What goes into Inventory and Cost of Goods Sold

Welcome. In the last module,

we talked about revenue,

and at that time,

I told you we would start to cover some expenses related to revenue.

Well, now, we're ready to do that.

We're going to talk about one of the major expenses related to revenue,

cost of goods sold and its related asset account inventory.

Now, as you think about cost of goods sold,

what you're really asking yourself is what does it cost me to sell

merchandise to our customers in the normal operation of my business?

Really, there's two questions that you have to be able to

answer as you think about this issue.

The first is when do I actually incur the cost to have made a sale?

Then, the second is once I know I've got a cost,

what is the amount actually of that cost?

Now, we can look at a timeline to think about when do we incur costs.

There's several times where we interact with our inventory.

When we order it, but we don't even have it yet.

When our supplier delivers it to us,

when we put it into our own accounting system

so that we're entering that onto our books as having something that we control,

when we pay our supplier for it,

or when we deliver to our customer.

Now, maybe we pay our supplier first and then deliver.

Maybe we actually are able to deliver to our customer before we pay our supplier.

Or should we wait until we actually collect money from our customer?

At least, hopefully, we're going to collect money from our customer.

You can look at any of these times and say, "Well,

which of these times should I think about I've incurred a cost?"

Well, it turns out that there's something that

can be really helpful for us to think about this.

That's what we call the matching principle.

Now, I want to point out, this is a principle.

It's not an immutable law of accounting or a rule that must always be followed.

Rather, it's a conceptual idea of how to think about when have we incurred an expense.

Basically, what the matching principle says is the best way to think about

what period and expense should occur is in the same period as the associated revenues.

Think back to our goal of what accounting was supposed to do.

It's supposed to give information to decision-makers.

Well, if we're really trying to reflect to

those people economically what's happened in the firm,

what would be really useful is when we tell you values come in,

we can also tell you what all value did we have to use up to get that?

That's the idea of the matching principle.

Now, this is relatively easy in some situations where we have a direct enough association

between the cost and

the related revenue that we can really say these occur in the same period.

In those situations, we would exactly follow

the matching principle and match up when the cost

occurs to the revenue that it helped to generate.

Now, I want to be really clear here.

What we do is we figure out when do I have revenue.

That's when we really struggle with what period does this occurring.

Once we know when we have revenue,

we say, "Okay, Now,

let us go out and match to it all of the related costs that are

direct enough that we can say it was clearly part of creating this revenue."

Okay. We know when now.

The question becomes what do we call inventory and the related cost of goods sold?

Now, in some ways, the answer to this is really easy and straightforward.

Inventory includes the cost to acquire or produce the goods you're going to use for sale.

Now, just like with revenue recognition,

we can give you this really general guidance,

but then you have to ask yourself, "Well,

how do I actually apply this to a given company?"

Again, just like revenue recognition,

you're going to find that it's highly related to the business model.

For example, if you're in a retail firm,

what you would generally say is it's

all the cost of acquiring the items you're going to sell.

Providing them to the people that you sell them to,

transporting them to and from.

What is the business of retail?

It's to buy items from a big producer and get them

to an end-user who just wants one or two of these items.

So, in that business, we're going to think of all the cost to make that happen.

Now, it's different if you're in a manufacturing firm.

In a manufacturing firm,

it's all the cost to complete a good.

This is going to include the direct cost you pay for component parts.

For example, if you're making that chair,

you might buy fabric.

You might buy already made screws or bolts.

You may buy some plastic that you're going to mould yourself.

So, all those component costs would be included in there for a manufacturing firm,

but also all the labor costs.

The person who takes that plastic and actually moulds it.

We're going to include that in there as well.

The use of any machines.

If I need a machine to stretch that fabric out and put it onto

the chair or a machine to put the bolt into

the plastic once I've molded it into the shape I want,

all of those cost of creating an item are going to be considered inventory cost.

Let's go ahead and take a look at an example.

