Charging Costs of Inventory to Income Statement

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Financial Statement Analysis-FIN621

Lesson-19

NOTES TO FINANCIAL STATEMENTS

(Continued)

Charging Costs of Inventory to Income Statement

This is also known as cost flows of inventory. Inventory units may be acquired at

different costs because of different purchase dates or different suppliers. Question is: Which of these

costs are to be used as "cost of goods sold"?

Purchase/ → Balance sheet → sale of goods → cost of → Income

Manufacture current assets.

Good

Statement

Cost of inventory

sold

(?)

Measuring "cost of goods sold" involves valuation and pricing of Inventory and this is

determined by Inventory Accounting Policies.

As on example consider that 2 ACs were purchased in January @ Rs.20, 000 each, and 3

@ Rs.25, 000 each in February. One AC was sold in March. What would be the cost of goods sold:

Rs.20, 000 or Rs.25, 000?

Two approaches can be adopted in this case i.e. specific identification and cost-flow

assumptions. Either is acceptable but an approach once selected, is to be applied consistently.

In specific identification approach, the Units are identified specifically, which clearly

shows as to which particular unit is being sold and what was its cost, which would be its "cost of goods

sold".

A Note on the Impact of Inventory Levels on Net Income

Fluctuations in inventory levels can cause profit variations when inventory is valued according to

GAAP standards. GAAP standards require that all manufacturing costs must be capitalized in inventory

regardless of whether the costs are variable or fixed.

The inclusion of fixed costs in the unit cost causes profits to rise as inventory levels raise because the

fixed cost in inventory is stored on the balance sheet instead of being carried over to the income

statement. When the inventory level falls, this fixed cost that has been stored on the balance sheet is

moved over to the income statement thereby causing net profit to fall.

To illustrate this phenomenon I first present a one month income statement constructed using only

variable costs in inventory (in this case, materials only).

Sales

$1,837,380

Cost of materials

458,000

Margin

1,379,380

Expenses

Labor

224,000

Overhead

344,288

Depreciation

270,000

Financial Statement Analysis-FIN621

Administrative

210,000

Marketing

175,000

Total expenses

1,223,288

Profit before taxes

156,092

Income taxes @ 35%

54,632

Net Profit

$101,460

Computation of Unit Values

Sales

Flow

Valves

Pumps

Controllers

Total

Units

7,500

12,500

4,000

24,000

Selling Price $57.78

$81.26

$97.07

$1,837,380

20.00

22.00

458,000

Material cost 16.00

Unit margin 41.78

61.26

75.07

Total margin

$313,350

$765,750

$300,280

$1,379,380

Next I show two income statements for two months with the identical sales as in the first income

statement that uses only variable costs in inventory. However, in these two income statements the

inventory levels change; in the Month 1 statement the inventory of Valves rises by 1,000 units, and in

the Month 2 statement Valve inventory falls by 1,000 units.

Month 1

Flow

Valves

Pumps

Controllers

Total

Unit Sales

7,500

12,500

4,000

24,000

Units Produced

8,500

12,500

4,000

25,000

Ending Inv.

1,000

Unit cost

37.75

48.87

100.57

Sales Price

$57.78

$81.26

$97.07

Dollar sales

433,350

1,015,750

388,280

1,837,380

Income Statement

Sales

$1,837,380

Cost of goods sold

Begin inv.

Costs added

Materials

474,000

Labor

155,600

Overhead

682,688

Total costs added

1,312,288

Goods available

1,312,288

Ending inv.

1,000

37,749

Cost of goods sold

1,274,539

Gross Profit

562,841

Financial Statement Analysis-FIN621

Administrative

210,000

Marketing

175,000

Total expenses

385,000

Profit before taxes

177,841

Income taxes @ 35%

62,244

Net Profit

$115,597

Month 2

Flow

Valves

Pumps

Controllers

Total

Unit Sales

7,500

12,500

4,000

24,000

Units Produced

6,500

12,500

4,000

23,000

Unit cost

37.75

48.87

100.57

Sales Price

$57.78

$81.26

$97.07

Dollar sales

433,350

1,015,750

388,280

1,837,380

Income Statement

Sales

$1,837,380

Cost of goods sold

Begin inv.

37,749

Costs added

Materials

442,000

Labor

155,600

Overhead

682,688

Total costs added

1,280,288

Goods available

1,318,037

Ending inv.

Cost of goods sold

1,318,037

Gross Profit

519,343

Administrative

210,000

Marketing

175,000

Total expenses

385,000

Profit before taxes

134,343

Income taxes @ 35%

47,020

Net Profit

$87,323

Financial Statement Analysis-FIN621

Notice how the net incomes changed from one month to the next even though sales remained the same.

This example used activity based costs for costing the units of product, but any costing method that

assigns fixed costs to units will give the same result.

To more clearly show why the incomes differ, consider the following table that shows variable unit

costs and the unit fixed costs assigned to the units by the ABC costing system.

Flow

Valves

Pumps

Controllers

ABC unit cost

$37.75

$48.87

$100.57

20.00

22.00

Unit variable cost

16.00

Fixed cost per unit

21.75

28.87

78.57

Times

Inventory change in units 1,000

Equals--Difference in pre$21,749

tax income

Profit before taxes--unit$156,092

variable costs

Profit before taxes--ABC177,841

unit costs Month 1

Difference in profit before(21,749)

taxes

Profit before taxes--unit$156,092

variable costs

Profit before taxes--ABC134,343

unit costs Month 2

Difference in profit before$21,749

taxes

The difference between the net income before taxes for the income statement with variable costs and the

one with the ABC costs is always explained by the unit change in inventory multiplied by the fixed

overhead per unit.

Inventory Errors and Financial Statements

Income statement effects.

An incorrect inventory balance causes an error in the calculation of cost of goods sold and,

therefore, an error in the calculation of gross profit and net income. Left unchanged, the error has

the opposite effect on cost of goods sold, gross profit, and net income in the following accounting

period because the first accounting period's ending inventory is the second period's beginning

inventory. The total cost of goods sold, gross profit, and net income for the two periods will be

correct, but the allocation of these amounts between periods will be incorrect. Since financial

statement users depend upon accurate statements, care must be taken to ensure that the inventory

balance at the end of each accounting period is correct. The chart below identifies the effect that

an incorrect inventory balance has on the income statement

Financial Statement Analysis-FIN621

Impact of Error on

Error in Inventory Cost of Goods Sold Gross Profit Net Income

Ending Inventory

Understated

Overstated

Understated

Overstated

Understated

Overstated

Beginning Inventory

Understated

Overstated

Understated

Balance sheet effects.

An incorrect inventory balance causes the reported value of assets and owner's equity on the

balance sheet to be wrong. This error does not affect the balance sheet in the following accounting

period, assuming the company accurately determines the inventory balance for that period.

Impact of Error on

Error in Inventory Assets =

Liabilities + Owner's Equity

Understated

Understated No Effect

Understated

Overstated

No Effect

Overstated

Financial Statements with Inventory

The statement of owner's equity and the statement of cash flows are the same for merchandising

and service companies. Except for the inventory account, the balance sheet is also the same. But a

merchandising company's income statement includes categories that service enterprises do not use.

A single-step income statement for a merchandising company lists net sales under revenues and

the cost of goods sold under expenses.

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