In the last edition in the financial analysis techniques series we read about equity analysis ratios. From this post onwards we begin a new topic, Inventory Management. In this post we will look at what are product costs and period costs, inventory valuation under GAAP and IFRS and the different inventory cost flow methods like LIFO and FIFO. So let’s begin…..
Inventory management of manufacturing and merchandising companies require them to record sales of inventories and profits earned through their sale. Merchandising companies such as retailers and wholesalers purchase inventories of goods ready for sale from manufacturing companies. Thus, they report only one type of inventory, i.e. finished goods or goods ready for sale. Manufacturing companies on the other hand record three types of inventories, raw materials, work-in-progress and finished goods. Work-in-progress are those raw materials that are currently being worked upon to convert them to finished goods.
An important metric in inventory management for calculating profits of such companies is Cost of goods sold (COGS) also as known as Cost of sales (COS) under IFRS. The cost of goods sold has a relationship with the beginning balance of inventory, purchases and ending balance of inventory. The following equation summarizes the relationship;
COGS = Beginning inventory + purchases – ending inventory
Product costs and Period Costs
Cost is the basis of inventory valuation. Inventory Management determines the costs included in the cost of inventory which are known as product costs. The costs expensed are called as period costs.
The product costs are capitalized as cost of inventory on the balance sheet and include;
- Purchase costs less trade discounts or rebates
- Conversion costs including labor and overheads
- All such other costs as are necessary to bring the inventory to its present location and condition.
- A portion of the fixed production overhead based on normal capacity levels.
The inventory costs that are not capitalized are expensed as period costs in the period in which they are incurred. They include;
- Abnormal waste of labor, material or overhead
- Storage costs ( Capitalize these costs if they are necessary part of production process)
- Administrative overheads
- Selling costs
Capitalizing inventory costs delays their recognition as an expense on the income statement until we sell the inventory and recognize revenue. (Click here to read about revenue recognition on the income statement) Capitalization of costs that should have otherwise been expensed, will lead to overstating of profits on the income statement and inventory on the balance sheet.
Inventory valuation under GAAP
Under GAAP, we measure inventories at the lower of cost or net realizable value. Net realizable value is the selling price in the ordinary course of business less estimated selling costs. In the event the value of the inventory declines below the value carried on the balance sheet, a write down (loss) should be recorded. On the subsequent increase in the value of the inventory, a reversal should be recorded maximum up to the amount of the previous write down.
We recognize write-downs as expenses in the period of the write-down. Likewise, we recognize reversals as a reduction of inventory costs expensed, in the period in which reversal occurs.
Inventory valuation under IFRS
Inventory valuation under IFRS is similar to GAAP, in that inventory is valued at lower of cost or market value. IFRS defines Market value as current replacement cost subject to an upper limit of net realizable value and a lower limit of net realizable value minus normal profit margin. IFRS prohibits reversal of a write-down.
Inventory Management or inventory accounting methods /Cost flow methods
If the event cost of inventory remained constant over time, inventory management or accounting would have been so simple. We would just multiply the number of units sold or number of units in ending inventory with the cost per unit and get an organization’s Cost of goods sold and ending inventory. However, the cost of purchasing or producing inventory changes over time. Therefore a cost flow method needs to be determined for allocating inventory cost to COGS (income statement) and the balance sheet.
Three methods for doing this as permitted under IFRS are;
- Specific identification
- First in, first out method
- Weighted average cost method
Specific identification method matches each unit sold with the unit’s actual cost.
First in First out method (FIFO) assumes the items purchased first are sold first. Therefore, under this method, ending inventory is measured at the most current prices while COGS at earlier prices. Hence in a rising costs environment, COGS is understated, and the profits on the income statement overstated.
Weighted average cost method, determines the average cost per unit by dividing the total cost of goods available for sale by the total goods available for sale. Therefore, we compute COGS and ending inventory by multiplying the number of units sold and the number of units in ending inventory by the weighted average cost per unit.
Besides these methods, GAAP permits a fourth inventory management method, called,
- Last in First out (LIFO) method
Last in first out method assumes the inventory purchased last is sold first. Therefore, the COGS will be valued at the most current prices and the ending inventory at earlier prices. In a rising costs environment, the COGS under FIFO will be lower than the COGS under LIFO. The profits on the income statement will be lower in the case of LIFO than under FIFO.
Effect of inflation and deflation on COGS, ending inventory and gross profit under the different cost flow methods
Under inflationary or rising prices scenario, when inventories stock is stable or increasing, LIFO COGS will be higher than FIFO COGS, because the last units purchased will have higher prices than the earlier purchased units.
Under a deflationary or falling prices scenario, when inventories stock is stable or increasing, LIFO COGS is lower than FIFO COGS. This is because we value the last units purchased at the most recent lower prices. Therefore, under a rising or falling prices scenario, COGS is valued at the most current prices under LIFO.
Under an inflationary scenario, when inventories stock is stable or increasing, ending inventory value is higher under FIFO than LIFO. This is because the units in ending inventory are the last units purchased under FIFO at current higher prices and the first purchased under LIFO at earlier lower prices.
As against this, in a deflationary scenario, ending inventory value is lower under FIFO than under LIFO. Therefore, in a rising or falling price scenario, ending inventory will be valued at the most current prices under FIFO.
Under an inflationary or rising prices scenario, Gross profit will be lower under LIFO as COGS is higher under LIFO (as already discussed above). We calculate Gross profit by deducting COGS from Revenue on the income statement.
Conversely, in a deflationary scenario, Gross profit will be higher under LIFO than FIFO as we value COGS at the most recent lower prices under LIFO.
In fact all profitability ratios such as gross profit, operating profit, net income and therefore taxes will be affected by choice of cost flow method during times when the prices are trending, either lower or higher.
During periods of stable prices, all three methods will give the same results. When prices are changing (not trending), values of COGS and ending inventory from weighted average cost method will lie between those of FIFO and LIFO.
For solved examples please refer to the CFA Institute books or CFA study notes. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
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