at the different costs at which they were acquired. Instead, the weighted average of all units in stock is determined, at which point all of the units in stock are ac- corded that weighted-average value. When parts are used from stock, they are all issued at the same weighted-average cost. If new units are added to stock, then the cost of the additions are added to the weighted average of all existing items in stock, which will result in a new, slightly modified weighted average for all of the parts in inventory (both the old and new ones). This system has no particular advantage in relation to income taxes, because it does not skew the recognition of income based on trends in either increasing or de- clining costs. This makes it a good choice for those organizations that do not want to deal with tax planning. It is also useful for small inventory valuations, where there would not be any significant change in the reported level of income even if the LIFO or FIFO methods were to be used. Exhibit 7-3 illustrates the weighted-average calculation for inventory valuations, using a series of 10 purchases of inventory. There is a maximum of one purchase per month, with usage (reductions from stock) also occurring in most months. Each of the columns in the exhibit show how the average cost is calculated after each pur- chase and usage transaction. We begin the illustration with the first row of calculations, which shows that we have purchased 500 units of item BK0043 on May 3, 2003. These units cost $10 per unit. During the month in which the units were purchased, 450 units were sent to production, leaving 50 units in stock. Because there has been only one pur- chase thus far, we can easily calculate, as shown in column 7, that the total inven- tory valuation is $500, by multiplying the unit cost of $10 (in column 3) by the number of units left in stock (in column 5). So far, we have a per-unit valuation of $10. Next we proceed to the second row of the exhibit, where we have purchased an- other 1,000 units of BK0043 on June 4, 2003. This purchase was less expensive, be- cause the purchasing volume was larger, so the per-unit cost for this purchase is only $9.58. Only 350 units are sent to production during the month, so we now have 700 units in stock, of which 650 are added from the most recent purchase. To determine the new weighted-average cost of the total inventory, we first determine the ex- tended cost of this newest addition to the inventory. As noted in column 7, we arrive at $6,227 by multiplying the value in column 3 by the value in column 6. We then add this amount to the existing total inventory valuation ($6,227 plus $500) to arrive at the new extended inventory cost of $6,727, as noted in column 8. Finally, we divide this new extended cost in column 8 by the total number of units now in stock, as shown in column 5, to arrive at our new per-unit cost of $9.61. The third row reveals an additional inventory purchase of 250 units on July 11, 2003, but more units are sent to production during that month than were bought, so the total number of units in inventory drops to 550 (column 5). This inventory reduction requires no review of inventory layers, as was the case for the LIFO and FIFO calculations. Instead, we simply charge off the 150-unit reduction at the av- erage per-unit cost of $9.61. As a result, the ending inventory valuation drops to $5,286, with the same per-unit cost of $9.61. Thus, reductions in inventory quanti- LIFO, FIFO, and Average Costing / 119 c07_4353.qxd 11/29/04 9:25 AM Page 119 120 Exhibit 7-3 Weighted-Average Costing Valuation Example Average Costing Part Number BK0043 Column 1 Column 2 Column 3 Column 4 Column 5 Column 6 Column 7 Column 8 Column 9 Net Net Change Extended Extended Average Date Quantity Cost per Monthly Inventory in Inventory Cost of New Inventory Inventory Purchased Purchased Unit Usage Remaining During Period Inventory Layer Cost Cost/Unit 05/03/03 500 $10.00 450 50 50 $500 $500 $10.00 06/04/03 1,000 $9.58 350 700 650 $6,227 $6,727 $9.61 07/11/03 250 $10.65 400 550 –150 $0 $5,286 $9.61 08/01/03 475 $10.25 350 675 125 $1,281 $6,567 $9.73 08/30/03 375 $10.40 400 650 –25 $0 $6,324 $9.73 09/09/03 850 $9.50 700 800 150 $1,425 $7,749 $9.69 12/12/03 700 $9.75 900 600 –200 $0 $5,811 $9.69 02/08/04 650 $9.85 800 450 –150 $0 $4,359 $9.69 05/07/04 200 $10.80 0 650 200 $2,160 $6,519 $10.03 09/23/04 600 $9.85 750 500 –150 $0 $5,014 $10.03 c07_4353.qxd 11/29/04 9:25 AM Page 120 ties under the average costing method require little calculation—just charge off the requisite number of units at the current average cost. The remaining rows of the exhibit repeat the concepts just noted, alternately adding units to and deleting them from stock. Although there are several columns noted in this exhibit that one must examine, it is really a simple concept to under- stand and work with. The typical computerized accounting system will perform all of these calculations automatically. 