To make this easy, I'll tell you,

let's think about it for a retail firm,

and ask ourselves are these going to be included in cost of goods sold or not?

Think about the freight expenses where you've moved

items from a distribution center to the stores.

Most big retailers will have some big distribution center somewhere.

They'll get big shipments there.

They then break things down into packages that will go to the store.

They send them to the store where they'll get put on the shelves.

So, what do we do with the cost of that distribution center?

Is that close enough that we would call it a cost of goods

sold direct enough to be called the cost of goods sold?

Let's move on to the next item, inventory shrink.

When people talk about inventory shrink,

they mean the inventory that you don't actually hand

to a customer who pays you and goes out the door with it.

It could shrink or disappear because say during the transportation,

some of it falls off the truck,

it gets stuck in a door,

or water leaks on it so it's destroyed,

or it may be that people steal it and it just walks out the door.

In either case, the inventory you have to sell has shrunk

and that's not going to result in direct revenue from somebody.

The question becomes though is the cost of having shrink in

a retail business direct enough that

you would call it a cost of goods sold for this period?

Well, we talked about the freight moving things to and from the distribution center.

What about all the other costs in that distribution center?

How about operating cost at stores in the headquarters?

The cost of having the lights on or shoveling the snow on the sidewalk.

What about the advertising that we do to get people in the door?

Is that direct enough to say it's a cost of sales in this period?

Pre-opening costs, those are common cost in

retail where as we get a store ready to make sales,

it's not even in business yet.

We're going to incur a whole bunch of cost.

Would we say that's direct enough to be

related to some sale that we make in the next year or two?

What about all the administrative costs?

There, I'm talking about important things like the accountants or the lawyers.

Are those direct enough to be considered a cost of sale?

It might even be worth pausing at this point.

Just pause your video,

take a look at these,

and really ask yourself,

are these a cost of goods sold?

Are they direct enough that I would say they

should be directly matched up against the revenue of a sale this period?

Or are they expenses,

but expenses that should be treated in some other way?

Did you pause? If you didn't,

here's another chance to do it before we give the answer.

Okay, now that you've thought about it,

we can look at targets 2015 annual report,

it's on page 40 if you want to check me.

They'll tell you, all those items on the left-hand side are cost of goods sold.

The items on the right-hand side they call those SG&A,

selling, general and administrative costs.

So, even though they're saying they're cost of this period,

they're not related enough to the inventory

to be put in that cost of goods sold category.

Seems like we have the answer.

But if we take a look at Walmart's 2016 annual report,

we're going to see that they're going to give us a different answer.

They say sure those first two items on the left-hand side go into cost of goods sold,

and we'll take a small portion of the distribution center cost and put them in there too,

but most of the distribution center costs

they consider selling general and administrative,

along with everything on the right-hand side.

Now at this point, you have to be asking yourself,

"How can we get different answers?

I thought you were going to explain to me how this works."

Well, if you actually went and looked at targets disclosures,

you would see at the very end of those statements they also point out

the classification of these expenses varies across the retail industry.

They're letting you know that,

"We thought with the way that our business model works,

this is our answer, but other people may view it differently."

In fact, if you go and look at Walmart's financial statements,

you're going to see that they actually say,

"It may not be comparable to those of other retailers."

In fact, they even pointed out to you that,

"Our choice of how to treat

these distribution centers is going to result in a different cost of sales,

a different gross profit,

and a different gross profit as percentage of

sales than other retailers who treat them differently."

What this is showing you is that with

that broad guidance of what inventory is and what goes into cost of goods sold,

different companies with different business models even

in the same industry may reach different conclusions.

It's really important that you look in the notes to

the financial statements to understand how

this company has thought about

their business model and how they've treated these different items.

Now, so far I've focused on retail.

It's probably worth taking a look at a manufacturing firm.

Of course, their business model is very different from a retailer.

I went ahead and grabbed General Motors

2015 annual report and I pulled out some of their discussion of this.

