I’m going to cover this topic in two posts. This one will be about what inventories are: the sub-categories of the inventory entry on the balance sheet, and three main ways companies choose to account for inventories. Tomorrow’s post will cover what kinds of information you can get about a company from comparing the inventory entries from different time periods.
There are three sub-categories of inventory on a company’s balance sheet:
—raw materials. This is pretty straightforward. Raw materials are inputs to production that the company owns but has not yet begun to process. They might be a pile of iron ore outside a steel mill or a bunch of windshield wipers stacked in a warehouse next to an auto assembly plant.
This entry records what the company owns, which may be something very different from what’s at the production site. The idea of “just in time” manufacturing is that the component suppliers have warehouses full of their wares that they deliver on the day they’re needed.
In today’s world, financing cost aren’t the big issue. Instead, it’s who takes the risk that the stuff in the warehouse falls in price while it’s just sitting there. The answer is whichever party has less market power, typically the component supplier.
—work in process (which a lot of people incorrectly call “work in progress”). This is stuff that has entered production and is in the process of being turned into finished goods. The increase in value of the raw materials will be a mix of direct costs involved in making the item, like salaries of assembly workers, and indirect, or period costs, like the cost of renting/leasing the production site, utilities (heating, lighting), and salaries of foremen and the plant manager.
The amount of work in process varies widely from industry to industry. Assembly of a PC or a cellphone may take a day. A semiconductor may take several months. Wine or whiskey may ferment for years.
—finished goods. This one is also straightforward. It’s the final products a company makes that are waiting in storage for a buyer to pick them up–or in some cases, to materialize in the first place.
How finished goods move from the balance sheet to the income statement
When a company records a sale of an item (exactly when is a topic of negotiation between the buyer and seller, but it’s normally when the item leaves the production site), it shows revenue on the income statement as well as the associated costs from the finished goods account.
There are three main ways of doing this:
1. specific identification. Under this method, you assign a specific cost, item by item, to everything in your inventory. When you sell an item, you used the amount assigned as the cost of goods.
If you make custom $500,000 dining room tables for the rich and famous, and you make only make one a month, you probably use this method. Otherwise, it’s too much work.
2. First In, First Out (FIFO). Under this method, you organize inventory of all items according to when they were put into inventory. When you sell an item of a specific type, you assign as cost of goods the cost of the first, i.e. oldest, item of that type in inventory.
This is the common-sense way to operate and the accounting mirrors what happens with the movements of the physical items in inventory. FIFO, however, is not regarded as a particularly conservative, or tax-efficient, inventory method.
Why? Over most time spans, and in most parts of the globe, we live in an inflationary world. In other words, prices in general are tending to rise. This means that the item I made nine months ago at a cost of $100 may now cost $105 to replace. If I sell it for $110, I show a profit of $10, on which I have to pay tax of $3.50, so I end up with $106.50. Of that I have to spend $105 to replace the item.
I would be better off if I could use the cost of the item I made yesterday for $105. I still want to physically deliver the oldest item in inventory to the buyer. But I’d prefer to use the most current manufacturing cost. That’s the more accurate assessment of the economic profit I’m making. And I have the added benefit of paying lower taxes.
This brings us to the third accounting method, LIFO, or Last In, First Out.
Note: there are industries, like technology, where the production cost of items continually falls. In such cases, the more conservative method is FIFO, which is also the most commonly used.
3. Last In, First Out (LIFO). As with FIFO, under LIFO you also order the items in inventory by when they were manufactured and put into inventory. LIFO users, however, use the cost of the most recent item as cost of goods on any sale.
LIFO is the more conservative method of accounting for most companies, and saves taxes as well. There are a number of quirks to LIFO that one should note, though.
–LIFO doesn’t necessarily mirror the physical movements of inventory. It captures the economics of a transaction better than FIFO by including in cost of goods any gains the company is making from holding inventory. But, to the extent they can, firms will virtually always sell the oldest items first.
–LIFO relies on estimates, three of them, in fact. The are estimates of how many items the firm will make, how many it will sell, and what average production costs for the year will be.
Suppose the company estimates that it will both make and sell 1,000,000 items this year, 250,000 each quarter,and that production costs, now $100/unit will rise to $105 by yearend and average $102 for the year.
For the first quarter, the company will use as cost of goods the number sold, say the anticipated 250,000 x $102, the estimated average unit cost of production for the year.
For each succeeding quarter, the company first checks to see whether the start of the year forecast is still valid. If so, it proceeds in the same manner it did in the prior quarter. If not, if it changes its assumptions, it must recalculate what the year-to-date figures should be. It subtracts what has already been recognized in the prior quarters and reports the remainder as the current quarter figures. In other words, the second-fourth quarter numbers are residuals, or adjustments to the already-reported figures, based on the new assumptions.
An example: the company continues to think it will manufacture and sell 250,00 units per quarter for the year. During the first quarter, it estimated production costs for the year at $102 per unit. Now, at the end of the second quarter, it has come to believe that productions costs will average $103 per unit this year. Therefore, in the second quarter income statement, cost of goods equals: 250,000 units produced in the second quarter x $103 + 250,000 units produced in 1Q x $1, the necessary adjustment to the under costing done in the first quarter report.
–LIFO reserve. This is where production units vs. sales units comes in.
Let’s assume that a company produces 100,000 units at a cost of $100 each in year one of its existence but sells nothing. Costs rise at an average rate of 6% yearly, meaning that after about 15 years, unit production costs have risen to $250.
Let’s also assume that in every subsequent year, production and sales match exactly at 100,000. If so, at the end of year 15, the company’s inventories have a replacement cost value of $25 million but a carrying value of $10 million. The difference, $15 million, is called a LIFO reserve (there’s also another, more obscure meaning for the term, but don’t worry about it).
Q: When, if ever, is the LIFO reserve tapped? A: Since under LIFO, the last units manufactured enter cost of goods before anything else, the only way to reach the LIFO reserve is to sell more than you produce. In our example, if the firm produces 50,000 units but sells 100,000, cost of goods will equal 50,000 x $250 + 50,000 x $100. Reported profits for the year will be enormous, but the company will also have to pay the tax bill it has been deferring for all these years.
That’s it for now. Next post: how to use this information.