Definition of Inventory, Impact of inventory valuation on profitability

Samreen Info ✅

13 Aug, 2024

In today's business landscape, effective inventory management plays a crucial role in ensuring operational efficiency and profitability. This post will delve into the definition of inventory and explore how inventory valuation directly impacts a company's profitability. By understanding these concepts, businesses can make informed decisions that enhance their financial performance.

Lets discuss about "Definition of Inventory, Impact of inventory valuation on profitability".

Introduction

Inventory is a crucial component of a company’s balance sheet and plays a significant role in the overall financial health of a business. According to IAS 2 (Inventories), inventory encompasses assets held for sale in the ordinary course of business, items in the process of production for such sale, and materials or supplies to be consumed in the production process.

The method and accuracy of inventory valuation are vital, as they have a direct impact on the cost of goods sold (COGS) and, subsequently, the profitability of a company. Proper inventory valuation ensures that financial statements reflect the true economic condition of the business, influencing decisions made by stakeholders.

Definition of Inventory

IAS 2 (International Accounting Standard 2) provides guidance on the accounting treatment for inventories. Under IAS 2 (International Accounting Standard 2), inventories are defined as assets that are:

Held for sale in the ordinary course of business

These are the finished goods that a company produces or purchases for the purpose of selling them to customers. For example, a retailer's inventory includes the merchandise it sells, while a manufacturer’s inventory includes the products ready for sale.

In the process of production for such sale

This includes work in progress (WIP), which refers to goods that are in the process of being manufactured but are not yet completed. For instance, in a car manufacturing company, partially assembled vehicles are considered inventory in the process of production.

In the form of materials or supplies to be consumed in the production process or in the rendering of services

These are raw materials and supplies that will be used in the production of goods or in providing services. For example, a furniture manufacturer’s inventory might include wood, nails, and glue, while a service provider’s inventory might include supplies like office stationery that are used in delivering services.

Detailed Explanation of Inventory Components

Finished Goods

These are products that have been completed and are ready for sale. For example, in a bakery, the bread and pastries that are baked and ready to be sold are considered finished goods.
For retail businesses, this category usually makes up the bulk of inventory, as they typically purchase goods in a ready-to-sell condition.

Work in Progress (WIP)

WIP refers to partially finished goods that are still in the production process. These items are not yet complete but have incurred some production costs, such as raw materials, labor, and overhead.
For example, in a construction company, a building that is halfway through completion is considered WIP.

Raw Materials and Supplies

Raw materials are the basic inputs that are used in the production of finished goods. Supplies include items that are consumed during the production process but are not part of the finished product.
For example, in a textile company, cotton and dyes are raw materials, while lubricants for machinery and cleaning supplies are considered supplies.

Key Considerations in Inventory Accounting

Valuation at Lower of Cost or Net Realizable Value

According to IAS 2, inventories should be measured at the lower of cost or net realizable value (NRV).
Cost includes all expenditures incurred in bringing the inventories to their present location and condition, such as purchase price, import duties, transport, and handling costs.
Net Realizable Value is the estimated selling price in the ordinary course of business, less the estimated costs of completion and the estimated costs necessary to make the sale.

Costs Included in Inventory

IAS 2 specifies that the cost of inventory includes the following:

Cost of Purchase

Purchase Price: The cost of purchase includes the purchase price of raw materials, finished goods, or any other items that are to be included in inventory.
Import Duties and Taxes: Any non-recoverable taxes and import duties paid on the inventory.
Transport Costs: Costs associated with bringing the inventory to its present location and condition, such as freight, handling, and other transportation costs.
Trade Discounts and Rebates: These should be deducted from the purchase price.

Cost of Conversion

Direct Costs: Costs directly attributable to the units of production, such as direct labor.
Indirect Costs: Systematic allocation of fixed and variable production overheads incurred in converting raw materials into finished goods.
Fixed Overheads: Indirect costs that remain constant regardless of the level of production, such as depreciation and maintenance of factory buildings and equipment.
Variable Overheads: Indirect costs that vary directly with the level of production, such as indirect labor and indirect materials.

