Accounting in a Nutshell 2
Inventory
Joel Shapiro has been an
Accounting instructor at Ryerson
University in Toronto, Canada for
20 years. Previously, he developed
an accounting and inventory
management software system for
small businesses. In his spare time,
he enjoys working on Kakuro and
cryptic crossword puzzles, and travels
throughout Ontario as a bridge
tournament director.
Joel Shapiro, MBA
Accounting Instructor, Ryerson University, Toronto,
Ontario, Canada
Abstract: This article will explain the generally accepted
methods of accounting for inventory and the related
cost of goods sold expense. Four methods of applying
dollar values to inventory are illustrated, with sample
problems and solutions. As well, the issues of goods in
transit, inventory shrinkage, and obsolescence are dis-
cussed. In addition, guidance is provided with respect
to the analysis and interpretation of key financial ratios
related to inventory.
Keywords: cost of goods sold, goods in transit, inven-
tory, obsolescence, shrinkage.
Definitions
Inventory is generally considered to comprise physical
goods which are intended for eventual sale to custom-
ers. It is almost always classified on a companys bal-
ance sheet (statement of financial position) as a current
asset, as it is normally expected to be sold within one
year. Some industries consider less tangible items to be
inventory as well, as long as they are limited in quantity
and self-replenish over timeexamples would be hotel
rooms and seats on airplanes. When inventory is sold,
the asset becomes an expense called cost of goods sold.
Introduction
Inventory is quite often one of the largest and most im-
portant assets on a companys balance sheet. In order to
account for it properly, several issues must be addressed.
First, it must be determined which costs should be in-
cluded in inventory and which should not be. Then it is
necessary to determine who owns the inventory, espe-
cially for items which are not physically on the compa-
nys premises. Once these issues have been dealt with,
one of four formulas must be used to assign dollar val-
ues to the inventorythe choice can have wide-ranging
implications for the companys net income and other
Expert Insights 1
 Accounting in a Nutshell 2
important measures. Also, adjustments to
the calculated inventory figure must be
considered, to take into account shrink-
age (theft, spoilage, human error, etc.) and
obsolescence.
This article will concentrate mostly on
the inventory of a wholesaler or retailer.
This is often referred to as merchandise.
Manufacturers have additional consider-
ations which will be discussed briefly in
the Appendix.
What Costs Are Included in
Inventory?
The general rule for inventory (and all
other assets as well) is that all costs which
have been laid out in order to get the item
to the location and condition in which it
can be sold, are included. Simply put, if
an expenditure was made in order to pur-
chase the item, if it is a one-time expense
for that item rather than a cost that will re-
cur over time, and if it was necessary in
order to make the item saleable, then that
cost is part of inventory. We say that such a
cost is capitalized. Anything else would be
expensed in the period.
Here are some examples. The actual in-
voice price of an item would obviously be
included, as well as any non-refundable
taxes paid. If the item is imported, any cus-
toms duties, excise taxes, etc. would be part
of its cost as well. Insurance, while the item
is in transit from the supplier, and the ship-
ping cost, would also be included ONLY if
the goods are the property of the purchaser
while in transitmore on that later. If any
repackaging or relabeling is needed in or-
der to sell the goods, that too is included
in the cost of the inventory. Ongoing costs
not attributable to specific items, such as
insurance on inventory on hand, or selling
expenses such as shipping to customers
or salespersons commissions, are not in-
cluded with inventory. Any discounts taken
after the fact, such as for prompt payment
to the supplier, would be deducted from
the cost of the inventory, as the inventory
now costs less than originally expected.
2 Expert Insights
Who Owns the Inventory?
When goods are shipped from supplier to
customer via a third-party freight company,
the invoice will specify who actually owns
the goods while in transit. It will always be
either the shipper or the receivernever
the freight company! These terms are
shown on the invoice as FOB (this stands
for Free on Board) either the shipping point
or the destination. The FOB point is the
place where legal title to the goods changes
hands. So, goods shipped at FOB shipping
point (sometimes called FOB origin) be-
long to the buyer while on the way. Goods
shipped to FOB destination belong to the
seller until actually delivered. The party
who owns the goods must pay the freight on
them. So if you are buying goods FOB ship-
ping point, the freight-in cost becomes part
of your inventory cost. If you are buying
goods FOB destination, you dont have to
worry about freight cost because the goods
are not yours until you get them. Freight-
out, however, is always a selling expense,
not part of inventory. You would pay this
if you are selling goods at FOB destination.
