It should be said that, due to the particular method of handling purchasing, delivery, and storage, it frequently is not practicable to take cognizance of all items which theoretically are constituents of cost. Each concern must establish a policy relative thereto and hold to it. Having done this, it is faced at inventory time with the problem of determining the cost figure applicable to each unit of the stock remaining unsold. Certain of the costs, such as freight and cartage, have probably been incurred by different lots of miscellaneous merchandise, and to distribute the proper charges to each unit comprising the lot is difficult. Usually a certain percentage sufficient to cover that particular item of cost is spread evenly over all units remaining on hand. Occasionally, especially where the stock is homogeneous and only a few varieties are dealt in, an effort is made to prorate these costs on a more accurate basis. In loading on the freight cost, for example, a combined weight and value record might bemused or, where possible, the official freight tariff might govern. Such minute accuracy is not often needed or desirable, the flat percentage rate on value giving in most cases sufficiently correct results.
The Pricing of the Inventory
A rule-of-thumb method of valuation requires that the purchase price as carried on the last invoice of the article shall be used for pricing the inventory. This usually proves a good working rule, but often raises perplexing problems and is subject to abuse and misuse. If several purchases have been made during the period at different prices, should the last price paid govern the valuation of the portion unsold? The argument for so doing is that the portions unsold probably belong to the last lot purchased, good merchandising requiring that the old stock be sold out before the new is brought forward. That, of course, is not always the case. If it is made an inflexible rule that the price of the last lot bought shall be the price of the inventory, a dangerous tool is placed in the hands of the unscrupulous. A manager needing or desiring to make a better showing of profits might in this way make an insignificant purchase at a high price near the end of the fiscal period and so secure a much higher valuation than the cost for the whole inventory. Where the inventory is likely to contain remnants of the various lots purchased during the period, or where the condition as to an insignificant final purchase may exist, the policy of using an average price for the inventory will be more accurate in its results. The weighted average, whereby each purchase price is weighted with the volume or quantities purchased, is fairer, though more complicated than the straight average. Thus 10 units bought at $100 per unit, 15 at $90, and 3 at $110, would give a straight average of $100 but a weighted average of $95.71, (1,000 + 1,350 + 330) ÷ (10 + 15 + 3). In manufacturing establishments where the fiscal period is short, say one month, and it is desirable to keep the raw material cost as nearly uniform as possible, the method of the weighted average is to be recommended.
As mentioned above, each concern must fix its own policy as to what items shall be included in the cost of goods purchased. Whatever that policy may be, care must be exercised to make sure that the same items and no others form part of the value of the inventory. In the case of any doubtful items, instead of trusting to memory, a house classification of accounts or an accounting guide book should be drawn up so as to secure from period to period a similar handling of all items.
Valuation of Manufacturing Inventory
The whole of the foregoing discussion concerns the valuation of goods bought for resale, i.e., the inventory of a trading business. Some points in the application of the same principles to a manufacturing concern will now be considered.
Finished Goods. So far as finished goods are concerned, the principle of valuation at cost applies. What constitutes the cost of manufacture was discussed in Chapter III, from which it is evident that many other elements in addition to those which must be considered in a trading concern must be taken into account. The manufacturing cost formula comprises the three items of: (1) raw material consumed, (2) direct labor applied, and (3) factory expenses incurred, this latter item sometimes called overhead expenses. When a concern operates a detailed cost system, the valuation of the finished product is not difficult, being the goal towards which the system works. Where no cost system is used, great care must be exercised to make sure that every item of cost is calculated as accurately as possible and that a proportionate share of such costs is applied to the finished product still on hand unsold. It is sometimes urged that instead of this cost-to-manufacture price, the price at which the article could be bought on the open market should govern; or, alternatively, that the article should be valued at least sufficiently above cost to give a theoretical profit to the factory. Just as in the case of the discussion of “cost or market price” for the trading concern, the same conclusion is reached here, viz., that cost should govern, because while good manufacturing is an element in profit-making, yet no profit is made until the sale is effected. It is true that if cost to manufacture is lower than cost to buy in the open market, a real saving has been made by the policy of manufacturing rather than of buying, but a saving is quite another thing from a profit. This differentiation between a saving and a profit will be fully discussed presently. Correct accounting, therefore, requires a valuation of finished goods at cost to manufacture.
Raw Material. The valuation of the inventory or raw material is on the same basis as that of a stock of goods bought for resale, i.e., raw material is to be valued at full cost up to the point of its consumption.
Goods in Process. The valuation of partially completed goods, i.e., “goods in process,” is a much more difficult problem. To simplify the discussion these will be divided into two groups, first, goods manufactured for stock, and secondly, those made on a specific contract or for special order. To the first group the principle of cost applies without any qualification. The problem involved is that of determining what has constituted cost up to that particular stage of completion. Where a detailed cost system is in use and a production schedule forms part of the system, it is possible at almost any moment to ascertain exactly the values accumulated on any article at each stage or process of manufacture. Where definite costs are not possible, a careful estimate based on full knowledge of conditions is the best that can be done. Where parts are first manufactured for assembly into a completed whole, they should be treated as finished goods and valued at full cost up to that point.
Contracts. The second group of goods in process, viz., those manufactured to fill specific orders, or, in large construction work, contracts taken but not completed, may be valued on a somewhat different basis from that applicable to the first group. Here a sale has actually taken place and only the intervention of the closing of the books raises the question of valuation. In a case of this sort it is customary to make a careful estimate of the costs of the work or contract, up to its present state, due weight being given to remaining costs necessary to complete it and to any provision for possible contingencies. When handled in this way, the estimated profit on the work already done is said to be applicable to the current period and is therefore taken into account. In other words, the portion completed is treated as sold, after making the provisions indicated above, and is charged off the books against a corresponding part of the sale price. Hence, the valuation involved here does not concern the inventory, but the cost of goods sold.