Inventory cost flows refer to the movement of inventory costs through the financial statements. Cost accountants should understand how inventory costs are recorded and how they flow through the balance sheet and income statement.
Inventory & the Balance Sheet
When a business purchases inventory, the inventory cost is recorded on the balance sheet as an asset. The inventory cost includes the purchase price of the goods and any additional costs incurred in bringing the goods to their present location and condition, such as shipping, handling, and storage costs.
Inventory balance sheet accounts
There are generally three types of inventory balance sheet accounts that businesses use to account for their inventory:
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Raw Materials Inventory: This account includes the cost of the materials used to produce finished goods that have not yet been used.
For example, a furniture manufacturer would have raw materials inventory for the wood, screws, nails, and other materials used in production.
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Work-in-Progress Inventory: This account includes the cost of unfinished goods that are still in the production process. This account reflects the cost of the direct materials, direct labor, and manufacturing overhead costs that have been incurred up to the point of measurement.
For example, a clothing manufacturer would have work-in-progress inventory of clothes that have been partially sewn but not yet finished.
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Finished Goods Inventory: This account includes the cost of the goods that have been completed and are ready for sale. This account reflects the total cost of direct materials, direct labor, and manufacturing overhead that have been incurred to produce the finished goods.
For example, a car manufacturer would have finished goods inventory for the cars that are ready for sale.
Some businesses may also have a fourth type of inventory account called “supplies inventory,” which includes materials and supplies used to support the production process, such as office supplies or cleaning supplies.
It’s important for businesses to accurately track their inventory levels and value, as it is a significant asset on their balance sheet. This enables the business to make informed production, pricing, and supply chain management decisions.
What are the financial watch-outs for inventory on the balance sheet?
Businesses should be aware of several financial watchouts for inventory on the balance sheet. These include:
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Excess Inventory: If a business has excess inventory on its balance sheet, it may indicate that it is not selling its products quickly enough or producing too much. This can tie up cash and increase storage and handling costs, impacting the business’s profitability.
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Obsolete Inventory: Obsolete inventory is inventory that is no longer in demand or has become outdated due to changes in technology or consumer preferences. If a business has obsolete inventory on its balance sheet, it may indicate that it is not keeping up with market trends or managing its inventory effectively.
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Shrinkage refers to theft, damage, or other causes of inventory loss. If a business has a high level of shrinkage, it can impact the inventory accuracy on the balance sheet and potentially affect its financial performance.
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Inaccurate Valuation: If inventory is not valued accurately on the balance sheet, it can lead to inaccurate financial reporting and potentially affect the business’s profitability. For example, if inventory is valued too high, it can inflate the business’s assets and net income, leading to an inaccurate portrayal of its financial health.
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Holding Costs: Holding costs refer to the costs associated with storing and maintaining inventory. If a business has high holding costs, it can impact its profitability and potentially indicate that it is not managing its inventory effectively.
In summary, businesses should closely monitor their inventory levels and values on the balance sheet to ensure they manage inventory effectively and accurately report their financial performance.
By addressing these financial watchouts for inventory, businesses can improve their profitability and better manage their inventory levels.
Inventory & COGS
When the inventory is sold, the cost of the goods sold (COGS) is recorded on the income statement as an expense. The COGS includes the cost of the goods sold and any additional costs directly related to the sale of the goods, such as sales commissions and delivery costs.
The calculation of COGS depends on the inventory valuation method used by the business. For example, if the business uses the FIFO (First-In, First-Out) inventory valuation method, the COGS is calculated based on the cost of the oldest inventory items in stock.
If the business uses the LIFO (Last-In, First-Out) inventory valuation method, the COGS is calculated based on the cost of the most recent inventory items purchased.
Example of how inventory cost flows through the financial statements:
ABC Company purchases inventory worth $10,000 on January 1st. The inventory is stored until it is sold on February 1st for $15,000. Shipping the inventory to the company’s warehouse cost $500. The company uses the FIFO inventory valuation method.
On January 1st, the cost of the inventory is recorded on the balance sheet as an asset:
Inventory = $10,000
On February 1st, when the inventory is sold, the cost of goods sold is calculated as follows:
COGS = Cost of oldest inventory items in stock + Direct costs related to the sale = $10,000 + $500 (shipping cost) = $10,500
The revenue from the sale of the inventory is recorded on the income statement:
Revenue = $15,000
The COGS is also recorded on the income statement:
COGS = $10,500
The gross profit is calculated by subtracting COGS from revenue:
Gross Profit = Revenue – COGS = $15,000 – $10,500 = $4,500
Understanding how inventory cost flows through the financial statements is essential for cost accountants in maintaining accurate financial records and making informed decisions about inventory management.
What are the financial watch-outs for inventory costs in COGS?