Another way to look at itthink about
whether your company is shipping goods
out or receiving them in. It doesnt matter if
you are buying, selling, returning goods, or
having them returned to youthink about
which way the goods are going. You are ei-
ther the shipping point or the destination.
If the FOB point is you, you do not have to
worry about any freight. If the FOB point
is the other party, you do. Remember that
freight-in is part of inventory. Freight-out
is a selling expensetheres no such thing
as outventory!
Another issue of ownership relates to
goods on consignment. If you ship goods
to your customers on consignment, you
havent really sold themthe arrangement
is that you still own the goods until your
customer actually sells them himselfhe
only has to pay you then and he can return
them (or you can reclaim them) at any time
before that. So goods that you have shipped
out on consignment must still be counted
 Accounting in a Nutshell 2
in your inventory as long as they are still
on your customers premises. On the other
hand, goods that you are holding on con-
signment for others, and which you have
not sold yet, are not yours and you do not
have to include them in your inventory.
Lets pause now for a quick review. Say
you purchase 100 widgets from a supplier
overseas. These cost $10 each. We will ig-
nore foreign exchange, just to keep things
simple. On top of that, you have to pay $25
to your customs broker for his importing
services, and a tariff of 5% on the goods
themselves. Your supplier shipped them
at FOB shipping point and the freight and
insurance while in transit cost a total of
$50. Once the widgets arrived, you spent
$25 more on packaging and labeling before
putting them on your shelf for your own
customers to buy. What is the total and
per-unit cost of the widgets?
SolutionInvoice cost: 100 $10 = $1,000.
Tariff at 5% is another $50. Add $25 for bro-
kerage fees, $50 for freight and insurance,
and $25 for packaging and labeling, for a
total inventory cost of $1,150. Your 100 wid-
gets cost you $11.50 each.
This is all very well and good if you
know, every time you sell a widget, that it
really did cost you $11.50. However, your
supplier can change his invoice price at
any time, and all those extra charges can
change too. If one widget looks and works
much the same as any other widget, and
you really cant tell which particular pur-
chase any specific widget came from, and
your customers cant tell and dont care ei-
ther, then you have to make some assump-
tions when assigning dollar figures to the
widgets still on hand at the end of the year
when you count them, and by extension, to
the cost of those widgets actually sold. This
is the topic of the next section.
Assigning Dollar Values to
Inventory
Most companies nowadays use a perpet-
ual method to control their inventory.
Point-of-sale or other modern computer
Expert Insights
systems will keep track of each item in-
dividually (bar codes, RFID tags, etc.) and
add to the quantities on hand every time a
purchase is made, and deduct every time a
sale is made. Nevertheless, no automated
system is perfect, because imperfect hu-
mans operate them. Companies must still
count their inventory physically at least
once a year and adjust their computer re-
cords to what is actually on hand. Whatever
is not on hand must be considered sold. In
mathematical terms, this is the formula:
Opening Inventory + Purchases =
Goods Available =
Ending Inventory + Cost ofSales
We always know what the left side of
the equation, the cost of goods available
for sale, is, because we have been keeping
track of it all along. The two components of
the right side of the equation have to be cal-
culated. Obviously, once we know one, we
can easily calculate the other. If 100 items
are available to be sold, and only 40 are
counted at year-end, then we assume that
we sold 60. If we counted 60 on hand, then
we sold 40. Units are easy. Assigning dollar
values to the units on hand is not.
Method 1Specific Identification
This method assumes that you can, in fact,
tell the actual cost of every single widget
that you have on hand. This method is
used in practice for inventory items of high
value which are either unique themselves
or can be uniquely identified with, say, a
model and serial number. Examples would
be automobiles, heavy equipment, fine
art and jewelry, and major appliances and
electronics.
To illustrate this method with a very
simple example, suppose you have three
widgets in stock. The green one cost you
$10, the blue one cost $11, and the red one
cost $12. Total inventory of $33 is available
for sale. Your customers arent fussy about
color and will pay $50 for any of them. If
you sell the green one only, you have sales
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