What is "Inventory"? The word inventory simply means the goods and services that businesses hold in stock.

There are, however, several different categories or types of inventory. The first is called materials and components. This usually consists of the essential items needed to create or make a finished product, such as gears for a bicycle, microchips for a computer, or screens and tubes for a television set. The second type of inventory is called WIP, or work in progress inventory. This refers to items that are partially completed, but are not the entire finished product. They are on their way to becoming whole items but are not quite their yet. The third and most common form of inventory is called finished goods. These are the final products that are ready to be purchased by customers and consumers. Finished goods can range from cakes to furniture to vehicles. Most people think of the finished goods as being part of an inventory stock, but the parts that create them are held accountable in inventory as well. There's many different ways that companies handle their inventory. Overall it depends on what kind of business it is. For example, a food manufacturer who makes canned fruit may take into account every single piece of that can in its inventory. The materials used to make the can, the labels, the fruit, and the sugary filling could all be part of the overall analysis of inventory. Keeping track of inventory can be a complex process. The term for watching inventory is called logistics. Logistics is a detailed process by which all inventory is tracked and logged. Several different people are involved in logistics. This can include everything from the owner of the company to the transportation company that delivers the goods to the manufacturing plant. By using complex systems such as barcode integration, every piece of inventory from the smallest parts to the largest finished product can be tracked and observed. You may wonder why companies keep such a close eye on their inventory. The answer is really simple: the bottom line. Without inventory control, millions of dollars could be lost each year just because there was no accountability for everything involved in making a product. Of course, inventory is also important on the checks and balances side. Accountants keep an eye on inventory counts in order to be sure that fraud or embezzlement is not occurring. This also serves as a backup to check and be sure that everything is

in its place and nothing out of the ordinary is taking place. There have actually been books written on how to reconcile inventory, keep accurate stock counts, reasons that errors occur, tools to use to help make sure inventory is on time and in its place, and much more. Once you learn about the various forms of inventory and the importance of making sure it is logged properly, the process of tracking it should be fairly streamlined and simple, giving your business a cost-effective and competitive edge.

Need for Inventory accounting As we said back in our Payables Accounting column "Inventory (products bought for resale, materials bought to manufacture products to be sold, etc., can't be expensed until sold and in the meantime are accounted in an inventory assetaccount, e.g., payable / amt inventory / amt+ ". So we got materials into the inventory account through payables. How do we get them out? That's the job of inventory accounting. If you're doing just custom jobs, where you're buying materials strictly for that job like a residential custom builder you could use a "percent completion" method. You buy the materials to a job-number and account your labor to the job-number accumulating them in an inventory account and then periodically expense them according to the percent the job is complete, inventory / amt cost-of-sales / amt+ . When the job is 100% complete, all of your costs for that job have been expensed, and no more sits in inventory. However, if you're manufacturing a product line, with subassemblies common to multiple products, things aren't quite as simple. If you walk through the plant, you'll find stocks of purchased parts and materials, stocks of subassemblies, and batches of end products being assembled and tested for scheduled shipping. Each of these is different. Purchased materials have no labor content but subassemblies do have labor content. And the end products have both labor and subassembly content.

How do you know what dollars you have invested in all these stocks and batches? And how do you know how many dollars to expense to cost-of-sales when you ship a product? Inventory Processing I'll lead you through a system I used back in the '70s. It's not the only system nor necessarily the best. It's just one that worked well for me. First, you'll need inventory accounts to reflect the inventories you have a purchased-materials account to account your purchased parts and materials... a subassembly-inventory account to account your subassemblies... and a productinventory account to account your end products. Parts and materials get into your purchased-materials account through payables, payable / amt purchased-materials / amt+ . The purchased-materials account balance contains the cost of all those stocks of parts and materials on the plant floor. Now you purchased those materials to build things subassemblies and products. Let's say we want to build 50 of some subassembly. So we compose a Job Order to tell the assembly people what we want to build. And we give this Job Order a number, say S001 "S" for subassembly. The assembly people pull the materials, build the subassemblies and return the Job Order showing they've completed the subassemblies. We now have that many fewer parts in stock and that many more subassemblies. So we take the costs of those parts out of our purchased-materials account and add them into our subassembly-inventory account, purchased-materials / amt subassembly-inventory / amt+ . The subassembly-inventory account balance now shows the material cost of those 50 subassemblies. But those subassemblies should also contain the cost of the labor expended in building them. So we have the assemblers charge their time to the S-job number they're building. In our Payroll processing, we recognize that any S-job laborexpense should be accounted to our subassembly-inventory account, accrued-

