INVENTORY GAME: WHAT IS IT, HOW TO CALCULATE IT, EXAMPLE - DUDAS - 2024

The inventory game is the procedure that companies use to calculate the cost of sales within a periodic inventory system. Cost of sales is the running total of all costs that were used to create a product or service that has been sold.

This cost is a key part of a company's performance indicators, as it measures a company's ability to design, source, and manufacture products at a reasonable cost.

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The term cost of sales is the one most commonly used by retailers. A manufacturer is more likely to use the term cost of goods sold.

Business managers analyze and monitor their cost of sales to make sure that expenses are within budgeted estimates and also that the company is making a profit.

However, for the cost of sales figure to be accurate, it must include all purchasing and production costs, plus all indirect costs.

What is the inventory game?

The cost of sales figure obtained with the inventory set is a valuable financial metric for companies, because it measures all the costs of manufacturing and selling a product.

The cost of sales line appears near the top of the income statement as a subtraction from net sales. The result is the gross margin obtained by the entity.

Tracking the cost of merchandise sold provides information on which products are profitable and should be promoted, and which products should be removed.

Production components

The various costs of sales are included within the following general subcategories:

- Direct materials used in the manufacture of a product.

- Indirect materials used to support the manufacture of the product.

- Direct labor required to manufacture a product.

- Indirect labor required in manufacturing.

- Cost of production facilities.

Cost of sales accounting

If a company uses the periodic inventory system, represented by the calculation shown for cost of sales, the costs of the purchased items are initially stored in the purchasing account.

This is a debit to the purchasing account and a credit to the accounts payable account. At the end of the period, the existing balance in the purchasing account is transferred to the inventory account, through a debit to the inventory account and a credit to the purchasing account.

Finally, the resulting book balance in the inventory account is compared to the actual amount of the ending inventory. The difference is amortized at the cost of merchandise sold, with a debit to the cost of merchandise sold account and a credit to the inventory account.

This is a simple accounting system for cost of sales that works well in smaller organizations.

How to calculate the inventory set?

For a retailer, the inventory set for cost of sales is the purchase costs of the items to be resold.

On the other hand, the inventory set for a manufacturer's cost of sales includes the raw materials and parts used to assemble the final products. The formula to determine the cost of sales for both is the same:

Cost of sales = Initial inventory + Purchases of materials - Supplier discounts - Returns to suppliers - Final inventory.

For example, a company has $ 10,000 of inventory on hand at the beginning of the month, spends $ 25,000 buying various inventory items during the month, leaving $ 8,000 of inventory on hand at the end of the month. To find out what the cost of sales was during the month, the following calculation is made:

(Starting Inventory: $ 10,000) + (Purchases: $ 25,000) - (Ending Inventory: $ 8,000) = (Cost of Sales: $ 27,000).

Cost of sales does not include general or administrative expenses. It also does not include expenses for the sales department.

Determine inventory value

Accountants use one of the following three methods to thus determine the value of inventory:

First in, first out (FIFO)

This method assumes that the first products bought or manufactured are sold first. During a period of rising prices, this method tends to report an increase in income over time.

Last in, first out (LIFO)

In this case, the last products purchased or manufactured are sold first. If prices increase, this method reduces revenue over time.

Average cost method

This approach uses the average purchase prices of all goods and materials in stock, regardless of their purchase date.

Determine labor costs

In addition to the cost of raw materials, any direct labor used in manufacturing the products must be included in the cost of sales.

However, indirect labor costs used to support the manufacturing process or make it more efficient are also included. Some examples of indirect labor are:

- Salary of the production supervisor.

- Salaries of quality assurance personnel.

- Administrative staff of the warehouse.

- Office and reception employees.

- Cleaning staff of the production area.

- Maintenance mechanics.

Determine indirect costs

Indirect costs are those expenses that are not directly related to the production or acquisition of the products. However, they are essential in calculating cost of sales. Below are several examples of indirect costs:

- Rent, services and insurance for warehouses and manufacturing facilities.

- Depreciation of buildings and equipment.

- Payments for the lease of production and transportation equipment.

- Parts for the maintenance and repair of equipment.

- Supplies used to maintain production machines.

- Property taxes on manufacturing and storage facilities.

Example

Consider a sample cost of sales calculation for Bob's Boot retail store.

- Initial inventory: $ 85,000.

- More purchases: $ 64,000.

- Less supplier discounts: $ 2,500.

- Less returns to suppliers: $ 1,100.

- Subtract ending inventory: $ 67,000.

- Total Cost of Sales: $ 78,400.

On the other hand, the method of calculating the cost of merchandise sold for a manufacturer is the same, but with a slightly different meaning. The following is an example of calculating the cost of merchandise sold for Blue Corporation:

- Initial inventory of raw materials and parts: $ 93,400.

- More purchases of materials and parts: $ 78,600.

- Less supplier discounts: $ 800.

- Less returns to suppliers: $ 1,700.

- Subtract final inventory of materials: $ 88,300.

- Therefore, the cost of merchandise sold will be: $ 81,200.

It should be noted that none of these calculations include any costs for direct labor or other indirect costs.

References

1. Steven Bragg (2019). The cost of sales. Accounting Tools. Taken from: accountingtools.com.
2. Jim Woodruff (2019). How to Calculate the Cost of Sales. Small Business - Chron. Taken from: smallbusiness.chron.com.
3. Harold Averkamp (2019). Inventory and Cost of Goods Sold. Accounting Coach. Taken from: accountingcoach.com.
4. Lumen (2019). Inventory Methods for Ending Inventory and Cost of Goods Sold. Taken from: lumenlearning.com.
5. Principles of Accounting (2019). Inventory Costing Methods. Taken from: principlesofaccounting.com.