Topic 3 - Accounting for Inventory

Question 1

What is inventory?

Answer 1

ALL assets:

• held for sale in the ordinary course of business
• in the process of production for a sale
• materials or supplies “used up” in the production of assets that will later be sold or “used up” in the delivery of a service

Question 2

Quantas uses its planes to provide a travel service to its customers.

Are the planes classed as inventory?

Answer 2

NO, because they are not “used up” during the provision of the service.

Question 3

A hairdresser uses shampoo to wash the hair of customers prior to cutting.

Is the shampoo inventory?

Answer 3

YES, because it is “used up” when providing the service.

Question 4

How must inventory be valued?

Answer 4

Each item of inventory must be valued at the lower of:

Cost

consideration paid + costs of conversion (production) + costs to bring the asset to its current location and condition

or

Net realisable value

sales proceeds – costs of completion and sale

Question 5

What does net realisable value consist of?

Answer 5

• expected sales proceeds

MINUS

• expenditures associated with completing the production of the items
• expenditures associated with selling the items
• marketing expenditures

BUT

NONE of these expenditures can be recognised when calculating the cost of inventory

Question 6

What items are not included in the cost of inventory?

Answer 6

• abnormal amounts of waste, including material and labour in the production process
• storage costs
• administrative overheads that are unrelated to the production of bringing inventory to its present location or condition
• selling costs
• advertising costs
• early payment discounts or late payment penalties
• finance costs >> except for qualifying assets

Question 7

While finance and borrowing expenditure are normally excluded from the cost of inventory, what is the exception to this rule?

Answer 7

Finance and borrowing expenditure directly associated with qualifying assets are part of cost:

• expenditures are directly associated when they are caused by the production of the asset
• qualifying assets are those that necessarily take more than 12 months to complete
• only finance/borrowing expenditures for the construction period can be included in the cost of inventory

Question 8

What do inventory costs include?

Answer 8

variable costs + fixed production overheads

Question 9

What are fixed production costs?

Also, give two examples.

Answer 9

• they are relatively uninfluenced by changes in production levels
• Examples*
  1. Depreciation of factory buildings
  2. Wage of factory manager

Question 10

What are two cost allocation techniques?

Answer 10

1) Absorption costing
2) Standard costing

Question 11

What is absorption costing?

Answer 11

• cost of inventory based on:

variable costs + fixed manufacturing overhead costs

Question 12

How do you use absorption costing to determine overhead allocation for an individual item?

Answer 12

• allocation is based on normal production outputs
• lower than normal production does not increase allocations:

· unallocated costs are treated as period expenses

• higher than normal production does lead to a reduction in allocations to avoid over-allocations

Question 13

What is standard costing?

Answer 13

• cost of inventory is based on variable costs plus fixed manufacturing overhead costs

Question 14

How is standard costing used to determine overhead allocation for an individual item?

Answer 14

• allocation is based on:

· planned cost levels and efficiencies

· expected capacity utilisation

(based on information from the production planning process)

• planned costs must be updated regularly to ensure that the cost allocation information is up-to-date:
• differences* between planned and actual costs can then be assessed

Question 15

When are inventory cost flow assumptions necessary?

Answer 15

• if costs per item change during the period

and

• it is impractical or inappropriate to determine and use the costs of individual items

Question 16

Which cost flow assumption should be used?

Answer 16

• the most practical accounting reflection of the reality that is available:

· specific identification of costs for each individual item

· weighted average cost

· first-in-first-out (FIFO)

(last two apply to perpetual AND periodic inventory accounting)

Question 17

How is the weighted average method calculated?

Answer 17

cost of opening inventory + cost of items purchased (or manufactured) during period / total number of items

Question 18

The weighted average method may be used in?

Answer 18

Perpetual inventory system

• the inventory account is updated after every purchase/sale
• the average value of inventory is updated after every purchase

Periodic inventory system

• the inventory account is updated once (after the inventory count/stock take)
• the average value of inventory for the period is calculated once

Question 19

How are costs allocated using the first-in-first-out method?

Answer 19

• costs are allocated on the assumption that items which are purchased first are sold first

Question 20

When can we use the first-in-first-out method?

Describe the result of Cost of Goods Sold when prices rise.

Answer 20

May be used in either:

• perpetual inventory system
• periodic inventory system

If prices are rising (normal), FIFO generates lower COGS and a higher ending inventory than the weighted average method