1.3: Inventory terminology and concepts
A manufacturer reports its product costs as one of three types of inventory in the current assets section of its balance sheet, depending on stages of completion. Materials consist of items in inventory that have not yet been entered into production or used. Work in process includes manufactured products that have been started but are not yet completed. In other words, they are currently in production. Finally, finished goods are manufactured products that have been completed but not yet sold to customers.
1.3.1 Financial Reporting for a Manufacturer
The three inventory accounts, and their balances at the end of the month, appear in the current asset section of a manufacturer’s balance sheet. A sample balance sheet follows.
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Assets |
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Current assets: |
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Cash |
$40,000 | ||
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Accounts receivable |
25,000 |
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Inventory |
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\(\ \quad \quad\)Materials |
$18,000 |
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\(\ \quad \quad\)Work in process |
31,000 |
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\(\ \quad \quad\)Finished goods |
26,000 |
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\(\ \quad \quad\)\(\ \quad \quad\)Total inventory |
75,000 |
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Prepaid insurance |
4,000 |
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Prepaid rent |
2,000 |
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\(\ \quad \quad\)Total current assets |
$146,000 |
When manufactured items are sold, their costs are removed from the Finished Goods inventory account and transferred to the Cost of Goods Sold expense account on the income statement. Cost of Goods Sold represents the amount a company paid for the manufactured items that it sold. Cost of Goods Sold is matched with Sales on the first two rows of the income statement. The difference between Sales and Cost of Goods Sold is gross profit, which is the amount of markup on the manufactured goods.
The income statement also includes expenses other than Cost of Goods Sold . Selling and administrative expenses are non-factory costs that are classified as operating expenses. These period costs are necessary to operate the business and generate sales.
A sample income statement follows.
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Sales |
$300,000 |
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Cost of goods sold |
140,000 |
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Gross profits |
$160,000 |
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Operating expenses: |
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\(\ \quad \quad\)Selling expenses |
$75,000 |
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\(\ \quad \quad\)Administrative expenses |
35,000 |
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Total operating expenses |
110,000 |
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Net income |
$50,000 |
The Cost of Goods Sold amount on the income statement is determined by considering the changes in the three inventory account balances during the period. The elements of its calculation contain important information for managers, but they are too detailed and lengthy to present directly on the income statement. Therefore, a separate statement of cost of goods sold is prepared to show the details of the calculations. The final cost of goods sold amount from the statement of cost of goods sold is what appears on the income statement.
The statement of cost of goods sold that follows presents how the $140,000 amount on the income statement is determined. The statement is followed by an explanation of its sections.
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Finished goods inventory, June 1 |
$34,000 |
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Work in process inventory, June 1 |
$42,000 |
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Direct materials |
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\(\ \quad \quad\)Materials inventory, June 1 |
$16,000 |
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\(\ \quad \quad\)Purchases |
59,000 |
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\(\ \quad \quad\)Cost of materials available to use |
$75,000 |
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\(\ \quad \quad\)Materials inventory, June 30 |
(18,000) |
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\(\ \quad \quad\quad \quad\)Cost of direct materials used |
$57,000 |
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Direct labor |
40,000 |
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Factory overhead |
24,000 |
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Total manufacturing costs in June |
121,000 |
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Total manufacturing costs |
$163,000 |
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Work in process inventory, June 30 |
(31,000) |
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Cost of goods manufactured |
132,000 |
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Cost of goods available for sale |
$166,000 |
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Finished goods inventory, June 30 |
(26,000) |
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Cost of goods sold |
$140,000 |
Three amounts that must often be solved for algebraically are the amounts of inventory transferred out of the Materials, Work in Process, and Finished Goods inventory accounts during a period. These amounts may be determined with an equation similar to that used for the periodic inventory system for merchandising. Beginning and ending inventory values are determined by taking physical inventory counts, and, therefore, they are known. Amounts for inventory added during the period are available from purchase orders and production reports that accumulate costs on manufactured goods. The following general equation summarizes the calculation of inventory transferred out of the inventory accounts:
Beginning inventory balance + additions during the month – ending inventory balance
The equations that follow for each inventory account use the amounts from the statement of cost of goods sold to illustrate the calculations for the amounts transferred out of Materials , Work in Process , and Finished Goods , respectively. The ledger account that corresponds to each type of inventory uses these same amounts to show increases, decreases, and running balances. The ledger accounts show the flow of manufacturing costs from Materials to Work in Process to Finished Goods to Cost of Goods Sold .
