Inventory:
Types of "For profit" companies which hold inventory:
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Manufacturing / Merchandising |
Manufacturing firms add value to the inventory by combining labor, materials and expertise to the product. They make a profit by selling the product units for more than the combined costs of production.
Merchandising firms do not change the product significantly. They make a profit by distributing, packaging and servicing the product.
The auto industry has both types of firms: Ford Motor Company manufacturers the product, while car dealer is the merchandising arm.
A vertically integrated Oil company also manufacturers and then merchandises.
| Question 6-1 What is the Merchandising arm of Marathon Corp? |
Service companies usually hold immaterial amounts of inventory. Service companies are the most rapidly growing segment of our society. Service companies, like consulting firms, use inventory methods to price out their labor costs to clients. Essentially, labor is their inventory.
| Question 6-2 What are some of the primary labor costs |
Inventory measurement methods:
Merchandising – Periodic vs. Perpetual inventory methods.
Periodic valuation measures the costs of inventory at regular intervals. The most common measures would be monthly, quarterly or annually, whereas, the perpetual method maintains a continuous record of inventory costs and units. Traditionally, periodic records were kept for low cost/high volume inventory items, whereas, perpetual tracking was maintained for high cost per unit items.
| Question 6-3 Name a few examples of inventory |
The Periodic method is still used for chemicals and gasoline
Manufacturing
We review the manufacturing environment in substantial detail during the last third of the course. Note the cost flows and terminology outlined on pages 156 and 157 in your text.
Terminology:
| Raw Materials flow to Work in Process and eventually into Finished Goods. |
Cost allocation: Product costs vs. Period Costs:
As the name indicates, costs that can be assigned directly to the product are product costs. This is important because even though costs have been incurred, i.e. we have spent the money, if the inventory remains unsold at year end we defer recognizing those costs as expenses (cost of goods sold), until next period when the sale is made. Period costs cannot be traced directly to a product, (examples: heat in the factory or janitorial services), these cost are expensed when incurred and are not allocated into inventory. Later we will discuss whether the costs are fixed or variable.
Inventory Costing methods
FIFO: (First in, First out), FIFO usually coincides with the physical flow of goods. It does a reasonably good job of measuring the value of inventory on the balance sheet. It does however, cause gross profit to look high because older costs are being matched with current sales.
LIFO: (Last in, First Out), LIFO takes the costs of the most recent purchases and matches these costs with the current sale. During a period of rising prices, LIFO does the best job of showing the true profit margins a company is earning on the sale of its products. Conversely, the balance sheet figure can be badly distorted and when analyzing financial statement it is important not to use a LIFO inventory value. Be sure to look through the LIFO example on page 162. The Lambert Corporation Case provides a comprehensive review of the calculations so you will have permanent record to review.
Average: The average method is fairly straightforward. Total costs over a period are accumulated and then divided by the total units purchased. This gives an average cost per unit.
| Question 6-4 What industries would likely use |
Specific Identification: Used when a company needs to maintain a record of each item sold. Most important, when the cost per unit is relatively high or the products are unique. We might keep a record of specific dresses sold to track fashion trends. With computers, an item only needs a bar code and we can keep a unique record of each article.
Comparisons: When is each method most appropriate?
This is one of the more interesting questions in accounting. We have four choices of inventory valuation methods. Each can give rise to substantially different profit measurements in a particular period. Accounting theory says we should select the method that best reflects the measurement of income. Therefore, LIFO should be selected for industries that build up stocks of similar items and then draw off the stocks as needed. Sort of the Coal pile scenario. Conversely, manufacturing firms with goods coming in one end and out the other fit FIFO.
| Question 6-5 Why do many firms select or switch to LIFO? |
Lower of Cost or Market: Basically, if the value of inventory drops below its cost we must recognize the loss in the period of the decline. It is important we know this concept because it can dramatically effect the valuation of inventory. Recall the significant drop in oil prices and how much that decline effected the value of inventory on oil companies and other companies that use petroleum products: utilities and airlines to name a few.
Inventory Analysis: At the end of the chapter, note the Inventory Turnover Ratio and the Gross Margin Percent. These are useful tools in analyzing whether a company is managing its inventory efficiently and effectively.