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Christian TerwieschAndrew M. Heller Professor at the Wharton School, Senior Fellow Leonard Davis Institute for Health Economics Co-Director, Mack Institute of Innovation Management
The Wharton School
Hello, I'm Professor Brian Bushee, welcome back.
We are now going to turn our attention to inventory.
We're first going to talk about inventory for manufacturing firms,
which is much more difficult and complicated to account for
than inventory for retail firms, which is what we've seen so far.
We're also going to start to talk about some of the assumptions you need to make
to figure out cost of goods sold and
the cost of the goods still held in ending inventory.
So let's get to it.
Let's start by reviewing the accounting for inventory for a retail firm,
which is what we saw with the Relic Spotter inventory earlier in the course.
So the first step is you go out and
buy inventory, which means you debit inventory.
Those are your purchases that increase the inventory.
And then you credit either accounts payable or cash,
depending on whether it's bought on account or with cash.
Then when you sell the inventory you credit inventory,
as the goods sold reduces it, and you debit
cost of goods sold which is the expense that shows up on the income statement.
We also earlier talked about the difference between product and
period costs.
So the product costs are the inventory costs which are matched to revenue,
but then selling, general and
administrative costs directly go into SG&A expense when we incur them.
Now what we're going to talk about is how this looks for a manufacturing firm, so
a company that actually makes the inventory as opposed to buy it.
And we just have to make a few small changes.
So as you can see, we need to add three accounts in the middle.
>> I can, but how do you expect us to understand this mess?
>> Yeah, okay, I know,
how about we go through a detailed example of how this works?
So the first step's going to look just like what we saw for the retail firm,
where we're making some initial purchases.
But instead of purchasing goods that we can turn around and sell,
as in the case of a retail firm, the first step is that we purchase raw materials.
And so we create an inventory account that's titled Raw Materials.
>> What types of items are considered raw materials?
>> Well, raw materials would be any materials that are not cooked.
So raw materials are any materials that are going to be used
in producing the product.
So if we were making eyeglasses, it would be the metal to the frames, the glass for
the lenses, the screws, the little nose pads that are here,
all the pieces that go into making the final product.
To make our walk through this flowchart a little bit more interesting, let's talk
about an example of a company and see how these flows work with some real numbers.
So Kirby Manufacturing Incorporated, their first transaction is they're going to
purchase 865 of raw materials on account.
And I guess to make it even more interesting,
why don't I throw up the pause sign here and
have you try the journal entry before I give you the answer.
So the answer here is that we're getting raw materials.
Raw materials inventory is an asset, so it's going to increase with a debit.
Debit raw materials 865.
On account, which means accounts payable.
Accounts payable's a liability.
We make a liability go up with a credit.
So we credit accounts payable for 865.
And then in our t accounts, we're going to post the increase in the payable and
the increase, the debit, in raw materials.
And then I've got on here the next step, which is as we use materials
in manufacturing, those materials come out of the raw materials
inventory account and they go into the work in process account.
So the next journal entry, transaction 2,
Kirby uses $806 of raw materials, inventory, and manufacturing,
so why don't you try to come up with the journal entry for this.
So what's going to here is we're going to put these raw materials into this new
inventory account called Work in Process, so we debit Work in Process for 806.
We take these out of the raw materials inventory account, that's an asset so
we reduce it by a credit, credit raw materials for 806.
>> If I understand this correctly, all you're doing is moving from one inventory
account to another, there is no transaction with outsiders.
Do you have to do this journal entry every time you use a roll of material in
production?
>> You're correct, this is not a transaction with outsiders,
external parties.
It's completely an internal transaction.
And so it's just like an adjusting entry and in fact,
we're probably going to do this as an adjusting entry.
It wouldn't make sense to do this entry every time we move
a little bit of raw materials into production because the only time this
breakdown matters is when we put together financial statements.
So at the end of the period, when it's time to put together financial statements,
then we will count up how many raw materials we've used in production and
do this as an adjusting entry.
So we post this journal entry to the t accounts.
We reduce or credit the raw materials.
And we increase or debit the work in process inventory account.
Now we're going to have more stuff come into work in process as we're starting to
produce our product.
We're going to have direct labor and overhead.
>> What is this overhead?
Do you also have to account for underfoot and against the wall?
>> [LAUGH] Good one.
No, we do not have to account for underfoot or
against the wall, only overhead.
Overhead is a catch-all term for
any cost of manufacturing that's not materials or labor.
So it would include things like the electricity for
the factory, the water bill, heating and air conditioning,
insurance that you have to take out against employee injuries or
theft, and depreciation on the plants and equipment used.
