Chapter 2

Tracking Purchases

In This Chapter

Tracking inventory and monitoring costs

Keeping your business supplied

Paying your bills

In order to make money, your business must have something to sell. Whether you sell products or offer services, you have to deal with costs directly related to the goods or services you sell. Those costs primarily come from the purchase or manufacturing of the products you plan to sell or the items you need in order to provide the services.

All companies must keep careful watch over the cost of the products to be sold or services to be offered. Ultimately, your company's profits depend on how well you manage those costs because, in most cases, costs increase rather than decrease over time. How often do you find a reduction in the price of needed items? Doesn't happen often. If costs increase but the price to the customer remains unchanged, the profit you make on each sale is less.

In addition to the costs to produce products or services, every business has additional expenses associated with purchasing supplies needed to run the business. The bookkeeper has primary responsibility for monitoring all these costs and expenses as invoices are paid. Bookkeepers can alert company owners or managers when vendors increase prices. This chapter covers how to track purchases and their costs, manage inventory, buy and manage supplies, and pay the bills for your purchases.

Keeping Track of Inventory

Products to be sold are called inventory. As a bookkeeper, you use two accounts to track inventory:

• Purchases: Where you record the actual purchase of goods to be sold. You use this account to calculate the cost of goods sold, which is an item on the income statement (see Book IV, Chapter 2 for more on the income statement).
• Inventory: Where you track the value of inventory on hand. This value is shown on the balance sheet as an asset in a line item called inventory (see Book IV, Chapters 3–5 for more on the balance sheet).

Companies track physical inventory on hand by using one of two methods:

• Periodic inventory: Conducting a physical count of the inventory in the stores and in the warehouse. This count can be done daily, monthly, yearly, or for any other period that best matches your business needs. (Many stores close for all or part of a day when they count inventory.)
• Perpetual inventory: Adjusting inventory counts as each sale is made. In order to use this method, you must manage your inventory by using a computerized accounting system that's tied into your point of sale (usually cash registers).

  Even if you use a perpetual inventory method, it's a good idea to periodically do a physical count of inventory to be sure those numbers match what's in your computer system. Because theft, damage, and loss of inventory aren't automatically entered in your computer system, the losses don't show up until you do a physical count of the inventory you have on hand.

When preparing your income statement at the end of an accounting period (whether that period is for a month, a quarter, or a year), you need to calculate the cost of goods sold in order to determine your profit.

In order to calculate the cost of goods sold, you must first find out how many items of inventory were sold. You start with the amount of inventory on hand at the beginning of the month (called beginning inventory), as recorded in the inventory account, and add the amount of purchases, as recorded in the purchases account, to find the goods available for sale. Then you subtract the inventory on hand at the end of the month, which is determined by counting remaining inventory.

Here's how you calculate the number of goods sold:

• Beginning inventory + Purchases = Goods available for sale – Ending inventory = Items sold

After you calculate goods available for sale, remember that your goods can end up in only two places: You may sell the goods (cost of goods sold) or have unsold goods sitting on your shelves (ending inventory).

After you determine the number of goods sold, you compare that number to the actual number of items sold by the company during that accounting period, which is based on sales figures collected through the month. If the numbers don't match, you have a problem. The mistake may be in the inventory count, or items may be unaccounted for because they've been misplaced or damaged and discarded. In the worst-case scenario, you may have a problem with theft by customers or employees. These differences are usually tracked within the accounting system in a line item called inventory shrinkage.

Entering initial cost

When your company first receives inventory, you enter the initial cost of that inventory into the bookkeeping system based on the shipment's invoice. In some cases, invoices are sent separately, and only a packing slip is included in the order. If that's the case, you should still record the receipt of the goods, because the company incurs the cost from the day the goods are received and must be sure it will have the money to pay for the goods when the invoice arrives and the bill comes due. (You track outstanding bills in the accounts payable account.)