7-7 Specific Identification Method When each individual item of inventory can be clearly identified, it is possible to create inventory costing records for each one, rather than summarizing costs by general inventory type. This approach is rarely used, because the amount of paper- work and effort associated with developing unit costs is far greater than under all other valuation techniques. It is most applicable in businesses such as home con- struction, where there are few units of inventory to track, and where each item is truly unique. LIFO, FIFO, and Average Costing / 121 c07_4353.qxd 11/29/04 9:25 AM Page 121 c07_4353.qxd 11/29/04 9:25 AM Page 122 123 8 The Lower of Cost or Market Calculation 8-1 Introduction A key aspect of generating an inventory valuation is the concept of the lower of cost or market. Under this concept, a company is required to recognize an addi- tional expense in its cost of goods sold in the current period for any of its inven- tory whose replacement cost (subject to certain restrictions) has declined below its carrying cost. If the market value of the inventory subsequently rises back to or above its original carrying cost, its recorded value cannot be increased back to the original carrying amount. The basis for this concept is contained within Statements 5 through 7 in Chapter 4 of Accounting Research Bulletin Number 43. Statement 5 notes that when the util- ity (as indicated by damage, obsolescence, and so forth) of a good falls below its recorded cost, one must recognize a loss for the full amount of the difference in the current period. Statement 6 defines “market” as the current replacement cost of an inventory item, except that the resulting market cost cannot be less than the item’s net realizable value less a normal profit margin, nor can it exceed the net realizable value less any completion and disposal costs. Statement 7 notes that the lower of cost or market rule can be applied either to individual items, groups of inventory, or the inventory as a whole; the application method chosen should be the one resulting in the most close approximation to pe- riodic income. Statement 7 has been the cause of considerable interpretation, be- cause its application to a large inventory group presents the possibility (allowed within Discussion Note 12 to the Statement) that a company can offset losses on reduced-utility items against gains experienced by increased-utility items within the same inventory group, resulting in no write-down of the total inventory valuation, as long as the offsetting items are in “balanced” quantities. However, in practice, the use of inventory groups for lower of cost or market calculations is unusual and so is not addressed further within this chapter. Discussion Note 14 accompanying State- ment 7 also suggests that large write-downs caused by application of the lower of cost or market rule can be itemized separately from the cost of goods sold within the income statement. c08_4353.qxd 11/29/04 9:26 AM Page 123 The remainder of this chapter explores the practical application of the lower of cost or market rule. 8-2 Applying the Lower of Cost or Market Rule 1 The lower of cost or market (LCM) calculation means that the cost of inventory cannot be recorded higher than its replacement cost on the open market; the re- placement cost is bounded at the high end by its eventual selling price, less costs of disposal, nor can it be recorded lower than that price, less a normal profit per- centage. The concept is best demonstrated with the four scenarios listed in the fol- lowing example: Completion/ Upper Lower Existing Market Selling Selling Price Normal Price Inventory Replacement Value Item Price Cost Boundary Profit Boundary Cost Cost (1) (2) LCM A $15.00 $4.00 $11.0 $2.20 $8.80 $8.00 $12.50 $11.00 $8.00 B 40.15 6.00 34.15 5.75 28.40 35.00 34.50 34.15 34.15 C 20.00 6.50 13.50 3.00 10.50 17.00 12.00 12.00 12.00 D 10.50 2.35 8.15 2.25 5.90 8.00 5.25 5.90 5.90 (1) The cost at which an inventory item could be purchased on the open market. (2) Replacement cost, bracketed by the upper and lower price boundaries. In the example, the numbers in the first six columns are used to derive the upper and lower boundaries of the market values that will be used for the LCM calculation. By subtracting the completion and selling costs from each product’s selling price, we establish the upper price boundary (in bold) of the market cost calculation. By then subtracting the normal profit from the upper cost boundary of each product, we establish the lower price boundary. Using this information, the LCM calculation for each of the listed products is as follows: Product A, replacement cost higher than existing inventory cost. The market price cannot be higher than the upper boundary of $11, which is still higher than the existing inventory cost of $8. Thus, the LCM is the same as the existing in- ventory cost. Product B, replacement cost lower than existing inventory cost, but higher than upper price boundary. The replacement cost of $34.50 exceeds the upper price boundary of $34.15, so the market value is designated at $34.15. This is lower than the existing inventory cost, so the LCM becomes $34.15. 