Financial vs. Operational Inventory

When measuring inventory levels it’s important to make a distinction between two different views: Financial, or what appears on financial statements, and Operational, what your planning team uses to make decisions.  Managers should understand the differences and be able to translate their operational decisions and actions to the balance sheet.

Operational inventory is simply what is visible in your company’s planning system (sometimes this is called Gross Inventory).  Generally speaking, this will be the quantity physically on hand.  There are of course exceptions to this as detailed below.  Operational inventory is valued at cost and so the total value of operational inventory is simply (quantity on hand) x cost.  Operational Inventory is important because it is what is used as the input to planning production and purchases.

What cost to use?  Every company has an established way of costing material in inventory, although one company may use different methods for different types of materials.  There are basically two approaches in common use: standard costing and average costing.  Standard costs are typically determined once a year determined during the annual budget process.  The standard cost represents what the company expects to pay for each unit of inventory.  ‘Expects’ being the operative word.  This can be very simple (e.g., the supplier contract price for the next year) or the result of complex calculations (e.g., for a manufactured item).  The important thing is that it’s a fixed number that typically only changes once per year.

Average costing seeks to compute the average cost for the items in inventory and is frequently used for spare parts and materials that are not end products or components of end products (otherwise known as indirect materials).  The average most often assumes FIFO, or First In, First Out, inventory movement, though other assumptions are possible (LIFO or Last In First Out, etc.).  Under this approach, if you have 97 units in inventory and a FIFO assumption of how inventory moves, the cost would be the average cost of the last 97 units to arrive.

Once you understand how your company handles costs, you should also get clarity of exactly what is included in Quantity ‘On Hand’.  If you work in a small company with only one location, it’s pretty safe to assume that ‘On Hand’ only includes the inventory that is physically present.  Larger companies, particularly those with more sophisticated ERP systems such as SAP, may also track inventory that is:

• In transit between company locations
• In the hands of suppliers (e.g., when a production step is outsourced)
• Inbound from suppliers (less common as it requires data integration with the supplier)

To make thing even more complicated, what is considered On Hand may vary by location, particularly if different systems are used.  Be sure to understand what the rules are for each location in your company.

Believe it or not, valuing Operational Inventory is the easy part.  Financial Inventory starts with Operational Inventory and applies a number of adjusting entries to get to the amount that the company shows on its balance sheet.  Let’s look at each of these adjustments:

Internal In-Transit

If quantities in-transit between company locations (e.g., from a manufacturing site to a distribution center) are not visible in the company systems, then an accounting adjustment is needed to capture the value of this inventory.  There are multiple ways to do this, such as looking at quantities shipped and not yet received at month end.

In the Hands of Suppliers

Some companies will send inventory to suppliers to perform a process step or other activity.  Some examples are sending material to a supplier for sterilization (medical devices) or sending inventory to a co-packer to build store displays (consumer goods).  Regardless of the reason, if this inventory is not visible in the company systems then it needs to be added back via an accounting entry.  Typically this will cover the time from shipment to the supplier to receipt of the resulting item

In-Transit from Suppliers

It’s common for a company to take ownership of inventory before it is physically received.  If inventory is purchased from suppliers at any INCOTERM that does not include delivery (i.e., other than DAP or DDP), and transportation is anything less than instantaneous, it will be necessary to add an amount for in-transit inventory.  For example, let’s say your company purchases material from a supplier in China and the goods are shipped by sea to your location in California.  If the terms of the purchase are Ex-Works, then you take ownership as soon as the goods leave the suppliers location.  However, they may not be received and visible in your inventory for a month or more.  One way to value this is to look at inbound shipments for which you have received an invoice from the supplier or other indication of shipment such as an ASN (Advanced Ship Notice) and subtract what has been physically received.  There are other approaches and you should ask your Finance team how it’s done at your company.

In-Transit to Customers

Similarly, if you ship to customers using an INCOTERM that causes title to transfer somewhere after the goods leave your location (e.g., a delivered term) then it’s necessary to account for the inventory that is no longer on your system (having been shipped), but which you still technically own.

Cost Variances

Good news! If your company uses average costing, you can skip this section.  For companies that use standard costing however, it’s necessary to adjust the value of inventory by any variances from the standard.  This is perhaps best explained through an example.  Last year you set the standard cost for an item at $1.00.  However, your purchasing team was later able to negotiate a discounted price of $0.98.  You have 100 units in inventory currently.  If you value that inventory at the standard cost it is worth $100.  But you only paid $98 to obtain it.  To correct for this, an accounting entry is added to reduce the value of the inventory by the amount of this favorable variance.  So the value of the inventory is then 100 units x $1.00 standard cost – (100 units x $0.02 favorable variance) = $98. Most companies will capitalize both purchasing cost variances and production cost variances into a special inventory account to address this.  These variances may or may not be tied to the specific items that generated them.  Even if they are, the variance account may not be reduced at the same time that the inventory is consumed or shipped as many companies will transfer these variances into cost of goods sold (COGS) on a fixed schedule (e.g., variances go to the balance sheet for three months and are then amortized or transferred to costs).  Note that variances can be negative (favorable) as in the example above or positive (unfavorable) resulting in an increase in inventory.

Reserves

Accounting rules require a company to value inventory at the “lesser of cost or market”.  Consequently, if the Operational Inventory value exceeds what the inventory could reasonably be sold for, a reserve must be taken.  From an accounting perspective, the difference between book (Operational) value and fair market prices is written off as a cost and the value kept in a reserve account that acts as an offset, or negative, to inventory value.  Reserves may be taken for a variety of reasons:

• Product cost exceeds selling price (i.e., a money losing product)
• Obsolescence.  There is no longer a market or need for the item
• Quality.  Items that failed quality inspection and are expected to be scrapped or that are otherwise unfit for use

The methodology for computing reserves can vary from simple to complex.  Best practice is to involve Planning in the identification and calculation of reserves, particularly for obsolescence.

Reserves may or may not be tied to the specific item(s) that caused them to be created.  Reserves are reduced by the value of inventory scrapped.

Intercompany Profit

If you work for a company that has more than one legal entity, then it’s necessary to adjust inventory to remove any internal profits.  Again, this is probably best explained via an example.  Your manufacturing site in the US produces a product at a cost of $100 per unit.  The US company then sells the product to your German subsidiary for $110.  The German company incurs $5 in freight cost and so the inventory in Germany reflects a cost of $115 per unit.  However, the actual cost to the company of the German inventory is only $105 (the original $100 manufacturing cost plus $5 in freight).  If we are going to aggregate total company inventory, we need to adjust the value of the German inventory to remove the $10 ($110 selling price – $100 cost) internal profit created by the sale between the two legal entities.  Companies that have this situation will typically capture the intercompany profit in an account that is an offset (negative) to inventory until the goods are sold to a customer outside the company.