The main objective of this chapter is to show the methods and procedures for valuing inventories on the balance sheet and for recording the cost of items sold in the income statement.
BUSINESS CLASSES AND THEIR INVENTORIES
Manufacturing companies: manufacturing companies are those that through a production process transform raw materials into a finished product with added value. From the accounting point of view, in a manufacturing company, the elements of the cost of production are: the cost of raw materials, the cost of labor and the indirect costs of manufacturing.
In a manufacturing company there are three kinds of inventories:
Inventory of raw materials: are those materials that are directly used in the manufacture of the product
Inventory of products in process: they are partially elaborated products that lack some steps or processes to become a finished product. They are also called production in process.
Finished Product Inventory: These are fully finished products available for sale.
Commercial companies: commercial companies are those that acquire a good from a third party, be it a producer or another merchant, to sell it to the final consumer. The commercial company delivers a tangible product to the consumer, for this reason, the cost of sales concept is generated, which is basically the cost of buying the merchandise that is being sold.
Companies in the commercial sector buy tangible products and then sell them without changing their basic form or without any transformation process, for this reason, they only maintain a single type of inventory, called inventory of merchandise available for sale.
INVENTORY SYSTEMS
Firms, regardless of whether they are manufacturing or industrial, require an inventory system to record the quantities of existing merchandise and to establish the cost of merchandise sold. There are basically two systems for carrying out inventory records: the periodic system and the perpetual system.
Periodic inventory system: with the periodic inventory system the cost of the items sold is determined at the end of the accounting period when a physical count of the existing inventory is carried out. The process of counting the existing physical inventory can be done once or twice during the year, however, most companies always do it at the end of the accounting period. This system does not keep a daily record of units sold or in inventory.
Perpetual inventory system: The perpetual inventory system keeps continuous, current, and daily records of inventory and the cost of items sold. This system permanently displays the merchandise available in the inventory and allows to develop an adequate control over the stocks by the administrators. In this system, cost of sales is determined each time a sale is made.
Currently, technological developments in the computer field facilitate the implementation of the perpetual inventory system in companies. This system has been widely used by commercial companies, especially chain stores. Important companies such as Carrefour, Éxito or Olímpica use the perpetual inventory system through computerized systems combined with optical recording equipment at cash registers; so every time a sale is made, the inventory is automatically updated and the cost of sales is calculated; Likewise, once the inventory has dropped to its minimum level, the computerized system automatically generates a purchase order for administrators to make the purchase from the suppliers of the goods.
The perpetual system allows for an up-to-date inventory record, however it does not eliminate the need for a physical inventory count. Physical inventory accounts (tonnage) must be carried out at least once a year at a general level or by sampling to verify the accuracy of computerized records and establish the so-called inventory contraction, which are the differences in inventories caused by theft, damage, loss or obsolescence of the goods.
THE INVENTORY GAME
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INVENTORY VALUATION METHODS
Regardless of the inventory system adopted by a company, the costs of individual items must be determined using an inventory valuation method. There are three main methods for inventory valuation that have been generally accepted in accounting practices in different countries: PEPS, UEPS and weighted average.
If the unit prices and costs of different goods did not fluctuate, all inventory valuation methods would provide the same results. However, the reality is that in the different existing economies prices change and these changes generate important aspects to take into account in relation to the final inventory of merchandise (measurement of current assets-balance sheet) and the cost of the items sold (gross profit-income statement).
PEPS: first to enter, first to exit. This method assumes that the inventory that was previously purchased is sold (consumed) first, for this reason, the ending inventory is made up of the last units purchased. In economies where prices are continually increasing, PEPS generally shows the highest gross profit.
UEPS: last to enter, first to exit. This method assumes that the most recently purchased inventory is the one that is sold (consumed) first, for this reason, the ending inventory is made up of the first units purchased. In economies where prices are continually increasing, UEPS generally shows the lowest gross profit.
WEIGHTED AVERAGE: average cost of purchased goods available for sale. This method calculates the cost of each unit of the ending inventory dividing the total acquisition cost of all the goods available for sale by the number of units available for sale. In economies where prices are continuously increasing, the weighted average generally shows an intermediate gross profit between that calculated by the PEPS and that obtained by the UEPS.
CASE STUDY AT EXCEL
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