124 / Inventory Accounting 1 The contents of this section have been adapted with permission from p. 44 of Bragg, GAAP Implementation Guide, John Wiley & Sons, 2004. c08_4353.qxd 11/29/04 9:26 AM Page 124 Product C, replacement cost lower than existing inventory cost and within price boundaries. The replacement cost of $12 is within the upper and lower price boundaries, and so is used as the market value. This is lower than the existing inventory cost of $17, so the LCM becomes $12. Product D, replacement cost lower than existing inventory cost, but lower than lower price boundary. The replacement cost of $5.25 is below the lower price boundary of $5.90, so the market value is designated as $5.90. This is lower than the existing inventory cost of $8, so the LCM becomes $5.90. Whenever there is a calculated inventory write-down, use the following jour- nal entry to record the valuation reduction. Although this loss can be recorded within the general cost of goods sold account, the magnitude of LCM losses tend to be lost that way, so use the “Loss on Inventory Valuation” account to more con- spicuously record the information. Debit Credit Loss on inventory valuation xxx Raw materials inventory xxx Work-in-process inventory xxx Finished goods inventory xxx Although the sample journal entry shows a credit to specific inventory accounts, it is also acceptable to credit an inventory valuation account instead. 8-3 Enforcement of the LCM Rule Given the considerable amount of manual calculation required to determine if there is a loss under the LCM rule, few inventory accountants are interested in fol- lowing its dictates regularly. One of the better approaches to enforcement is to have the Board of Directors formally approve a company policy requiring at least an an- nual LCM review, and to then include this policy in the job description of the in- ventory accountant. An example of possible policy wording follows: Lower of cost or market calculations shall be conducted at least an- nually for the entire inventory. This policy may be modified to require more frequent reviews, based on the vari- ability of market rates for various inventory items. Even with a policy in place, the LCM calculation is only likely to be conducted at such infrequent intervals that the inventory accountant forgets how the calcula- tion was made in the past. Thus, there is a considerable risk that the calculations will be conducted differently each time, yielding inconsistent results. To avoid this problem, consider including in the accounting procedures manual a clear definition of the calculation to be followed. A sample procedure is shown in Exhibit 8-1. The Lower of Cost or Market Calculation / 125 c08_4353.qxd 11/29/04 9:26 AM Page 125 Exhibit 8-1 Lower of Cost or Market Procedure Use this procedure to periodically adjust the inventory valuation for those items whose market value has dropped below their recorded cost. 1. Export the extended inventory valuation report to an electronic spreadsheet. Sort it by declining extended dollar cost, and delete the 80% of inventory items that do not comprise the top 20% of inventory valuation. Sort the remaining 20% of inventory items by either part number or item description. Print the report. 2. Send a copy of the report to the materials manager, with instructions to compare unit costs for each item on the list to market prices, and be sure to mutually agree upon a due date for completion of the review. 3. When the materials management staff has completed its review, meet with the materials manager to go over its results and discuss any major adjustments. Have the materials management staff write down the valuation of selected items in the inventory database whose cost exceeds their market value. 4. Have the accounting staff expense the value of the write down in the accounting records. 5. Write a memo detailing the results of the lower of cost or market calculation. Attach one copy to the journal entry used to write down the valuation, and issue another copy to the materials manager. 