Hello, I'm professor Brian Bouche, welcome back. We're now going to turn our attention to inventory. In this video, we're going to talk about how to account for inventory for a manufacturing firm, which is much more difficult and complicated than inventory for a retail firm, which is what we've seen so far. We'll also start to talk about the assumptions that we need to make to calculate the cost of goods sold, and the costs of goods still held in ending inventory. Let's get started. Let's start by reviewing the accounting for inventory for a retail firm, which is what we saw in the Relics Butter case. So the first step for a retail firm is they go out and buy inventory. So we would debit inventory to increase it, and then either credit cash or accounts payable, depending on how they acquired the inventory. When they sell the inventory, we take the cost of the goods sold out of inventory, and we debit a cost of goods sold expense, which will appear on the income statement. These are what we call product costs in the earlier videos. These are different from period costs, which are these selling, general, and administrative costs, which do not run through an inventory account. Instead, as we incur these costs, we move them into an SG&A expense, and then either credit the cash to the payables. Now what we're going to do is talk about how this looks for a manufacturing firm. A manufacturing firm is a company that actually makes the inventory instead of buys it. So we just have to make a couple small changes. >> Ay carumba! How do you expect us to understand this mess? >> Yeah, okay, I know, why don't we go through a detailed example to see how this works. So the first step will look just like what we saw for the retail firm, where we're making some initial purchases of inventory with payables or cash. But instead of purchasing finished goods that could be sold immediately as in the case of a retail firm, for a manufacturing firm, the first step is to purchase raw materials. So we create an inventory account that's titled Raw Materials. >> What types of items are considered raw materials? >> Well, raw materials would be any materials that aren't cooked. So raw material is any material that goes into producing the product. So if we were making eyeglasses, it would be the metal for the frames, glass for the lenses, the screws, little nose pads here, basically anything that you put together to make the final product. To make our walk through this flow chart a little bit more interesting, not that it needs it, I want to go through an example of a company and do these flows with real numbers. So in the first transaction Kirby Manufacturing Incorporated purchased $865 of raw materials on account. And to make it even more interesting, why don't I go ahead and throw up the pause sign here, have you try to do the journal entry, and then I'll come back and give you the answer. So the answer here is that we are going to debit raw materials for $865, raw materials, inventories, and assets, we make you go up with a debit. We credit the accounts payable and liability for 865. It's a liability; we owe our suppliers money, so we make that go up with a credit. Then we post this to T accounts, and for simplicity, I'm just going to have this general payables or cash T account instead of separate T accounts for accounts payable and cash and other things, because I really want the focus to be on the inventory accounts. So next thing that you see on the inventory accounts is materials used. So once those raw materials start being used to produce the goods, we take those cost out of raw materials, and move them into work in process. So Kirby used $806 of raw materials inventory and manufacturing, what would be the journal entry? So here, we're going to debit into an inventory account called Work in Process, an asset which is going to go up by 806, and we're going to credit the raw materials account to reduce it by 806. >> If I understand this correctly, all you are doing is moving from one inventory account to another. There is no transaction with outsiders. Do you have to do this journal entry every time you use a raw material in production? >> You're correct, this is not a transaction with outsiders, it's completely an internal transaction, so it's a lot like an adjusting entry. And in fact, you'll probably do it as an adjusting entry. It would be very tedious to have to do this entry every time you took a screw or a nose pad out of raw materials, and started to make eyeglasses with it. When really, it doesn't matter what's in raw materials and work in process, until you put together financial statements. So what you do is that the end of the period when you're doing your adjusting entries, you'll count up how many raw materials were used in production, and you'll make this journal entry then as an adjusting entry. So, we post this to T accounts, we take the cost of the materials used of 806, and reduce it from raw materials, and then add those costs to work in process inventory. Now, we have more stuff that's going to come into work in process, as we produce the product. So ,we're going to have direct labor, and overhead. >> What is this overhead? Do you also have to account for underfoot and against the wall? >> [LAUGH] That's a good one, no we do not have to account for underfoot or against the wall, only overhead. Overhead is a catch all term for any cost of manufacturing that's not materials or labor. So it would include costs like electricity bill for the factory, the water bill for the factory, heating and air conditioning costs, and depreciation, and any machinery used in production. So let's take a look at how Kirby would account for direct labor and