The Inventory-Cost Connection: Inventory Transforms into Cost of Goods
Whether you are a manufacturer, a wholesaler, or a retailer, you sell some kind of product. When you sell some kind of product, ﬁrst you have to create or buy it. The products you have on hand, the ones that you intend to sell to your customers, make up your inventory asset. Your inventory can include ﬁnished merchandise (such as a desk), raw materials (wood to make the desk), or anything in between. If your company makes products, you are a manufacturer, and your inventory has to go through a few steps before it makes its journey to the sales ﬂoor.
If you have a consignment shop, the consigned merchandise you’re selling does not count as inventory for you. Since your company never actually owns the goods, they never show up as inventory or cost of goods sold on your financial statements.
As soon as you sell one of your products, it stops being part of your inventory and turns into a special kind of business expense known as cost of goods sold. At that point, it also makes the transformation from a balance sheet item to a piece of the proﬁt-and-loss puzzle. In accounting, though, the conversion of inventory to cost of goods may not show up in the books immediately, depending on the inventory system you choose to use. Also, as you’ll see in a later section in this chapter, there are four different ways to compute the value of your inventory once you know exactly how much you have on hand.
Periodic or Perpetual?
In accounting, you have a choice between two basic inventory systems: periodic or perpetual. Their names describe how they work. In a periodic system, you ﬁgure out the value of your system periodically; with a perpetual system, you update your inventory every time you make a sale.
The system you use will dictate how you record product sales. In the periodic system, you record a simple, one-step entry that includes only the revenue part of the entry. In a perpetual system, each sales entry has two parts, one that addresses the sale and one that addresses the shift from inventory to cost of goods. With perpetual inventory, you will always have a pretty good idea of your current inventory value. When you use a periodic system, though, you can really only tell what you have when you take a count.
Although it seems that you would know your inventory to the penny at all times using the perpetual system, that’s not always the case. In reality, some inventory just disappears; some breaks, some goes bad, and some- times people just make entry errors. That’s why both systems require at least an annual physical inventory-taking, where you count every single item you have available for sale.
Three Stages of a Manufacturer’s Inventory
Manufacturers make things and then sell them. Throughout that process, everything they haven’t sold yet is inventory. For manufacturers, though, not all inventory is equal; in fact, not all inventory is necessarily even created yet.
It takes time to make things, and your creation schedule may not neatly match the ﬁnancial accounting calendar. At any point in time, manufacturers usually have three different kinds of inventory on hand:
- Raw materials
- Work in process
- Finished goods
Raw materials aren’t necessarily things like rough diamonds or full tree trunks. In accounting, this term really just means the things you need to make your product (which could include rough diamonds or full tree trunks). Anything that goes into creating the ﬁnal goods counts as part of your raw materials inventory, from beads to marble to glue to fabric. Work in process is any item you’ve started making but just haven’t ﬁnished yet. Finished goods are anything that’s ready to be shipped out.