Inventory in a Manufacturing Firm

Tracking inventory in a manufacturing firm is more difficult than in other types of businesses. When you boil everything down to its essence, the problem stems from a couple of tricky accounting requirements:

• In a manufacturing environment, the manufacturer combines raw materials items into finished goods items. This means—and this is the challenging part—that the manufacturing process reduces the inventory count and value for some items (the raw materials or the components) while at the same time it increases the count and value of the other, finished goods items.

• In a manufacturing environment, the rules say that you don't just count the value of items in the finished goods item inventory values. You also count the cost of labor and factory overhead used in manufacturing the items.

QuickBooks solves the first problem related to manufacturing inventory; however, QuickBooks doesn't solve or address the second problem. Fortunately, as long as you're a small manufacturer, you probably don't need to worry too much about the second problem. You should ask your CPA about this. But don't worry—Congress and the Internal Revenue Service have provided a bunch of loopholes for making the accounting easier for the small guys.

Manufactured Inventory the Simple Way

If you're using QuickBooks Pro or some earlier versions of QuickBooks Premier, you don't have the capability to account for the manufacture of inventory in QuickBooks. The best that you can do is to use group items to combine into individual items on a customer's invoice. This approach sounds sloppy, but it isn't quite as bad as you may think at first blush. You can choose to show only the group item on a customer invoice. This means—getting back to the example of the florist selling red roses and vases—that the florist can "manufacture" a crystal vase of a dozen red roses and then show the manufactured item as a group item on the customer's invoice.

The one thing that's problematic about the "just use a group item" approach is that it doesn't give you a way to track the finished goods' inventory values.

Inventory Accounting in QuickBooks Premier

To account for the manufacture of inventory in QuickBooks Premier, you add inventory assembly items to the Item list for those items that you manufacture. You also record the manufacture of items as you, well, manufacture them.

For example, suppose that Pine Lake Porcelain mostly just buys and resells coffee mugs and other porcelain doodads. But also suppose that once a year, Pine Lake Porcelain assembles a collection of red coffee mugs into a boxed St. Valentine's Day gift set. In this case, QuickBooks can record the assembly of a boxed gift set that combines, for example, four red coffee mugs, a cardboard box, and some tissue wrapping paper.

Adding Inventory Assembly Items

To describe manufactured items, follow these steps:

1. Choose Lists ð Item List.

   QuickBooks displays the Item List window.

2. Click the Item button in the Item List window and select New from the drop-down list.

   QuickBooks displays the New Item window.

3. Select the Inventory Assembly item from the Type drop-down list.

   QuickBooks displays the Inventory Assembly version of the New Item window, as shown below.

   The Inventory Assembly version of the New Item window

4. Specify the account to use for tracking this item's cost when you sell it.

   QuickBooks suggests the Cost of Goods Sold account. If you've created other accounts for your COGS, however, select the other appropriate account.

5. Describe the manufactured item.

   Type in a description of the item that you want to appear on documents, such as invoices and so on, that your customers see. (QuickBooks suggests the same description that you used in the Description on Purchase Transactions text box as a default.)

6. Enter the amount that you charge for the item into the Sales Price box.

7. Indicate whether the manufactured item is subject to sales tax using the Tax Code box.

8. Use the Income Account box to specify the account that you want QuickBooks to use for tracking the income from the sale of the item.

9. Identify the components that go into the finished item.

   Use the Components Needed list to identify the individual component items and the quantities needed to make the inventory assembly. Each component item goes on a separate line in the list. Not to be too redundant, but do note that you both identify the component item and the number of component items needed.

10. Identify the Asset Account.

    Specify the other current asset account that you want QuickBooks to use for tracking this inventory item's value.

11. Select a Build Point.

    Use the Build Point box to specify the lowest inventory quantity of this item that can remain before you manufacture more. When the inventory level drops to this quantity, QuickBooks adds a Reminder to the Reminders list, notifying you that you need to make more of the item.