overhead. Ive got three transactions for you. First Kirby paid $524 cash for manufacturing labor. So those are the people actually working on producing the product. Number four, Kirby paid $423 cash for power, heat, light, and other overhead in the factory. And number five, Kirby recognized $81 of depreciation for plant equipment, this is the equipment that was used to produce the product. So let's do the journal entries step by step starting with number three. So we debit work in process inventory for $524, so that adds those costs to the costs that we're accumulating in the work and process inventory. And we credit cash, because we're paying cash for the labor. Now let's try number four. The journal entry is going to be the same. We debit work in process inventory for $423 to add those costs to the work in process account. And we credit cash, because we paid cash for all this overhead costs. Now try number five. So for this one we're again going to debit work in process inventory for $81, because we want to add that costs of using the plant equipment, which is the depreciation, into the work in process account, and we're going to credit accumulated depreciation. Remember that's a contra asset, so by crediting accumulated depreciation we increase the amount of depreciation so far that we've recorded for our equipment. >> If I recall correctly, at the 10 minute and 13 second mark of video 2.2.1, you said that the journal entry for depreciation is always debit deprecation expense and credit accumulated depreciation. What is this debit work in process stuff? >> Well, when I said always, I clearly meant until we get to the video on inventories for manufacturing firms. So depreciation on machinery equipment is a product cost. Remember, product cost gets stored up in inventory until we sell the product. Then when we recognize revenue from sale, we take the cost of the products sold out of inventory, and show them as costs have been sold expense on the income statement. So for depreciation that should be product costs, the way we get into inventory is to debit work in process inventory. If we debited depreciation expense, it would put it on the income statement immediately, which is not what we want in this case. We would only debit depreciation expense immediately if it was a period cost, so a selling general and administrative cost like, say, the depreciation on the CEO's Jaguar. But if it's part of a product cost, it needs to go into work in process inventory. Then we post these three transactions to our T accounts. Notice on the left, I added accumulated depreciation to the payables and cash as the heading of the account, because cost can come out of not only cash and payables, but as we've seen, the cost can come out of accumulated depreciation that go into work in process. The next step is, once we finish the goods, we take the cost of the goods that we finished out of work in process, and move them into a finished goods inventory account. So for Kirby Manufacturing, they finished manufacturing goods that cost $1,960, what's the journal entry? So we're going to debit the finished goods inventory account for 1,960, the cost of the goods we finished. And we credit the work in process inventory account to take those costs out of work in process because the goods are no longer in process. >> So the finished goods account is what we have been calling the inventory account in prior videos. Except, instead of the inventory balance being the cost of purchasing inventory, the balance is the cost of manufacturing the inventory. >> Exactly, I couldn't have said it better myself. Then let's put these numbers in the T accounts, we reduce work in process and increase finished goods inventory. The next step is we actually sell the finished goods to our customers. So we want to pull the cost of those goods out of the finished goods inventory account, and put those costs into the costs of goods sold expense account on the income statement. So Kirby sold $2,862 of goods to customers on account, the goods originally cost $1,938 to manufacture. I'm going to put up the pause sign and I want you to try to both journal entries at once, because these two journal entries always go together. The journal entry for the revenue piece is that we're going to debit accounts receivable for 2,862, because the sales remain on the account, and this represents the selling price of the goods to the customer, and we get to call this sales revenue, so we credit sales for 2,862. Then we have to account for the cost of the goods that we sold. So we debit cost of goods sold, 1,938, at the cost of producing the goods. And we credit the finished goods inventory account for 1,938, which again, is the cost of producing the goods. And hopefully, the cost of producing the goods is less than the selling price that we received from the customer so that we can book a profit. >> How do you keep track of the costs of the specific goods that you just sold? Do you have a T account for every individual item you manufacture? >> No, you don't have to keep a T account for every individual good that you produce. Instead we have to make some assumptions about what were the costs of the goods that we just sold. We'll talk about those assumptions a little bit more in the rest of this video and a lot more in the next video. So then we could post those cost of goods sold to T accounts, basically reduce finished goods and increase the cost of goods sold sold expense. After this you would move in to period costs, like selling and administrative costs. But we're not going to talk about this now, because this is a video on inventory. So what this flow chart should highlight is that these costs flow through a lot