Each Tuesday, our new series ‘Accounting Tips Tuesday’, brought to you by Zoho Books, will present articles that fit into one of two categories. First, the theory behind basic, and even not so basic, accounting concepts with practical applications including the old ‘debits and credits’ appropriate to the situation. Second, we will go beyond the practical theory and actually cover fundamental software use in the proper recording of these types of transactions using Zoho Books.
Today’s article is the second in a mini-series one of accounting's basic concepts, 'Inventory'. We will be examining both theory as it relates to the 'traditional inventory costing methods' and some basic set-up procedures for inventory software tracking.
Last time we looked at the fundamentals of inventory, typically focusing on the ‘count’ side of things, in other words the quantities. We also learned the valuable concept of ‘when inventory’ becomes the owner’s property. With the exception of a single, simple, example of a ‘quantity for sale’ in which we valued everything at $1.00 each we really made no attempt to discuss the principles of ‘inventory valuation’ which will begin to focus on in today’s article.
Unlike last week’s example of everything having the same value ($1.00 each) the likelihood of that occurring in any inventory rich environment (retail, wholesale or manufacturing) is highly improbable only if you sold one single type of item. Over time the value of that item in terms of either the price you purchase it from your supplier, or the costs of the raw materials used in production, will vary (up or down, but usually up over time). New quantities you purchase to replenish stock will have cost more than the remaining stock you still have on hand. We will use the rising cost assumption in our models, although it is possible you might actually see some cost decline due to discounting or economics; regardless, the principles outlined here remain the same.
Back in our Accounting 101 mini-series our new business example was that of a ‘dongle maker’ (again, don’t ask me what a dongle is, I just like the sound of it). In fact, last week in Inventory Part 1, we created a new “Dongle” Inventory Item in our Zoho Books account. This new dongle (version) will cost us $1.25 from our supplier at the time of our initial order. With this scenario in mind, let’s look at our little blocks again and assume that each block represents a box containing a quantity of 25 of our new dongles.
Inventory 2 - figure 1
If we purchase 100 new dongles, they are shipped to us in 4 boxes of 25. With each dongle costing $1.25, then each box of 25 costs $31.25, and our total order cost us $125.00. So every dongle from blue boxes cost us $1.25.
Over time we might sell down part of this inventory and need to replenish it, or we might have one of our customers call us up and say that they need 250 of our new dongles delivered in three weeks. In this case let’s assume we still have the entire 100 ‘blue boxed’ dongles in stock, but in order to fulfill this order we must purchase an additional 150 dongles from our supplier. When we call up our supplier they tell us that they had a ‘price increase’ on July 1st, and that this dongle is now $1.35 each, in other words our 150 additional dongles are going to cost us $202.50. These higher priced dongles are now being shipped in ‘red’ boxes of 25 each, so every box has a value of $33.75.
Inventory 2 - figure 2
So now we have a total inventory of 250 dongles, but 100 of the dongles cost us $125.00 and 150 of the dongles cost us $202.50. Our total inventory is worth $327.50.
Inventory 2 - figure 3
So how much is each dongle actually worth? To deal with this ‘accounting question’ a company with inventory must adopt an inventory costing method which must be applied consistently from year-to-year. You cannot simply change cost methods because you ‘want to’, the Internal Revenue Service frowns on such changes in accounting practices. Sometimes it becomes necessary to change valuation when there are violent cost swings in the value of goods due to market conditions, at other times it becomes necessary to make change when switching accounting or inventory management software.
So how does a company select which inventory costing method to use? The answer is fairly simple, for 99% of most businesses the cost method will be the one that their inventory, point-of-sale, or accounting software uses. Most of these packages offer a single valuation method; a few do offer choices, and in those cases a company’s accountant will typically help them select the method that best reflects their inventory patterns.
So what are the most common inventory costing methods, and how do they differ? They are Average Cost, First-In First-Out (FIFO), and Last-In Last-Out (LILO). Notice I said these are the ‘most common’, they are not the only versions that maybe applied, but they are the most common.
Average Cost – what really is ‘weighted average’ relies on average unit cost to calculate cost of goods sold and ending inventory valuation. This method determines average cost by dividing the total cost of inventory available for sale by the total number of units available for sale. When I asked the question earlier, “So how much is each dongle really worth” in regard to the example above, this may have been the way in your mind you should answer the question. Let’s look at how Average Cost would apply, by looking again at our illustration of our current dongle inventory.
Inventory 2 - figure 3
In this case we would divide the total cost of inventory available ($327.50) by the total number of units available for sale (250). The result is that each dongle would have an Average Cost of $1.31.
In this case our average cost rose by 6-cents over what the initial 100 dongles cost, so this maybe why our Dongle-business Owner feels he can still sell the total order to his customer for the retail price he had computed based upon the original cost.
In this limited scenario, Average Cost makes sense, it is the way that most small business owners tend to think about a quantity of items that is made up of several past purchases. But as I mentioned earlier, cost swings and market conditions can cause some significant shifts in your inventory costs and what you buy today may be much higher in cost than what you paid for the exact same thing (and quantity) just a couple of months ago. Typically, a merchant will feel the need to increase the selling (retail) price in order to maintain adequate margins to cover not on the cost of the product but the cost of doing business. This is where the FIFO and LIFO cost methods come into play, but we will look at them next time.