When you buy a sheep, how much is it worth to you, what is its value? For starters, its value is at least what you paid for it, but that’s not quite it. Say you paid a hundred dollars for it. If you want to sell it now, how do you determine your selling price? A hundred-twenty? A hundred-fifty? Obviously, you need to increase the price by some percentage over whatever you paid initially, but regardless of what you increase your price, if you don’t know your true costs, you might be at loss.
If you had to travel twenty miles by truck to get the sheep, than its value is whatever you paid for it, plus the cost of gas to get there and back. It gets more complicated. If you keep the sheep for five days before you sell it, the sheep must have eaten some food, which you had to acquire somehow, most likely having paid some price for it too, so the sheep’s value increases by the cost of the food it ate. So far it is still fairly simple, because you know how much you had to pay for transportation and feeding the sheep.
However, if you have a flock of sheep, and you have to pay a shepherd to keep an eye of the sheep, you probably need to pay that shepherd a salary. So you need to make sure that the by the end of the month you have sold enough sheep to pay his salary, and still make some money. If you lease your truck, it adds some costs to your equation. The cost of shepherd’s salary and truck monthly lease add certain amount to the value of the sheep, but calculating how much exactly is far from simple. It can depend on a number of variables, such as how many sheep you sold in the course of a month.
In any case, the value of an item is made of all sorts of costs. In accounting, a cost is defined as a sacrifice, measured by the price paid, to acquire, produce or maintain goods or services. In accounting, anything you can apply the costs against is called a cost object. If you handle goods, these goods are cost objects.
There are several kinds of costs:
Direct costs: These are simple. Direct costs are those costs that you can easily trace to a cost object in a cost-effective way. For example, the purchase price and the transportation costs can be easily traced to purchased goods, because you usually know how much you paid for both the goods and transportation. Direct costs in our example were the price you paid to get the sheep plus cost of gasoline to transport it.
Indirect costs: These are all but simple. Indirect costs are those costs that you cannot easily trace to a cost object in a cost-effective way, but still affect the selling price. Indirect costs are all supporting costs of a business in order to prepare goods for sale. These include the salaries of personnel handling the goods, costs of electricity to power the warehouse where the goods are stored, and such. In order for business to make money by selling goods, all these costs have to be included in the selling price, to determine how much exactly all of these costs affect any single item sold, would in itself cost you too much, and therefore it isn’t cost-effective. In our example the shepherd’s salary and truck monthly lease are indirect costs. Some would say that shepherd’s salary can be regarded as direct cost, which may or may not be true, because it is hard to trace the salary of the shepherd to any specific sheep, especially if you are through a tough period with no sheep to watch at all, but the shepherd is on the payroll nonetheless.
The costs also can be regarded from another perspective:
Variable costs: These are the costs that change, or vary, with the proportion of business activity. For example, if we double the volume of sales, then we need to double the volume of purchases, therefore doubling the costs. Most of direct costs are usually also variable costs.
Fixed costs: These are the costs that do not change, and stay the same, regardless of the amount of business activity. For example, rental and electricity costs of a warehouse stay the same regardless of the volume of sales. Your shepherd’s salary and monthly lease for the truck are all fixed costs, because they are, well, fixed, regardless of whether you actually buy and sell sheep or play golf. Most of indirect costs are usually also fixed costs.
The value of inventory is therefore calculated based on costs. In accounting, there is a term inventory valuation, which is defined as determination of the costs assigned to inventory items.
As I already mentioned, market is not a particularly stable thing. There are many factors influencing the way how prices are formed around the world, with demand and supply being only one of them. One of the best examples today is the oil. The price of the oil goes up because demand is high, but even if the total supply of the world could easily outgrow the demand, the suppliers of oil have internal deals to limit the supplies to keep the prices artificially high. The prices of oil affect basically everything, even your sheep, because everything needs to be transported from the place where it is produced to the place where it is consumed, and transportation mostly depends on oil. This is just one simple example of what else can influence a price, and how market prices of many other goods can fluctuate accordingly.
Obviously, if you purchase something at one price, and market value of the same item changes before you manage to sell it, you may be affected in two ways. If the market price went up, you can sell your goods at higher prices, which is good for you. However, if the market price went down, if you want to sell your goods in a competitive market, you need to lower your price, sometimes going even below your initial cost. So, how do these changes affect the inventory value?
There are five methods of valuing the inventory:
Acquisition cost: Also called historical cost, this method assumes that the value of an item in the inventory is the price of acquisition. If the market value of the item changes after the acquisition, these changes are not recognized.
Standard cost: You estimate what an item should cost, based on previous information about the item. This method assumes that costs are going to stay the same, and any difference between the actual cost and standard cost is regarded as variance and you keep a watchful eye on these as a warning that something somewhere might be going wrong.
Replacement cost: Also called entry value cost. Cost of any item at any time equals the amount of money you would have to pay for it if you were to buy that same item at that very time.
Net realizable value: Also called exit value cost. Cost of any item you sell equals the amount a willing buyer would pay for it.
Lower-of-cost-or-market basis: This one works exactly as acquisition cost, except when market prices drop, in which case you may write down the costs of items to match market prices.
Your choice of the inventory valuation method can depend on many things. Regulatory requirements or local accounting practices can be quite a convincing reason to choose one method over another.
There are few other things you may choose to do regarding inventory value, one of them being the timing the valuation is done.
There are two approaches regarding the timing:
Periodic inventory: You don’t record increases or withdrawals in the inventory account. Instead, at the end of an accounting period, you do physical inventory count, and adjust the value of inventory to that figure. This method is less costly because you invest less time into recording transactions, but the drawback is that you don’t have timely information about actual inventory value.
Perpetual inventory: You continually track inventory increases and decreases throughout the accounting period, therefore knowing the exact value of your inventory at any time. This method provides benefits, but at the cost of having to calculate the value after each sales or purchases transaction. Plus, you still need to make periodic physical inventory counts, just to make sure quantities are where you expect them to be, which is rarely so.
The way you approach your inventory valuation from timing perspective can be better understood if you take a closer look at how the inventory equation looks like in these two scenarios.
When you run a company, it is presumed that you know the beginning inventory (both quantity and value), so that part of the inventory equation is always known. What is also presumed to be known is value of purchases, because you know how much money you paid for whatever you brought into your warehouses. However, there are two unknowns, cost of goods sold, and ending inventory, which is basically what these two approaches address in different ways. It’s the simple matter of which one is easier to calculate, ending value or cost of goods sold. It can be tricky.
When you do periodic inventory, you just go and calculate the ending inventory. This is simple, because you get your ending inventory value by multiplying the quantity you got from doing the physical count and cost calculated based on any of the five inventory valuation methods mentioned. The difference between the purchases and the ending inventory is the cost of goods sold, and you simply record it in your general ledger.
On the other hand, when you do perpetual inventory, you need to calculate the cost of goods sold at the time you do any sales transaction, because it is the only way to know the exact value of your inventory at any given time.
Calculating the cost of goods sold continually, or perpetually, is far from simple, and it brings a whole bunch of gremlins to deal with, yet most companies go for it due to a simple reason: if you want to stay competitive, and stay in business, you must control the costs at all times. With this, we come to the issue of cost flow which is something I leave for tomorrow.