Definition and Scope of Term

Stock-in-trade, as the term is usually understood, comprises all commodities purchased for resale. Thus, assets, which in one concern belong to the fixed asset group, may be the stock-in-trade of other concerns. In stating the principles of valuation for these assets, it is definitely to be understood that they apply only to such as are used as stock-in-trade, and not to the same items when used as fixed assets. Oftentimes the process of manufacture intervenes between the purchase of a commodity and its sale. In such a case the commodity, at the time of valuation, may be in different stages of completion. It is then usually so listed on the balance sheet under suitable titles, such as Raw Material, Goods in Process, and Finished Goods, all of which are treated as current assets. Included in the problem of valuation of stock-in-trade is the treatment of goods out on consignment, goods of others held for sale on a commission basis, and scrap material. Finally, some points to be observed in taking the physical inventory will be considered.

Valuation at Market or Cost Price

Inasmuch as stock-in-trade is purchased solely for resale or ultimate conversion into cash, it is desirable for the balance sheet to reflect the proper value of what remains on hand unsold. Such goods may have a realizable value higher or lower than cost value, from the standpoint of the market in which they were purchased, and will usually have a higher value in the market where they are to be sold. The value of all current assets to be shown on balance sheet is usually stated at the present realizable value. As applied to stock-in-trade, that must not be understood to mean sale or retail value. To value the stock-in-trade on such a basis would result in taking into the current period the profits on sales not effected until the next period; furthermore, these profits would not even be offset by the costs of making the sale. It may be laid down as a principle of business practice based on sound reason, that the period in which the sale is made should be given credit for it. Stock-in-trade must therefore be valued on the basis of its purchase or wholesale market price and according to well-established practice, either at cost or market, whichever is the lower. This principle has the support of conservative practice throughout the world.

Objections to Valuation at Less than Cost

The effect of valuing the stock-in-trade at a lower market than cost is to bring into the period’s results a loss which may never be realized, either because the change in the purchase market may not be reflected in the sale market, or because, if so reflected, the market may swing back before actual sale of the stock is made. If valuation is to be at the market when that is lower than cost, consistency would seem to demand that, when the market is higher than cost at the time of preparing the balance sheet, market value should be used and the profit occasioned thereby be credited to the current period. The answer to this argument is that operation would thus be placed on a speculative basis.

Again, it is sometimes argued that good buying is just as essential to profit-making as good selling. Accordingly, the purchasing department, with the foresight to buy in a favorable market, should receive the credit for it; if conditions are reversed, it should bear the blame, i.e., the loss. In other words, the period in which the purchase effort is expended should be credited or charged with the gain or the loss brought about by a favorable or unfavorable condition of the current market as compared with its condition at the time the purchase was made.

Anticipation of Profits or Losses Undesirable

In answer to these various contentions, it may be stated that though good buying is an essential factor in profit-making, no refinement of logic can obscure the obvious fact that goods are bought to be sold and that no profit arises until the sale takes place. All effort before the sale, whether directed towards good buying, careful storing and display, the placing of advertising, or the selection of a sales force, will come to naught unless sales are made. It would seem, therefore, that potential profit or loss on any or all effort preliminary to the actual sale has no place in the current record. From the standpoint of the profit and loss statement, this conclusion as to the policy of valuation of stock-in-trade at cost can be stated without fear of contradiction. In support of this is a direction of the Treasury Department in connection with the federal income tax returns. This reads, as revised in October, 1916: “In case the annual gain or loss is determined by inventory, merchandise must be inventoried at the cost price, as any loss in salable value will ultimately be reflected in the sales during the year when the goods are disposed of.”

From the viewpoint of the balance sheet, objection is sometimes raised—and supported by conservative practice and legal requirement as indicated above—that a balance sheet showing stock-in-trade at cost may thus very obviously under-or over-value the item, a situation not at all desirable. In this discussion, the whole problem of valuation is being treated from the point of view always of a going concern and not of one facing dissolution and the forced sale of its properties. Under these circumstances, such a balance sheet must frequently be used as the basis for asking credit, and credit extended on inflated values of current assets is not properly extended.

