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Inventory
Definitions
Inventory is generally considered to comprise physical
goods which are intended for eventual sale to custom-
ers. It is almost always classified on a companys bal-
ance sheet (statement of financial position) as a current
asset, as it is normally expected to be sold within one
year. Some industries consider less tangible items to be
Joel Shapiro has been an inventory as well, as long as they are limited in quantity
Accounting instructor at Ryerson
University in Toronto, Canada for
and self-replenish over timeexamples would be hotel
20 years. Previously, he developed rooms and seats on airplanes. When inventory is sold,
an accounting and inventory the asset becomes an expense called cost of goods sold.
management software system for
small businesses. In his spare time,
he enjoys working on Kakuro and
Introduction
cryptic crossword puzzles, and travels Inventory is quite often one of the largest and most im-
throughout Ontario as a bridge portant assets on a companys balance sheet. In order to
tournament director. account for it properly, several issues must be addressed.
First, it must be determined which costs should be in-
cluded in inventory and which should not be. Then it is
necessary to determine who owns the inventory, espe-
cially for items which are not physically on the compa-
nys premises. Once these issues have been dealt with,
one of four formulas must be used to assign dollar val-
ues to the inventorythe choice can have wide-ranging
implications for the companys net income and other
Expert Insights 1
Accounting in a Nutshell 2
2 Expert Insights
Accounting in a Nutshell 2
in your inventory as long as they are still systems will keep track of each item in-
on your customers premises. On the other dividually (bar codes, RFID tags, etc.) and
hand, goods that you are holding on con- add to the quantities on hand every time a
signment for others, and which you have purchase is made, and deduct every time a
not sold yet, are not yours and you do not sale is made. Nevertheless, no automated
have to include them in your inventory. system is perfect, because imperfect hu-
Lets pause now for a quick review. Say mans operate them. Companies must still
you purchase 100 widgets from a supplier count their inventory physically at least
overseas. These cost $10 each. We will ig- once a year and adjust their computer re-
nore foreign exchange, just to keep things cords to what is actually on hand. Whatever
simple. On top of that, you have to pay $25 is not on hand must be considered sold. In
to your customs broker for his importing mathematical terms, this is the formula:
services, and a tariff of 5% on the goods
themselves. Your supplier shipped them Opening Inventory + Purchases =
at FOB shipping point and the freight and Goods Available =
insurance while in transit cost a total of Ending Inventory + Cost ofSales
$50. Once the widgets arrived, you spent
$25 more on packaging and labeling before We always know what the left side of
putting them on your shelf for your own the equation, the cost of goods available
customers to buy. What is the total and for sale, is, because we have been keeping
per-unit cost of the widgets? track of it all along. The two components of
SolutionInvoice cost: 100 $10 = $1,000. the right side of the equation have to be cal-
Tariff at 5% is another $50. Add $25 for bro- culated. Obviously, once we know one, we
kerage fees, $50 for freight and insurance, can easily calculate the other. If 100 items
and $25 for packaging and labeling, for a are available to be sold, and only 40 are
total inventory cost of $1,150. Your 100 wid- counted at year-end, then we assume that
gets cost you $11.50 each. we sold 60. If we counted 60 on hand, then
This is all very well and good if you we sold 40. Units are easy. Assigning dollar
know, every time you sell a widget, that it values to the units on hand is not.
really did cost you $11.50. However, your
supplier can change his invoice price at Method 1Specific Identification
any time, and all those extra charges can This method assumes that you can, in fact,
change too. If one widget looks and works tell the actual cost of every single widget
much the same as any other widget, and that you have on hand. This method is
you really cant tell which particular pur- used in practice for inventory items of high
chase any specific widget came from, and value which are either unique themselves
your customers cant tell and dont care ei- or can be uniquely identified with, say, a
ther, then you have to make some assump- model and serial number. Examples would
tions when assigning dollar figures to the be automobiles, heavy equipment, fine
widgets still on hand at the end of the year art and jewelry, and major appliances and
when you count them, and by extension, to electronics.
the cost of those widgets actually sold. This To illustrate this method with a very
is the topic of the next section. simple example, suppose you have three
widgets in stock. The green one cost you
Assigning Dollar Values to $10, the blue one cost $11, and the red one
Inventory cost $12. Total inventory of $33 is available
Most companies nowadays use a perpet- for sale. Your customers arent fussy about
ual method to control their inventory. color and will pay $50 for any of them. If
Point-of-sale or other modern computer you sell the green one only, you have sales
Expert Insights 3