Inventory

Calculating Inventory Cost

Inventory costs are constantly changing. Companies must decide how inventory costs will be calculated for the purposes of expensing that inventory when it is sold. There are a number of accepted methods and the method of calculation does not have to match how products actually leave the building. Companies pick a method based on profit and tax objectives. We will look at four methods of calculating costs and the advantages and disadvantages of each method.

Important Terminology

There are a number of important terms that will be used when discussing inventory cost. It is crucial that you know this terminology in order to master this topic. All of these terms can be used to describe a dollar value or a number of units.

Beginning inventory is the amount of inventory a company has at the start of the period. Remember that inventory is an asset and appears on the balance sheet. Purchases are additional units of inventory that have been acquired during the period. If you add beginning inventory and purchases, the total is called Goods Available for Sale. Goods Available for Sale is an important concept because we can use this figure as a check figure when doing calculations.

Goods Available for Sale is the total of all the goods that could have been sold during the period. Some of those units will be sold, which is called Cost of Goods Sold. The items that were not sold are still in inventory. Since it is the end of the period, we refer to this as Ending Inventory. If you add cost of goods sold and ending inventory, it should match the amount in Goods Available for Sale. Whenever you are doing calculations involving inventory, you should make sure you have accounted for everything by adding Cost of Goods Sold and Ending Inventory to ensure it matches Goods Available for Sale.

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Periodic and Perpetual Inventory

The rules for periodic and perpetual inventory methods still apply when we look at cost determination. Remember that under the periodic inventory system, cost of goods sold is determined at the end of the year via an adjusting entry. Therefore, when entering sales entries, inventory and cost of goods sold is not a factor. Companies that use the perpetual inventory system are always updating inventory balances. Every sales transaction includes the entry for cost of goods sold. Therefore, under the perpetual system, we must figure out the cost of inventory for every sales entry.

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What Is a Discount?

We all love discounts, but why would a business offer offer a discount on their products? Typically, a business might offer a discount to increase sales, make an unhappy customer happy or incentivize a customer to pay quickly.

Understanding Payment Terms

Typically when customers purchase inventory, they are not expected to pay cash. The seller extends credit to the buyer, but extending credit comes at a cost for the seller. The seller does not have the cash and therefore must pay its bills from other sources, either cash reserves or borrowing. The seller may lose out on interest earned on cash reserves or possibly even pay interest on loans or lines of credit. In order to decrease the time a receivable is outstanding, a company may offer a discount for fast payment. When a company offers this type of discount, it is listed in the payment terms on the bill:

Payment terms: 2/10, n/30

What does this mean? Well, first notice the comma. That means there are two parts to the payment terms. So let’s look at each part, starting with 2/10. This does not mean that the bill is due on February 10. It means “2% discount if paid in 10 days”. Therefore, if the date of the bill is February 15 and you pay the bill on or before February 25, you get a 2% discount off the balance due. What happens if you don’t pay in the first 10 days? For that, we have to look at the statement after the comma: n/30. The “n” in the statement stands for net. So the statement tells us that the net, or entire, amount is due in 30 days. Taking it all together, the statement is as follows:

Payment terms: If paid within 10 days, we will give you a 2% discount, or you can pay the full balance within 30 days.

Can you see why businesses prefer 2/10, n/30? Takes up a lot less space on a bill. What happens if you don’t pay with bill within 30 days? After 30 days, your payment is now late and the seller can add on late charges or interest, depending on state law.

Let’s look at some examples using payment discounts.

Example #1:

Medici Music purchased instruments to sell in its stores from Whistling Flutes, LLC on August 13. The total purchase was $5,000 with terms 3/10, n/30. Medici paid for the purchase on August 20. Record the necessary journal entries for Medici Music.

The first step is to break down the information. Medici purchased inventory for $5,000 on August 13 and paid the bill on August 20. Looks like we have two transactions. Wait! We are dealing with inventory. Have you realized we are missing something? If not, take a second to see if you can figure it out. <Insert Jeopardy theme here> Is Medici using periodic or perpetual inventory? Remember, we are about to record an entry dealing with the movement or change in value of inventory! I know we are talking about payments here but we are still talking about inventory. That trumps the payment discussion!

