Editing Inventory (section)

==Accounting for inventory==
{{Accounting}}

Each country has its own rules about [[accounting]] for inventory that fit with their financial-reporting rules.

For example, organizations in the U.S. define '''inventory''' to suit their needs within [[US generally accepted accounting principles|US Generally Accepted Accounting Practices]] (GAAP), the rules defined by the [[Financial Accounting Standards Board]] (FASB) (and others) and enforced by the [[U.S. Securities and Exchange Commission]] (SEC) and other federal and state agencies. Other countries often have similar arrangements but with their own accounting standards and national agencies instead.

It is intentional that [[financial accounting]] uses standards that allow the public to compare firms' performance, [[cost accounting]] functions internally to an organization and potentially with much greater flexibility. A discussion of inventory from standard and [[Theory of Constraints]]-based ([[throughput]]) [[cost accounting]] perspective follows some examples and a discussion of inventory from a [[financial accounting]] perspective.

The internal costing/valuation of inventory can be complex. Whereas in the past most enterprises ran simple, one-process factories, such enterprises are quite probably in the minority in the 21st century. Where 'one process' factories exist, there is a market for the goods created, which establishes an independent market value for the good. Today, with multistage-process companies, there is much inventory that would once have been finished goods which is now held as 'work in process' (WIP). This needs to be valued in the accounts, but the valuation is a management decision since there is no market for the partially finished product. This somewhat arbitrary 'valuation' of WIP combined with the allocation of overheads to it has led to some unintended and undesirable results.{{Example needed|date=February 2024}}

===Financial accounting===
An organization's inventory can appear a mixed blessing, since it counts as an [[asset]] on the [[balance sheet]], but it also ties up money that could serve for other purposes and requires additional expense for its protection. Inventory may also cause significant tax expenses, depending on particular countries' laws regarding depreciation of inventory, as in [[Thor Power Tool Company v. Commissioner]].

Inventory appears as a [[current asset]] on an organization's balance sheet because the organization can, in principle, turn it into cash by selling it. Some organizations hold larger inventories than their operations require in order to inflate their apparent asset value and their perceived profitability.

In addition to the money tied up by acquiring inventory, inventory also brings associated costs for warehouse space, for utilities, and for [[insurance]] to cover staff to handle and protect it from fire and other disasters, obsolescence, shrinkage (theft and errors), and others. Such [[holding cost]]s can mount up: between a third and a half of its acquisition value per year. <!-- An organization that reduced its inventory by $1,000,000 would add that amount to its net income [huh???  Its net income would only increase by the income received minus the cost of the goods sold], an attractive prospect that helps to explain the popularity of programs like [[Just in time]] (JIT) inventory.   -->

Businesses that stock too little inventory cannot take advantage of large orders from customers if they cannot deliver. The conflicting objectives of cost control and customer service often put an organization's financial and operating managers against its [[sales]] and [[marketing]] departments. Salespeople, in particular, often receive sales-commission payments, so unavailable goods may reduce their potential personal income. This conflict can be minimised by reducing production time to being near or less than customers' expected delivery time. This effort, known as "[[Lean production]]" will significantly reduce [[working capital]] tied up in inventory and reduce manufacturing costs (See the [[Toyota Production System]]).

===Role of inventory accounting===
By helping the organization to make better decisions, the accountants can help the public sector to change in a very positive way that delivers increased value for the taxpayer's investment. It can also help to incentive's progress and to ensure that reforms are sustainable and effective in the long term, by ensuring that success is appropriately recognized in both the formal and informal reward systems of the organization.

To say that they have a key role to play is an understatement. Finance is connected to most, if not all, of the key business processes within the organization. It should be steering the stewardship and accountability systems that ensure that the organization is conducting its business in an appropriate, ethical manner. It is critical that these foundations are firmly laid. So often they are the litmus test by which public confidence in the institution is either won or lost.

