Definition of Inventory Cost
Inventories are reported at cost, not at selling prices.
A retailer’s inventory cost is the cost to purchase the items from a supplier plus any other costs to get the items to the retailer. A manufacturer’s inventory consists of the cost to produce the items (the costs of direct materials, direct labor, and manufacturing overhead).
Sometimes a company’s inventory cost has to be reduced to a lower amount known as the net realizable value (NRV). Net realizable value is defined as the expected selling price in the ordinary course of business minus any costs of completion, disposal, and transportation. When the cost of the inventory is reduced to the NRV, the amount of the write down is reported as a loss on the income statement. (There are a few industries where it is acceptable to report the inventory at its net realizable value instead of at its cost.)
Examples of Inventory Cost
Assume that a retailer purchases 100 units of a product for $30 per unit. In addition, the retailer must pay a freight bill of $200 to get the products from the supplier to the retailer’s location. These products will be included in inventory at their cost of $3,200.
A manufacturer produces a batch of 100 units of Product X23 by using the following costs: materials $600, direct labor $700, and manufacturing overhead $1,200. The 100 units of X23 will be included in inventory at their production cost of $2,500.
Since the unit cost of items purchased or produced may be increasing with inflation, the costs used for inventory reporting will be based on a cost flow assumption. For example, the FIFO cost flow assumption will result in the inventory being reported at the more recent costs, since the first costs are assumed to have been the first costs out of inventory to become part of the cost of goods sold. Under the LIFO cost flow assumption, the inventory will be valued at the older costs, since the more recent costs are assumed to be the first costs to flow out of inventory.
