unit units cost cost dollars sales Beginning inventory 100 $ 5.00 $ 500 purchase Nov 2 200 5.10 1020 --- ---- Balance 300 5.66 1520 sale Nov 3 200 5.66 1013 1013 --- ---- Balance 100 5.07 507 purchase Nov 10 100 5.20 520 purchase Nov 15 300 5.30 1590 --- ---- Balance 500 5.23 2617 sale Nov 18 200 5.23 1047 1047 --- ---- Balance 300 5.23 1570 purchase Nov 20 200 5.50 1100 --- ---- Balance 500 5.34 2670 sale Nov 21 400 5.34 2136 2136 --- ---- Balance 100 5.34 534 purchase Nov 30 400 6.00 2400 ---- ---- ----- ----- Balance 500 5.87 2934 4196 As calculated above the ending inventory cost is $2934 and the cost of goods sold is $4196 using the average cost method. FIRST-IN, FIRST-OUT METHOD-PERPETUAL SYSTEM -------------------------- Referring to the information above, the COST OF GOODS SOLD is: Cost of goods sold on Nov. 3- 200 units 100 units at 5.00 = 500 100 units at 5.10 = 510 --- 1010 Cost of goods sold on Nov 18- 200 units 100 units at 5.10 510 100 units at 5.20 520 ---- 1030 Cost of goods sold on Nov. 21-400 units 300 units at 5.30 1590 100 units at 5.50 550 ---- 2140 ---- Total Cost of Goods Sold (FIFO) 4180 Referring to the above example the ENDING INVENTORY is Ending Inventory 400 units at 6.00 2400 100 units at 5.50 550 ---- 2950 ---- Check method: Cost of Goods Sold + Ending Inventory = Goods Available for Sale 4180 + 2950 = 7130 LAST-IN, FIRST-OUT METHOD-PERPETUAL SYSTEM ------------------------- Cost Available per Units Sale unit total Beginning inventory 100 $5.00 $ 500 Purchases-Nov 2 200 5.10 510 Sale -Nov 3 200 Purchase -Nov 10 100 5.20 520 -Nov 15 300 5.30 1590 Sale -Nov 18 200 Purchase -Nov 20 200 5.50 1100 Sale -Nov 21 400 Purchase -Nov 30 400 6.00 2400 ---- --- ---- Goods Available 1300 7130 Sales-units 800 Referring to the above information, the Cost of Goods Sold using the LIFO method would be calculated as follows: Sale- Nov 3 - 200 units 200 units at 5.10 (purchased Nov. 2) 1020 Sale- Nov 18 -200 units 200 units at 5.30 (purchased Nov. 15) 1060 Sale- Nov 21 -400 units 200 units at 5.50 (purchased Nov. 20) 1100 100 units at 5.30 (purchased Nov. 15) 530 100 units at 5.20 (purchased Nov. 10) 520 ----- COST OF GOODS SOLD-Last-in,First-out Method 4230 ----- The cost of the Ending Inventory would be calculated as follows: 400 units at 6.00 (purchased Nov. 30) 2400 100 units at 5.00 (beginning inventory) 500 ---- COST OF ENDING INVENTORY-Last-in,First-out Method 2900 ---- Check Method Cost of Goods Sold + Ending Inventory = Cost of Goods Available 4230 + 2900 = 7130 THE GROSS PROFIT METHOD ----------------------- Generally it is necessary to take a physical inventory count at least once a year. If we do not want to take an inventory count each month we can estimate our ending inventory using the GROSS PROFIT METHOD. Most firms have a gross margin (gross profit) percentage that remains stable. Therefore the firm's gross margin percentage from previous years can be used to estimate the gross margin for the current year. Assume the following. The book store has had a gross margin percentage of 25% in the past. This month the sales are $100,000, the beginning inventory was $ 10,000, the net purchases for the month are $ 85,000. What is the ending inventory? The known facts may be summarized as follows: Sales $100,000 Cost of Goods Sold Beginning Inventory $10,000 Net Purchases 85,000 ------- Goods Available for Sale 95,000 Less:Ending Inventory ? ------ Cost of Goods Sold ( 75 %) ? -------- Gross Margin (25 % of sales) $ 25,000 How do we calculate the unknowns above? The following formulas apply: Sales - Cost of Goods Sold = gross margin Therefore Sales + Cost of Goods Sold + gross margin Since Sales = 100%, and gross margin = 25 % Cost of Goods Sold = 100 % - 25% = 75 % Cost of Goods Sold = $100,000 X 75% = $75,000 Since Goods Available for Sale - Ending Inventory = Cost of Goods Sold then Goods Available for Sale - Cost of Goods Sold = Ending Inventory 95,000 - 75,000 = 20,000 Therefore we can conclude that if our sales for the month are $100,000, then our Cost of Goods Sold will be $75,000 and our Ending Inventory