Other Costs

Costs Incurred to Bring Inventory to Present Condition and Location: Costs that are directly attributable to bringing the inventory to its present location and condition, such as design costs for specific customers.
Borrowing Costs: Borrowing costs are included in the cost of inventory if they are directly attributable to the acquisition, construction, or production of inventory that takes a substantial period of time to get ready for its intended use or sale (as per IAS 23 - Borrowing Costs).

Costs Excluded from Inventory

Abnormal amounts of wasted materials, labor, or production costs should not be included in the cost of inventory.
Administrative overheads and selling costs are also excluded unless they are directly attributable to bringing the inventories to their present location and condition.
Storage costs, unless required as part of the production process, are excluded from the cost of inventory.

Impact of inventory valuation on profitability of the company

Inventory valuation has a significant impact on a company's profitability because it directly affects both the cost of goods sold (COGS) and the net income reported on the income statement. Here’s how:

1. Impact on Cost of Goods Sold (COGS)

Higher Inventory Valuation: If the ending inventory is valued higher, the COGS will be lower because COGS is calculated as:

COGS=Beginning Inventory+Purchases−Ending Inventory
Lower COGS leads to higher gross profit and, consequently, higher net income.

Lower Inventory Valuation: Conversely, if the ending inventory is valued lower, the COGS will be higher, leading to lower gross profit and net income.

2. Impact on Gross Profit

Gross profit is calculated as- Gross Profit=Sales−COGS

Therefore, the method and accuracy of inventory valuation directly influence gross profit. If inventory is undervalued, gross profit decreases and if it is overvalued, gross profit increases.

3. Impact on Net Income

Since COGS is deducted from revenue to arrive at gross profit, and then operating expenses are deducted from gross profit to calculate net income, the valuation of inventory ultimately affects net income.

Overvalued Inventory: Leads to understated COGS, overstated gross profit and thus overstated net income.
Undervalued Inventory: Leads to overstated COGS, understated gross profit and thus understated net income.

4. Impact on Financial Ratios

Profitability Ratios: Ratios like gross profit margin and net profit margin are influenced by inventory valuation, as changes in COGS directly affect these ratios.
Inventory Turnover Ratio: This ratio, which measures how quickly inventory is sold, is also affected by inventory valuation. Overvaluation can result in an artificially lower turnover ratio, while undervaluation can lead to a higher ratio.

5. Example

Consider a company with-

Beginning Inventory: Tk. 50,000
Purchases: Tk. 100,000
Sales: Tk. 200,000

If the ending inventory is valued at Tk. 60,000. Then-

COGS = Tk. 50,000 + Tk. 100,000 - Tk. 60,000 = Tk. 90,000
Gross Profit = Tk. 200,000 - Tk. 90,000 = Tk. 110,000

Now, if the ending inventory is revalued at Tk. 40,000. Then-

COGS = Tk. 50,000 + Tk. 100,000 - Tk. 40,000 = Tk. 110,000
Gross Profit = Tk. 200,000 - Tk. 110,000 = Tk. 90,000

This shows a Tk. 20,000 decrease in gross profit due to a lower inventory valuation, directly impacting the company's profitability.

In summary, accurate inventory valuation is crucial for providing a true and fair view of a company’s profitability. Any misevaluation can lead to misleading financial statements, affecting decision-making by investors, creditors, and management.

Conclusion

In conclusion, the definition and valuation of inventory under IAS 2 are integral to accurate financial reporting and the assessment of a company’s profitability. The way inventory is valued directly affects the cost of goods sold, gross profit, and net income, thereby influencing key financial ratios and overall financial performance.

Misevaluation of inventory can lead to distorted profitability, impacting the decisions of investors, creditors, and management. Therefore, ensuring that inventory is valued accurately and consistently is essential for maintaining the integrity of financial statements and the financial health of the business.

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