Level 1 CFA® Exam:
Inventory - Basics
As we all know, to generate revenue a company sells previously manufactured or purchased inventory to its clients, and thanks to it it makes a profit.
To compute the value of profit generated by selling inventory we need to compute revenue and costs related to this inventory. It is easy to compute revenue because revenue equals the number of units sold multiplied by the price of one unit
However, the cost of inventory, which is called cost of sales or cost of goods sold or simply COGS, depends on some assumptions. These assumptions are the basis of inventory valuation methods. There are 4 valuation methods that we will discuss in detail in the next lesson.
What is the most important assumption that impacts the value of recognized COGS? It is the assumption about what inventory is sold first. For example, one of the methods (called the first-in-first-out method) assumes that the company sells the oldest inventory first. Another method (namely the last-in-last-out method) assumes that the most recent inventory is sold first.
Because inventories purchased on different dates will usually differ in prices, the choice of the valuation method impacts the value of COGS.
The formula below says that goods available for sale are the sum of beginning inventory and purchases of inventory in the period:
\(\text{goods available for sale}= \\=\text{inventory}_0+\text{purchases}\)
The second formula implies that ending inventory for a given period is equal to the sum of its beginning inventory and purchases of inventory in the period reduced by the cost of goods sold:
According to the second formula, the value of COGS impacts the ending inventory. So, depending on assumptions and the method used for valuing inventory we will not only get different costs and profits but also inventory reported in the balance sheet will differ.
In your exam, you should be able to indicate what types of costs are capitalized and what costs are expensed.
Remember that capitalizing is including the cost in the value of an item. On the other hand, expensing means treating costs as expenses in the period.
(...)
Costs that the company will treat as expenses in the period in which they occurred are:
- abnormal costs due to waste of materials,
- storage costs of finished inventory (in most cases),
- labor,
- administrative overheads, and
- selling costs.
Manufacturers purchase raw materials from suppliers and using these materials make products (which we call finished goods) and sell them to merchandisers who resell them to customers.
(...)
- To compute the value of profit generated by selling inventory we need to compute revenue and costs related to this inventory.
- The cost of inventory is called cost of sales or cost of goods sold or COGS.
- The most important assumption that impacts the value of recognized COGS is the assumption about what inventory is sold first.
- The value of COGS impacts the ending inventory.
- Capitalizing is including the cost in the value of an item.
- Expensing means treating costs as expenses in the period.
- Manufacturers purchase raw materials from suppliers and using these materials make products and sell them to merchandisers who resell them to customers.