🧾Financial Accounting I Unit 10 – Inventory

What's Inventory All About?

• Inventory represents goods held for sale in the ordinary course of business
• Includes raw materials, work-in-progress, and finished goods
• Key component of a company's current assets on the balance sheet
• Inventory management is crucial for maintaining optimal stock levels and avoiding stockouts or overstocking
• Proper inventory valuation is essential for accurate financial reporting and decision-making
• Inventory turnover ratio measures how efficiently a company sells and replaces its inventory ($\frac{Cost of Goods Sold}{Average Inventory}$)
• Inventory can be a significant source of cash flow for businesses when managed effectively

Types of Inventory Systems

• Periodic inventory system updates inventory records at the end of each accounting period through a physical count
  • Does not track inventory continuously
  • Cost of goods sold is determined by adding beginning inventory to purchases and subtracting ending inventory
• Perpetual inventory system continuously updates inventory records in real-time as transactions occur
  • Uses technology (barcode scanners, RFID tags) to track inventory movement
  • Cost of goods sold is calculated with each sale transaction
• Just-in-time (JIT) inventory system aims to minimize inventory holding costs by receiving goods just as they are needed for production or sale
• ABC inventory classification categorizes inventory items based on their value and importance (A: high value, B: moderate value, C: low value)
• Economic order quantity (EOQ) model determines the optimal order quantity to minimize total inventory costs (holding costs and ordering costs)

Valuation Methods: FIFO, LIFO, and Average Cost

• First-In, First-Out (FIFO) assumes that the oldest inventory items are sold first
  • Ending inventory consists of the most recently purchased items
  • Results in lower cost of goods sold and higher gross profit during periods of rising prices
• Last-In, First-Out (LIFO) assumes that the most recently purchased inventory items are sold first
  • Ending inventory consists of the oldest purchased items
  • Results in higher cost of goods sold and lower gross profit during periods of rising prices
• Average Cost method calculates the average cost per unit of inventory based on the total cost of goods available for sale divided by the total number of units available
• Specific identification method tracks the actual cost of each individual inventory item sold
  • Used for high-value, unique items (artwork, jewelry)
• Choice of inventory valuation method can significantly impact a company's reported profits and tax liabilities

Inventory on the Financial Statements

• Inventory appears as a current asset on the balance sheet
• Cost of goods sold (COGS) on the income statement represents the direct costs attributable to the production or acquisition of the goods sold
  • COGS = Beginning Inventory + Purchases - Ending Inventory
• Inventory valuation affects the reported cost of goods sold and gross profit
• Inventory write-downs may be necessary when the market value of inventory falls below its cost
  • Recorded as an expense on the income statement
• Inventory footnotes in financial statements disclose the inventory valuation method used and any significant changes in inventory value

Key Calculations and Formulas

• Inventory Turnover Ratio = $\frac{Cost of Goods Sold}{Average Inventory}$
  • Measures how efficiently a company sells and replaces its inventory
• Days Sales in Inventory (DSI) = $\frac{365}{Inventory Turnover Ratio}$
  • Represents the average number of days it takes to sell inventory
• Gross Profit Margin = $\frac{Gross Profit}{Net Sales}$
  • Indicates the percentage of revenue remaining after deducting COGS
• Inventory Holding Cost = Carrying Cost per Unit × Average Inventory
  • Represents the cost of holding inventory over a specific period
• Economic Order Quantity (EOQ) = $\sqrt{\frac{2 × Annual Demand × Ordering Cost}{Holding Cost per Unit}}$
  • Determines the optimal order quantity to minimize total inventory costs

Common Inventory Issues and Errors

• Inventory shrinkage due to theft, damage, or obsolescence
  • Requires periodic physical counts and adjustments to inventory records
• Inaccurate inventory counts leading to over- or under-stating inventory value
  • Implement proper inventory counting procedures and train employees
• Incorrect application of inventory valuation methods (FIFO, LIFO, Average Cost)
  • Ensure consistency in applying the chosen valuation method
• Failure to record inventory write-downs when necessary
  • Regularly assess inventory for obsolescence or market value declines
• Inadequate inventory management systems and controls
  • Invest in robust inventory tracking technology and establish clear policies and procedures

Real-World Applications

• Retailers (Walmart, Target) rely on efficient inventory management to meet customer demand and maintain profitability
• Manufacturing companies (Ford, Boeing) use inventory systems to manage raw materials, work-in-progress, and finished goods
• E-commerce businesses (Amazon, eBay) leverage advanced inventory tracking technologies to fulfill orders quickly and accurately
• Pharmaceutical companies (Pfizer, Johnson & Johnson) must carefully manage inventory to ensure product safety and compliance with regulations
• Food and beverage companies (Coca-Cola, Nestlé) use inventory management to minimize spoilage and maintain freshness

Exam Tips and Tricks

• Understand the differences between periodic and perpetual inventory systems and their impact on financial statements
• Practice calculating inventory turnover ratio, days sales in inventory, and gross profit margin
• Know how to apply FIFO, LIFO, and Average Cost valuation methods and their effects on cost of goods sold and ending inventory
• Be familiar with common inventory issues and errors and how to prevent or address them
• Review real-world examples to better understand the practical applications of inventory concepts
• Practice solving problem sets and reviewing past exam questions to reinforce your understanding of key concepts and calculations