We will look at this transaction under both methods so you can see the difference. Before we start looking at each method, let’s start by discussing what is the same under each of the methods. We have two transactions. The first transaction deals with the purchase of the inventory. The second transaction deals with the payment for the instruments already received.

When working with discounts, we generally calculate the discount and record it at the time of payment. Some textbooks may show you two different methods for recording the discount, one in which the discount is recorded at the time of the purchase and one where the discount is recorded at the time of the payment. I prefer the second method. When you record the discount at the time of the purchase and the discount is not taken because the buyer does not pay within the discount window, we must alter the payment entry to undo the discount taken in the first entry. By recording the discount at the time of the payment, we are only recording a discount that has actually been taken and we never need to undo something from the first entry.

Perpetual Inventory

First, we need to record the entry to show the purchase of the inventory.

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Notice that we used Inventory, because under the perpetual method, whenever the value of inventory is changing, we must show that change in the account.

Now let’s look at the second transaction. We are paying off what is owed but we are receiving a discount. We must show the accounts payable fully paid off, so we must debit Accounts Payable for $5,000. How are we paying the balance? With cash, so we must credit Cash for the amount of cash being paid. Because of the discount, the amount will be less than $5,000. If we take 3% of $5,000, we calculate the discount as $150. Therefore, the amount of cash needed to fulfill the obligation is $4,850.

What do we do with the $150? Remember the rules for perpetual inventory. If the value of the inventory is changing, we need to target the inventory account. Is the value of the inventory changing? Currently, we have $5,000 in the Inventory account for this purchase. Did we actually pay $5,000 for the inventory? Well, no, we didn’t. We actually paid $4,850 for the inventory. Therefore, the value of the inventory is not $5,000 but $4,850. We need to reduce the value of the inventory by $150 to reflect the discount received. Now, we have all the information we need to complete the second entry.

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Now the process is complete. The Accounts Payable balance is now zero and the Inventory balance is $4,850 which matches what we actually paid for the inventory.

Periodic Inventory

Under the periodic method, we do not update the value in the inventory account until we do the adjusting entries at the end of the period. Therefore, we should never use the inventory account in purchase transactions for companies that use the periodic method. Instead, we use the purchases account.

Let’s look at the first entry.

DISC3

Pretty similar to the perpetual method, except for the use of the purchases account. The second entry will also be similar to the perpetual method, except for one difference. Can you figure out what that difference would be?

We will not be using the Inventory account. Instead we will use an account related to the Purchases account. We do not use the Purchases account because we want to preserve the balance in that account, in case we need to match it up with purchase documents. In order to preserve the original balance in the Purchases account, we will use a contra account. A contra account is an account that is linked to an account but acts in the opposite way. It acts contrary to the account it is linked to. Since Purchases has a normal debit balance, the contra account will have a normal credit balance because it will be used to decrease the value in the Purchases account. The account we will use is called Purchase Discounts (very tricky, huh?). Here is the entry:

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The Sales Side

So far, we have looked at the purchase side of the transaction. What about the sales side? Let’s look at our original example again. This time, we will look at it from the seller’s perspective.

Example #2:

Medici Music purchases instruments to sell in its stores from Whistling Flutes, LLC on August 13. The total purchase was $5,000 (with a cost of $3,000), terms 3/10, n/30. Medici paid for the purchase on August 20. Record the necessary journal entries for Whistling Flutes, LLC.

When recording sales transactions, we still must be concerned with whether the company uses perpetual or periodic inventory. We will review perpetual inventory first.

Perpetual Inventory

Under the perpetual method, when inventory changes or the value changes, we must record that change. When a business sells merchandise, inventory is leaving the building, therefore the amount and value of the inventory left is changing. There will be two parts to the August 13 entry. The first part will record the sale and increase in an asset (Accounts Receivable). The second part will record the change in Inventory and the cost of the sale. Let’s look at the entry:

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The value of Inventory dropped $3,000, which moves to the income statement as an expense.