will be $20,000 in this example. If our company's gross margin tends to be approximately the same, we can use the GROSS MARGIN METHOD to estimate our Ending Inventory each month and then take a physical inventory at the end of the year. THE RETAIL INVENTORY METHOD --------------------------- Retail stores,such as grocery stores, can take a physical inventory using an optical scanner and entering the number of items of that type into a portable keyboard recorder. This data is then processed by the computer to print out an inventory report listing the inventory items , their retail price and the extension (price times number of units). Or if we do not have a computerized system, we can take a physical inventory by hand and make the extensions by hand. Assume the following example: Cost Retail Beginning Inventory $10,000 $ 13,333 Net purchases 95,000 126,666 Freight-in 100 ------ ------- Goods Available for Sale 105,100 139,999 Ratio of cost to retail $105,100 ------- = .75 or 75 % $139,999 Less:Net sales during month 100,000 ------- Ending Inventory at Retail 39,999 Ratio of Cost to Retail .75 ------- Ending Inventory at Cost 29,999 ------- There are various methods of estimating the ending inventory and cost of good sold. Each firm will select the method that is best for that type of business. THE INVENTORY SYSTEM --------------------- The Inventory System is designed to provide the information required by management to properly manage inventory. The MAIN MENU of the inventory system provides the following options: ================================================================= I N V E N T O R Y S Y S T E M SELECT OPTION 1 OR 2 FIRST 1 = TO READ INTO MEMORY INVENTORY FILE INFORMATION 2 = TO ENTER OR CHANGE AN INVENTORY RECORD 3 = TO RETRIEVE OR CHANGE INVENTORY ITEM BY INVENTORY CODE 4 = TO PRINT OR WRITE INVENTORY FILE 5 = TO READ INTO MEMORY OLD TRANSACTION FILE 6 = TO ENTER INVENTORY SALES 7 = TO ENTER INVENTORY PURCHASES 8 = TO PRINT OR WRITE TRANSACTION FILE 9 = TO LIST INVENTORY ON HAND AND COST REPORT 10= TO LIST INVENTORY GROSS PROFIT REPORT 11= TO ZERO OUT SALES PURCHASES LOCATIONS IN FILE 12= TO LIST OR PRINT INVENTORY REPORT 13= TO EXIT SELECT OPTION (1-13)? 2 SELECT OPTION 1 = CHANGE RECORD 2 = ADD NEW RECORD 3 = EXIT ENTER OPTION (1,2,3)? 2 ADD NEW INVENTORY RECORDS RECORD # IS 1 ENTER INVENTORY DESCRIPTION (20 CHARS) ? ADHES SPOTS 7/8" RD ENTER SIZE ? EA ENTER INVENTORY CODE ? 95 ENTER COST PER UNIT ? .56 ENTER PRICE PER UNIT ? 2.91 ENTER PURCHASES IN UNITS ? 100 ENTER BEGINNING INVENTORY IN UNITS ? 74 ENTER TOTAL COST ? 97.44 ENTER TOTAL SALE IN DOLLARS ? 00 IS INPUT CORRECT (Y/N)? Y ================================================================= The Inventory System creates two data files, the Inventory Master File and the Inventory Transaction File. The user will proceed through the following steps: PART 1. INITIAL CREATION OF DATA FILES. 1. Enter your inventory information as prompted ;by selection option 2 from the menu. 2. Save your inventory file on a disk by selecting option 4. 3. Print inventory file for future reference by selecting option 4. 4. Proofread your printout. If errors exist selection option 3 or 2 to retrieve the inventory record by inventory code or by record # to make corrections. 5. Repeat steps 2 and 3 for the corrected inventory files. PART 11 DAILY, WEEKLY, OR MONTHLY ROUTINE 6. Select option 1 to load your inventory file into the computer memory. 7. Enter your sales for the day, week, or month by selecting option 6. 8. Enter your inventory purchases for the day, week, or month by selecting option 7. 9. Save your transaction file by selecting option 8. 10. Save your Inventory Master File by selecting option 4. 11. Print your inventory on Hand & Cost Report by selecting option 9. 12. Print your Inventory Gross Profit Report by selecting option 10. 13. Print your Inventory Report by item by selecting option 12. At this point you have gone through the complete cycle of inventory processing. Option 11 would not ordinarily be used unless you wished to start over due to gross errors. END