wages / amt subassembly-inventory / amt+ . Our subassembly-inventory account balance now includes the labor cost of those subassemblies. Now let's say we want to build 25 of a product, and that product contains 2 of the subassemblies we just built plus some purchased materials. So we compose a Job Order to tell the product assembly people what we want to build. And we give this Job Order a number, say P001 "P" for product. The assembly people pull the parts and subassemblies, build the products and return the Job Order showing they've completed the products. We now have that many fewer parts and subassemblies in stock and that many more products. So we take the costs of those parts out of our purchased-materials account, and the costs of those subassemblies out of our subassembly-inventory account, and add them into our product-inventory account, purchased-materials / amt subassembly-inventory/amt product-inventory/amt+ . The productinventory account balance now shows the materials cost of those 25 products. But those products should also contain the cost of the labor expended in building them. So we have the assemblers charge their time to the P-job number they're building. And in our Payroll processing, we recognize that any P-job labor-expense should be accounted to the product-inventory account, accrued-wages / amt product-inventory/amt+ . Our product-inventory account balance now includes the labor cost of those products. We now know what each of those products cost us to build 1/25 of the productinventory account balance. When we ship one, we can account its cost-of-sales in our Sales Journal transaction, receivable / amt+ revenue / amt product-inventory / amt cost-of-sales / amt+ . Now let's take a look at what these Job Orders look like. They obviously have to contain a list of materials so the assemblers know what parts and materials to pull. And somewhere there have to be some instructions on what to do with those parts and materials. So why not combine them, e.g., like a recipe "pull these parts, do this with them, then pull these parts, do this with them, etc, etc."

This "recipe", for building one (subassembly or product), can be your engineering documentation it carries a subassembly or product (part) number that you assign when you design it. If the assemblers need a drawing to refer to, the recipe can simply say, "refer to drawing so-and-so". Now the Job Order becomes simply a copy of that "recipe" with the quantity changed to the number you want to build. Inventory Ledgers In practice, you'll have many parts and materials flowing through this process into subassemblies and products into shipping in various stages of completion. How do you keep track of all this? You'll need a subsidiary ledger for each of your inventory accounts a Purchased-Materials ledger (one sheet per part number), a Subassembly ledger (one sheet per subassembly part number), and a Product ledger (one sheet per product part number). When you purchase parts, you not only post the cost to the Payables ledger but you also post the quantity and cost to the Purchased-Materials ledger. When you get an S-job back from the floor, you post the quantity and cost of the parts used to the Purchased-Materials ledger (referencing the S-job number). The totaled cost of the parts posted is the material cost of the subassemblies which you then post to the Subassembly ledger. When payroll is run, you post the S-job labor not only to the Payroll ledger but also to the Subassembly ledger (to the sheets corresponding to the subassembly part numbers built). When you get an P-job back from the floor, you post the quantity and cost of the parts used to the Purchased-Materials ledger (referencing the P-job number), and you post the quantity and cost of the subassemblies used to the Subassembly ledger (referencing the P-job number). The totaled cost of the parts and subassemblies posted is the cost of the products which you then post to the Product ledger. When payroll is run, you post the P-job labor not only to the Payroll ledger but also to the Product ledger (to the sheets corresponding to the product part numbers built).