Now let’s look at the entry on August 20. This is the date that Whistling Flutes, LLC gets paid in full. However, because of the discount, the Company will not receive the full $5,000. Therefore, we must show the obligation fully paid even though the amount received is less than the amount in Accounts Receivable. The amount of the discount is 3% of $5,000 or $150. The amount of cash received is $4,850. Is Inventory changing? No, the payment on August 20 has no effect on Inventory. We will use a contra account, Sales Discounts, to record the discount amount.

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By using a contra account, the company knows how much its sales were over the course of the year and how much was lost because of discounts and other items. This is good information for managers to have in order to make decisions about the effectiveness of company policy.

Periodic Inventory

How would the entry be different under a periodic system? On the sales side, the only difference is the fact that we would not track the change in inventory at the time of the sale. The rest of the entry is exactly the same. Let’s look at both entries together, since we already discussed the methodology. Again, the only difference is that we do not track the changes in inventory under the periodic system.

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Read Transactions Slowly!

The biggest problem students have with this topic is confusing purchase and sale transactions. I have had students do the problem perfectly, except they give me the journal entries for the purchase when I ask for the sale or vice versa. Spend extra time if needed to make sure that you understand what the transaction actually means. Do not jump right into the entries until you know what is happening in the transaction. Typically, a problem will state which company you should do the entries for. Go back through the transactions to see if the company is the buyer or seller. Sometimes, I will even note that when I am reading the problem. Read the transactions carefully or you may lose a lot of points on a problem you know how to do.

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What Is a Return?

A return occurs when inventory is purchased and later returned to the seller. When this happens, the purchaser no longer has the merchandise. This transaction has an effect on inventory for both the seller and the buyer, because inventory is physically moving. Remember, the rules for perpetual and periodic inventory still apply so we will look at both cases here. We will also look at the transactions from the seller and buyer’s perspectives.

Returns Under Perpetual Inventory

Let’s look at an example.

Example #1:

On August 14, Medici Music returns $700 worth of merchandise to Whistling Flutes, LLC because the wrong merchandise was received. The merchandise cost Whistling Flutes $400.

First, let’s look at this from the perspective of Medici Music, the buyer. Medici is returning inventory, which means the balance in the inventory account is decreasing. Medici also owes less money to Whistling Flutes because the merchandise is returned.

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Essentially, we are reversing a portion of the original purchase journal entry.

Now, let’s look at the entry from Whistling Flute’s perspective. As the seller, Whistling Flute needs to show not only the return of the inventory but also the reduction in sales. Because we want to preserve the original sales data and track returns, we are going to use a contra account called Sales Returns and Allowances to record the revenue portion of the transaction. The value being returned to inventory is the cost that Whistling Flute paid for the inventory, which is $400.

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Notice there is no contra account for Cost of Goods Sold. We just reduce the amount in Cost of Goods Sold. Since we are tracking the returns through Sales Returns and Allowances, there is no need to create a contra account for Cost of Goods Sold.

Returns Using Periodic Inventory

Under periodic inventory, we do not use the Inventory account to record day-to-day transactions. Instead, we use Purchases and the contra accounts related to Purchases. When we discussed discounts, we used Purchase Discounts. Since we are now discussing returns and allowances, can you figure out what account we will use? It’s really tricky. Can you guess? Purchase Returns and Allowances! Really tricky, huh? Most of the time in accounting, the account names describe what is going on. The names are pretty basic. So let’s look at the entry for the same transaction under periodic inventory.

First, the entry for Medici Music:

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This entry is very similar to the entry used under perpetual inventory, but instead of Inventory we use Purchase Returns and Allowances.

Now, the entry for Whistling Flutes:

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Under period inventory, we do not record changes in inventory until the end of the period, so this entry is fairly simple.

What Is an Allowance?