Entering the receipt of inventory is a relatively easy entry in the bookkeeping system. For example, if your company buys $1,000 of inventory to be sold, you make the following record in the books:

The purchases account increases by $1,000 to reflect the additional costs, and the accounts payable account increases by the same amount to reflect the amount of the bill that needs to be paid in the future. The purchases account is used to isolate inventory purchased during the period (month or year). Purchases are part of the formula to calculate cost of goods sold (Book II, Chapter 2 explains this formula in detail):

• Cost of goods sold = Beginning inventory + Purchases – Ending inventory

When inventory enters your business, in addition to recording the actual costs, you need more detail about what was bought, how much of each item was bought, and what each item cost. You also need to track

• How much inventory you have on hand.
• The value of the inventory you have on hand.
• When you need to order more inventory.

Tracking these details for each type of product bought can be a nightmare, especially if you're trying to keep the books for a retail store. That's because you need to set up a special inventory journal with pages detailing purchase and sale information for every item you carry. (See Book I, Chapter 3 for the scoop on journals.)

Computerized accounting simplifies this process of tracking inventory. Details about inventory can be entered initially into your computer accounting system in several ways:

• If you pay by check or credit card when you receive the inventory, you can enter the details about each item on the check or credit card form.
• If you use purchase orders, you can enter the detail about each item on the purchase order, record receipt of the items when they arrive, and update the information when you receive the bill.
• If you don't use purchase orders, you can enter the detail about the items when you receive them and update the information when you receive the bill.

When you receive inventory with a bill, you can collect the data in a computerized accounting software program. Similar information is collected on the software program's check, credit card, and purchase order forms.

In addition to recording the name of the vendor, date received, and payment amount, you also record details about the items bought, including the quantity and cost. When you load each item into the computerized accounting system, you can easily track cost detail over time.

After you receive the inventory, you then set up an inventory item in the computerized accounting system. Note that in addition to the item name, two descriptions are added to the accounting system: One is an abbreviated version you can use on purchase transactions (to save time), and the other is a longer description that's displayed on customer invoices (sales transactions). You can input a cost and sales price if you want, or you can leave them at zero and enter the cost and sales prices with each transaction.

If you have a set contract purchase price or sales price on an inventory item, it saves time to enter it on this form so you don't have to enter the price each time you record a transaction. But, if the prices change frequently, it's best to leave the space blank so you don't forget to enter the updated price when you enter a transaction.

Your accounting system should collect information about inventory on hand and when inventory needs to be reordered. To be sure your store shelves are never empty, you can enter a number that indicates at what point you want to reorder inventory. Accountants refer to this point as the reorder point. When the number of units on hand declines to the reorder point, you order more product.

After you complete and save the form that records the receipt of inventory, your accounting software should automatically:

• Adjust the quantity of inventory you have in stock.
• Increase the asset account called inventory.
• Lower the quantity of items on order (if you initially entered the information as a purchase order).
• Average the cost of inventory on hand.
• Increase the accounts payable account.

Managing inventory and its value

After you record the receipt of inventory, you have the responsibility of managing the inventory you have on hand. You also must know the value of that inventory. You may think that as long as you know what you paid for the items, the value isn't difficult to calculate. Well, accountants can't let it be that simple, so there are actually four different ways to value inventory:

• LIFO (last in, first out): You assume that the last items put on the shelves (the newest items) are the first items to be sold. Retail stores that sell nonperishable items, such as tools, are likely to use this type of system. For example, when a hardware store gets new hammers, workers probably don't unload what's on the shelves and put the newest items in the back. Instead, the new tools are just put in the front, so they're likely to be sold first.
• FIFO (first in, first out): You assume that the first items put on the shelves (the oldest items) are sold first. Stores that sell perishable goods, such as food stores, use this inventory valuation method most often. For example, when new milk arrives at a store, the person stocking the shelves unloads the older milk, puts the new milk at the back of the shelf, and then puts the older milk in front. Each carton of milk (or other perishable item) has a date indicating the last day it can be sold, so food stores always try to sell the oldest stuff first, while it's still sellable.
• Weighted average: You average the cost of goods received, so there's no reason to worry about which items are sold first or last. This method of inventory is used most often in any retail or services environment where prices are constantly fluctuating and the business owner finds that an average cost works best for managing the cost of goods sold.
• Specific identification: You maintain cost figures for each inventory item individually. Retail outlets that sell big-ticket items, such as cars, which often have a different set of extras on each item, use this type of inventory valuation method.