Method of Treatment and Summary

To meet this situation, particularly in the case of large fluctuations in the market, the true status of affairs is disclosed by appending to the balance sheet a footnote in which is stated the present market value of the inventory. Without this information, oftentimes, when the market is showing steadily rising values, as much harm and financial ruin may result through the extension of insufficient credit, as under other conditions might arise from an ill-advised inflation of credit. Sometimes the present market value is indicated by setting up a reserve out of profits, called “Reserve for Market Fluctuations in Merchandise”—or other similar title—when the market is lower than cost. This method retains the inventory on the books at cost value and so does not burden the current profit and loss, although it does lessen the amount of profits available for dividend distribution. Without doubt the policy is good in cases of extreme and somewhat permanent changes in the market.

To sum up, therefore, the valuation formula of cost or market, whichever is the lower, while based on conservatism may unnecessarily and improperly burden the current income account. Valuation at cost, on the other hand, while placing the profit or the loss in the period when realized may cause the balance sheet to present an entirely inadequate and even misleading story as the basis for credit. To remedy this, three courses are open, viz.:

It would seem, therefore, that valuation at cost with the present market value shown on the face of the balance sheet, is the most desirable practice from every viewpoint.

Depreciation of Stock-in-Trade

Quite apart from this discussion of the proper basis for valuation, which concerns itself with marketable merchandise, is the problem of the method of handling deterioration or depreciation of stock-in-trade as distinguished from fluctuations in value. Such deterioration may result from shelf wear, use of goods for display purposes, changes in style and shape, overstocking which causes an accumulation of goods which soon are out of date or of sizes and qualities seldom used, broken lots where such will injure the sale value, and so on. Many devices, such as the “spiff” or the offer of a premium to salesmen, are employed by up-to-date merchants to keep their stocks free from these items of deterioration; but in spite of all that can be done, it usually proves impossible to keep the stock live in every particular. A valuation at cost under these circumstances would be an obvious inflation of values. If the concern had purchased that quality of goods originally with the expectation of resale, valuation at cost, under the limitations suggested above, would be the correct basis for showing. Since, however, such is not usually the case, the proper basis of valuation is now the market price—the present price at which goods of similar kinds and qualities can be bought.

It may be objected that the effect here also is unduly to burden the current period with unrealized losses, but this is not the case. The deterioration in value is a very real loss which is entirely independent of any fluctuations in the market. If goods are shelf-and window-worn from display usage, the deterioration is just as much an expense incurred for advertising as a display advertisement in a daily paper. The deterioration due to overstocking is a penalty which the current period should bear because of its poor buying effort or its inadequate sales efficiency. Thus, valuation of the inventory of any stock of goods must have regard to the effect of its present condition on its marketability. Any deterioration which renders the stock less salable is an expense to be borne by the present period and not the period in which the sale is made.

Full Costs of Stock-in-Trade

Cost having been established as the basis for valuing a stock of marketable merchandise, there must next be considered the elements of cost and their application to different classes of goods. By cost of goods is meant full cost, i.e., not only invoice price but all additional costs, needed to place them ready for sale. All costs, therefore, up to the point where goods are ready to create income are proper charges against the stock-in-trade. Customary costs of this kind are freight, drayage, insurance during transit and storage, duty, seasoning or aging costs, warehouse charges, and all similar items. The information as to these costs is usually recorded separately, but at a summary period they are loaded on the invoice cost of stock-in-trade.