12. Ignore the On Hand and the Total Value boxes.

    See that On Hand box? Leave it set to zero. To enter a number now is to record an uncategorized transaction, and you don't want to do that. Go ahead and leave the Total Value field set to zero, too. You can also leave the As Of box empty, or you can enter the current date here. It doesn't matter.

Recording Manufacture or Assembly of Items

To build some assembly, choose the Vendors ð Inventory Activities ð Build Assemblies command. QuickBooks displays the Build Assemblies window, as shown. All you do is select the thing that you want to build from the Assembly Item drop-down list and then the quantity that you (or some hapless co-worker) have built in the Quantity to Build box. (In Figure 1, I've created an assembly—ValentineBox—which consists of some colorful coffee mugs, an attractive gift box, and some scented tissue paper.) Then you click either the Build & Close or Build & New button. (Click the Build & New button if you want to record the assembly of some other items.)

Figure 1: The Build Assemblies version of the New Item window

While I'm on the subject, let me make a handful of observations about the Build Assemblies window and the Build Assemblies command:

• In the top-right corner of the window, QuickBooks shows the quantities of the assembly that you have on hand and for which customers have placed orders. That's pretty useful information to have, so, hey, remember that it's there.

• A table in the Build Assemblies window shows you what goes into your product. Not that you care, but this is a bill of materials.

• At the bottom of the bill of materials list, QuickBooks shows you the maximum number of assemblies that you can make, given your current inventory holdings.

• When you build an item, QuickBooks adjusts the inventory item counts. For example, in the case where you make boxed gift sets, each with four red coffee mugs and two wrapping tissues, QuickBooks reduces the item counts of red coffee mugs and wrapping tissues and increases the item counts of the boxed gift sets when you record building the assembly.

Some of the components used in an assembly may not be inventory items. You can use non-inventory parts in an assembly.

Adjusting Physical Counts and Inventory Values

Inventory shrinkage, spoilage, and, unfortunately, theft all combine to reduce the inventory that you physically have. In order to record these inventory reductions, you periodically physically count your inventory and then update your QuickBooks records with the results of your physical counts.

Figure 1: The Adjust Quantity/Value on Hand window

To use the Adjust Quantity/Value on Hand window, follow these steps:

1. Use the Adjustment Date box to record the date of your physical count.

   In other words, you want to adjust your quantities as of the day you took or completed the physical inventory count.

2. Use the Adjustment Account drop-down list to identify the expense account that you want to use to track your inventory shrinkage expense.

3. (Optional) Identify the customer:job and class.

   If it's appropriate, and in many cases it won't be, use the Customer:Job box to identify the customer:job associated with this inventory shrinkage. In a similar fashion, if appropriate, use the Class box to identify the class that you want to use for tracking this inventory shrinkage.

4. Supply the correct inventory quantities.

   The Item, Description, and Current Qty columns of the Adjust Quantity/ Value on Hand window identify the inventory items that you are holding and the current quantity counts. Use the New Qty column to provide the correct physical count quantity of the item. After you've entered the new quantity, QuickBooks calculates the quantity difference and shows this value in the Qty Difference column.

   Tip

   You can actually enter a value into either the New Qty column or the Qty Difference column. QuickBooks calculates the other quantity by using the current quantity information that you supply. For example, if you enter the new quantity, QuickBooks calculates the quantity difference by subtracting the new quantity from the current quantity. If you enter the quantity difference, QuickBooks calculates the new quantity by adjusting the current quantity for the quantity difference.

5. Adjust the value.

   This window lets you enter both the correct physical count quantity and the updated value for the inventory item. You enter the physical count quantity, obviously, in the New Qty column. You enter the new updated value in the New Value column. You probably use this version of the Adjust Quantity/Value on Hand window only if you're using a lower-of-cost or market inventory valuation method. For example, both financial accounting standards and tax accounting rules allow you to mark down your inventory to the lower of its original cost or its fair market value. If you're doing this-and how you do this is beyond the scope of this book-you enter the new inventory value in the New Value column.

