Inventory and Cost of Goods Sold [Part 5]

Specific Identification

In addition to the six cost flow assumptions presented in Parts 1 - 4, businesses have another option: expense to the cost of goods sold the specific cost of the specific item sold. For example, Gold Dealer, Inc. has an inventory of gold and each nugget has an identification number and the cost of the nugget. When Gold Dealer sells a nugget, it can expense to the cost of goods sold the exact cost of the specific nugget sold. The cost of the other nuggets will remain in inventory. (Alternatively, Gold Dealer could use one of the other six cost flow assumptions described in Parts 1 - 4.)

LIFO Benefits Without Tracking Units

In Part 1 and Part 2 you saw that during the periods of increasing costs, LIFO will result in less profits. In the U.S. this can mean less income taxes paid by the company. Most companies view lower taxes as a significant benefit. However, the process of tracking costs and then assigning those costs to the units sold and the units on hand could be too expensive for the amount of income tax savings. To gain the benefit of LIFO without the tracking of costs, there is a method known as dollar value LIFO. This topic is discussed in intermediate accounting textbooks. The Internal Revenue Service also allows companies to use dollar value LIFO by applying price indexes. (You should seek the advice of an accounting and/or tax professional to assess the cost and benefit of these techniques.)

Inventory Management

Over the past few decades sophisticated companies have made great strides in reducing their levels of inventory. Rather than carry large inventories, they ask their suppliers to deliver goods "just in time." Suppliers and merchandisers have learned to coordinate their purchases and sales so that orders and shipments occur automatically.

A company will realize significant benefits if it can keep its inventory levels down without losing sales or production (if the company is a manufacturer). For example, Dell Computers has greatly reduced its inventory in relationship to its sales. Since computer components have been dropping in costs as new technologies emerge, it benefits Dell to keep only a very small inventory of components on hand. It would be a financial hardship if Dell had a large quantity of parts that became obsolete or decreased in value.

Financial Ratios

Keeping track of inventory is important. There are two common financial ratios for monitoring inventory levels: (1) the Inventory Turnover Ratio, and (2) the Days' Sales in Inventory. (These are discussed and illustrated in the Explanation of Financial Ratios.)

Estimating Ending Inventory

It is very time-consuming for a company to physically count the merchandise units in its inventory. In fact, it is not unusual for companies to shut down their operations near the end of their accounting year just to perform inventory counts. The company may assign one set of employees to count and tag the items and another set to verify the counts. If a company has outside auditors, they will be there to observe the process. (Even if the company's computers keep track of inventory, accountants require that the computer records be verified by actually counting the goods.)

If a company counts its inventory only once per year it must estimate its inventory at the end of each month in order to prepare meaningful monthly financial statements. In fact, a company may need to estimate its inventory for other reasons as well. For example, if a company suffers a loss due to a disaster such as a tornado or a fire, it will need to file a claim for the approximate cost of the inventory that was lost. (An insurance adjuster will also compute this amount independently so that the company is not paid too much or too little for its loss.)
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