In connection with this question of the proper composition of cost, attention is called to two other items sometimes requiring consideration. The first deals with the handling of cash discounts. The point at issue is as to whether the invoice figure should be recorded at the price quoted on a cash basis or on a credit basis. This point is discussed at length in Chapter XXXVI of the first volume where the conclusion reached is that the credit policy of each concern must govern the manner of making the record. If the concern has a fixed policy of buying at a cash price, that price should be the price of record; whereas if all financial and other related policies are based on a 30-or 60-day credit term, the credit price for that term should be the price of record. Particularly is this true when viewed from the sales standpoint where the fixing of the selling price is a part of the financial policy. The second point requiring consideration in connection with cost is the item of interest on the money invested in stock. At the close of the fiscal period should the stock sold and that left on hand be burdened with interest on the average amount of capital tied up in it during the period? The student is referred to Chapter XXVI of this book, where a full presentation of the case for and against the inclusion of interest is made.

The Distribution of Costs Over Stock-in-Trade

It should be said that, due to the particular method of handling purchasing, delivery, and storage, it frequently is not practicable to take cognizance of all items which theoretically are constituents of cost. Each concern must establish a policy relative thereto and hold to it. Having done this, it is faced at inventory time with the problem of determining the cost figure applicable to each unit of the stock remaining unsold. Certain of the costs, such as freight and cartage, have probably been incurred by different lots of miscellaneous merchandise, and to distribute the proper charges to each unit comprising the lot is difficult. Usually a certain percentage sufficient to cover that particular item of cost is spread evenly over all units remaining on hand. Occasionally, especially where the stock is homogeneous and only a few varieties are dealt in, an effort is made to prorate these costs on a more accurate basis. In loading on the freight cost, for example, a combined weight and value record might bemused or, where possible, the official freight tariff might govern. Such minute accuracy is not often needed or desirable, the flat percentage rate on value giving in most cases sufficiently correct results.

The Pricing of the Inventory

A rule-of-thumb method of valuation requires that the purchase price as carried on the last invoice of the article shall be used for pricing the inventory. This usually proves a good working rule, but often raises perplexing problems and is subject to abuse and misuse. If several purchases have been made during the period at different prices, should the last price paid govern the valuation of the portion unsold? The argument for so doing is that the portions unsold probably belong to the last lot purchased, good merchandising requiring that the old stock be sold out before the new is brought forward. That, of course, is not always the case. If it is made an inflexible rule that the price of the last lot bought shall be the price of the inventory, a dangerous tool is placed in the hands of the unscrupulous. A manager needing or desiring to make a better showing of profits might in this way make an insignificant purchase at a high price near the end of the fiscal period and so secure a much higher valuation than the cost for the whole inventory. Where the inventory is likely to contain remnants of the various lots purchased during the period, or where the condition as to an insignificant final purchase may exist, the policy of using an average price for the inventory will be more accurate in its results. The weighted average, whereby each purchase price is weighted with the volume or quantities purchased, is fairer, though more complicated than the straight average. Thus 10 units bought at $100 per unit, 15 at $90, and 3 at $110, would give a straight average of $100 but a weighted average of $95.71, (1,000 + 1,350 + 330) ÷ (10 + 15 + 3). In manufacturing establishments where the fiscal period is short, say one month, and it is desirable to keep the raw material cost as nearly uniform as possible, the method of the weighted average is to be recommended.

As mentioned above, each concern must fix its own policy as to what items shall be included in the cost of goods purchased. Whatever that policy may be, care must be exercised to make sure that the same items and no others form part of the value of the inventory. In the case of any doubtful items, instead of trusting to memory, a house classification of accounts or an accounting guide book should be drawn up so as to secure from period to period a similar handling of all items.

Valuation of Manufacturing Inventory

The whole of the foregoing discussion concerns the valuation of goods bought for resale, i.e., the inventory of a trading business. Some points in the application of the same principles to a manufacturing concern will now be considered.

