I'm Larry Walther, this is principlesofaccounting.com, Chapter 8.
In this particular module, we will be considering the methods to monitor and
the importance of management of inventory,
as well as considering the effects of errors that might occur in inventory.
In considering inventory management, one must give careful
consideration to the fact that inventory is a very costly asset.
It's subject to spoilage, loss, theft, obsolescence.
There are a number of risks and
those risks are very real and very costly for a company that
makes a mistake of stocking inventory that they're not eventually able to resell.
Counterbalancing that risk however, is the very significant loss that can occur from
lost customer satisfaction and lost sales if sufficient inventory is not maintained,
readily available, to meet customer demands.
So companies must be very careful to establish the correct inventory level and
monitor that level very carefully.
Often times a company will calculate an Inventory Turnover Ratio.
The Turnover Ratio shows the number of times each year or
each period, that inventory recycles or is replenished.
It's calculated by dividing the Cost of Goods Sold by the Average Inventory level.
It's hard to say what's good or bad, for example,
a biker would have a very high inventory turnover ratio.
After a day or two the inventory becomes stale so
you expect to cycle the inventory perhaps 100 or 200 times per year.
Compare that to a lumber yard, they may only cycle inventory once or
twice or three times per year, obviously, the lumber that's
kept protected from the weather is not highly vulnerable to spoilage.
It's very important not only to look at the level of inventory turnover, but
also to look at transient inventory turnover.
If the Inventory Turnover Ratio, or frequency is decreasing,
this can often be an indication that the company is experiencing slowing sales,
carrying of poor moving goods, misstocking of inventory, things of that nature.
So for a specific company, it's important to monitor what that ratio would be,
what the inventory turnover rate is from period, to period, to period to look for
trends that might foretell a change in business circumstances.
Let's next turn our attention to Inventory Errors.
Goods on hand might be overlooked or counted twice or
other mathematical mistakes might occur during a physical count of inventory.
At least annually, a company should take a physical count of inventory and
make sure that what they believe they have on hand by reference to their accounting
records is, in fact, what they have on hand.
But in the process of counting, if errors occur,
those errors will become very significant in determining profitability.
A general rule is that overstatements of ending inventory
will cause a similar overstatement of income.
Now this is a before tax consideration so pre-tax income is overstated by
the same amount as inventory is overstated and vice versa.
If you understate or under count or undervalue your ending inventory,
you'll similarly undervalue income by a like dollar amount.
And so it becomes very important that in taking a physical count of an inventory
that it's gotten right, that it's done correctly.
Let's look at an example here.
We have ending inventory.
The correct amount on the left is shown to be $4,000.
But for whatever reason, a mistake was made and it was counted or
valued at $5,000.
Let's follow this through.
By overstating ending inventory,
notice that that causes an understatement of Cost of goods sold.
The 16,000 goods available for sale minus the incorrect $5,000 gives you
11,000 of Cost of goods sold which appears also in the income statement.
Sales minus the understated Cost of goods sold
triggered the overstatement in Gross profit.
So again, the general rule of thumb,
overstating ending inventory overstates income.
Now, one year's error in ending inventory becomes
an error in next year's beginning inventory.
And the effects tend to be reversing.
That is, overstatements of beginning inventory
generally cause that year's income to be understated and vice versa.
Understating beginning inventory generally causes
that year's income to be overstated.
By way of example, here's our data from the previous year carried forward.
Our incorrect Beginning inventory is 5,000, when in fact it was actually 4,000.
When we calculate Cost of goods available for sale, that gives rise to $16,000 for
Cost of good available for sale when, in fact, on 15,000 were actually available.
And subtracting, now I'm assuming inventory is correctly
counted at the end of the second year at $3,000.
That causes Cost of goods sold to be 13,000 rather than the correct 12,000.
Appearing again in the income statement and
causing the understatement in gross profit or income.
So, overstating Beginning inventory caused an understatement of Gross
profit in this case.
Now, I'm assuming of course,
that purchases were correctly measured when reporting.
That we're only talking about a error in physically counting or
determining what is on stock in these cases.
Notice that inventory errors tend to be counterbalancing.
That is for
the two consecutive year period, while one year's profit was overstated and
the next year was understated, it counterbalanced out to the correct amount.
However the amount for each specific year is critically flawed.
Some people look at this and go all's well that ends well.
We got to the correct income over the two year period, but
of course that's not appropriate accounting.
We need to measure income correctly period by period.
So again it in underscores the very important nature of
absolutely getting your inventory evaluations correct.