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Beginning Materials balance |
$16,000 |
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|
+ |
Purchases of materials during the period |
+ 59,000 |
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- |
Ending Materials balance (still in inventory) |
- 18,000 |
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= |
Materials used and transferred to Work in Process |
$57,000 |
The following ledger also reflects the movement in and out of the Materials account, with a debit entry representing an increase and a credit entry showing a decrease.
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Date |
Item |
Debit |
Credit |
Debit |
Credit |
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1. |
Balance, June 1 |
16,000 |
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Purchases of materials during June |
59,000 |
75,000 |
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3. |
Materials moved to production in June |
57,000 |
18,000 |
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The following excerpt from the statement of cost of goods sold presents the information shown in the equation and ledger for Materials .
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Direct materials |
$57,000 was transferred from one inventory account to the next: from Materials (credit) to Work in Process (debit) |
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\(\ \quad \quad\)Materials inventory, June 1 |
$16,000 |
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\(\ \quad \quad\)Purchases |
59,000 |
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\(\ \quad \quad\)Cost of materials available to use |
$75,000 |
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\(\ \quad \quad\)Materials inventory, June 30 |
(18,000) |
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\(\ \quad \quad\)\(\ \quad \quad\)Cost of direct materials used |
$57,000 |
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Beginning Work in Process balance |
$42,000 |
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+ |
Materials, labor, and factory overhead added to production |
+ 121,000 |
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- |
Ending Work in Process balance (still in inventory) |
- 31,000 |
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= |
Work in Process completed and transferred to Finished Goods |
$132,000 |
The following ledger also reflects the movement in and out of the Work in Process account, with a debit entry representing an increase and a credit entry a decrease.
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Date |
Item |
Debit |
Credit |
Debit |
Credit |
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1. |
Balance, June 1 |
42,000 |
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Materials moved to production in June |
57,000 |
99,000 |
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3. |
Labor added to production in June |
40,000 |
139,000 |
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| 4. |
Overhead added to production in June |
24,000 |
163,000 |
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| 5. |
Work in process completed in June |
132,000 |
31,000 |
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The following excerpt from the statement of cost of goods sold presents the information shown in the equation and ledger for Work in Process .
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Work in process inventory, June 1 |
$42,000 |
$132,000 was transferred from one inventory account to the next: from
Work
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Total manufacturing costs in June |
121,000 |
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Total manufacturing costs |
$163,000 |
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Work in process inventory, June 30 |
(31,000) |
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Cost if goods manufactured |
132,000 |
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Beginning Finished Goods balance |
$34,000 |
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+ |
Work in Process completed during the period |
+ 132,000 |
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- |
Ending Finished Goods balance (not yet sold) |
- 26,000 |
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= |
Finished Goods sold and transferred to Cost of Goods Sold |
$140,000 |
The following ledger also reflects the movement in and out of the Finished Goods account, with a debit entry representing an increase and a credit entry a decrease.
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Date |
Item |
Debit |
Credit |
Debit |
Credit |
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1. |
Balance, June 1 |
34,000 |
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2. |
Work in process completed in June |
132,000 |
166,000 |
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| 3. |
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140,000 |
26,000 |
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The following excerpt from the statement of cost of goods sold presents the information shown in the equation and ledger for Finished Goods .
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Finished goods inventory, June 1 |
$34,000 |
$140,000 was trans- ferred from one inven- tory account to the next: from Finished Goods (credit) to Cost of Good Sold (debit) |
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Cost of goods manufactures |
132,000 |
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Cost of goods available for sale |
$166,000 |
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Finished goods inventory, June 30 |
(26,000) |
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Cost of goods sold |
$140,000 |
Cost of Goods Sold:
$140,000 was transferred from one inventory account to an expense account when the product was sold: from Finished Goods (credit) to Cost of Goods Sold (debit)
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Date |
Item |
Debit |
Credit |
Debit |
Credit |
| 1. |
Cost of product sold in June |
140,000 |
140,000 |
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The accumulation of production costs, and the transfer of those costs from account to account based on stage of completion, track the manufacturing process from beginning to end, when the products are sold. This information is critical to managers in manufacturing companies who make purchasing decisions, determine selling prices, prepare sales budgets, and schedule production.