Inventory values are required for the Balance Sheet and Cost of Sales and is essential to understanding profitability.
Balance Sheet Inventory is listed in the Current Assets section of the Balance Sheet. Cost of Sales The inventory value is the basis for the Cost of Sales on the Income Statement. Current Assets Raw Materials 1,000,000.00 Work in Process 500,000.00 Finished Goods 300,000.00 Gross Inventory 1,800,000.00
-150,000.00 Net Inventory 1,650,000.000 Income Statement Sales 1,000,000.00 Cost of Sales -450,000.00 Gross Income 550,000.00
Inventory Valuation Regulations
To comply with Generally Accepted Accounting Principles (GAAP), inventory valuations must be accurate and must include the fully absorbed manufacturing cost, including overhead.
Under the International Financial Reporting Standards (IFRS) rules, inventories are valued at variable cost and overhead is considered a period cost.
Flow of Inventory
Manufacturing Activity Debit Credit Receipt of Item Inventory Cash (or Accounts Payable) Sale of Item Cost of Sales Inventory Activity Debit Credit Receipt of Raw Materials Raw Materials Goods Received, Not Invoiced Issuing Raw Material to a Job
Work in Process (WIP)
Raw Materials On Payment Goods Received, Not Invoiced Cash (or Accounts Payable) Upon Job Completion
Work in Process (WIP)
Cost of Sales
Who Owns the Inventory?
The shipping terms dictate when the buyer takes possession of goods from the seller.
FOB Shipping Point (or FOB Origin)
The buyer takes possession of the items during shipping and Inventory in Transit is included on the Balance Sheet of the buyer.
The seller retains possession of the items during shipping and Inventory in Transit is included on the Balance Sheet of the seller.
The 80/20 Rule for Inventory
The 80/20 Rule (see The Pareto Distribution presentation for more information) is a great tool to test inventories. Here are a couple of examples of how to apply the rule:
Approximately 80% of the value of the inventory is based on approximately 20% of the quantity of items.
Approximately 80% of the turnover of items in inventory is from approximately 20% of items.