Accountants are big on consistency. After you choose an accounting method, you should stick with it. If your accounting method is the same each year, your financial results will be comparable year-to-year. A financial statement reader will be able to compare your results and notice trends. If you decide to change the method, you need to explain the reasons for the change in your financial statements. You also have to go back and show how the change in inventory method impacts your prior financial reporting.

Figuring out the best method for you

You may be wondering why it matters so much which inventory valuation method you use. The key to the choice is the impact on your bottom line as well as the taxes your company will pay.

The total cost of your inventory and the number of units purchased and sold are the same — regardless of whether you choose the FIFO, LIFO, or weighted average method (see the previous section for explanations of these methods). Also, if prices rise over time (which is normally the case), your newer inventory items will be more expensive. This analysis assumes that the three inventory methods use the same sale prices per unit. After all your inventory items are sold, your total profit will be the same for the three methods.

FIFO, because it assumes the oldest (and most likely the lowest-priced) items are sold first, results in a low cost of goods sold number. Because cost of goods sold is subtracted from sales to determine profit, a low cost of goods sold number produces a high profit. For more on cost of goods sold, see “Keeping Track of Inventory,” earlier in this chapter.

The opposite is true for LIFO, which uses cost figures based on the last price paid for the inventory (and most likely the highest price). Using the LIFO method, the cost of goods sold number is high, which means a larger sum is subtracted from sales to determine profit. Thus, the profit margin is low. The good news, however, is that the tax bill is low, too.

Rather than constantly dealing with the ups and downs of inventory costs, the weighted average method smooths out the numbers used to calculate a business's profits. Cost of goods sold, taxes, and profit margins for this method fall between those of LIFO and FIFO. If you're operating a business in which inventory prices are constantly going up and down, you should definitely choose this method.

Comparing the methods

To show you how much of an impact inventory valuation can have on profit margin, this section compares three of the most common methods: FIFO, LIFO, and weighted average (see the earlier section “Managing inventory and its value” for details on each). In this example, assume Company A bought the inventory in question at different prices on three different occasions. Beginning inventory is valued at $500 (that's 50 items at $10 each).

Here's the calculation for determining the number of items sold (see “Keeping Track of Inventory”):

• Beginning inventory + Purchases = Goods available for sale – Ending inventory = Items sold
• 50 + 500 = 550 – 75 = 475

Here's what the company paid to purchase the inventory:

Here's an example of how you calculate the cost of goods sold by using the weighted average method:

As mentioned earlier in the section “Keeping Track of Inventory,” your goods available for sale can end up in only two places: cost of goods sold or ending inventory. The total inventory listed in the previous table is also goods available for sale. Your total inventory ($11,750) should equal the sum of cost of goods sold and ending inventory ($10,146 + $1,602 = $11,748). The slight difference is due to rounding the weighted average cost per unit. Use this formula to check any inventory valuation method.

Here's an example of how you calculate the cost of goods sold by using the FIFO method. With this method, you assume that the first items received are the first ones sold, and because the first items received here are those in beginning inventory, this example starts with them:

Note: Only 125 of the 200 units purchased on April 30 are used in the FIFO method. Because this method assumes that the first items into inventory are the first items sold (or taken out of inventory), the first items used are those on April 1. Then the April 15 items are used, and finally the remaining needed items are taken from those bought on April 30. Because 200 were bought on April 30 and only 125 were needed, 75 of the items bought on April 30 are left in ending inventory.

Here's an example of how you calculate the cost of goods sold by using the LIFO method. With this method, you assume that the last items received are the first ones sold, and because the last items received were those purchased on April 30, this example starts with them:

Note: Because LIFO assumes the last items to arrive are sold first, the ending inventory includes the 25 remaining units from the April 1 purchase plus the 50 units in beginning inventory.

