Financial Accounting: An Integrated Statements Approach, 2nd Edition

INVENTORY CLASSIFICATION FOR

MERCHANDISERS AND MANUFACTURERS

In Chapter 5, we defined a merchandiser as a company that purchases products for re-

sale, such as apparel, consumer electronics, hardware, or food items. We stated that

the merchandise on hand (not sold) at the end of the period was a current asset called

merchandise inventory. Inventory sold becomes the cost of merchandise sold.

Merchandise inventory is a significant current asset for most merchandising compa-

nies, as illustrated for four well-known merchandising companies in Exhibit 1.

What costs should be included in merchandise inventory? As we illustrated in ear-

lier chapters, the cost of merchandise is its purchase price, less any purchases dis-

counts. These costs are usually the largest portion of the inventory cost. Merchandise

inventory also includes other costs, such as transportation, import duties, property

taxes, and insurance costs. The underlying accounting concept is that the inventory

cost must include all the costs of ownership. For example, the CarMax division of

Circuit City Stores, Inc., states:

Parts and labor used to recondition vehicles, as well as transportation and other in-

cremental expenses associated with acquiring vehicles, are included in the CarMax

Group’s inventory.

In contrast, manufacturing companies convert raw materials into final products,

which are often sold to merchandising businesses. A manufacturing company has

three types of inventory, as illustrated in Exhibit 2.

Materials inventoryconsists of the cost of raw materials used in manufacturing a

product. For example, Hershey Foods Corporationuses cocoa and sugar in making

chocolate. The cost of cocoa and sugar held in the storage silos at the end of the period

would be reported on the balance sheet as materials inventory.

Work-in-process inventoryconsists of the costs for partially completed prod-

uct. These costs include the direct materials, which are a product’s component mate-

rials that are introduced into the manufacturing process. For example, Hershey

introduces cocoa and sugar in the process of making chocolate. Other costs are also

added in the manufacturing process, such as direct labor and factory overhead

costs.Direct labor costsare the wages of factory workers directly involved with mak-

ing a product. Factory overhead costsare all factory costs other than direct labor and

materials, such as equipment depreciation, supervisory salaries, and power costs.

The balance sheet reports the work-in-process inventory at the end of the period as

a current asset.

Finished goods inventoryconsists of the costs of direct materials, direct labor,

and factory overhead for completed production. The finished goods inventory for

Hershey Foods is the cost of packaged chocolate held in a finished goods ware-

house at the end of the period. When the finished goods are sold, the costs are

transferred to the cost of goods soldor the cost of merchandise soldon the income

statement.

266 Chapter 6 Inventories

Identify the types of inven-

tory used by merchandis-

ers and manufacturers.

1

Merchandise Merchandise

Inventory as a Percent Inventory as a Percent

of Current Assets of Total Assets

Wal-Mart 77% 25%

Best Buy 41 28

Home Depot 68 26

Kroger 74 21

Exhibit 1

Size of Merchandise

Inventory for

Merchandising

Businesses