It is important to identify the type of company you are working with in managerial accounting. Depending on the type of company, you will identify different costs and set up reports differently. There are three major types of companies we will deal with in this course:
- Service companies
- Merchandising companies
- Manufacturing companies
Service firms make up the largest business sector in the United States. Service companies are those that do not sell a physical product but instead provide services to their customers. Service firms include accounting firms, law firms, marketing firms, IT services firms, banks, dry cleaners, health care organizations, educational institutions and many other businesses we interact with on a daily basis.
One major difference between service companies and the other two types is that service companies do not have cost of goods sold because there is no product being sold. Service firms also do not have inventory, also because no physical product is being sold. There many be direct costs associated with providing the service, but no physical product.
Merchandising companies are those which sell products but do not make products. Merchandising companies are broken up into two different types: retailers and wholesalers.
Retailers sell products directly to the end user. Staples, Wal-Mart, Target, American Eagle, GAP, and Home Depot are all retailers. They sell products that consumers and businesses use, rather than resell.
Wholesalers buy products from manufacturers and sell them to other merchandising companies, usually retailers. For example, most small breweries will use a distributor to help get their beers into stores and restaurants. These distributors have established relationships with local stores and restaurants, making easier for small breweries to get their beers to the public. A distributor is a wholesaler. Wholesalers are sometimes referred to as “middlemen” because they act as an intermediary between a manufacturer and a retailer.
Merchandising companies purchase inventory (an asset) and sell that inventory. When inventory is sold, the asset is considered used up and the cost of that inventory is transferred from the balance sheet to the income statement as an expense. This expense is called cost of goods sold. For merchandising companies, the inventory account can also be referred to as merchandise inventory.
Manufacturing companies are companies that make make a product. Monster Beverages, Dell Computers, Boeing, and General Motors are all companies that produce a product. These companies use labor and machinery to turn materials into a product. Some manufacturing companies sell their products directly to the end user, like Boeing. Some companies like Dell, sell their product directly to consumers and to retailers. Monster Beverages and General Motors sell their products to retailers who sell the product to the end user.
All manufacturing companies have three different inventory accounts to account for the steps in the production process.
- Raw materials inventory – Raw materials are the components that companies use to produce their products. Don’t let the word “raw” lead you to think that this account is full of wood, plastic, metal or bolts of fabric. Many companies purchase components already manufactured and use them in their finished products. For example, Dell purchases processors from Intel to put in their computers. These processors are considered raw materials until those processors actually go into a computer. Raw materials are any materials that have not yet been used in the production process.
- Work-in-progress – Companies are continuously making products, which means that at the end of each day or week or month there are products that are not finished. These products have entered the manufacturing process but are not completed. Work-in-progress is inventory that has gone into the production process but has not yet been finished. Think of an aircraft at Boeing that does not have the seats or engines installed, but the rest of the plane is built. We cannot call this raw materials, but we also cannot say that it is finished. This plane would be considered part of work-in-process.
- Finished goods inventory – When a product is finished it is transferred to finished goods inventory. Typically when we think of inventory we think of finished goods inventory, the stuff that is ready to be sold to our customers. Once a product is classified as finished goods inventory, no additional costs can be added to the product. This is a very important concept when we start talking about types of costs.
Many companies do not fit neatly into one of these categories. For example, restaurants make a product (meals), sell products it does not make (wine and beer), and provides a service (serving the meal). These companies are considered hybrid companies. When classifying companies, make sure to consider that a company could fit into more than one of the categories above.
Considering the type of company you are working with can help you better identify the types of costs the company will incur, how those costs should be allocated and the types of reports that would be useful in the planning, decision making and controlling aspects of managerial accounting.
What is a warranty?
Most of the products we purchase come with some type of warranty. A warranty is guarantee that the manufacturer of the product will repair or replace the product for a certain period of time. In 2013, I bought my husband a Weber Smokey Mountain Cooker, because he likes to smoke meat and I like to eat smoked meat. It works out well for everyone! This product came with a 10-year limited warranty. That means that if something breaks because of a defect (not normal wear and tear or abuse), the company will replace the part that broke. This was not something that we purchased in addition to the product. It came with the product as part of the purchase.
Do not confuse standard warranties with extended warranties that consumers purchase for an additional fee.
Why must companies record a liability?
When a company provides a warranty with its product, the company has an obligation to repair or replace the product if it is defective. That obligation generates a liability at the time the product is sold because the company has a liability that starts when the product is sold.
When must the company record the warranty expense?
The matching principle states that a company must match revenue with expenses. If Weber sells a smoker in 2013 but expenses a warranty claim in 2020 (remember it is a 10-year warranty), the company is violating the matching principle. The warranty expense occurs because the sale took place. The expense is a cost of the sale and therefore should be matched with the revenue generated by that sale.
How does the company record an expense for a repair that has not happened yet?
It might seem a little strange to ask a company to record an expense when it hasn’t occurred yet but we have done this many times in accounting. Accounting requires the use of many estimates. Warranties are no exception. Remember when we recorded Bad Debt Expense under the allowance method and had to estimate the expense at the time of the sale? Warranty expense is very similar. We must estimate the expense based on previous company history and record the journal entry.
In order for a company to estimate the warranty expense and liability, we need to know three things:
- How many units of the product were sold during the period of time we need to record?
- What percentage of the products sold will need repairs or replacement based on previous experience?
- What is the average cost of the repair or replacement under warranty?
All of this information is readily available to managers and accounts within the company. To calculate the warranty expense, first figure out how many products will need repair or replacement:
Total number of units sold X Percentage of units that are defective
Next, calculate the cost of repair or replacement for those units:
Units needing repair or replacement X cost per unit to repair or replace
Let’s look at an example to see how a company would estimate and record warranty expense.
Hydration-on-the-Go makes stylish water bottles. Each water bottle includes a one-year warranty against manufacturing defects. Based on five years worth of data, the company estimates that 3% of the water bottles sold will be returned because of a defect. When this occurs the company replaces the water bottle. Each water bottle costs $4 to produce.
In 2013, the company sold 250,000 water bottles. Record the amount of warranty expense that the company should record for 2013.
To record the warranty expense, we need to know three things: units sold, percentage that will be replaced within the warranty period, and the cost of replacement.
First calculate the number of units the company believes will need to be replaced under warranty.
250,000 water bottles sold x 3% defect rate = 750 water bottles potentially defective
Next, calculate the cost of replacing those potentially defective water bottles.
750 water bottles potentially defective x $4 replacement cost = $3000 estimated warranty liability
That is all there is to it. Recording the expense and the liability as an adjusting journal entry.
Recording customer warranty claims
When a customer requests a repair or replacement under warranty, the customer files a claim. The company must record this claim. Every time the company fulfills a claim, a portion of the warranty liability is also fulfilled. In other words, every time a claim is fulfilled, the company must decrease the amount of the liability by the cost of fulfilling the claim.
There are a number of ways that the company can fulfill a claim. It can replace the item with an item from inventory, therefore decreasing inventory. The company could repair the product using parts from inventory and outside labor (which would require cash) or inside labor (wages payable). Always record the replacement or repair at cost, not at the retail value of the item or parts.
On February 1, Hydration-on-the-Go received 14 water bottles in the mail that had been returned by customers to be replaced under warranty. Each water bottle costs $4 to produce and sells for $9. Record the entry for fulfillment of the warranty claims.
The problem is asking us to record the warranty claim. When the company fulfills a warranty claim, we need to debit the estimated warranty liability. This is because part of the warranty obligation is being fulfilled. The amount of liability is decreasing.
Now to determine the account to credit. Ask yourself how how the liability is being fulfilled. How is the company fulfilling the liability in this case? The company is replacing the water bottle. Water bottles are the product that the company sells. They are inventory. Therefore, we will reduce inventory by the amount that the bottles cost. When we use inventory to fulfill the warranty liability, the value of inventory falls.
How much should we record as the cost of the water bottles? If we are removing them from inventory, we should remove them at cost. Therefore, use $4 per water bottle.
14 water bottles x $4 per water bottle = $56 cost of inventory
We have all the information we need to record the journal entry.
What Is a Weighted Average?
Most people know how to do a simple average, but have trouble with a weighted average. Weighted averages are all around us, although you may not have realized it. In most classes, your grade is calculated using a weighted average. Not all assignments count the same when calculating your final grade. Some assignments count more than others. Your professor is giving more weight to tests than to homework. Your final exam might have more weight than a regular exam.
In accounting, weight is given based on the number of units. Say we sold two units last month, one was $100 and one was $500. What is the average cost? $500 + $100 = $600 / 2 = $300. How would the average change if we sold two units at $100 and one at $500? The average would be closer to $100 because there are two units pulling the average down. $500 + $100 + $100 = $700 / 3 = $233.33. We gave more weight to the $100 units because there were more of them.
When dealing with large numbers of units, rather than adding them up individually, we can calculate the total cost of the units and divide by the total number of units. What if we had 20 units at $100 and 10 units at $500. You might notice that the ratio of $100 units to $500 units is still the same (2:1). Let’s do the calculation to confirm that the weighted average will be the same.
The total cost of all the units is $7,000 and there are 30 units. Divide $7,000 by 30 and the weighted average is $233.33.
Weighted Average Periodic
Weighted average periodic is probably the easiest of all the inventory methods. Since the calculation is done at the end of the period, we figure out the total cost of goods available for sale and divide by the number of units. It is helpful to separate the purchases from the sales.
Goods available for sale is 415 units with a total cost of $3,394.00. If we divide $3,394.00 by 415, we get a weighted average cost of $8.18 (rounded) per unit. The rest of the calculation is very simple at this point. The company sold 245 units. We will use $8.18 as the cost of each unit, therefore the total cost of goods sold is $2.004.10. There are 170 units remaining in ending inventory (415 – 245). We will use $8.18 as the cost of those units as well which gives is an ending inventory balance of $1,390.60.
If we add cost of goods sold and ending inventory, the total is $3,394.70. Because we rounded up when calculating cost per unit, we should expect our total to be a bit higher than goods available for sale. When doing weighted average, always make sure to tie back to goods available for sale.
Weighted Average Perpetual
If weighted average periodic is the easiest of all the methods, weighted average perpetual is the hardest. It is not that the method is hard, it is just annoying because you must calculate a new weighted average cost for each sale, based on the units available for sale at that time. When doing weighted average perpetual, do not separate the purchases and sales.
Perpetual inventory systems require cost of goods sold to be calculated each time there is a sale. Therefore, at the time of each sale, we must calculate the weighted average cost of the units on hand at the time of the sale. On January 7, the company sold 100 units. We must calculate the average cost of the 225 units on hand as of that date.
We calculate the average cost by taking total cost divided by the number of units on hand. This gives us a weighted average cost of $8.03 per unit. Does this make sense? The simple average would be $8.05, but there are twice as many units at $8.00, so the weighted average should be closer to $8.00 than it is to $8.10. Doing a mental check to make sure your numbers make sense is a great habit to start!
Now we can calculate the cost of the sale by taking the average cost per unit multiplied by the number of units sold.
Next, calculate the value of the remaining units. There are 125 units left. We will assign $8.03 per unit because that is the weighted average cost of those units on January 7. We will use this figure in the calculation for January 17. For the sale on January 17, we need to do another weighted average calculation.
Add the 50 units purchased on January 12 to the 125 units remaining and calculate the total cost of all those units. Then divide cost by the total number of units. The weighted average cost on January 17 is $8.09. The inclusion of the units costing $8.25 increased the weighted average cost slightly. Using $8.09 as the unit cost, calculate the cost of the sale.
Cost of goods sold for the January 17 sale is $525.85.
One more sale on January 31, so we need to do this calculation one more time. Start with the remaining units at $8.09 then add in the additional purchases.
Cost of goods sold for the January 31 sale is $660.80.
We can now calculate total cost of goods sold for the month of January by adding cost of goods sold for each sale.
The value of ending inventory is the number of units remaining multiplied by the average cost at the time of the last sale, in this case $8.26. Add cost of goods sold and ending inventory to see if it matches goods available for sale. In this case, there was some rounding so things may not be exact.
Be patient when doing weighted average, especially under the perpetual method. Tie back to goods available for sale to ensure you did your calculations correctly. Do a quick mental check to make sure your weighted average cost per unit makes sense. If you take a few seconds to do these things, you will greatly increase the chance that your calculations are correct.
Weighted Average Inventory Calculation
Last-in, first-out (LIFO) is an inventory method popular with companies that experience frequent increases in the cost of their product. LIFO is used primarily by oil companies and supermarkets, because inventory costs are almost always rising, but any business can use LIFO. Remember, there is no correlation between physical inventory movement and cost method.
To visualize how LIFO works, think of one of those huge salt piles that cities and towns keep to salt icy roads. The town gets a salt delivery and puts it on top of the pile. When the trucks need to be filled, does the town take the salt from the top or bottom of the pile? The trucks are filled from the top of the pile. The last delivery in is the first to be used. This is the essence of LIFO. When calculating costs, we use the cost of the newest (last-in) products first.
When costs are rising, LIFO will give the highest cost of goods sold and the lowest gross profit. LIFO will also result in lower taxes than the other inventory methods.
LIFO Using a Periodic Inventory System
For all periodic methods we can separate the purchases from the sales in order to make the calculations easier. Under the periodic method, we only calculate inventory at the end of the period. Therefore, we can add up all the units sold and then look at what we have on hand.
We sold 245 units during the month of January. Using LIFO, we must look at the last units purchased and work our way up from the bottom. Start with the 50 units from January 26th and work up the list. We would then take the 90 units from January 22nd, and 50 units from January 12th. That gives us 190 units. We are still 55 short, so we will take 55 from January 3rd.
The cost of goods sold for the 245 units, using LIFO, is $2,032.00. Now we need to look at the value of what is left in ending inventory. We have 20 units left from the January 3rd purchase and all the units from beginning inventory.
Gross profit (sales less cost of goods sold) under LIFO is $2,868.00. Under LIFO, our cost of goods sold is higher than it was under FIFO and our ending inventory is lower than under FIFO. Gross profit is lower under LIFO than FIFO, which would result in lower income taxes because overall profit would be lower.
Adding cost of goods sold and ending inventory gives us $3,394.00 which ties back to goods available for sale. Everything has been accounted for in our calculation.
Under a perpetual inventory system, inventory must be calculated each time a sale is completed. The method of looking at the last units purchased is still the same, but under the perpetual system, we can only consider the units that are on hand on the date of the sale.
Imagine you were actually working for this company and you had to record the journal entry for the sale on January 7th. We would do the entry on that date, which means we only have the information from January 7th and earlier. We do not know what happens for the rest of the month because it has not happened yet. Ignore all the other information and just focus on the information we have from January 1st to January 7th.
LIFO means last-in, first-out. Based on the information we have as of January 7th, the last units purchased were those on January 3rd. We will take the cost of those units first, but we still need another 25 units to have 100. Those units will come from beginning inventory.
The cost of the January 7th sale is $807.50. Now, we can move on to the next sale, updating our inventory figures. There are no units remaining from the January 3rd purchase and 125 left in beginning inventory. Before the January 17th sale, we purchased 50 units on January 12th.
We need 65 units for this sale. Since we are using LIFO, we must take the last units in, which would be the units from January 12th. Then we would take the remaining 15 units needed from beginning inventory.
One more sale remaining. Again, we will update the remaining units before considering the sale.
The company sold 80 units on January 31st. Which units should we use for cost using LIFO? The last units in were from January 26th, so we use those first, but we still need an additional 30. We take those from January 22nd.
To calculate total cost of goods sold, add the cost of each of the sales.
You could also add $807.50 plus $532.50 plus $673.00 which also equals $2,013.00.
You may have noticed that perpetual inventory gave you a slightly lower cost of goods sold that periodic did. Under periodic, you wait until the end of the period and then take the most recent purchases, but under perpetual, we take the most recent purchases at the time of the sale. Under periodic, none of the beginning inventory units were used for cost purposes, but under perpetual, we did use some of them. Those less expensive units in beginning inventory led to a lower cost of goods sold under the perpetual method. You will also notice that ending inventory is slightly higher. Look at the differences in the units that are left in ending inventory.
Under perpetual we had some units left over from January 22nd, which we did not have under periodic.
When using a perpetual inventory system, dates matter! Make sure to only consider the units on hand at the time of the sale and work backwards accordingly.
Calculating Cost Using First-In, First-Out (FIFO)
The First-In, First-Out method, also called FIFO, is the most straight-forward of all the methods. When determining the cost of a sale, the company uses the cost of the oldest (first-in) units in inventory. This does not necessarily mean the company sold the oldest units, but is using the cost of the oldest ones. When I think of FIFO, it reminds me of milk being sold at the grocery store. In most grocery stores, the coolers are built to allow staff to put the new milk in from the back, pushing the old milk forward, and encouraging shoppers to purchase the older milk (first-in) before the new milk.