of different accounts as we go from cash and accounts payable for raw materials, all the way to the costs of the goods sold. And by using these different accounts, we're able to see the costs that are locked up in each of the different stages of the manufacturing process. What I want to talk about next is this question of how do we know the cost of goods that we sold, versus the cost of the goods that we still have in inventory? There's a basic equation for this, which is that the cost of goods available for sale, which is beginning inventory plus any new inventory, has to equal the cost of the goods we sold, which goes into the income statement through COGS, plus the cost of the goods we still hold, which shows up as ending inventory. Now the tricky thing is that only two of these things are known with certainty, the other two are unknown, and we have to make some kind of assumption to figure this out. So beginning inventory is known for certain, because it's whatever ending inventory was last period. The new inventory is going to either be the cost of purchasing the goods for retail firms, or the cost of producing the goods for manufacturing firms. But now we need an assumption about how we divide this up between cost of goods sold and cost of goods held. As always there are two methods for doing this. One would be the periodic system, where at the end of the period we count all our ending inventory, figure out the cost of that ending inventory, and then we can plug cost of goods sold. Or the perpetual system, where we track cost of goods sold as sales are made, and then we plug ending the inventory. If we know what we sold, then we just figure out what we have left over. >> Do companies really count every single piece of inventory just so they can calculate COGS? It seems much easier to track what you sell. >> Even if companies use some of this new fangled computer technology to track goods that they sell as they sell them, they still need to count their inventory at least once a year. They need to count their inventory so that they can track what we call none revenue sales, which a non accountant would call theft. So if a customer or employee steals inventory, their not going to let the computer system know about it as they walk out the door. The only way that you´re going to track theft is to count the inventory at least once a year, and then write down the inventory for any inventory that's disappeared due to theft or some other kind of way that inventory disappears. Before we move on, I should note that the periodic versus perpetual system helps you figure out the number of goods you've sold versus the number of goods you still have. But in terms of what the actual cost you need to assign to those goods are, well, you have to make some additional assumptions. And those additional assumptions are going to take up, oh, the rest of the videos for the week. But before we get onto that part, one more topic I need to do in this video is something else you have to think about when you're figuring out the value of that ending inventory. The ending balance of inventory must be carried at the lower of historical cost or fair market value. We call this lower of cost or market. Historical cost is the original cost of purchasing or producing the inventory. And fair market value is generally thought of as the replacement cost of the inventory given the current market prices. >> How do you determine the replacement value of the inventory? Is this a number that accountants just make up off the top of their head? >> Actually, management is responsible for making up this number off the top of her head [LAUGH]. So clearly, replacement value is not going to be an exact number. But, management should be in a good position to come up with a reasonable estimate for how much it would cost to re-manufacture the product, or re-acquire the product, given current prices. And if that value is below the original cost, they need to take a write down. So even though we can't get an exact value for replacement value, any estimate is going to be better than ignoring it completely when it's clear the value of the inventory has dropped below what we show it on the balance sheet. So now that you have historical cost and fair market value, the rule is that if historical cost is less than or equal to the fair market value, the ending inventory equals that original cost. There's no adjusting entry needed, we do not write the inventory up to its fair market value, we just leave it alone at the original cost. If the fair market value though is below historical cost, then we have to write the ending inventory down to its replacement value. So we're going to need an adjusting entry to do that, and the adjusting entry will be debit cost of goods sold and credit inventory. The credit to inventory reduces it from original cost to this replacement value and then the debit shows an extra expense on the income statement for the write down. One key international difference is that under US GAAP, once inventory is written down from original cost to fair market value, it can't be written back up if the market value subsequently rises. In contrast, under IFRS, if inventory is written down, it can be written back up, but only as high as the original cost. So, that's one little difference that we haven't yet ironed out between US GAAP and IFRS. So, now that you've seen how we have to make assumptions to figure out cost of goods sold and cost of ending inventory, we can now turn our attention to assumptions we need to make to figure out the cost of each individual good sold. Those cost flow assumptions are going to be the topic of the next video. I'll see you then! >> See you next video.
