Introduction

In this chapter, we learn inventory in greater detail. Obviously, inventory is a significant asset on the balance sheet. Therefore, it must be a standard principle for assigning value to it. In reality, not all firms operating exactly the same way, thus the methods are also different.

Recall My Favorite Local Merchants from Units 5 and 6. 

There's a bookstore chain called "Eslite Bookstore (https://www.eslitecorp.com/eslite/index.jsp)" who sells books and stationery in where I live. 

What inventory valuation method would you advise them to use? 

To do this suggestion, we must understand what inventory they are dealing with and digging some history of this industry. In this case, the store purchases multiple books for inventory to sell, and the merchandise that the bookstore stocks are books. Although there are so many electronic gadgets and apps such as Kindle Fire(Amazon), iPad, or other forms of e-books that tend to replace traditional books, they do not work as easily as they thought before. Traditional book sales still stand out in these modern days, regardless the prices are normally way more expensive than the electronic version(Pdf or word). We can not definitely predict the future, we only predict it probably. I suppose that if the resources for printing physical books are all on an increasing trend, and either the cost of owning a physical bookstore, then the prices of physical books are also on an increasing trend. Therefore, I advise them to use the LIFO (Last In, First Out) method to produce lower income on the financial reports and creating an increasing trend of the income statement.

Why?

Before we actually choose a mothod, we can do some comparison. Assume their business activities as the samples below:

Sample :

Day 1. Beginning Inventory = 200,000 books ($8 per book) = $1,600,000

Day 2. Net purchase 200,000 books ($10 per book) on Jan 31, 2020

Day 3. Net sales = 300,000 books at $30 each = $9,000,000

Day 4. Net purchase another 200,000 books ($12 per book)

Day 5. Net sales = 100,000 books at $30 each = $3,000,000

Based on the given information, we can do the calculate the cost of goods sold as below:

LIFO (Last In, First Out):

On the day 3, the cost of goods sold was $2,800,000 ( = 200,000 X $10 + 100,000 X $8 )

On the day 5, the cost of goods sold was $1,200,000 ( = 100,000 X $12 ) 

The total cost of goods sold = $2,800,000 + $1,200,000 = $4,000,000

The total net sales = $9,000,000 + $3,000,000 = $12,000,000

The gross profit = The Total Net Sales - Cost of goods sold = $12,000,000 - $4,000,000 = $8,000,000

FIFO (First In, First Out):

On the day 3, the cost of goods sold was $2,600,000 ( = 200,000 X $8 + 100,000 X $10 )

On the day 5, the cost of goods sold was $1,000,000 ( = 100,000 X $10 ) 

The total cost of goods sold = $2,600,000 + $1,000,000 = $3,600,000

The total net sales = $9,000,000 + $3,000,000 = $12,000,000

The gross profit = The Total Net Sales - Cost of goods sold = $12,000,000 - $3,600,000 = $8,400,000

Weighted Average:

The average cost on day 3 was = $9 ((200,000 x $8 + 200,000 x $10)/400,000)

On the day 3, the cost of goods sold was $2,700,000 ( = 300,000 X $9 )

The average cost on day 5 was = $11.33 ((100,000 x $10 + 200,000 x $12)/300,000)

On the day 5, the cost of goods sold was $1,133,000 ( = 100,000 X $11.33 ) 

The total cost of goods sold = $2,700,000 + $1,133,000 = $3,830,000

The total net sales = $9,000,000 + $3,000,000 = $12,000,000

The gross profit = The Total Net Sales - Cost of goods sold = $12,000,000 - $3,830,000 = $8,170,000

As a result, the LIFO (Last In, First Out) method produces the lowest profit while the cost of books is on an increasing trend. If we do the opposite of calculations, the amounts of FIFO and LIFO will be quite the opposite. The weighted average will be somewhere in between. Although the LIFO (Last In, First Out) method produces the lowest profit, it reflects the most recently incurred costs with the recently generated revenues. Lower profit also reduces the cost of the tax payments while the cost of books is on an increasing trend. 

