This simply means that the flow of inventory follows a certain pattern. Most companies use a cost flow assumption. The cost of an accounting system (or any other venture) should be outweighed by the benefits, or it is not cost-effective to follow that course of action.įor most companies, the Specific Identification method is far too costly and the additional information that could be gained is of little value. The cost of keeping that much detailed information would exceed the usefulness, or benefit, of the information. Most business would answer “No” to that question. Is it necessary to place a value on each and every sheet of paper? But does that apply to each and every item? What about a ream (500 sheets) of typing paper. The Specific Identification method assumes that each inventory item is special enough, unique enough, and costly enough to merit tracking one at a time. Lumber, nails, nuts and bolts (simple average) Īccounts for quantities of homogeneous productsĬan be used with either Periodic or Perpetual costing system Items remaining at the end are the earliest ones bought in the yearĬlothing, seasonal items a highly specialized methodĬost of items bought are averaged across the year theĪverage cost is used at the end of the year a moving weighted average The items remaining at the end are the last ones bought in the yearĮggs, milk, meat, produce this is the defaultįlow assumption, unless a different method is specifiedĬost of last purchases flow to COGS we assume that the Separately the exact cost of each item is used in the value of endingĪuto sales, gems and jewelry, works of art, unique, oneĬost of earliest purchases flow to COGS we assume that The cost of each individual inventory item is tracked A company should select and use the method that best matches their merchandise and how it is sold.Ĥ Methods of Inventory Valuation Inventory method There are four methods commonly used to calculate a value for ending inventory. We will discuss Gross Profit a little more later in this section. Without enough Gross Profit a company can’t pay it’s operating expenses, such as salaries and wages, rent and utilities, etc. That is the cost used to determine Gross Profit. It is also important to know the correct value of merchandise sold. The inventory value will be reported on the Balance Sheet at the end of the year. They must also place a dollar value on that inventory. It is important for companies to count the physical inventory at the end of the year. In the example above, you determined a value for Item Z at the end of the year. If Item Z is sold in 2003, the cost will flow to the Income Statement for 2003, and the gross profit will be reported on that income statement. If Item Z cost $50 that is the amount that will be shown on the Balance Sheet.īalance Sheet Dec. There will be no sale to report, so the cost will remain on the Balance Sheet. Assume you buy Item Z for late in 2002, and you are still holding it. Now let’s think for a moment about Item Z. Nothing will be left on the Balance Sheet. This is the information that will be included in the 2002 Income Statement. Income Statement 2002 Selling Price of Item X If Item X costs you $40, and you sell it for $65, you made a Gross Profit on the item of $25. Everything about Item X relates only to the past. Nothing about Item X will affect the company in the future. If the customer has paid for Item X there will be absolutely no accounting left to do, except show the sale and related COGS on the 2002 Income Statement. If you buy, hold and sell Item X all in the same year, say 2002, the entire transaction relating to Item X will be a completed and realized transaction. Let’s think for a moment about a hypothetical inventory item, we’ll call it Item X. So the three important times in an item’s life are buying, holding and selling. Once the item is sold, the cost is transferred to COGS. It then holds the item on a shelf or warehouse, until a customer wants to but the item. The company must first order and buy the item. There are several important points, or events, in the life on an inventory item. That covers a large and broad group of businesses. This would include grocery stores, clothing stores, in fact all the stores you would visit in the mall, or shop at on a regular basis, are retailers. This lesson focuses on inventories of merchandise, those inventories held by retailers for sale to their customers. A journal entry transfers costs from the Balance Sheet to the Income Statement. Inventory cost is an asset until it is sold after merchandise is sold, the cost becomes an expense, called Cost of Goods Sold (COGS). In all cases, inventory is something the company will re-sell to someone else. Retailers have one inventory: merchandise. Manufacturing companies have three types of inventory: materials, work in process and finished goods.
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