You'll notice that they say

the most significant element of our automotive cost is material cost,

which makes up approximately two-thirds of the total amount.

So, they're giving you a pretty good sense that,

the cost of the items that we have to buy to build a car are a big part of the cost.

But then they point out the remaining one-third include labor costs,

the people who put all these together,

depreciation and amortization of the tools that we're using to do this,

the engineering to design the whole process for making a car,

policy, product warranties, recall campaigns, et cetera.

Now, we need to understand all of these items and how they become part of the inventory.

We are going to do an entire module on depreciation and amortization.

When we do that, I'll come back to how they become part of inventory,

but it's important to notice that because their business models different from retail,

they're putting different amounts in there.

Now, something else that I want to point out to you is,

when we look at the income statement,

we're going to see this cost of goods sold.

Including that cost of goods sold,

they're all the costs that we call inventory.

As soon as we put something in inventory,

we know when we get related revenue,

that's going to be one of the cost in costs of goods sold.

However, we add other items to cost of goods sold that were never treated as inventory.

Let me give you a few examples.

Remember that bad debt expense that we talked about in the last module?

That was that cost of doing business this period

and making some sales that people aren't going to pay us for.

Well, a lot of firms will add that into cost of goods sold.

They'll say, "Sure, there was a cost of actually making the item we sold,

and then there's this additional costs that some of

the items we sell are never going to get paid for."

Not all companies will put it into costs of goods sold though,

some of them may net it against revenue,

saying, "Well, that was never really a sale."

Others might put it in selling,

general and administrative cost because they believe in their business model,

it's not really directly related to the sale that they made.

Let me give you another example, product warranty cost.

Remember back on our GM footnote?

They said, "Well, the product warranty costs for a sale go in here."

What they're doing there is saying,

"When we sell a car,

we know that there's some amount of work that we're going to have to do afterwards,

maybe it'll be a company-wide recall,

when we figured out there's something that needs to be adjusted on a car,

or it just might be that this particular car,

during the period that we've promised that

we'll fix things for free will have a problem."

So, what they do is estimate the cost that they're going to incur in the future,

the expenditures that they're going to make into the future to service

those promises that they've made under

the warranty and they're going to pull those into that period,

match it against the revenue from selling that car.

This is a perfect example of trying to get that match and expense.

Not only did we wait to recognize

the material cost of the inventory until they generated revenue,

but we also have looked forward and said,

"What other costs are we going to incur from making this sale?

Let's get those matched into this period when we are

going to recognize that we've created value as well."

Okay, I want to pause now before we move on to the next module and just

walk you through an overview of Cost Flow so we don't get all caught up in the details.

So, what happens is that when we spend

some money and we decide that that's an inventory item,

we capitalize that, that is we treat it as an asset on our balance sheet,

and we'll just hold it as an asset until it's sold.

At the time that it sold, for example,

say we bought all the parts for a chair and we've been calling those inventory,

then we actually sell them.

Well, we transfer that into the cost of goods sold line-item on the income statement.

That's to reflect to people that this was one of the cost of generating that revenue.

What that does is match the cost of

generating that revenue up against the actual revenue,

the value that's created.

If you think back to what I told you financial statements they're supposed to do,

they're suppose to give information to decision makers.

It's really helpful for them to have those two things matched up.

But of course as I said before,

there's other cost of making that sale as well that weren't part of inventory,

like the bad debt expense and the warranty.

So, we're going to take those other period expenses or expenses in the future,

and we're going to add those into the cost of goods line-item as well.

Now, we've got our cost of goods sold and our revenue.

So, if we take our revenue and we subtract out the cost of goods sold,

that's going to give us our gross profit.

We'll still have to think about other expenses and we'll do that in future modules,

but this gives us a start at what sort of expenses

it cost us in order to generate the value of that revenue.

We're going to dig a little deeper into how we think

about which items it is we've actually sold.

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