126 / Inventory Accounting c08_4353.qxd 11/29/04 9:26 AM Page 126 127 9 Applying Overhead to Inventory 9-1 Introduction The cost structure of most organizations contains a small proportion of variable costs and a great many other costs that are lumped into overhead. It is common for companies to have three or more times the amount of their variable costs invested in overhead. Because GAAP requires that some portion of overhead costs be as- signed to inventory, the inventory accountant has the dual tasks of determining which costs to include in overhead and how to assign these costs to inventory. The latter task is especially difficult, because the basis of allocation has historically been direct labor, which usually constitutes only a small portion of a product’s cost, and which therefore can result in significant misallocations of overhead costs to spe- cific inventory items. In this chapter, we review the types of costs to assign to inventory through over- head allocation, the assignment of overhead costs to raw materials, the contents of a bill of activities, and the use of activity-based costing to derive the most accurate possible overhead allocation. 9-2 Overhead Identification and Allocation to Inventory 1 Some overhead costs can be charged off to inventory, rather than being recognized in the cost of goods sold or some other expense category within the current period. Because the proper allocation of these costs can have a large impact on the level of reported income in any given period, it is important for the inventory accoun- tant to fully understand which costs can be shifted to a cost pool for eventual allo- cation and how this allocation is to be accomplished. The first question is answered by Exhibit 9-1, which itemizes precisely which costs can be shifted into a cost pool. The only cost category about which there is some uncertainty is rework labor, scrap, 1 Adapted with permission from Chapter 14 of Bragg, Accounting Reference Desktop, John Wiley & Sons, 2002. c09_4353.qxd 11/29/04 9:26 AM Page 127 and spoilage. The exhibit shows that this cost can be charged in either direction. The rule in this case is that any rework, scrap, or spoilage that falls within a normally expected level can be charged to a cost pool for allocation, whereas unusual amounts must be charged off at once. This is clearly a highly subjective area, where some historical records should be maintained that will reveal the trend of these costs and that can be used as the basis for proving the charging of costs to either category. With Exhibit 9-1 in hand, one can easily construct a cost pool into which the correct costs can be accumulated for later distribution to inventory as allocated overhead costs. The next problem is how to go about making the allocation. This problem consists of four issues, which are as follows: How to smooth out sudden changes in the cost pool. It is common to see an un- usual expenditure cause a large jump or drop in the costs accumulated in the cost pool, resulting in a significant difference between periods in the amount of per-unit costs that are allocated out. This can cause large changes in overhead costs from period to period. Although perfectly acceptable from the perspective of GAAP, one may desire a more smoothed-out set of costs from period to pe- 128 / Inventory Accounting Exhibit 9-1 Allocation of Costs Between Cost Pool and Expense Accounts Description Cost Pool Expense Advertising expenses XXX Costs related to strikes XXX Depreciation and cost depletion XXX Factory administration expenses XXX General and administrative expenses related to overall operations XXX Income taxes XXX Indirect labor and production supervisory wages XXX Indirect materials and supplies XXX Interest XXX Maintenance XXX Marketing expenses XXX Officer’s salaries related to production services XXX Other distribution expenses XXX Pension contribution related to past service costs XXX Production employees’ benefits XXX Quality control and inspection XXX Rent XXX Repair expenses XXX Research and experimental expenses XXX Rework labor, scrap, and spoilage XXX XXX Salaries of officers related to overall operations XXX Selling expenses XXX Taxes other than income taxes related to production assets XXX Tools and equipment not capitalized XXX Utilities XXX c09_4353.qxd 11/29/04 9:26 AM Page 128 [...]