Introduction to Inventory Costing
Inventory accounting may sound like a huge undertaking but in reality, it is quite straightforward and easy to understand. You start with the inventory you have on hand. No matter when you sell a product, the value of your inventory will remain constant based on accepted and rational methods of inventory accounting. Those methods include perpetual average cost, specific identification method (the two used by Total Office Manager), weighted average, first in/first out, and last in/first out.
Perpetual Average Cost
This method is used by the Total Office Manager when the “Inventory Part” invoice item type is used.
Under the perpetual system, the Inventory account is constantly (or perpetually) changing. When a retailer purchases merchandise, the costs are debited to its Inventory account; when the retailer sells the merchandise to its customers the Inventory account is credited and the Cost of Goods Sold account is debited for the cost of the goods sold. Rather than staying dormant as it does with the periodic method, the Inventory account balance under the perpetual average is changing whenever an increase in quantity occurs.
Under the perpetual system, two sets of entries are made whenever merchandise is sold: (1) the sales amount is debited to Accounts Receivable or Cash and is credited to Sales, and (2) the cost of the merchandise sold is debited to Cost of Goods Sold and is credited to Inventory.
Under the perpetual system, “average” means the average cost of the items in inventory as of the date of the sale. This average cost is multiplied by the number of units sold and is removed from the Inventory account and debited to the Cost of Goods Sold account. We use the average as of the time of the sale because this is a perpetual method.
Average Cost History
Total Office Manager tracks the average cost by date. When you backdate or postdate an invoice, it will use the average cost as of that date. You can see what the average cost of an item was at any given time. Open the Invoice Item List | Right Click on that item | click Item History | go to the Avg. Cost History tab. If an item has no average cost, the estimated cost of the item will be used on invoices and sales to record the cost to debit to Cost of Goods Sold and credit from the inventory asset account. Once the item is purchased to bring the quantity positive, any difference in the cost removed from the asset account will be reconciled at the time of purchase.
Specific Identification Method (AKA: Exact Cost)
This method is used by Total Office Manager when the “Serialized” invoice item type is used.
The specific identification method of inventory costing attaches the actual cost to an identifiable unit of product. This is accomplished by looking at the serial number of the item.
This method is easy to manage and 100% accurate. We highly recommend that you used serialized items because they are typically a large portion of your direct costs. Serialized items will improve your job costing and other financial reporting.
- When you buy a “Non-inventory Part” invoice item type, it does not go on the balance sheet as an inventory asset. It immediately becomes a cost of goods sold or it reduces the income account that it is associated with. Use this type of item sparingly.
- Purchase orders do not affect inventory. It is when you enter an item receipt or a bill, that “Inventory Part” and “Serialized” item types will affect your balance sheet. Note: There are other activities where these items will affect your balance sheet. Purchase transactions include checks and credit card charges. You can receive against a purchase order on these transactions as well.
- We recommend you use purchase orders. When the items arrive, enter an item receipt from that purchase order (usually you will have a packing slip). The item receipt is entered as soon as you take possession of the inventory assets. Your last step is to enter a bill from that item receipt.
- Inventory control is an essential part of job costing and financial reporting. The better your inventory control, the more accurate your financial and job cost reports will be.
- The Item History form will show you the history of the average cost of an item with the change in quantity for each month.
- The Invoice/Sale/Credit/Estimate List includes a utility to scan transactions to see if there is new information that might change the average cost of one or more items on that transaction. For example, you may have backdated a bill. If the invoice has already been created, that invoice would not “know” about the new information. That invoice would need to be resaved. You can resave invoices in a batch too. This may completed under Invoice/Sale/Credit/Estimate List menu. Highlight a range of transactions, under the Actions menu, click Recalculate Selected. The utility will update the recorded cost for any transactions with differences. Use this utility on the list with caution. A more powerful version of this utility is located at Tools | Utilities | Database Checkup | Scan Invoices/Sales/Credits. Using the utility option will enable you to review the changes before updating in batches.
- To ensure the cost you pay for an item is the most recent, Total Office Manager does has the ability to update this cost when purchase transactions are created. Each time the cost entered is different from the estimated cost on the item, the software will prompt to update this information. If you are not seeing this prompt, navigate to Edit | Preferences | Company and click the button Bring back all one time messages.
Other Methods (just FYI)
Although Total Office Manager uses the Perpetual Average Cost and Specific Identification Method, the following methods are explained in detail for reference purposes.
Weighted Average Cost
Weighted average measures the total cost of items in inventory that are available for sale divided by the total number of units available for sale. Typically this average is computed at the end of an accounting period.
Suppose you purchase five parts at $10 apiece and five widgets at $20 apiece. You sell five units of product. The weighted average method is calculated as follows:
Total Cost of Goods for Sale at Cost (divided)
Total Number of Units Available for Sale =
Weighted Average Cost per Widget
Five widgets at $10 each = $50
Five widgets at $20 each = $100
Total number of widgets = 10
Weighted Average = $150 / 10 = $15
$15 is the average cost of the 10 widgets
First In/First Out (FIFO)
First in, first out means exactly what it says. The first widgets you bring into inventory will be the first ones sold as a product. First in, first out, or FIFO as it is commonly referred to, is based on the principle that most businesses tend to sell the first goods that come into inventory.
Suppose you buy five widgets at $10 apiece on January 3 and purchase another five widgets at $20 apiece on January 7. You then sell five widgets on January 30. Using first in, first out, the five widgets you purchased at $10 would be sold first. This would leave you with the five widgets that you purchased at $20, which would leave the value of your inventory at $100.
Last In/First Out (LIFO)
This method, commonly referred to as LIFO, is based on the assumption that the most recent units purchased will be the first units sold. A “widget” is an imaginary item that could be just about any product. The advantage of last-in, first-out accounting, or LIFO, is that typically the last widgets purchased were purchased at the highest price and that by considering the highest-priced items to be sold first, a business is able to reduce its short-term profit, and hence, taxes.
Suppose you purchase five widgets at $10 a piece on January 4 and five more widgets at $20 apiece on February 2. You then sell five widgets on February 20. The value of your inventory, using LIFO, would be $50, since the most recent widgets purchased, at a total value of $100 on February 2, were sold. You were left with the five widgets valued at $10 each.