Here's how the use of inventory under the LIFO method impacts the company profits. The example assumes the items are sold to the customers for $40 per unit, which means total sales of $19,000 for the month (that's $40 × 475 units sold). This example looks only at the gross profit, which is the profit from sales before considering expenses incurred for operating the company. See Book IV, Chapter 2 for information about the different profit types and what they mean. Gross profit is calculated with the following equation:

• Sales – Cost of goods sold = Gross profit

Table 2-1 shows a comparison of gross profit for the three methods used in this example scenario.

Looking at the comparisons of gross profit, you can see that inventory valuation can have a major impact on your bottom line. LIFO is likely to give you the lowest profit because the last inventory items bought are usually the most expensive. FIFO is likely to give you the highest profit because the first items bought are usually the cheapest. And the profit produced by the weighted average method is likely to fall somewhere between the two.

Keep in mind that all three inventory valuation methods generate the same total cost and total profit, when all the inventory items are sold, as explained earlier in this section.

Buying and Monitoring Supplies

In addition to inventory, all businesses must buy supplies that are used to operate the business, such as paper, pens, and paper clips. If the supply cost can't be directly traced to the manufacturing or purchase of goods or services for sale, the cost is immediately expensed.

Your best bet is to carefully track supplies that make a big dent in your budget with an individual account. For example, if you anticipate paper usage will be very high, monitor that usage with a separate account called “paper expenses.”

Many companies don't use the bookkeeping system to manage their supplies. Instead, they designate one or two people as office managers or supply managers and keep the number of accounts used for supplies to a minimum. Other businesses decide they want to monitor supplies by department or division and set up a supply account for each one. That puts the burden of monitoring supplies in the hands of the department or division managers.

Staying on Top of Your Bills

Eventually, you have to pay for both the inventory and the supplies you purchase for your business. In most cases, the bills are posted to the accounts payable account when they arrive, and they're paid when due. A large chunk of the cash paid out of your cash account (see Book VIII for more information on the cash account and handling cash) is in the form of the checks sent out to pay bills due in accounts payable, so you need to have careful controls over the five key functions of accounts payable:

• Entering the bills to be paid into the accounting system
• Preparing checks to pay the bills
• Signing checks to pay the bills
• Sending out payment checks to vendors
• Reconciling the checking account

As you pay bills, you need to take precautions to keep everyone honest and try to take advantage of any discounts vendors offer for early payment, as discussed in the following sections.

Segregating duties to prevent theft

Segregation of duties is the process of delegating different tasks to different people to prevent fraud. To segregate duties, assign one person to each of the following three roles:

• Custodian: An individual in your organization who has physical custody of assets, such as the checkbook and keys to the company warehouse.
• Check signer: The check signer has authority to access or move assets. When you write a check, you're moving cash.
• Record keeper: After the transaction is completed, the record keeper records the transaction in the accounting system.

In your business, the person who enters the bills to be paid into the system probably also prepares the payment checks, but someone else should do the other tasks. You should never allow the person who prepares the checks to review the bills to be paid and sign the checks, unless of course that person's you, the business owner.

Properly managing accounts payable can save your company a lot of money by avoiding late fees or interest and by taking advantage of discounts offered for paying early. If you're using a computerized accounting system, the bill due date and any discount information should be entered when you receive the inventory or supplies.

If you're working with a paper system rather than a computerized accounting system, you need to set up some way to be sure you don't miss bill due dates. Because an increasing number of businesses are using computerized systems, this book won't spend more time explaining the nuances of a paper system.

Taking advantage of discounts

In some cases, companies offer a discount to customers who pay their bills early. Assume a vendor gives you payment terms of “2% 10 Net 30.” That means that if the bill is paid in 10 days, the vendor company can take a 2 percent discount; otherwise, the amount due must be paid in full in 30 days. In addition, many companies state that interest or late fees will be charged if a bill isn't paid in 30 days.

A firm has an amount due for the bill of $1,000. If the company pays the bill in ten days, it can take a 2 percent discount, or $20. That may not seem like much, but if your company buys $100,000 of inventory and supplies in a month and each vendor offers a similar discount, you can save $2,000. Over the course of a year, discounts on purchases can save your business a significant amount of money and improve your profits.