Finished Goods. So far as finished goods are concerned, the principle of valuation at cost applies. What constitutes the cost of manufacture was discussed in Chapter III, from which it is evident that many other elements in addition to those which must be considered in a trading concern must be taken into account. The manufacturing cost formula comprises the three items of: (1) raw material consumed, (2) direct labor applied, and (3) factory expenses incurred, this latter item sometimes called overhead expenses. When a concern operates a detailed cost system, the valuation of the finished product is not difficult, being the goal towards which the system works. Where no cost system is used, great care must be exercised to make sure that every item of cost is calculated as accurately as possible and that a proportionate share of such costs is applied to the finished product still on hand unsold. It is sometimes urged that instead of this cost-to-manufacture price, the price at which the article could be bought on the open market should govern; or, alternatively, that the article should be valued at least sufficiently above cost to give a theoretical profit to the factory. Just as in the case of the discussion of “cost or market price” for the trading concern, the same conclusion is reached here, viz., that cost should govern, because while good manufacturing is an element in profit-making, yet no profit is made until the sale is effected. It is true that if cost to manufacture is lower than cost to buy in the open market, a real saving has been made by the policy of manufacturing rather than of buying, but a saving is quite another thing from a profit. This differentiation between a saving and a profit will be fully discussed presently. Correct accounting, therefore, requires a valuation of finished goods at cost to manufacture.

Raw Material. The valuation of the inventory or raw material is on the same basis as that of a stock of goods bought for resale, i.e., raw material is to be valued at full cost up to the point of its consumption.

Goods in Process. The valuation of partially completed goods, i.e., “goods in process,” is a much more difficult problem. To simplify the discussion these will be divided into two groups, first, goods manufactured for stock, and secondly, those made on a specific contract or for special order. To the first group the principle of cost applies without any qualification. The problem involved is that of determining what has constituted cost up to that particular stage of completion. Where a detailed cost system is in use and a production schedule forms part of the system, it is possible at almost any moment to ascertain exactly the values accumulated on any article at each stage or process of manufacture. Where definite costs are not possible, a careful estimate based on full knowledge of conditions is the best that can be done. Where parts are first manufactured for assembly into a completed whole, they should be treated as finished goods and valued at full cost up to that point.

Contracts. The second group of goods in process, viz., those manufactured to fill specific orders, or, in large construction work, contracts taken but not completed, may be valued on a somewhat different basis from that applicable to the first group. Here a sale has actually taken place and only the intervention of the closing of the books raises the question of valuation. In a case of this sort it is customary to make a careful estimate of the costs of the work or contract, up to its present state, due weight being given to remaining costs necessary to complete it and to any provision for possible contingencies. When handled in this way, the estimated profit on the work already done is said to be applicable to the current period and is therefore taken into account. In other words, the portion completed is treated as sold, after making the provisions indicated above, and is charged off the books against a corresponding part of the sale price. Hence, the valuation involved here does not concern the inventory, but the cost of goods sold.

It may be objected that, in the case of large contracts, perhaps running over a period of years, many unforeseen things may happen to wipe out any seeming profits on the completed portion, and that conservatism would demand that no profits be taken until the contract is completed or in a sufficiently advanced stage as to be reasonably sure of results. In such a case it frequently happens, however, that not only are stockholders impatient of delay, but very serious injustice may result to any who might be forced to give up their holdings before the completion of the contract. Moreover, a fair method of making payment on the contract is usually in force, the sale price often being on the basis of units of work accomplished, so that the contingencies giving rise to the objection mentioned are greatly minimized. Thus, some contracts may be on a fixed price per cubic yard of earth removed, per unit of goods manufactured, or other similar basis for periodic payment, a certain per cent being retained as a guarantee for the satisfactory completion of the whole. Again, where the price is for a lump sum, engineers representing the contracting parties may agree on the amount completed and periodical payment may be made on that basis.

This topic of uncompleted contracts will come up again for treatment when considering the profit and loss summary for the year. It is sufficient to note here that some share of the profit on the completed portion of a contract may be taken as indicated above, in which case the inventory problem may be disposed of either by adding the amount of estimated profit to the cost value of the uncompleted contract, or by treating the payments made as sales.