An allowance is similar to a return in the fact that the seller is giving the buyer a credit on the account because something is wrong with the order. In the case of an allowance, the physical inventory is not returned to the seller. The buyer gets to keep the merchandise but receives a discount on the merchandise. Sometimes this happens because the inventory is incorrect but the buyer thinks it can still be sold. Maybe it was the wrong color or maybe there is slight damage to the product but it can still be sold at a discount. When dealing with allowances, it is important to note if the value of the inventory is changing on each side of the transaction and record that change correctly depending on the inventory method being used.

Example #2:

On August 16, Medici Music discovers that two of the flutes it ordered from Whistling Flutes, LLC were slightly scratched. Whistling Flutes agreed to discount the flutes by $200 and Medici agreed to keep the flutes.

Allowances Under Perpetual Inventory

Under the perpetual method, we must always track changes to the cost of inventory. Did the cost of the inventory purchased by Medici change? Yes, the cost is now $200 lower than it was previously recorded because of the allowance provided by Whistling Flutes. Therefore, we must record the decrease in the cost of the inventory. Even though the quantity of inventory is the same, the cost has changed.

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Notice the entries for returns and allowances are the same for the buyer. We are not tracking physical quantities of inventory here. We are tracking dollar value. In both cases the dollar value of the inventory has changed, so the entry is the same.

What about the seller’s entry? We know the amount of the sale has changed along with the amount owed on the receivable. Did the seller’s cost of inventory change? Does the seller have more or less value in the Inventory account because of the allowance? There is no change to the Inventory account. Whistling Flutes has the same amount of value in inventory that it had before the transaction.

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Allowances Under Periodic Inventory

When using the periodic method, the entries for allowances are the same as entries for returns because we do not track inventory under the periodic method.

The entry for Medici Music:

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The entry for Whistling Flutes:

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NOTE: When working with discounts, returns and allowances, it is very important to track the balances in Accounts Payable and Accounts Receivable. Every time there is a return or an allowance, the balances in Accounts Payable and Accounts Receivable decrease. I find it very helpful to do a T-account for these accounts so you can keep track of the balances, especially when you must calculate the amount that should be paid. Remember that each transaction affects the account balance. Make sure you have factored all transactions into your balance.

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What is Inventory?

Inventory is an asset account composed of items a company is planning to sell to customers. In financial accounting, we deal primarily with merchandising companies. A merchandiser is a company that purchases products from other companies to sell to customers. There are two major types of merchandisers: wholesalers and retailers. Wholesalers are middlemen. They purchase products from manufacturers and then sell them to retailers. Retailers sell products to the end users, either individual consumers or businesses who will use the product.

Perpetual and Periodic Inventory Systems

Every business that deals with inventory must decide how it will track its inventory. Large retailers and even some small retailers have computer systems which track inventory coming into the business and each item as it is sold. This is called a perpetual inventory system. According to Merriam-Webster, perpetual means “happening all the time or very often.” When a company using perpetual inventory, like Target, gets products shipped to them, all products are scanned into the computer system to let the system know how many units of each product the store has. When items are purchased, the computer system not only records the sale of the product (the revenue), it also records the decrease in inventory. When you purchase a roll of paper towels, the checkout system tells the store there is one less roll of paper towels in inventory.

What if the business doesn’t have a computerized inventory system? It would be very difficult to manually record how many of each item the company has at all times. These businesses use a periodic inventory system. The company tracks the dollar value of purchases and then counts what is left over at the end of the year. If the business knows what it had at the beginning of the year and how much it purchased, this tells the business how much product it could have sold. We call this goods available for sale. When we subtract how much we have left, called ending inventory, from goods available for sale, we can calculate how much we sold. We call this cost of goods sold.

Beginning Inventory + Purchases = Goods Available for Sale – Ending Inventory = Cost of Goods Sold

We call this a periodic system because we only know the exact balances in inventory at the end of each period, usually the end of the year. The business must do an inventory count and do an entry to adjust the inventory account to the proper dollar value. The offset account for this adjusting entry is cost of goods sold.