... all inventory items in stock, it required 17,250 hours of machine time to create the items currently stored in inventory Using the current cost per machine hour of $4, this means that $69,000 (17,250 hours × $4/hour) can be charged to inventory However, the inventory overhead account already contains $52,000 of overhead that was charged to it in the preceding month, so the new entry is to debit the inventory. .. cost per unit should then be multiplied by the total amount of the basis of activity related to the period-end inventory to determine the total amount of overhead that should be charged to inventory This is then compared to the 130 / Inventory Accounting amount of overhead already charged to inventory in the previous reporting period to see if any additional overhead costs should be added or subtracted... charged off in total to the on-hand inventory at the end of the month, because the result would be an ever-increasing overhead balance stored in the on-hand inventory that would never be drawn down On the contrary, much of the overhead is also related to the cost of goods sold In order to make a proper allocation of costs between the inventory and cost of goods sold, the inventory accountant must determine... such as the number of receipts or shipments related to a product, or the number of parts in it 2 Adapted with permission from Chapter 16 of Bragg, Cost Accounting: A Comprehensive Guide, John Wiley & Sons, 2001 132 / Inventory Accounting It is evident from this list that most overhead costs have not the slightest relationship to direct labor and that a good cost allocation cannot depend on just one...Applying Overhead to Inventory / 129 riod If so, it is allowable to average the costs in the cost pool over several months, as long as the underlying inventory is actually in stock for a similar period For example, if the inventory turns over four times a year, then it is acceptable to allocate overhead costs each month... materials would not be a proper matching of expenses with effort expended The cost may be more properly treated as manufacturing overhead for application to other types of inventory and the cost of goods sold Applying Overhead to Inventory / 131 9-4 The Shortcomings of Traditional Cost Allocation Systems2 Activity-based costing was developed in response to the shortcoming of traditional cost allocation... include any differences between actual and allocated overhead costs, so the variance should be allocated between inventory and the cost of goods sold at that time, using the usual bases of allocation If shareholder reporting occurs more frequently than that (such as quarterly), then the inventory accountant should consider making the same adjustment more frequently However, if the amount in question... Number of parts in stock Number of price negotiations Number of purchase orders Number of scheduling changes Number of shipments Number of inspections Number of supplier reviews Inventory turnover Number of times handled 138 / Inventory Accounting accumulated into each cost pool to derive a cost per unit of activity For example, if the activity measure is the number of insurance claims processed, and... cost pool that have no relationship whatsoever to the most common allocation measure, direct labor: Building rent A better allocation is based on the square footage of the facility that the machinery and inventory storage areas related to a product line are using Building insurance The better allocation is again square footage Industrial engineering salaries A better allocation is the total number of units... of overhead costs Another criterion that is frequently overlooked is that the accounting or manufacturing system must have a means of accumulating information about this activity measure, so that the inventory accountant does not have to spend additional time manually compiling the underlying data An example of an activity measure that generally fulfills these three criteria is machine hours, because . Period Inventory Layer Cost Cost/Unit 05/03/03 500 $10.00 450 50 50 $500 $500 $10.00 06/ 04/03 1,000 $9.58 350 700 65 0 $6, 227 $6, 727 $9 .61 07/11/03 250 $10 .65 400 550 –150 $0 $5,2 86 $9 .61 08/01/03 475 $10.25 350 67 5 125 $1,281 $6, 567 $9.73 08/30/03 375 $10.40 400 65 0 –25 $0 $6, 324 $9.73 09/09/03 850 $9.50 700 800 150 $1,425 $7,749 $9 .69 12/12/03 700 $9.75 900 60 0 –200 $0 $5,811 $9 .69 02/08/04 65 0 $9.85 800 450 –150 $0 $4,359 $9 .69 05/07/04 200 $10.80 0 65 0 200 $2, 160 $6, 519. $10.00 06/ 04/03 1,000 $9.58 350 700 65 0 $6, 227 $6, 727 $9 .61 07/11/03 250 $10 .65 400 550 –150 $0 $5,2 86 $9 .61 08/01/03 475 $10.25 350 67 5 125 $1,281 $6, 567 $9.73 08/30/03 375 $10.40 400 65 0 –25 $0 $6, 324 $9.73 09/09/03 850 $9.50 700 800 150 $1,425 $7,749 $9 .69 12/12/03 700 $9.75 900 60 0 –200 $0 $5,811 $9 .69 02/08/04 65 0 $9.85 800 450 –150 $0 $4,359 $9 .69 05/07/04 200 $10.80 0 65 0 200 $2, 160 $6, 519. it. Applying Overhead to Inventory / 131 2 Adapted with permission from Chapter 16 of Bragg, Cost Accounting: A Comprehensive Guide, John Wiley & Sons, 2001. c09_4353.qxd 11/29/04 9: 26 AM Page 131 It