Because one of the costs that we want to make sure we get into the cost of
producing these goods is the depreciation on the machinery used to produce
the goods.
So let's see how Kirby would account for direct labor and overhead.
So, three transactions here.
Kirby paid $524 cash for the labor that went into manufacturing,
Kirby paid $423 of cash for power, heat, light and other overhead,
and Kirby recognized $81 of depreciation for plant equipment.
So let's do the journal entry step by step starting with number three.
So here we're going to debit work in process inventory to increase it by 524,
and since we're paying cash, cash goes down, we credit cash.
So now try number 4, Kirby paying 423 cash for power, heat, light and other overhead
Journal entry here is going to be the same.
We debit work in process inventory for 423 and
credit cash, since we're paying cash for 423.
Now try number 5.
Kirby recognized $81 of depreciation for plant equipment.
The journal entry here is we're going to debit work in process inventory for
81 to recognize this cost as part of the cost of producing the inventory,
and credit accumulated depreciation by 81.
Remember, this a contra asset, so crediting increases the accumulated
depreciation which is reducing the net book value of our plant equipment.
>> If I recall correctly, at the 10 minute and 13 second mark of video 2.2.1,
you said that the journal entry for depreciation is always debit
depreciation expense and credit-accumulated depreciation.
What is this debit work in process stuff?
>> Well when I said always, I clearly meant until we get to the video where we
talk about inventory accounting for manufacturing firms.
So the depreciation on the machinery and equipment is going to be a product cost,
which means we want to store it in inventory until we sell the product,
when we recognize revenue on the product.
Then we take the cost of the product and show them as an expense,
cost of goods sold.
To do that, we can't debit depreciation expense,
which would immediately put this on the income statement.
Instead we're going to debit the inventory account work in process to help store up
these costs.
So yeah, in this situation we actually do have a debit to an inventory account
instead of debit to depreciation expense.
That'll always be the case when depreciation is a product cost.
So then we would post all these to t accounts.
Notice on the left I added accumulated depreciation as one of the accounts that
gets a credit, so were not just acquiring inventory or putting things in work in
process with credits to cash and credits to accounts payable.
We also have that credit to accumulated depreciation for the depreciation that
goes into the manufacturing process, and hence goes into work in process.
Then once we finish producing the goods, they're all ready to be sold,
we're going to take the cost out of work in process.
So we're going to credit work in process and move them in to finished goods, so
we debit finished goods.
So for Kirby, they finished manufacturing goods that cost 1,960.
What's their journal entry for this transaction?
We’re going to debit finished goods inventory 1,960,
to increase this asset, and credit work in process inventory for
1,962, reduce the costs that are kept in the work in process inventory.
>> So the finished goods accounts is like what we have been calling the inventory
account in prior videos.
Except instead of the inventory balance being the cost of purchasing inventory,
the balance is the cost of manufacturing the inventory.
>> Exactly, I couldn't have said it better myself.
So now let's look at how these flow through the t account.
So work in process goes down, it's credited by 1,960,
and finished goods is increased by 1,960.
The next step is that we're actually going to sell the finished goods.
And when we sell the finished goods,
we're going to take it out of the finished goods inventory account and
recognize the cost as cost of goods sold on the income statement.
So now we've got transactions 7 and 8 for Kirby.
Kirby sold 2,862 of goods to customers on account and
the goods cost 1,938 to manufacture.
So the journal entry for number 7 would be?
So this is the transaction for the revenue piece.
So we debit accounts receivable for 2,862 because it's on account.
We're not getting cash,
instead we're getting the promise that the customer is going to pay us in the future.
And we credit sales for 2,862 to recognize the revenue for
the goods at the selling price.
Now try to do number 8.
So, hopefully you remember this from earlier in the course.
You debit cost of goods sold, the expense for 1,938,
and we credit finished goods inventory 1,938.
>> How do you keep track of the cost of the specific goods that you just sold?
Do you have a t account for every individual?
How can you manufacture?
>> No, you do not have to keep track of a t account for
every individual good you produce.
Instead, you have to make some assumptions, and
we'll talk about a little bit in this video.
And then in the subsequent videos is the kind of assumptions you need to make
to assign costs to the goods that you have sold.
And then let's put these in our t accounts at least from the, not the revenue but
at least the inventory side, you reduce finish goods and
we increase cost of goods sold.
And then, of course, selling and
administrative costs directly go into SG&A expenses.
But this chart basically shows you how a manufacturing firm acquires materials and
services.
It's a long time between the cash or the accounts payable or accumulated
depreciation for acquiring materials and services actually turns into an expense.