   
   Figure 2: The expanded version of the Adjust Quantity/ Value on Hand window

   Tip

   Essentially, using the lower-of-cost or market inventory evaluation method just means you do what it says. You keep your inventory valued at either its original cost or, if its value is less than its original cost, at its new value. Obviously, assessing the value of your inventory is a little tricky. But if you have questions, you can ask your CPA for help. One thing to keep in mind, however, is that you can't go changing your accounting methods willy-nilly without permission from the Internal Revenue Service. And changing your inventory valuation method from cost, say, to lower-of-cost or market is a change in accounting method.

6. Provide a memo description.

   If you want to further describe the quantity or value adjustment, use the Memo box for this purpose. For example, you may want to reference the physical count worksheets, the people performing the physical count, or the documentation that explains the valuation adjustment.

7. Save the adjustment.

   After you've used the Adjust Quantity/Value on Hand window to describe the quantity changes or value changes in your inventory, click either the Save & Close button or the Save & New button to save the adjustment transaction. As you probably know at this point in your life, Save & Close saves the transaction and closes the window. Save & New saves the transaction but leaves the window open in case you want to make additional changes.

Inventory Accounting

Thankfully, most of the inventory accounting that goes on in a business gets handled automatically by QuickBooks. For example, when you purchase an inventory item by writing a check or recording an accounts payable bill, QuickBooks automatically adjusts your inventory accounts both for the dollar value of the inventory and the quantity of the items. When you sell an inventory item to a customer, QuickBooks again automatically adjusts the dollar value of your inventory and adjusts the quantity counts of the items you sell.

Basically, all this means is that QuickBooks maintains a perpetual inventory system—an inventory system that lets you know at any time what quantity of items you have in inventory and what value your inventory amounts to. (In the past, smaller firms often used a periodic inventory system, which meant that business owners never really knew with any precision the dollar value of their inventory or the quantity counts for the inventory items that they held.)

Although everything in the preceding paragraph represents good news, several inventory-related headaches do require a bit of accounting magic. Specifically, if your firm carries inventory, you need to know how to deal with obsolete inventory, disposal of obsolete inventory, and inventory shrinkage. I discuss all three accounting gambits in the following paragraphs.

Dealing with Obsolete Inventory

Obsolete inventory refers to items that you've purchased for sale but turn out not to be saleable. Perhaps customers no longer want it. Perhaps you have too much of the inventory item and will never be able to sell everything that you hold.

In either case, you record the fact that your inventory value is actually less than what you purchased it for. And you want to record the fact that, really, the money you spent on the obsolete item is an expense. For example, suppose that you purchased some $100 item that you now realize is obsolete. How do you record this obsolescence? Table 1 shows the conventional approach.

Account	Debit	Credit
Inventory obsolescence	1,00
Allowance for obsolete inventory		1,00

Table 1 - Journal Entry 7: Recording an Allowance for Obsolete Inventory

As Journal Entry 7 shows, to record the obsolescence of a $100 inventory item, you first debit an expense account called something like "inventory obsolescence" for $100. Then you credit a contra-asset account named something like "allowance for obsolete inventory" for $100. As I mention in the discussion of accounts receivable, a contra-asset account gets reported on the balance sheet immediately beneath the asset account to which it relates. The contra-asset account, with its negative credit balance, reduces the net reported value of the asset account. For example, if the inventory account balance was $3,100 and you had an allowance for an obsolete inventory contra-asset account of $100, the net inventory balance shows as $3,000. In other words, the contra-asset account gets subtracted from the related asset account.

Remember

QuickBooks requires you to record Journal Entry 7 yourself using the Make Journal Entries command.

When you ultimately do dispose of obsolete inventory, you record a journal entry like the one shown in Table 2. This journal entry debits the contra-asset account for $100 and credits inventory for $100. In other words, this journal entry removes the value of the obsolete inventory both from the allowance for obsolete inventory account and from the inventory account itself. You record this journal entry when you actually physically dispose of the inventory. This may be, for example, when you pay the junk man to haul away the inventory or when you toss the inventory out into the large Dumpster behind your office or factory.

