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Inventories

Inventories. Accounting for Inventories. Inventory, in accounting, refers to the capitalized cost of goods purchased for resale to customers. It thus includes the cost only of those goods owned by the firm. The term FOB defines when ownership transfers from buyer to seller

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Inventories

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  1. Inventories

  2. Accounting for Inventories • Inventory, in accounting, refers to the capitalized cost of goods purchased for resale to customers. • It thus includes the cost only of those goods owned by the firm. • The term FOB defines when ownership transfers from buyer to seller • Consigned goods are not owned. • The flow of physical inventory does not always follow cost flow. They are two distinct things. • As inventories are sold, the cost is removed from the balance sheet and expensed as “Cost of Goods Sold”

  3. How are Inventories valued on the Balance Sheet? • Cost? • Market? • Lower of cost or market?

  4. Analysis of Inventory Management • Inventory holding policies reflect the trade-off between the costs of holding inventory and the risk of losing sales from stock-outs. • Inventory holding costs include: • Storage costs • Financing costs • Risks of damage, obsolescence, etc.

  5. Analysis of Inventory Turnover and Liquidity • Inventory Turnover Ratio is the average rate at which inventories mover through the firm. • = COGS / average inventory held in the period • Days inventory is the same thing, stated a different way, i.e., 365/ Inv turnover

  6. Interpreting the meaning of the Inventory Turnover ratio • Very industry-specific • Typically a trade-off with net profit margin.

  7. Margin vs. Turnover

  8. Analysis of Inventory Turnover and Liquidity • High Inventory turnover might evidence • insufficient investment in inventory resulting in order backlogs and customer dissatisfaction. • A Successful JIT system in place • Low inventory turnover might signal • a problem with product obsolescence and/or unsuccessful marketing policies.

  9. How are Inventoriable Costs Expensed? • A problem occurs when costs vary across an item of inventory. The question is what costs should be expensed when?

  10. Example: • A firm buys 3 identical TV sets in a period of falling prices: • TV 1, purchased 1/15, cost $ 3,000. • TV 2, purchased 3/15 cost $ 2,500. • TV 3, purchased 5/15 cost $ 2,000. • If the firm sells one of these TVs on 6/30 for $ 5,000, what would it earn?

  11. FIFO vs LIFO • When prices are rising: • LIFO results in lower taxable income and lower inventory on the balance sheet • When prices are falling: • LIFO results in higher taxable income and higher inventory on the balance sheet.

  12. How are Inventoriable Costs Expensed? • The Options: • Specific ID (Cost and Physical flow remain linked) • LIFO (last cost incurred is assumed to be first out) • FIFO (first cost incurred is assumed to be first out) • Weighted average (ignores cost differences and assumes all inventory for a given item cost the same)

  13. The Interaction between Cost Flow Assumptions and Periodic vs Perpetual Inventory Systems • FIFO- No difference • Averaging- “moving average” under perpetual system. • LIFO- perpetual differs from periodic

  14. Issues that Drive Inventory Cost Flow Choices • Companies can choose any method. • Conformity rule: requirement to choose the same method for tax reporting purposes • Choice of method can thus be driven by management incentives and/or beliefs, or tax considerations, or both. • GAAP: Cannot switch back and forth every other period.

  15. In many countries: • LIFO is not allowed. • Why might that be?

  16. The problem of LIFO reserves: • The costs in old inventory layers become very outdated over time. • This causes the balance sheet to become more and more meaningless as to inventoriable cost. • In addition, if the firm ever liquidates the old layers, huge profits can be reported that are an artifact of LIFO, as opposed to true profitability

  17. Manufacturing Inventories • Manufacturers have three types of inventoriable cost: • Direct materials • Direct labor • Overhead • Of these, overhead is often the largest, and also the least connected to specific product production.

  18. Manufacturing Inventory • Manufacturers also have three types of inventory: • Raw material • Work-in-Progress • Finished goods

  19. Manufacturing Inventory • As good are made, and reach various stages of completion, costs flow into work-in-progress and then finished goods. Finally they are expensed. • Cost flow assumptions are made as these movements occur (LIFO, FIFO, etc.). • Hard-to-map costs (e.g., overhead) are allocated.

  20. Analysis of Inventory Management-Manufacturers • Very similar to retailers, but, because there are more steps, the accounting is more complex. • Because much of the cost is not directly traceable to production, there is also much more “allocating” and “assuming”. • A major question is how overhead is accounted for. • ABC (activity-based costing) was developed to improve inventory cost management for manufacturers.

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