It has to flow through raw materials, work in process, and
finished goods inventory before it actually shows up on the income statement.
What I want to talk about next is getting to this question of how do we know
the cost of the goods we sold versus the cost of the goods that we still have
in inventory?
And there's a basic equation for this, which is that the cost of goods available
for sale, which is what you start with, your beginning inventory, plus any new
inventory acquired during a period has to equal the cost of goods you sold and
the cost of goods that you still hold, which would be your ending inventory.
Now the tricky thing is that beginning inventory is known
because it's the ending inventory from last period.
New inventory is known, but the other two are going to be unknown.
So new inventory is known, because for
retail firms, it's just the cost of purchasing goods.
So whatever the total invoice amount was for the goods you purchased,
that's going to go into the new inventory.
Or for manufacturing firms, it's just the flowchart we look at a second ago where
it's all of those costs of producing goods during a period go into the new inventory.
But where we need some kind of assumption is how to figure out either COGS or
ending inventory, once we figure out one, we can plug the other.
There's basically, as always, two different methods that you can do it.
There's the periodic system,
which says that at the end of the period you count up all your inventory,
figure out how much inventory you have, and then you plug cost of goods sold.
Or the perpetual system,
which means you track cost of goods sold as sales are made, and
then you plug ending inventory because it's gotta be whatever is left over.
>> Do companies really count every single piece of inventory just so
they can calculate COGS?
It seems much easier to track what you sell.
>> Even if companies use some of that new-fangled computer technology to
keep track of all the goods they sell as they sell them, they still have to
count inventory at least once a year to get non-revenue sales,
what a non-account would call theft.
So if a customer or employee steals your inventory,
they're not going to let the computer system know to record it.
The only way that you're going to find out is at least once a year you gotta count
what you have and
then take a write-off of any inventory that you can't find that's been stolen.
I should also note before we move on that the periodic versus perpetual system helps
figure out how many goods you have versus how many goods you sold, but in terms of
what the actual costs are, we're going to have to make some additional assumptions.
And those additional assumptions are going to take up
the rest of the videos in the week.
But before we get to that part, there's one more topic I want to do on this video,
which is another thing you have to think about in valuing that ending inventory.
So the ending balance of inventory must be carried at the lower of historical cost or
fair market value, which is what we're going to call lower of cost or
market or LCM.
Historical cost is the original cost of either purchasing the inventory if you're
a retail firm, or producing the inventory if you're a manufacturing firm.
Fair market value was generally thought of as
the cost to replace the inventory given current market prices.
>> How do you determine the replacement value of the inventory?
Is this a number that accountants just make up off the top of their head?
>> Actually, management is responsible for
making up this number off the top of their head.
So clearly replacement value, replacement cost,
is not an exact number, but management should be in a position where
they can estimate how much it would cost to either re-manufacture the product or
reacquire the product if they're a retail firm.
And usually when you see these write-downs, it's obvious that the value
of the inventory has dropped below what it is on the balance sheet.
So even though we can't get an exact number, any write-off is better
than no write-off when it's clear that the value of your inventory has dropped.
So once you have these two values calculated, historical cost and
fair market value, if historical cost is less than fair market value,
then the ending inventory stays at original cost.
You don't need to change anything, no adjusting entry is need.
You certainly don't write it up in value because it's lower of cost or market.
What you have to worry about is if this fair market value or
replacement value drops below historical cost,
then your ending inventory has to be valued at this replacement value.
So you need to do an adjusting entry to write down your inventory.
And it's essentially going to be debit, cost of goods sold for the amount of
the write-down, credit, inventory for the amount of the write-down.
So our inventory account on the balance sheet is going to drop to replacement
value, and then the amount of the write-down will show up as an additional
expense on the income statement.
Now one key international difference comes up here.
Under US GAAP, once inventory is written down to fair market value,
essentially that becomes the new historical cost.
It can't be later written up to its original cost if the market value
subsequently rises.
So the way to think about it is once you write it down that's the new
historical cost,
and then you start looking at historical cost versus future fair market values.
But under IFRS, if you write inventory down,
you can actually write it back up to the amount of the original cost.
You just can never write it over the original cost.
So one little difference that we haven't yet ironed out between US GAAP and IFRS.
So now that we've started to talk about the assumptions you need to make
to figure out costs of good sold and the cost of the ending inventory,
we still haven't addressed the question of how do you figure out the cost of
each individual good that you sell?
Well, that's going to take a lot of assumptions and
those costful assumptions are what we're going to tackle in the next video.
I'll see you then.
>> See you next video.
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