Inventory
Companies manufacturing and selling physical goods must record them as assets in their books and expenses at their sale. Manufacturing companies usually deal with three inventories: materials, work in process, and finished goods. Retailers must deal with only one list, which is merchandise. In all cases, a company must sell inventories to make profits. Before trading, it serves as an asset for the company; however, after merchandise is sold, the cost covers an expense called Cost of Goods Sold (COGS). The price is then transferred from a balance sheet to an income statement via journal entry in bookkeeping terms.
Companies maintain a significant amount of inventory to manage their day-to-day operations. However, it is an important asset that you should monitor closely. Storing too much inventory can cause issues related to decreasing cash flows, storage costs, and losses if the item turns archaic. Similarly, too little of it can result in lost sales and customers.
Indirect costs or overhead costs that cover depreciation, factory maintenance, cost of factory management, electricity, etc., are allocated to inventory, depending on the production levels. Overheads are frequently assigned based on direct labor hours or the number of machine hours.
Cost of Goods Sold
Cost of Goods Sold represents the cost of goods or merchandise sold to customers. Unlike inventory on the balance sheet, the cost of goods is reported on the income statement. All the costs occur to get the merchandise into the inventory and are included in the cost of goods. The cost of acquiring it from the supplier, shipping costs, and all other costs are included. Direct materials, labor, and overhead costs are also included in the goods sold.
The cost of goods would account for labor, payrolls, and service benefits. All the direct costs associated with the production of the product are the cost of goods. It is essential to highlight that goods not sold during the year and still in inventory are not included in calculating the COGS. Only the goods that were sold are included.
Cost Flow Assumptions
There are three methods that the IRS accepts to move the cost from the balance sheet to the income statement. The accepted methods are FIFO (First Out), LIFO (Last in First Out), and Average Cost. They are what the names suggest. First in, first out means that goods that arrive first should be removed first at an original cost. It does not matter if the cost of goods sold has increased for the new batch; you would have to record at an actual price.
Each cash flow assumption can be used in both systems mentioned below.
Periodic Inventory System
Under the periodic system, the amount in the inventory account is not updated at the time of purchase. The charge is only updated at the end of the year. This means that the report would show the cost of last year’s stock for the whole year.
All the purchases related to merchandise are recorded in either one or more purchase accounts. At the time of year-end, the purchase accounts are closed, and the stock account is matched with the cost of merchandise at hand. Under the periodic system, the cost of goods sold does not exist in the budget to record the sale of merchandise. It is calculated as beginning stock + new purchases – ending supply. You could not figure it out while looking at a general ledger account.
Perpetual Inventory System
Under a perpetual system, the stock account is continuously updated. The cost of merchandise purchased is added to the statement, while what is sold to the customers is reduced from the account. There is no room for purchase accounts under this system.
The cost of goods sold account is debited at the time of the sale, precisely for the cost associated with the merchandise. There must be two recorded journal entries for the sale of any merchandise. Sales and accounts receivable are recorded as one entry, while the other caters to the reduction of inventory and the cost of goods sold.
FIFO, LIFO, and Average cash flow assumptions are combined with either perpetual or periodic systems to account for the cost of the stock at hand. It is up to you to choose any one of them at your convenience.
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