Inventory Accounting 101 – Part 1

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Each Tuesday, our new series ‘Accounting Tips Tuesday’, brought to you by Zoho Books, will present articles that fit into one of two categories. First, the theory behind basic, and even not so basic, accounting concepts with practical applications including the old ‘debits and credits’ appropriate to the situation. Second, we will go beyond the practical theory and actually cover fundamental software use in the proper recording of these types of transactions using Zoho Books.

Today’s article is the first in another mini-series on basic accounting concepts, this time 'Inventory Accounting'. We will be examining both theory as it relates to the 'traditional inventory costing method' and some basic set-up procedures for inventory software tracking.

Inventory Accounting 101 – Part 1

Inventory consists of the goods available for resale. For retailers, inventory is the merchandise they offer for sale to their customers; for a manufacturer inventory consists of raw materials (to be used in production), materials in production (work in process) and finished goods (ready for delivery). The success of inventory related businesses depend on how well the business can maintain adequate quantities of items for sale, while at the same time not over-stocking items, especially those items that are ‘dead wood’.

While these businesses concern themselves on a moment-to-moment basis with the quantity of inventory items ‘on hand’, from a financial standpoint they are more concerned with the value of that inventory on hand. Not-only does inventory produce ‘income’ but it also represents the cost of producing that income, commonly known as Cost-of-goods Sold, as such the relationship between Inventory value on the Balance Sheet (inventories should be recorded as current assets on the Balance Sheet) and Cost-of-goods Sold on the Profit & Loss statement, directly impacts the Gross Profit of these businesses.

The traditional inventory costing model is based upon what is known as the ‘actual counting piece’ method. It involves actually counting inventory item-by-item on some frequency, but no less than annually, for the purpose of determining the ending inventory at the close of a period, and then using that same figure as the beginning inventory at the start of the next period. 

Starting with the Beginning Inventory (in terms of both quantity and value) for one period, and then adding to that inventory the Total of Purchases (for inventory in quantity and value by item) during the entire period, it is easy to determine the Quantity (and value) of Inventory Available for Sale during the period.  At the end of the period the inventory ‘count’ is taken again and the value computed as the Ending Inventory. When this Ending Inventory is subtracted from the Inventory Available for Sale, the difference is the Cost-of-Goods Sold for the valuation period.  You can see this method applied in the model (figure) shown:

Of course, this model is displaying ‘quantities’ only, it isn’t taking into account the fact that each of the little ‘inventory blocks’ has a value, and it isn’t taking into account that each of the little ‘inventor blocks’ may not be valued all the same.  That’s why this traditional method, even though it is reflected on many IRS forms as the way to report your inventory and cost-of-goods sold, is really far inferior to perpetual inventory methods. Be that as it may, we can still look briefly how at least part of the model would look if we were to value each of the little blocks as if they were actually a ‘box of tea’ valued at $1.00 per box.

In this example we can see that using an ‘average cost’ of $1.00 allows us to compute the Beginning Inventory in our model at $4.00 ($1.00 for each blue block) and value the period purchases at $6.00 ($1.00 for each red block), which means that we have a total Quantity (available) for Sale of $10.00.  Remember this assessment is based on the assumption that each block, regardless of color (blue or red) costs the same $1.00 be that their true cost or ‘average cost’.  We will look at the rest of this example, and some different ‘valuation methods’ in Part-2 of this mini-series.

With almost the advent of the abacus, and paper and pencil, pencil-pushers were hired by companies having substantial inventories to ‘count the beans’ so to speak. Management wanted to know the actual value of what they had in stock in the way of inventory, not just the quantity on hand for sale. Then they wanted the best overall way to ‘state’ that value in relationship to either their ‘bottom line’ or ‘overall worth of their company.’  In the eyes of their bankers they wanted a better company value, in the eyes of the IRS man they wanted as small a taxable bottom-line as they could get away with.

The result, was ‘inventory valuation’ or ‘inventory cost’ methodologies. Logically inventory valuations should include all costs that are ‘ordinary and necessary’ to make the items available for sale.  Therein is where the controversy soon begins, you see under these conditions just about anything that impacts inventory prior to sale would be added-to the actual cost (purchase price) of the item(s). In fact, the controversy may have begun even before that, with trying to determine ‘when inventory’ actually changes hands.

