Accounting for Inventory Purchases

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  • 0:35 Before Recording
  • 6:37 Recording Inventory Purchases
  • 7:34 Lesson Summary
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Lesson Transcript
Instructor: Rebekiah Hill

Rebekiah has taught college accounting and has a master's in both management and business.

A merchandising company must purchase inventory, and it has to be accounted for in the accounting records. In this lesson, you will learn how to calculate inventory purchase amounts as well as how to record them in the accounting journals.

Inventory Purchases Defined

I have always wanted to open my own business. I can mentally picture it - the store layout, the bright, neon sign flashing the word 'Open', and customers streaming in. However, I know it really isn't that easy. There are so many things that have to be done to successfully operate a business. One of those, and a very important one, is accounting for inventory purchases.

Inventory purchases, in the sense of a merchandising company, refers to buying items that are meant to be resold to customers.

Before Recording

In order to keep your accounting records straight, all of the purchases made in an accounting period must be recorded. Before inventory purchases can be recorded, the value of the inventory has to be calculated. There is a pretty straightforward way to calculate the total cost of purchasing inventory. You simply use the following formula:

original selling price - trade discounts - purchase discounts - purchase returns and allowances + transportation costs + ownership and transfer fees = cost of purchasing inventory

I know that is a lot to grasp at one time, so let's break it down and discuss each part of the equation.

The original selling price is easy. It is the price that is on the price tag or in the catalog. The original selling price is quite simply the base price of the item. Let's say that I own a candy store and I want to order 40 pounds of gummy worms from Willy's Candy Direct. The original selling price per pound for the gummy worms is $6.00, so my total purchase for the candy is $240.00.

A trade discount is the amount of discount that is given by a manufacturer to a reseller on the price of an item. Oftentimes, trade discounts are given to customers who order in bulk. For example, Willy's Candy Direct offers a 20% discount for any candy orders over 25 pounds. Since I ordered 40 pounds of gummy worms, then I get the 20% discount. And that discount will total $48.00.

Purchase discounts are different than trade discounts. They are discounts that are given by suppliers to merchants for paying invoices on time. Remember the gummy worms that I just ordered from Willy's Candy Direct? I ordered the gummy worms on account with the terms 3% net 10. What that means is that if I pay the total invoice amount within 10 days of receiving the invoice, then I can deduct 3% of the invoice as a discount. So, if the invoice is for $192.00, then I would be able to deduct $5.76 from the total and only pay $186.24, as long as I paid the invoice within the 10-day time period.

Purchase returns and allowances are any credits that a buyer may be issued by the seller for damaged or returned goods. Let's say that of the 40 pounds of gummy worms that I ordered, several of the candies were melted together. I can't sell them that way, so I need to return them. The first thing that I do is weigh the melted candies since I purchased them by the pound. I need to know how much of the candy has to be returned. I certainly don't want to pay for something that I can't sell. Since I paid $4.80 a pound after my trade discount, and there are 5 pounds of melted candy that must be returned, my credit allowance is $24.00. That amount is deducted from my total invoice before I pay it.

Now that we have discussed everything that is deducted from the original selling price of an item, let's talk about what is added in the equation. Transportation cost is the first thing that is added. Transportation cost is the cost of moving merchandise from one place to another. When it comes to adding transportation costs to the cost of purchase inventory equation, it is very important to remember that only the cost of merchandise coming in is added. The cost of merchandise going out is categorized differently and is not a part of accounting for inventory purchases.

If it costs me $8.10 to get the gummy worms from Willy's Candy Direct to my store, then that is the dollar amount that I must add in the equation.

The last component of the cost of purchases equation is ownership and transfer fees. Ownership and transfer fees are any fees associated with transferring ownership of an asset from one business to another. Not every inventory purchase will have ownership and transfer fees associated with it. For example, when I ordered the gummy worms from Willy's Candy Direct, I didn't pay ownership or transfer fees.

If, however, I was in a different line of business, say a used car lot, I would have ownership and transfer fees that would have to be paid. Why? Because the inventory that I would acquire would be used cars. When the used cars are purchased, there must be a title transfer to transfer ownership, which requires a title transfer fee.

Now, let's put it all together and figure out the cost of purchasing inventory for my candy store.

Here is what I know:

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