Inventory Basics
🎯 Learning Objectives
- Identify goods that should be included in inventory
- Understand ownership criteria (FOB shipping point vs. destination)
- Identify goods that should be excluded from inventory
- Determine all costs that should be included in inventory cost
- Apply the lower of cost or market (LCM) rule
- Prepare for physical inventory counts and understand internal controls
📚 Background & Principles
Inventory is often the largest current asset for merchandising companies, and accurate inventory accounting is crucial for financial statements. The fundamental question is: What items belong in inventory, and at what cost?
The Warehouse Rules
FOB Shipping Point:
Buyer owns goods as soon as they leave seller's dock. The truck is YOUR inventory moving to you.
Owner changes at shipping point.
FOB Destination:
Seller owns goods until they reach buyer's location. The truck is THEIR inventory delivering to you.
Owner changes at destination.
Consignee (holder) ≠ Owner
Goods held by another business remain owned by the shipper (consignor) until sold. The retailer never owns consignment goods.
Only the owner counts these in inventory.
Unsold ≠ Inventory
Broken, damaged, or obsolete items are not inventory—they're a loss. If damaged goods can be sold at a discount, value at Net Realizable Value (NRV).
Only marketable goods count.
🔑 Key Concepts
Goods held for sale by a merchandising company. Includes all goods owned, regardless of location, that have not yet been sold.
Shipping term indicating when ownership transfers. FOB Shipping Point = ownership transfers at shipping; FOB Destination = ownership transfers at delivery.
Arrangement where goods are held by another party for sale. Consignor (owner) includes goods in inventory; consignee (holder) does not.
Estimated selling price minus estimated completion and disposal costs. Used to value damaged or obsolete inventory.
All expenditures necessary to acquire goods and bring them to a salable condition and location. Includes purchase price, freight, insurance, etc.
The process of counting, weighing, or measuring all inventory on hand. Essential for accurate financial statements and internal control.
🔍 Deep Dive
Explore inventory basics at different levels of depth:
🟢 Foundational Level
Understanding what belongs in inventory and basic cost principles.
The Birthday Party Analogy
Question: You're planning a birthday party. Which items are "inventory" (yours to use)?
YES - You own them, they're for the party. These are your inventory.
DEPENDS - If it's FOB Shipping Point, it belongs to you as soon as it leaves the bakery (even though it hasn't arrived).
NO - They're not yours, even though they're in your hands. Your friend owns them.
NO - It's garbage, not inventory. You wouldn't count broken items as part of your party supplies.
🟡 Standard Level
Understanding inventory costs and physical count procedures.
What Costs Belong in Inventory?
Inventory cost includes MORE than just the invoice price. It includes ALL necessary costs to get goods ready for sale.
- Invoice price (after discounts)
- Freight-in / Shipping costs
- Insurance during transit
- Import duties and tariffs
- Sales taxes (non-recoverable)
- Storage costs before sale
- Assembly/Preparation costs
- Purchase discounts taken
- Freight-out (shipping to customers)
- Advertising costs
- Administrative overhead
- Interest on inventory loans
- Damaged goods (write off)
Inventory Cost Calculator
Calculate the total cost to include in inventory:
Physical Inventory Count Checklist
Internal control requires a physical count at least once a year. Use this checklist:
🔴 Advanced Level
Understanding LCM rule, valuation methods, and complex scenarios.
Lower of Cost or Market (LCM) Rule
Inventory should be reported at the lower of its cost OR its current market value. This is a conservatism principle—if inventory value has declined, recognize the loss immediately.
NOT selling price, NOT net realizable value. Market value is what it would cost to REPLACE the inventory today (current purchase price from supplier).
Example: Item cost $100, replacement cost now $85 → Use $85 (lower). Item cost $100, replacement cost now $110 → Use $100 (cost is lower).
Item A: Cost $10, Market $8 → Use $8
Item B: Cost $15, Market $18 → Use $15
Total: $8 + $15 = $23
By Category: Apply LCM to total cost and total market by category.
Electronics Total Cost: $1,000, Market: $950 → Use $950
Clothing Total Cost: $800, Market: $850 → Use $800
Total: $950 + $800 = $1,750
If inventory needs to be written down from cost to market:
Dr Cost of Goods Sold $X
Cr Inventory $X
Effect: Reduces inventory asset, increases COGS (reduces income), reflects the loss in the period of decline.