And when you get shipping papers back from the floor telling you products have shipped, you post the quantity and cost of the products shipped to the Product ledger (referencing the Sales (or Shipping) Order) which cost is the cost-of-sales amount posted to the Sales Journal when you prepare and account the Customer Invoice. As parts are purchased and used, subassemblies built and used, products built and shipped, the sheets in your ledgers tell you the current quantity and cost balance of each of your parts, subassemblies and products. The individual cost balances in your Purchased-Materials ledger should total to the balance in your purchasedmaterials account. Similarly, the individual cost balances in your Subassembly ledger should total to the balance in your subassembly-inventory account, and the individual cost balances in your Product ledger should total to the balance in your product-inventory account, Now this is a lot of work manually. But it's not a big deal on computer. If your "recipes" are on computer, you just print them out for a new Job Order and if your payables and payroll are already on computer all the data's there for your computer to construct and maintain these ledgers. Standard Cost One alternative to the above system should be mentioned a standard cost system. Rather than tracking "actual" costs through the manufacturing process, we track "estimated" (or standard) costs and periodically correct our inventory accounts to reality, e.g., through inventory counts. This avoids the inventory ledgers and multiple accounts. Rather we estimate the material and labor cost of each subassembly and product and assign it that (standard) cost. When we ship a product, we move its standard materials cost from our purchased-materials account and its standard labor cost from our manufacturing-labor-expense account into our cost-of-sales account, receivable / amt+ revenue / amt purchased-materials / amt manufacturing-labor / amt cost-of-sales / amt+

This system buys you simplicity at the cost (loss) of considerable visibility and control. Of course, if you're not going to use that visibility to better control your manufacturing process anyway, then you might as well go the route of simplicity.

The inventory formula: Beginning Inventory Rs.XXX.XX

Add purchases during the month + XXX.XX Subtract ending Inventory Cost of Goods Sold - XXX.XX Rs.XXX.XX

The first step is to conceptualize the inventory process. In other words, think about what is going on. For example, suppose your company is in business to sell a product. The product is acquired either by manufacturing it or purchasing it as a finished product. During an accounting period, such as one month, all, or a portion of the inventory is sold. Hopefully, the cost of the product did not exceed its sale price so that a profit was realized. With the money from the profit, more inventory can be purchased to sell, cover overhead expenses, and pay yourself. The challenge is to determine, as accurately as possible, your Cost of Goods Sold (COGS). There are various ways to do this depending on whether a periodic or perpetual system of recording inventory is used. In case you are unfamiliar with these terms.

TYPES OF INVENTORY ACCOUNTING Periodic Periodic inventory accounting involves an increase (debit) to Purchases when acquisitions are made. Remember, Purchases is a general ledger (GL) account found in the cost of sales section of the Profit & Loss Statement. At the close of the period, a physical count of the remaining inventory is required to determine the amount unsold. The quantity is then priced and recorded in order

to determine the COGS. Here is a quick example, using T-Accounts: (a)Beginning inventory was Rs.3,000 (b)Purchased new inventory of Rs.1,000 (c)Counted remaining inventory of Rs.2,500 (d)Adjusted Purchases and Inventory to reflect actual ending Inventory Cash Inventory Purchases | 1,000 (b) (a) 3,000 | 500 (d) (b) 1,000 | 2,500 (d) 500 1,500 Perpetual As acquisitions of new inventory are made, they are charged (debited) to the Inventory account. Each time a sale is made a corresponding entry is made removing (crediting) the item from Inventory and charging (debiting) COGS (or Purchases). The result is that the Inventory account maintains a current balance, and the COGS account reflects the cost of goods sold to date. One of the benefits of using a perpetual inventory system is that you can run interim financial statements without the necessity of a physical inventory count. In addition, shortages and any other discrepancies may be discovered and corrective action taken. One way to remember the difference between the two methods is that the periodic system discloses what is on hand, whereas, the perpetual system discloses what should be on hand. Once the inventory system you are going to use has been selected, the method by which to price the inventory has to be selected. You may have heard of some of these methods, i.e., FIFO (First-in, First-out); LIFO (Last-in, First-out); Weighted Average; Specific Identification; and Retail Method. Here is a brief overview of each: Conventional Inventory Pricing Methods FIFO First-in, first-out (Last-in, Still-here) implies that the items that were purchased first will be sold first. Cost of goods sold is calculated by using the oldest prices, and ending inventory is calculated based on the most recent prices. Using this method tends to result in a fair statement of inventory on the Balance Sheet.

This is because the ending inventory was purchased most recently. Further, when inventory turns over regularly, the prices used for the cost of goods sold are somewhat current resulting in fair presentation of the cost of sales amount. LIFO Last-in, first-out (First-in, Still-here) implies that the items most recently acquired will be the first sold. Cost of goods sold is calculated by using recent prices, while ending inventory is calculated using the oldest prices. This method tends to emphasize the matching concept accounting principle by matching current costs with current sales on the Profit and Loss Statement. Eventually however, the inventory prices used for balance sheet purposes may become outdated and unrealistic. This is because current prices may rise or fall causing the true value of the ending inventory to become under or overstated. Weighted Average This method involves assigning the same unit price to items in Inventory and to items in COGS. The price assigned is the average price for the period calculated by taking the total cost of beginning inventory plus the cost of all units purchased during the period and dividing the total by the number of units involved. For instance: Using Periodic: 100 units purchased @ RS.1.00 on Jan 1 = RS.100 150 units purchased @ RS.2.00 on Jan 14 = RS.300 130 units purchased @ RS.2.50 on Jan 26 = RS.325 380 Cost per unit (RS.725/380) = RS.1.908 RS.725 Cost of Goods Sold 140 (380 240) @ RS.1.908 RS.267 Ending Inventory 240 @ RS.1.908 RS.458 Total Units Reconciled RS.725 Using Perpetual: January 1 - Balance 100 units @ RS1.00 RS100 14 - Purchased 150 units @ RS2.00 RS300 Balance 250 units @ RS1.60 (RS400/250) RS400 19 - Sold 140 units @ RS1.60 Cost of Goods Sold RS224

Balance 110 units @ RS1.60 RS176 26 - Purchased 130 units @ RS2.50 RS325 Balance 240 units @ RS2.09 (RS501/240) Ending Inventory RS501 Summary: Cost of Goods Sold RS224 Ending Inventory RS501 Total Units Reconciled RS725 Notice that, in this particular case, the COGS using the periodic system is higher (RS267) than the perpetual system (RS224). Translating the outcome further, you can see that Gross Profit will be higher using the perpetual system because COGS is lower. For example: Periodic System Perpetual System Sales RS1000 RS.1000 Cost of Goods Sold -267 -224 Gross Profit RS 733 RS 776 Suffice it to say that using a FIFO method, the outcome is the same when using either the periodic or perpetual system. LIFO is a different story because the outcome varies when using either the periodic or perpetual system. FIFO and LIFO will produce different results in calculating the value of the closing inventory. In times of inflation when prices are rising, LIFO will produce a larger COGS and a lower closing inventory. In time of falling prices, FIFO will produce the larger COGS. Specific Identification This method is used to identify the cost of each inventoried item by matching the item with its cost of acquisition in addition to other allocable costs, such as labor and transportation. Although this method tends to be more accurate than the other methods, it requires a sophisticated software program for inventories that have large quantities of small items. Retail Method This is a method used for estimating COGS and ending inventory. The value of ending inventory is determined by applying an average markup percentage to the total retail price of goods on hand. The main point of this discussion is that fundamental accounting for the inventory