Finance should also be providing the information, analysis and advice to enable the organizations' service managers to operate effectively. This goes beyond the traditional preoccupation with budgets—how much have we spent so far, how much do we have left to spend? It is about helping the organization to better understand its own performance. That means making the connections and understanding the relationships between given inputs—the resources brought to bear—and the outputs and outcomes that they achieve. It is also about understanding and actively managing risks within the organization and its activities.

===FIFO vs. LIFO accounting===
{{main|FIFO and LIFO accounting}}

When a merchant buys goods from inventory, the value of the inventory account is reduced by the [[cost of goods sold]] (COGS). This is simple where the cost has not varied across those held in stock; but where it has, then an agreed method must be derived to evaluate it. For inventory [[trade item|items]] that one cannot track individually, accountants must choose a method that fits the nature of the sale. Two popular methods in use are: FIFO (first in, first out) and LIFO (last in, first out).

FIFO treats the first unit that arrived in inventory as the first one sold. LIFO considers the last unit arriving in inventory as the first one sold. Which method an accountant selects can have a significant effect on net income and [[book value]] and, in turn, on taxation. Using LIFO accounting for inventory, a company generally reports lower net income and lower book value, due to the effects of inflation. This generally results in lower taxation. Due to LIFO's potential to skew inventory value, [[UK GAAP]] and [[International Accounting Standards|IAS]] have effectively banned LIFO inventory accounting. LIFO accounting is permitted in the United States subject to section 472 of the [[Internal Revenue Code]].<ref>[https://www.gpo.gov/fdsys/pkg/USCODE-2011-title26/pdf/USCODE-2011-title26-subtitleA-chap1-subchapE-partII-subpartD-sec472.pdf Internal Revenue Code, § 472: Last-in, first-out inventories] {{webarchive|url=https://web.archive.org/web/20161223134628/https://www.gpo.gov/fdsys/pkg/USCODE-2011-title26/pdf/USCODE-2011-title26-subtitleA-chap1-subchapE-partII-subpartD-sec472.pdf |date=2016-12-23 }}, accessed 23 December 2016</ref>

===Standard cost accounting===
{{main|Standard cost accounting}}
Standard cost accounting uses [[ratio]]s called [[Efficiency (economics)|efficiencies]] that compare the labour and materials actually used to produce a good with those that the same goods would have required under "standard" conditions. As long as actual and standard conditions are similar, few problems arise. Unfortunately, standard cost accounting methods developed about 100 years ago, when labor comprised the most important cost in manufactured goods. Standard methods continue to emphasize labor efficiency even though that resource now constitutes a (very) small part of cost in most cases.

Standard cost accounting can hurt managers, workers, and firms in several ways. For example, a policy decision to increase inventory can harm a manufacturing manager's [[performance evaluation]]. Increasing inventory requires increased production, which means that processes must operate at higher rates. When (not if) something goes wrong, the process takes longer and uses more than the standard labor time. The manager appears responsible for the excess, even though s/he has no control over the production requirement or the problem.

In adverse economic times, firms use the same efficiencies to downsize, rightsize, or otherwise reduce their labor force. Workers laid off under those circumstances have even less control over excess inventory and cost efficiencies than their managers.

Many financial and cost accountants have agreed for many years on the desirability of replacing standard cost accounting. They have not, however, found a successor.

===Theory of constraints cost accounting===
[[Eliyahu M. Goldratt]] developed the [[Theory of Constraints]] in part to address the cost-accounting problems in what he calls the "cost world." He offers a substitute, called [[throughput accounting]], that uses [[Throughput (business)|throughput]] (money for goods sold to customers) in place of output (goods produced that may sell or may boost inventory) and considers labor as a fixed rather than as a variable cost. He defines inventory simply as everything the organization owns that it plans to sell, including buildings, machinery, and many other things in addition to the categories listed here. Throughput accounting recognizes only one class of variable costs: the truly variable costs, like materials and components, which vary directly with the quantity produced

Finished goods inventories remain [[balance sheet|balance-sheet]] assets, but labor-efficiency ratios no longer evaluate managers and workers. Instead of an incentive to reduce labor cost, throughput accounting focuses attention on the relationships between throughput (revenue or income) on one hand and controllable operating expenses and changes in inventory on the other.