Believe it or not, the concepts of 'inventory valuation' really stretch back to the bookkeepers working for both shippers (including Her Majesty's Royal Mail Ships) and Lloyd's of London (the first insurer of merchandise); they considered it extremely important to have the 'correct value' of merchandise being loaded onto ships and insured while at sea.

When does inventory change hands from a manufacturer in China and a wholesaler in Chicago? It all depends! The terms regarding ‘freight’ commonly recorded as F.O.B. (free on board) are of critical importance in regard as to when the seller transfers ownership of goods to the buyer. As a result, F.O.B. terms are also an indicator when items should be included in whose (seller or buyer’s) inventory. 

Technically, merchandise sold as “F.O.B. Destination” does not belong to the purchaser until the merchandise arrives at the final destination; in other words, until the buyer ‘takes physical possession’ of the merchandise. On the other hand, merchandise sold “F.O.B. Shipping Point” becomes the property of the purchaser once that merchandise has been shipped by the seller; in such cases the buyer hasn’t even received the merchandise, but we might say they have taken ‘fiscal possession’ of the merchandise. As a result, at any inventory ‘valuation period’ it becomes necessary to include the value of goods being transported but not yet received.

From a seller standpoint:

  • F.O.B. Shipping Point – Credit the Inventory at the Departing Dock
  • F.O.B. Destination – Credit the Inventory at the Buyer’s Business

From a buyer’s standpoint:

  • F.O.B. Shipping Point – Debit the Inventory at the Departing Dock
  • F.O.B. Destination – Debit the Inventory at the Buyer’s Business

Makes us wonder, just who's Tea actually went into Boston Harbor, doesn't it?

Obviously in days-of-old, when merchandise (like ‘tea’ for example) crossed the oceans by ship, there was a great deal of concern over ‘who owned the merchandise when’ in order for the appropriate party to purchase insurance for the cargo.  If the Shipper owned the cargo until it was received by the buyer, then the shipper wanted to insure the cargo so as to guarantee some ‘return’ on the value of the merchandise if the ‘ship was lost at sea’ (or the tea was thrown overboard by an angry mob.) On the other hand, if the buyer was the lawful owner of the merchandise at the time it left the dock, then the buyer wanted to insure the cargo in case the ship went down so they were not out the cost of lost merchandise. 

Beyond Theory

We will come back to ‘Inventory theory’ in Part-2, but for now let’s look at starting the process of managing Inventory in Zoho Books.  While your software maybe somewhat different, the basic concepts should apply.

The first step is to activate ‘Inventory functionality’ in the software.  In Zoho this step is accomplished by selecting the inventory preference under Settings > Preferences >Items.  The actual preference reads Would you like to enable Inventory?  You will need to check this option to enable the inventory feature in the items module. With this option enabled you can track the inventory of your items, set the re-order point to get notified and replenish your items.

There is a companion preference you may want to set as well. Do you want to be notified when an item quantity drops below reorder point?  If you select this option, you will be notified when an item drops below the reorder point in your inventory. You can enter the email address of the person in the Email Address field, who you wish to notify on the drop in inventory.  Here is an example of an Email I received about one of my inventory items being below the reorder point.

Of course you must also set-up your Inventory Items.  Previously in our Accounting 101 mini-series we went through the steps to set-up an item, but that wasn’t an ‘inventory item’.  The set-up remains pretty much the same with the exception of the entire lower section of the New Item window as can be seen in the figure below.

Check the box, Track Inventory for this item to ​enable inventory tracking for this item. ​If you do not wish to track the inventory for a particular item, keep the Track Inventory for this item unchecked.

For the Account select the inventory account you wish to use to track the value of your items. If you want to track some of the items in a different inventory account, an additional inventory account can be added before creating an item.

The Opening Stock is the quantity present on the date of starting your business. This quantity will be recorded against the Business Start Date; if you don’t have inventory on-hand already at the time you start your business, simply record this value as zero.

The field titled Opening stock rate per unit represents the initial rate (value) of the item associated with the opening stock quantity.

You can enter a Reorder Point at the time of creating an item, or can change this at a later time.  Earlier I mentioned how Zoho Books will email you when your quantity on hand falls below this Reorder Point, if you elected that option under your preferences.

Selecting a Preferred Vendor will help you in ordering the items which are below reorder point so that you can easily re-order them.

Next time we will look at how inventory is valued, and then relate that to the First-In, First-Out (FIFO) cost methodology Zoho Books uses.