When the cost of inventory is rising, FIFO will ensure that the older, less expensive inventory cost is transferred to Cost of Goods Sold. This creates a lower expense on the income statement and higher profit. Higher profit also leads to higher income taxes. Inventory on the balance sheet will be higher than when using other inventory methods, assuming costs are rising.
The wonderful thing about FIFO is that the calculations are the same for both periodic and perpetual inventory systems because we are always taking the cost for the oldest units.
All periodic inventory systems calculate inventory at the end of the period. Therefore, we are not concerned about which units are on hand when a sale occurs. When calculating any inventory method under periodic, it is best to separate the purchases from the sales.
We now have a much clearer picture of what happened during the month of January. Our goods available for sale (beginning inventory plus purchases) is 415 units or $3,394. We know we sold 245 units during the month. When using FIFO, we pick the units that were acquired first and use the cost of those units first. We keep picking units until we have accounted for the cost of all the units sold, in this case 245 units.
First we select the units from beginning inventory.
That gives us 150 of the 245 units we need. We still need 95 more units. We move to the first purchase on January 3.
Taking all the units from January 3 still leaves us 20 units short of the 245 units we need. We will take those 20 units from the 50 purchased on January 12.
We have now accounted for all 245 units sold and have determined that the cost of those units is $1,972.50. We sold the units for $4,900. Now we can calculate gross profit. Gross profit is sales less cost of goods sold. Gross profit tells us how much profit we are making off the sale of our product before all other expenses.
Our gross profit is $2,927.50. Remember that as prices rise, FIFO will give you the lowest cost of goods sold because the oldest and least expensive units are being sold first. This also gives us the highest gross profit.
Now to calculate ending inventory. Remember that ending inventory is what is left at the end of the period. The units from beginning inventory and the January 3rd purchase have all been sold. The company also sold 20 of the 50 units from the January 12 purchase. That leaves 30 units from that purchase and the units purchased on January 22 and 26.
Ending inventory contains 170 units with a value of $1,421.50. To ensure we accounted for all the units and their value, add cost of goods sold and ending inventory.
This agrees to our original goods available for sale. While this check figure will not ensure that you picked the right units, it will ensure that you accounted for all the units and calculated the cost correctly.
As stated previously, FIFO periodic and FIFO perpetual will give you the same result for cost of goods sold and ending inventory. However, with perpetual inventory systems we must be concerned with calculating cost of goods sold at the time of each sale.
When calculating using the perpetual systems, do not separate purchases and sales. At the time of each sale, we must consider what units are actually available to be sold. Only consider units that are on hand at the time of the sale. Look at the sale on January 7. What units are on hand on that date? The company has the units from beginning inventory and the purchase on January 3rd.
If we take 100 units out of inventory, we would take them from beginning inventory.
The cost of goods sold for the January 7th sale is $800. That would leave 50 units from beginning inventory and 75 from the purchase on January 3rd. Now we can move on to the next sale on January 17. Update the list of goods available for sale to reflect what was sold and the additional purchase on January 12.
The company sold 65 units on January 17. Using FIFO, we would take the first units in, taking 50 units left from beginning inventory and an additional 15 from the purchase on January 3rd.
The cost of the January 17th sale is $521.50. We have now used up all the units from beginning inventory and 15 of the units from January 3rd. Now let’s look at the last sale, again updating what is on hand as of that date.
The sale on January 31 of 80 units would be taken from the purchase on January 3rd and the purchase on January 12th.
The total cost of the sale is $651.00. We can now figure out the total cost of goods sold for the month by adding the cost of goods sold from each transaction.
Cost of goods sold for the month of January is $1,972.50. Notice this is the same as the cost of goods sold calculated until FIFO periodic. We can also calculate ending inventory, which is just the sum of what is left over.
If we add cost of goods sold and ending inventory, we get $3,394.00 which is our goods available for sale.
Remember that under FIFO, periodic and perpetual inventory systems will always give you the same cost of goods sold and ending inventory. This will only occur under FIFO.
When doing this by hand, I always cross out the number of units and write in the remaining amount. This is much faster than rewriting the list. Keeping track of the number of units remaining will help to ensure that you take your units from the correct date and calculate ending inventory properly.
FIFO Inventory Calculations
FIFO Inventory Journal Entries