Deborah teaches college Accounting and has a master's degree in Educational Technology.
Manufacturing companies convert raw materials into finished goods that are sold to consumers. Inventory in various stages of completion must be reported on company financial statements.
Cost Classifications of Inventory
The Super Scoop Company manufactures ice cream that is sold in grocery stores. The owner of the company, Mr. Scoop, is trying to gain an understanding of the different components of his company's inventory and how it is reported on the financial statements.
Inventory in a manufacturing company consists of raw materials, work-in-process (WIP), and finished goods that will be sold to consumers. Raw materials are unprocessed goods that the company uses at the start of its manufacturing process. For the Super Scoop Company, raw materials could include things like sugar and milk. Work-in-process (WIP) includes goods that have started the conversion process from raw materials to finished goods, but aren't yet complete. For example, the Super Scoop Company could have pasteurized its base product, but may not have added the flavoring to finish making the chocolate ice cream batch yet. Finished goods include the items that have completed the conversion process and are ready to sell to the consumer. Ice cream packaged in cartons and ready to ship to grocery stores are an example of finished goods for the Super Scoop Company.
In order to value its inventory, a company must keep track of all the costs of its inventory at each stage of the process. For example, the Super Scoop Company would want to keep track of the costs of milk and sugar, its direct labor costs (including the cost of its hourly employees), and its manufacturing overhead, which would include rent, utilities, salaries of plant supervisors, and depreciation. Depreciation is the process of allocating the cost of an operating asset, such as a machine or a piece of equipment, over its useful life as it is used in the manufacturing process to create sales for the company.
Calculating & Reporting Inventory
Financial statements summarize the financial position of a company. Types of financial statements include the income statement and the balance sheet. The income statement summarizes the sales revenue that the company earned by selling its products to customers and the expenses it incurred in order to make those sales. It also illustrates the company's net income, revenues greater than expenses, or net loss, expenses greater than revenue.
The balance sheet shows the assets, liabilities, and equity of a company. Assets represent items that a company owns, like inventory. Liabilities represent what the company owes to others, and equity represents the owner's investment in the company plus any earnings of the company over time. Inventory will impact both the income statement and the balance sheet. The amount of inventory a company has at the end of the period will be reported on the balance sheet as 'Inventory' and should include raw materials, work-in-process, and finished goods inventory. The cost of inventory is recorded on the income statement as 'Cost of Goods Sold'.
The formula for calculating cost of goods sold for a manufacturing company is:
beginning finished goods inventory + cost of goods manufactured = finished goods available for sale - ending finished goods inventory
This calculation is summarized on the cost of goods sold statement and total cost of goods sold is then reported on the company's income statement.
In order to track its costs and calculate cost of goods sold for the period, companies must prepare a cost of goods manufactured statement. This statement considers the raw materials and work-in-process inventory balances, as well as direct labor and overhead costs. In order to prepare this statement for the Super Scoop Company, we need information about its beginning and ending inventory balances, its purchases, and the amount of labor and overhead used to make ice cream throughout the year.
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Let's assume that the Super Scoop Company has the following inventory balances at the beginning of the year:
Raw materials inventory = $120,000
Work-in-process inventory = $95,000
Finished goods inventory = $110,000.
At the end of the year, the balances were:
Raw materials inventory = $100,000
Work-in-process inventory = $75,000
Finished goods inventory = $90,000.
During the year, the company purchased $140,000 in raw materials, direct labor used in the manufacturing process was $250,000, and total overhead was $130,000. Total overhead consisted of:
Rent = $50,000
Depreciation = $20,000
Utilities = $25,000
Salaries of indirect labor = $35,000
The cost of goods manufactured would be $560,000.
Notice that the finished goods inventory does not appear on the cost of goods manufactured statement. The finished goods inventory is needed for the cost of goods sold calculation and not the cost of goods manufactured. The cost of goods sold for the Super Scoop Company is $580,000.
Now that the Super Scoop Company has calculated its cost of goods sold, it can take this amount to its income statement to determine its profit or loss for the period. Let's remember that manufacturing overhead only includes expense items associated with producing its ice cream products. There are other expenses that aren't production costs, like sales reps, headquarters administrators and executives salaries. We call the expenses not attached to products as manufacturing overhead selling,general and administrative expenses. Let's assume that total sales for the period = $950,000, cost of goods sold = $580,000, rent = $50,000, Selling, general and administrative expense = $130,000 The amount of Super Scoop's net income before taxes would be $240,000 and the income statement would look something like this:
All ending inventory, including balances in raw materials, work-in-process, and finished goods, would be reported as a current asset on Super Scoop's balance sheet. In practice, all three categories would be totaled and reported as one figure. The breakdown of the balance into its three components would be disclosed in the company's notes to the financial statements so the reader would be able to easily identify each component.
The Super Scoop Company's total inventory reported on the balance sheet would be $265,000 (raw materials of $100,000 + work-in-process inventory of $75,000 + finished goods inventory of $90,000).
The raw materials, work-in-process (WIP), and finished goods inventory of a manufacturer must be tracked and are used to calculate the company's cost of goods sold, which is used in the determination of a company's net income.
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