Businesses should be aware of several financial watchouts for inventory costs in COGS. These include:
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Fluctuating Costs: Inventory costs can fluctuate due to changes in raw material prices, shipping costs, and other factors. If these costs are not accurately reflected in COGS, it can impact the business’s financial reporting accuracy and potentially affect its profitability.
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Misallocation of Costs: If costs are misallocated to inventory, it can impact the accuracy of COGS and potentially affect the business’s profitability. For example, if manufacturing overhead costs are allocated incorrectly to inventory, it can lead to an over or underestimation of COGS.
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Inaccurate Valuation: If the inventory is not valued accurately, it can impact the accuracy of COGS and potentially affect the business’s profitability. For example, if inventory is valued too high, it can lead to overestimating COGS and potentially impact the business’s net income.
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Holding Costs: Holding costs, such as storage and handling costs, can impact the profitability of a business if they are not accurately reflected in COGS. If holding costs are not accurately reflected in COGS, it can lead to underestimating the true cost of the inventory sold.
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Inventory Write-Downs: Inventory write-downs occur when inventory is written down to its lower of cost or market value. If inventory write-downs are not accurately reflected in COGS, it can impact the business’s financial reporting accuracy and potentially affect its profitability.
In summary, businesses should closely monitor inventory costs in COGS to ensure that they accurately reflect the cost of goods sold and manage their inventory effectively. By addressing these financial watchouts for inventory costs in COGS, businesses can improve their profitability and better manage their inventory levels.
What is the difference between cost of inventory production vs cost of goods sold? Why does it matter?
The cost of inventory production refers to the total cost of producing a unit of inventory, which includes the direct materials, direct labor, and overhead costs incurred during the production process. The cost of goods sold (COGS), on the other hand, refers to the cost of the inventory that was sold during a particular period.
The main difference between the cost of inventory production and COGS is that the former represents the cost of inventory that has not yet been sold. In contrast, the latter represents the cost of inventory that has been sold. In other words, the cost of inventory production is a balance sheet account, while COGS is an income statement account.
It matters because understanding the difference between the two is important for businesses in managing their finances and making informed decisions.
For example, if a business has a high cost of inventory production but low COGS, it may indicate that they have excess inventory levels that need to be reduced. On the other hand, if the business has a high COGS but low cost of inventory production, it may indicate that they are pricing their products too low or they are not producing enough to meet demand.
In addition, understanding the difference between the two is important for accurate financial reporting. Accurate financial reporting is essential for compliance with accounting standards and regulations and for maintaining the trust of stakeholders such as investors and lenders.
In summary, while the cost of inventory production and COGS may seem similar, they represent different aspects of a business’s inventory management and financial performance.
Businesses need to track both to manage inventory levels effectively, make informed decisions, and ensure accurate financial reporting accurately.
How does the standard cost affect the inventory balance sheet and COGS costs?
Standard cost is a method of valuing inventory that assigns predetermined costs to the direct materials, direct labor, and overhead costs associated with producing a product. These predetermined costs are typically based on historical data or industry benchmarks.
The use of standard cost can impact the inventory balance sheet and COGS costs in the following ways:
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Inventory Balance Sheet: The use of standard cost can impact the inventory balance sheet by valuing inventory at a predetermined cost rather than the actual cost of production. This can result in a difference between the actual inventory cost and the inventory value recorded on the balance sheet. The difference between the two is known as a variance and is recorded on the balance sheet as a separate account.
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COGS Costs: The use of standard cost can impact COGS costs by assigning predetermined costs to the direct materials, direct labor, and overhead costs associated with producing a product. This can result in a difference between the actual cost of goods sold and the COGS value recorded on the income statement. The difference between the two is known as a variance and is recorded on the income statement as a separate account.
In summary, the use of standard cost can impact the inventory balance sheet and COGS costs by assigning predetermined costs to inventory and goods sold.
This can result in variances between the actual and standard costs in the financial statements. Businesses need to monitor these variances and adjust their standard cost calculations as needed to ensure accurate financial reporting.
Inventory Cost Flows- Understand the Balance Sheet and COGS Impact- Conclusion
Inventory cost flows are an important aspect of any business that deals with physical goods. Properly understanding these flows can greatly impact a company’s balance sheet and cost of goods sold (COGS) figures. It is essential to keep track of inventory purchases, production processes, and sales to ensure accurate reporting.
When inventory costs are not properly accounted for, it can lead to over or under-reporting of assets and liabilities on the balance sheet and inaccurate COGS figures.
As a result, it is crucial to clearly understand how inventory cost flows impact financial reporting and to regularly review and assess these figures to maintain the accuracy of a company’s financial statements. Investing in proper inventory management can save companies from costly mistakes and help ensure their long-term success.
Inventory Cost Flows- Understand the Balance Sheet and COGS Impact- Recommended Reading
Updated: 5/20/2023