Account	Debit	Credit
Allowance for obsolete inventory	1,00
Inventory		1,00

Table 2 - Journal Entry 8: Recording Disposal of Inventory

Why not just credit the asset account?

If you're really getting into this double-entry bookkeeping, you may wonder why you don't just credit the inventory account in the case of something like obsolete inventory. Wouldn't that save you time and trouble? Well, yes and no.

Simply crediting the inventory account does make sense. Such an approach saves you the task of having to set up a goofy contra-asset account. However, accountants have concluded over the centuries that it makes sense to keep a record of your obsolete inventory as long as you own it. There are a bunch of different reasons for this, but one reason is that you want to know what inventory you need to get rid of or dispose of.

It's not necessary to set up some sort of separate system for keeping track of obsolete inventory. By using the contra-asset account, you can continue to store information about your inventory in the accounting system without making the balance sheet information and income statement information incorrect.

This logic applies to other contra-asset accounts, too. For example, I describe how to set up a contra-asset account for uncollectible accounts receivable. The business about wanting to have some record of your uncollectible accounts receivable—perhaps so you know you don't want to deal with those customers again—means that you may as well keep this information in the accounting system. A contra-asset account allows you to do so and at the same time not have the presence of uncollectible receivables overstate your accounts receivable balance.

Tip

In general, one of the things you should do every year for tax accounting reasons is deal with your obsolete inventory. The tax rules generally state that you can't write off obsolete inventory unless you actually dispose of it for income purposes. You can, however, typically write down inventory to its liquidation value. Such a write-down works the same way as a write-down for obsolete inventory. A write-down can be a little tricky if you've never done it before, however, so you may want to confer with your tax advisor.

One more really important point about recording disposal of obsolete inventory: Within QuickBooks, you record inventory disposal by adjusting the physical item count of the inventory items. So even though I won't go down that path here, you should know that you don't actually enter a journal entry like the one shown in Journal Entry 8. You adjust the inventory accounts for the obsolete inventory. This adjustment would automatically reduce the inventory account balance. When QuickBooks asks you which account to debit, you specify the allowance for obsolete inventory account.

Dealing with Inventory Shrinkage

The other chronic inventory headache that many business owners and business managers have to deal with is inventory shrinkage. It's very likely, sometimes for the most innocent reasons, that your inventory records overstate the quantity counts of items. When this happens, you must adjust your records. Essentially, you want to reduce both the dollar value of your inventory and the quantity counts of your inventory items.

Table 3 shows the journal entry that QuickBooks makes for you to record this event. This journal entry debits an appropriate expense account—in Journal Entry 9, I call the expense account shrinkage expense — for $100. A journal entry also needs to credit the inventory account for $100.

Account	Debit	Credit
Shrinkage expense	1,00
Inventory		1,00

Table 3 - Journal Entry 9: Recording Inventory Shrinkage

Within QuickBooks, as I mentioned, you don't actually record a formal journal entry like the one shown here. You use something called a physical count worksheet to adjust the quantities of your inventory item counts to whatever they actually are. When you make this adjustment, QuickBooks automatically credits the inventory account balance and adjusts the quantity counts. QuickBooks also requires you to supply the expense account that it should debit for the shrinkage.

Tip

In the old days (by the "old days," I mean a few decades ago), businesses compared their accounting records with the physical counts of inventory items only once a year. In fact, the annual inventory physical count was a painful ritual that many distributors and retailers went through. These days, I think, most businesses have found that it works much better to stage physical inventory counts throughout the year. This approach, called cycle counting, means that you're probably comparing your accounting records with physical counts for your most valuable items several times a year. For your moderately valuable items, you're probably comparing your inventory accounting records with physical counts once or twice a year. With your least valuable inventory items, you probably only irregularly compare inventory records with physical counts, and you may accept a degree of imprecision. For example, rather than counting screws in some bin, you may weigh the bin and then make an estimate of the screw count. In any case, you want some system that allows you to compare your accounting records to your physical counts. Inventory shrinkage and inventory obsolescence represent real costs of doing business that won't get recorded in your accounting records in any other way.