Inventory Valuation Methods Comparison
Different methods assign costs to COGS and ending inventory differently:
First-In, First-Out
Oldest costs → COGS
Newest costs → Ending Inventory
Last-In, First-Out
Newest costs → COGS
Oldest costs → Ending Inventory
Average Cost
All costs averaged
Same cost for COGS & Ending
| Scenario | FIFO | LIFO | Weighted Avg |
|---|---|---|---|
| Rising Prices (Inflation) | Lower COGS, Higher NI | Higher COGS, Lower NI | Between |
| Falling Prices (Deflation) | Higher COGS, Lower NI | Lower COGS, Higher NI | Between |
| Ending Inventory Value | Higher (newer costs) | Lower (older costs) | Moderate |
- Financial statements: COGS, Net Income, Inventory value
- Taxes: During inflation, LIFO provides tax advantages (lower income = lower taxes)
- Financial ratios: Inventory turnover, current ratio, gross margin all affected
- Credit agreements: Loan covenants may restrict method changes
🎨 Interactive: Inventory Ownership Explorer
Explore inventory ownership rules through interactive scenarios. Click tabs to learn different concepts!
Click on each location to determine ownership
Scenario: TechMart bought 100 laptops from Supplier Inc. The shipment is in transit on Dec 31. Terms: FOB Shipping Point.
Understanding FOB Terms
Factory
Store
Shipping Point = Ship Owner's (buyer owns in transit)
Destination = Delivered Buyer's (seller owns in transit)
Build the Inventory Cost
Click on costs that should be INCLUDED in inventory value:
✅ Include in Inventory
❌ Exclude from Inventory
🎉 Congratulations!
You've mastered inventory ownership rules!
🚫 Common Misconceptions & Professional Tips
✅ Reality: Not true! Consigned goods in your store belong to the consignor, not you. You only hold them—they're their inventory until sold.
✅ Reality: Freight-IN (shipping to get goods to your store) is inventoriable cost. Freight-OUT (shipping to customers) is a selling expense. The timing and purpose matter.
✅ Reality: For LCM, "market value" means replacement cost—what it would cost to buy the same item today from suppliers. Not what you can sell it for.
✅ Reality: Perpetual systems need periodic counts to verify accuracy. Theft, damage, and recording errors create discrepancies between records and actual inventory. Counts are essential for internal control regardless of system type.
🧠 Memory Aids & Quick Reference
Shipping Point = Ship Owner's
FOB Shipping Point: Ownership transfers when goods LEAVE the shipper.
Destination = Buyer's
FOB Destination: Ownership transfers when goods ARRIVE at buyer.
COST = Purchase Price + Get Ready Costs
Include: Invoice, Freight, Insurance, Duties, Storage
Exclude: Discounts taken, Freight-out, Admin costs
✓ Goods in transit (check FOB terms)
✓ Consigned goods (owner ≠ holder)
✓ Damaged goods (exclude or write down)
✓ Third-party locations (who owns?)
Market = Replacement Cost
Use LOWER of Cost OR Market
Apply to individual items or categories
Write down if market < cost
Count at least annually
Segregate counting duties
Use pre-numbered tags
Supervise and verify
FIFO: Oldest → COGS, Newest → Ending
LIFO: Newest → COGS, Oldest → Ending
Weighted: Average for both
📖 Glossary
Goods held for sale by a merchandising company. Includes all goods owned regardless of location that have not yet been sold.
Shipping term indicating point of ownership transfer. FOB Shipping Point: buyer owns in transit. FOB Destination: seller owns in transit.
Arrangement where goods are held for sale by a party other than the owner. Consignor owns; consignee holds but doesn't own.
Estimated selling price minus estimated completion costs and disposal costs. Used for damaged/obsolete inventory valuation.
Inventory valuation rule requiring inventory to be reported at the lower of its cost or current market (replacement) value.
All expenditures necessary to acquire goods and prepare them for sale, including purchase price, freight, insurance, duties, etc.
The process of counting, weighing, or measuring all inventory on hand at a specific date. Essential for accurate financial statements.
Shipping costs to bring goods to the buyer's location. These costs are inventoriable (included in inventory cost).
🎯 Final Knowledge Check
Test your understanding of Inventory Basics:
Question 1: Goods shipped FOB Shipping Point on Dec 30 arrive Jan 2. Who includes them in Dec 31 inventory?
Question 2: Goods held on consignment at a retailer belong to:
Question 3: Which cost is inventoriable (included in inventory cost)?
Question 4: In LCM, "market" refers to:
Question 5: Damaged goods that can be sold should be valued at: