Elementary costing 1: Sheep and bricks

Unless you are a non-profit, the point of the business is making money. It is surprising how many different ways of making money there are out there, but if you are in business, it is extremely likely that you make the money the easiest and the most common way around: by selling goods.

There are many ways goods come to be, but from perspective of a single business goods can be either purchased, or manufactured. But even companies manufacturing the goods they sell have to somehow get hold of the raw materials used to produce their goods. The most common way to get the raw materials for your manufactured goods is to purchase them. So in the end of the day it comes down to the simple fact that the most common way of making money is by purchasing and selling goods.

When people first started purchasing goods with intent to sell them later, and this was much longer ago than any written history remembers, they had to know several things about the goods. One of the basic things to be known about the goods is how many, or how much, of these goods you have at your disposal at any given time. This is called inventory. It is extremely important to know how much you have because otherwise you don’t know how much you can sell.

Although this seems elementary, inventory is not a static thing, and it tends to grow and shrink over time. At any point in time, calculating available inventory is fairly easy, and the following simple equation can explain all inventory situations:

Beginning Inventory
+ Inventory Increases
– Inventory Decreases
= Ending Inventory

Einstein said that every time you include an equation, you cut your audience in half. So for those half of you that decided to stay, I’m going to reveal an ugly fact that there is something awfully fishy with this equation. Einstein also said that you need to make things as simple as possible, but not simpler. Well, this equation is way too simple, and way simpler than it should have been in the first place. To start with, it doesn’t tell us anything really useful.

The problem with the equation above is that by itself it doesn’t explain whether you are making or losing money. It has been quite a while since sheep and bricks were widely accepted currency, so if you are up to making any money, simply knowing how big your herd of sheep is or how high up your pile of bricks goes, you aren’t really going to make much money.

In order to make money, you must make sure that you sell your goods at higher price that you paid for it, and here we come to the most important thing to know about the inventory: the value.

Value is no simple thing. There is a big problem with value: it exhibits an unstoppable tendency to change over time. Value comes mostly from price you pay, and if the price were constant, then the value of any item would always be the same, and the equation above would apply. But there is nothing as volatile as a price.

What happens to goods that affects the change of price? Usually nothing happens to goods themselves, but something important happens to market, and it is called supply and demand. If you had ten sheep for sale, and there were twenty people willing to buy a sheep each, you rock, because you can reasonably expect that anyone eager enough to get a sheep will pay more than it is really worth, because if they don’t do so, someone else will. So the price goes up. On the other hand, if there were only five potential buyers and you really need the money, you are toast, because in order to really sell your sheep, you need to both offer lower price than your competitors, and convince your buyers to buy two sheep each. So the price goes down.

There are many other reasons why prices vary, but the important fact is that no matter what, prices will vary. And you better take that into account, because to make money, you must make sure that the price by which you sell your goods is higher than the price by which you buy them.

So, we better adjust the equation above to include something that will make sure we don’t lose money along the long way of trade:

Beginning Inventory Value
+ Value of Inventory Increases
– Value of Inventory Decreases
= Ending Inventory Value

If the value was comprised of only the price you paid for something, this would be no brainer. Unfortunately, it’s not that simple. If the first equation wasn’t rocket science, with this one we are getting close.

From a perspective of a company doing typical trade, which is purchasing goods, then selling them, and hopefully making some money in the process, the equation above has to be changed a little bit. Inventory increases are typically purchases, and inventory decreases are typically sales, so when we implement these changes into our equation, we get to the result that all of the accountants are pretty familiar with:

Beginning Inventory
+ Purchases
– Cost of Goods Sold
= Ending Inventory

As you can see, the word value is simply understood. And that is true about accounting almost everywhere else, because accounting doesn’t care much about quantities, it cares about financial values. So when we talk about inventory from accounting perspective, we talk about inventory value. There are several issues with the inventory value:

  1. What costs are included in the acquisition cost of purchased or manufactured inventory?
  2. How do you treat any changes in market value of already purchased inventory?
  3. What kind of cost flow assumption have you made with regard to movement of goods into and out of inventory?

With this, I have merely scratched the surface of theory behind inventory costing, so you bet there is more to come tomorrow.

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