take care when choosing the method you will be using. four illustrations.
by ed mendlowitz
77 ways to wow!
materials purchased are comprised of many elements in addition to the actual product purchased. following is an illustrative cost sheet that accumulates and calculates unit cost. usually, a large unit such as a case, skid or truckload would be measured and the per unit cost determined by dividing the total by the number of units. all costs are included.
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cost sheets are maintained for every separate product or sku (stock keeping unit) and is a string of characters that uniquely identify a product or part with a separate sku for every item with a distinguishing difference such as size, color, material and packaging.
note that each company determines its skus based on the attributes of the product and uses it primarily for inventory and distribution purposes. a barcode or upc (universal product code) for a product is the same at every retailer.
illustration: cost sheet
| unit measured: ladies sweater | your company | illustration | |
| costs to bring in the merchandise | |||
| initial (or first) purchase price | $1000.00 | ||
| freight in | 80.00 | ||
| duty charges | 210.00 | ||
| commissions on purchases | 30.00 | ||
| letter of credit fees | 12.50 | ||
| ocean marine insurance | 17.50 | ||
| subtotal | 1350.00 | ||
| processing costs | |||
| cartons | 10.00 | ||
| price tags | 1.00 | ||
| cards | 1.00 | ||
| stuffing | 3.00 | ||
| i.d. tag | 1.50 | ||
| staples and similar items | .50 | ||
| direct labor (including taxes and benefits) | 200.00 | ||
| indirect labor (incl. taxes and benefits) | 50.00 | ||
| factory overhead allocated | 90.00 | ||
| subtotal | 357.00 | ||
| total costs | 1707.00 | ||
| quantity represented | 10 | ||
| cost per item | 170.70 | ||
| additional info for class that is not part of cost sheet | |||
| expected gross margin | 40% | ||
| wholesale price [170.70 ÷ (1-40%)] | 284.50 | ||
| retail price with a 40% gross margin [284.50 ÷ (1-40%)] | 474.17 | ||
illustration: playing games with inventory
the above illustration shows a situation where the controller (or bookkeeper or cfo) prepares a monthly financial statement and increases the inventory by $120,000 per month to cover a $100,000 monthly loss. this continues for the entire year, starting in february. january appears to be accurate. this is an illustration for teaching purposes, so the monthly sales and all of the costs are shown as being the same every month.
neither the owner nor the bank, which received monthly financial statements from the controller, noticed that anything was wrong or questionable.
this was found by applying a percent of the monthly material purchases to the monthly sales. while this might not be accurate for any one month, this technique is pretty accurate when you take that percentage for any three consecutive months.
this works for a company with relatively stable monthly sales. most companies only purchase to meet orders or current demand. very few companies manufacture to build up inventory unless they are expecting increases in sales. further, most mature companies already have inventory levels as low as they can be while still being able to ship orders they receive. therefore, it is rare for inventory levels to drop.
when i apply the percentage of purchases to sales, and it is higher for a given month, this means they increased inventory (and i expect a corresponding decrease the following month). when the percentage of the purchases is lower, it means they reduced inventory that month, and i look to see it replenished the following month – unless they actually sold off some old inventory.
illustration: interim inventory valuation
when a manufacturing company (or division or department) prepares monthly financial statements, the month-end inventory is usually valued. the valuation is usually based on a percentage to arrive at a proper gross margin or an amount based on a perpetual inventory, or, rarely, based on an actual count.
using the above illustrations, it appears the company made less profit than it should have when sales increased, and had a lower loss when sales decreased. this is because the payroll and overhead were “fixed” in that it did not change when sales changed.
by valuing inventory to include payroll overhead, the profit and loss amounts were distorted, and inaccurate results were shown.
my suggestion, in this case, is: only value the change in materials when preparing interim statements.
illustration: inventory valuation method
shown below is a comparison between lifo, average cost and fifo.
the inventory method affects the bottom line, so take care when choosing the method you will be using.