Assume the tax rate is 20% times the Gross profit. The tax bills will be $1,600,000(LIFO), $1,680,000(FIFO), and $1,634,000(Weighted Average) as we sold exactly the same amounts of books. 

Specific Identification Method

As we learned during this chapter, another method is the specific identification method, which requires the bookstore to identify each book with its cost and retain that identification until the inventory is sold. Once the specific book(or inventory) is sold, the cost of the specific book is assigned to cost of goods sold. It's pretty similar to your phone number. You are on the records each time you send messages, calling someone, or even doing purchases on your phone. With advanced information technology, computers and programs generate a barcode for each book, to identify each specific book. It's not impossible, but the problem is that does it is necessary and greater than the other methods we just described? If so, for instance, every coffee you order in Starbucks will have its own name, not the name on the menu, a real name. It needs tons of storage space and cloud computing. All of these cost money and make no sense to be an improvement in the financial report and management. Therefore, specific identification is suggested only used for uniquely identifiable goods that have a fairly high per-unit cost (Luxury cars, fine jewelry, or houses ).

The Perpetual or The Periodic System?

Whether the approach is perpetual or periodic, the financial statement results are the same. This is anticipated because the beginning inventory and early purchases are being allocated and charged to cost of goods sold in the same order. The difference is the calculations are done as soon as you click the button (perpetual) or at the time you prepare to report (periodic). Similar to the cloud sync function, it automatically syncs the data you just edit on your devices.

With tons of books to manage, I would advise them to use the perpetual system. Because it's an efficient one for managing such a huge bookstore who has so many books in stock.

The Lower of Cost or Market Technique

Before we decide to adjust the value and apply any method, we need to know the reason why we do this first. Start with the net realizable value (NRV), it helps us to know how worthy is the inventory when we convert it to cash. Assume that you are trying to sell your iPhone XR, and you post it on Amazon.com. Two weeks later, the iPhone XR sold and you get paid from the buyer. You convert your iPhone XR to the cash you get. 

We all want to keep the value forever after we purchase expensive goods. Unfortunately, obsolescence, oversupply, defects, and major price declines all cause the prices to decline. As this happens, your inventory is carried on the accounting records at greater than its net realizable value (NRV). To truly reflect the value, some adjustments are necessary. For instance, if you have 1,000 phonebooks in stock and you want to convert it to cash. The NRV would be very different when you value it in 1950 and 2020.

Overall, books are consist of knowledge, papers, and inks. Knowledge can be replaced by the electronic version but papers and inks are the special physical appearance of traditional books. The electronic version of books might be way cheaper than physical books, but in the real world, people prefer physical books, even though they have to pay more money. 

To apply the lower of cost or market rule means a business must record the cost of inventory at whichever cost is lower – the original cost or its current market price. Assume that Eslite Bookstore Imports resells five listed books. At the end of its reporting year, Eslite calculates the lower of its cost or net realizable value as the following table:

Merchandise	Quantity on Hand	Unit Cost	Inventory at Cost	Market per Unit	Lower of Cost or Market
Herry Porter	1,000	$19	$19,000	$23	$19,000
Don Quixote	750	$14	$10,500	$17	$10,500
The Little Prince	200	$14	$2,800	$12	$2,400
Rich dad, Poor dad	1,200	$28	$33,600	$16	$19,200
A Tale of Two Cities	800	$20	$16,000	$22	$16,000

Based on the table, the market value is lower than the cost on The Little Prince and Rich dad, Poor dad. Therefore, Eslite Bookstore recognizes a loss on The Little Prince of $400 ($2,800 - $2,400), as well as a loss of $14,400 ($33,600 - $19,200) on the Rich dad, Poor dad.