process is straightforward once you have established values for Beginning Inventory, Purchases, and Ending Inventory. With those values you can deduce (squeeze) what the value is for COGS. In addition, you can begin to see that there is a lot more to valuing inventory than first meets the eye. Using a particular inventory valuation system can achieve various outcomes so make sure to use the one that most helps your business. Due to the complexities involved, you would be well advised to seek an opinion from your accountant. How Does Manufacturing Inventory Accounting Work? Managing a manufacturing inventory system can become quite complex, even for the very small business. The following provides a general idea of how it works: First, think about the process in terms of stages. For example, raw materials (Stage 1) are used to create a product. When the raw materials are used to start the construction of the product, but are not yet finished (Stage 2), the product is said to be in progress. Once the product is finished (Stage 3), then, of course, the product is ready to sell. When the product is sold (Stage 4), the product cost has to be taken out of Inventory and recorded as a COGS. Manufacturing companies usually follow a format similar to this: Raw Materials: Beginning raw materials inventory RS.10,000 Add purchases 5,000 Subtract ending raw materials inventory <7,000> Work-in-process RS. 8,000 Work-in-Process: Beginning work-in-process RS.6,000 Add new goods from raw materials 8,000 Add labor, overhead burden, supplies 4,000 Subtract ending work-in-process <9,000> Finished Goods RS. 9,000 Finished Goods: Beginning finished goods RS.15,000 Add new finished goods from work-in-process 9,000 Subtract ending finished goods <7,000> Cost of Goods Sold RS.17,000 The most difficult part of this process is determining the cost of raw materials,

labor, overhead, and other supplies, etc., that go into each finished good. Establishing these costs accurately is critical, because you must price your finished goods to ensure that a profit will be made, while at the same time stay competitive with other similar industry manufacturers. One of the pitfalls for the entrepreneur, who single-handedly tries to start his/her own small manufacturing concern, is wearing too many hats. If you are the person with the knowledge of how to create fashionable bicycle wear garments; the seamstress; the sales clerk; the sales representative; the marketing executive; the bookkeeper; the buyer; etc., you will soon wear yourself out and fail. Enter this arena with great caution, otherwise you may find yourself holding onto the tigers tail and unable to let go. TIP: Using Accrual Or Cash Basis For Inventory. Formerly, at least in the U.S., if your business carried inventory, it automatically meant you were on an accrual method of accounting. Times have changed and now the Internal Revenue Service (IRS) allows those of us with average annual gross receipts of RS.1 million or less to use the cash method of accounting. Average annual gross receipts are computed for the three-year period prior to the year to which the test applies. Why does this matter to anybody? Lets say you are a little guy struggling to keep your business alive. If you are forced to use an accrual method for tax purposes, the impact on your cash position might be devastating. When using an accrual method, all sales are counted as revenue whether payment has been collected or not. Taxes are paid on the net profit of your business, regardless of collections. Result: Big tax bill, no money to pay. Under the cash basis method, you are required to report as income only the cash received from sales. Additionally, only those purchases that have been paid for can be deducted. However, if you recorded all cash purchases of inventory as COGS even though they had not been sold, there will be little correlation between sales and cost of sales. For this reason, the IRS ruling requires those businesses that qualify for the less than RS.1 million in gross receipts rule to only count as expense (deduct) inventories that have been paid for, or actually used, whichever is later. What this means is that you do not have to use a full accrual system if you carry inventory, but inventory that has not been sold cannot be counted as a COGS.

Therefore, it must be counted as an inventory asset on the balance sheet. In addition, inventory purchased through Accounts Payable cannot be recorded as a COGS, or an inventory asset, because it has not been paid for or sold. If you are an accrual basis taxpayer and want to change your accounting method because you qualify for the less than RS.1 million gross receipts rule you can get automatic approval from the IRS by filing Form 3115. Be aware, though, that shifting from accrual to cash can have certain tax consequences because you have to make up the difference in income and expenses that occur from changing accounting methods. Completing this form can become an ordeal. The real significance of this IRS ruling is that the small business taxpayer who, in the past, was carrying inventory and using a cash basis method of accounting is now in compliance with the law. Keep in mind that my intention here is to offer a heads up in case you are unfamiliar with these issues, not to give any specific tax advice. For that, be sure to check with your tax advisor.