Does a perpetual inventory system negate the need for a physical count? Absolutely not! All businesses must count inventory at least once a year. There are many reasons why physical inventory would not match the computer records. Theft, damaged goods and cashier error can all cause inventory errors. I worked for a number of retailers in high school and college and each of them did inventory counts multiple times a year to look for inventory errors.

Journal Entries: Purchasing Inventory

We stated earlier that under the perpetual system, changes in inventory are always recorded. Therefore, if inventory levels are changing, either because inventory is increasing or decreasing, we must include the Inventory account in the journal entry. Let’s look at some examples.

Example #1 – Perpetual Inventory

On July 17, ABC company purchases $1200 worth of inventory on account. Record the journal entry for this company, which uses a perpetual inventory system.

Break down this statement. What is happening here? ABC is purchasing inventory, which means it is acquiring or getting inventory. Therefore, the balance in inventory is going up. What is the company exchanging for this inventory? Because the transaction is on account, ABC is not paying for the inventory today. Instead, the company is promising to pay for the inventory in the future. The account we use for that promise is accounts payable. Here is the journal entry:

II1

Notice we used the inventory account in the journal entry because the company uses the perpetual inventory system. How would this entry be different if we used the periodic system?

Example #2 – Periodic Inventory

On July 17, ABC company purchases $1200 worth of inventory on account. Record the journal entry for this company, which uses a periodic inventory system.

Remember the formula we used to calculate cost of goods sold under the periodic inventory system:

Beginning Inventory + Purchases = Goods Available for Sale – Ending Inventory = Cost of Goods Sold

In order to do this calculation, we must keep purchases separate from inventory. Therefore, we need an account to place those purchases in. We will use an account called Purchases (not very creative, is it?). That is the only difference in the journal entry.

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At the end of the year, we will close out the purchases account to update the balance in inventory after a physical count has been completed. We will discuss that process at the end of this discussion.

Journal Entries: Selling Inventory

In a perpetual inventory system, we must always include inventory in our journal entries when the balance in the account is changing. When we sell inventory to generate revenue, the balance in the inventory account is decreasing. Therefore, we need to add that information to the entry. Let’s look at an example.

Example #3 – Perpetual Inventory

On August 2, ABC company, which uses a perpetual inventory system, sells $1,000 worth of inventory to KLI, LLC on account. The inventory cost ABC $600.

Break down the transaction. What is happening here? ABC sold stuff to another company on account. The stuff ABC sold was purchased for $600. Therefore, ABC has a $1,000 sale and the cost of that sale is $600. First record the sale, then record the inventory adjustment. Here is the journal entry:

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Because the company uses a perpetual inventory system, we not only have to record the sale, we also have to record the change in inventory. Now let’s look at the transaction under a periodic inventory system.

Example #4 – Periodic Inventory

On August 2, ABC company, which uses a periodic inventory system, sells $1,000 worth of inventory to KLI, LLC on account. The inventory cost ABC $600.

When using a periodic inventory system, the company only updates the inventory balances periodically or occasionally. That means that we are not tracking inventory with every journal entry. Inventory is only updated at the end of the period (quarterly or annually). Since we are not constantly tracking the inventory balances, we do not include the change in inventory in our journal entry.

Under periodic inventory, the sales transaction looks just like those we have done previously for service based companies. All we need to do is record the revenue.

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That’s it. Record the revenue and you are done.

Final Thoughts

When working with inventory, it is important to keep the difference between perpetual and periodic straight in your mind.

Under perpetual inventory, we are constantly updating the balance in inventory. Anytime the quantity or value of inventory changes, it must be recorded to the Inventory account. This includes purchasing inventory, selling inventory and transactions related to returns and purchase discounts.

Under periodic inventory, we are only updating the balance in inventory periodically. Therefore, the only time you should use the Inventory account is when doing the adjusting entry to close out the Purchases account. When purchasing or selling inventory, do not use the inventory account. For purchases, use the Purchases account. When selling inventory, only record the sale. Inventory is not part of the transaction.

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