Reference

Chapter 8: Inventory. (n.d.). Retrieved from https://www.principlesofaccounting.com/chapter-8/

Specific Identification Method

Specific Identification Method Overview

As I learned during this chapter, the specific identification method requires the business to identify each unit of their inventory with its cost and retain that identification until the inventory is sold. Once the specific unit is sold, the cost of the specific unit is assigned to the cost of goods sold. Assume that Apple gives every iPhone a specific serial number, and records these numbers in an inventory management system. While Apple sold an iPhone, the system matches each serial number to its record to recognize its cost. 

Specific Identification Method Requirements

Be able to track each inventory item individually, such as paper labels, serial numbers, or unique numbers to identify each product.

Tracking the cost of each unit which means clearly identify the cost of each purchased item, and associate it with a unique identification.

Advantages and Disadvantages

These days, we have advanced information technology, computers and programs generate a barcode for each unit in inventory. In other words, It's not impossible. But the problem is, does it is necessary and greater than the other methods? It needs tons of storage space and cloud computing, and all of these cost money to maintain, another operating expense to pay. If it makes no sense to be an improvement in the financial report and management, it becomes a waste. For instance, assume that a cloud services company offering such services, but they charge the purchaser $100 per TB(1,000GB) and $3,000 monthly management fee. If your bookstore needs 1,000 TB to storage and operating with their algorithm, you will be charged $103,000 ($3,000 + $100 x 1,000) per month. Suppose your profits are around $10 per unit, the service expense has already offset your 10,300 units on the amounts of sales. On the other hand, if you are selling a Lamborghini Urus(A SUV) at $399,000, and the profit is $150,000 per car. The service expense just costs you 1 unit of your sales and It's 10,300 times less than the bookstore's space used to store that information. It is also very time-consuming to track inventory on an individual unit basis. Therefore, specific identification is suggested only used for uniquely identifiable goods that have a fairly high per-unit cost (Luxury cars, fine jewelry, or houses ).

The specific identification method provides a high degree of accuracy to the cost of inventory since the exact cost at which something was purchased can be identified, and connecting to the cost of goods sold when the related item is sold.

Example

In Taiwan, a big construction company called Huaku which holds a lot of building inventory. Each building, house, or other real estate, has its own specific name. They track each case individually by those specific names, and identify the cost of each built item, and associate it with the unique names. For instance, they built an apartment named “Huaku Sky Garden” and "Huaku Sky Lake" for sale. The Huaku Sky Garden and Huaku Sky Lake are two very different buildings and houses. Just like you can not sell the house in Alaska and then value its cost with the house in California or New York City. In the Huaku Sky Garden and Huaku Sky Lake cases, the cost of inventory is only valued by each apartment itself.

Retail Inventory Method

To estimate their ending inventory balances, the method is based on the relationship between the cost of the merchandise and its retail price. But be careful that the method is not entirely accurate, and periodically adjusted by physical inventory count is needed. As such, this method is normally for retailers to deal with their sales of small items since a hard count is often impractical. Retailers can attempt to estimate inventory levels and the cost of inventory based on the total cost and retail value of goods available for sale and the total sales over a certain period.

To calculate the cost of ending inventory using the retail inventory method:

1.The cost-to-retail percentage = Cost / Retail price.

2.The cost of goods available for sale = Cost of beginning inventory + Cost of purchases

3.The cost of goods sold = Sales × cost-to-retail percentage

4.The ending inventory = Cost of goods available for sale - Cost of sales during the period

For instance, Eslite bookstore sells Harry Potter for an average of $20, and it costs $14. This is a cost-to-retail percentage of 70%. Suppose Eslite bookstore’s beginning inventory has a cost of $100,000 it paid $180,000 for purchases during the month, and it had sales of $240,000. The ending inventory is $112,000 :

$100,000(Beginning inventory) + $180,000(Purchases) - $168,000(Sales of $240,000 x 70%) = $112,000(Ending inventory)

Retail Method? The Advantages and Disadvantages

The retail inventory method is a quick and easy way to determine an approximate ending inventory balance. However, It's only an estimate, not a physical inventory count. It only works if the business has a consistent mark-up across all products sold. If the mark-up was different, the results of the calculation will be incorrect.