Contracts and Length of Cost Period

In some lines of business, orders are booked several months ahead of delivery date, the factory operations depending somewhat closely on the contracts entered into. During the period of manufacture there may be few deliveries of the product, and therefore no actual profit. Obviously, the easiest method of handling such a situation is to make the fiscal period long enough to include the greater part of the deliveries, and so leave the inventory comparatively free of goods in process. Where this method is adopted, there is no serious objection to valuing the goods still in process at the close of the period so as to take a fair portion of the profit, although conservative practice usually values them at cost. The difference in the amount of profit under the two methods is insignificant under the condition named. Under other conditions valuation at cost is the rule.

Valuation of Scrap

Raw materials are never completely used up in manufacture; portions too small for the main product, corners, odd-shaped pieces, defective pieces, etc., are usually thrown into scrap. This scrap is frequently utilized in the manufacture of side lines if a market can be developed; otherwise it may be valueless. The problem of the valuation not only of the scrap but of any product that may be made from it presents some interesting features. If the entire cost of the raw material is charged to the main product, the scrap material used in the side line costs nothing, and to charge anything for it, either on the basis of cost or some arbitrary estimate, would result in inflation. Furthermore, the cost figures of a side line which is not charged for material might at some time be made the basis for a bid on a contract too large to be filled entirely out of scrap material, and so result in a loss. On the other hand, if the main product is charged only for the material actually consumed, and the side line is compelled to bear the cost value of the material it consumes, the cost of the side line may so increase that it cannot be marketed at a profit. The lowered cost of the main product might lead, in the face of keen competition, to the cutting of its price below real cost, unless, of course, all the scrap is being utilized in the side line which is also being sold at a profit. If such is the case, the valuation of the main product, the side line, and the scrap should be on a cost basis. This is not usually the case, however. No basis for valuation can be found which will prove entirely satisfactory under all circumstances.

In the light of the conditions involved, particularly as to whether there is a constant market for the utilization of all the scrap material in the manufacture of the side line, each concern must adopt whatever policy best suits its peculiar needs. At all times the application of materials costs to the product should provide an intelligent basis for entering into future contracts. A blind use of cost figures frequently invites disaster. In cases where scrap is not utilized in a side line, it has only scrap value. The thing to guard against is the double charge for the same material, i.e., a charge to the main product and also to the side line, resulting in an inflation of values.

Inventory-Taking

There remains, as a corollary to the problem of valuation, a consideration of the method of taking the inventory, for if the count is wrong the most careful valuation per unit will not give true total value. In connection with the count of the inventory, two fundamental rules must be observed. These are: (1) make sure that everything, i.e., all stock-in-trade, belonging to the business is included; and (2) be careful that there is no duplication of count nor inclusion of any stock belonging to others.

In accordance with the first fundamental rule, care should be exercised to include all goods out for sale in other markets—these to be valued at full cost in those markets—and all goods not yet received into stock but belonging to the business. These latter include goods invoiced but not received, and goods received but not unloaded prior to the close of the period.

In accordance with the second fundamental rule, any goods of others held for sale on a commission basis must be carefully excluded from the count, as should also goods received before the close of the period but with invoices dated some time in the future. Furthermore, all goods inventoried from their invoices, i.e., all goods not taken into stock, must be earmarked so as not to be charged into the next period’s purchases. This is best accomplished by stamping the invoices as “Included in the 19.... Inventory.”

Inventory Methods. The careful organization of the physical stock to be inventoried, sorting any misplaced items, and separating them into classes, and an equally careful organization of the clerical force, acting under explicit directions based on a well-thought-out plan, are fundamentally essential to accuracy and to the prevention of any duplication of count. In some cases the use of duplicate or coupon tags proves very valuable. On these tags provision is made for recording in duplicate the number of units and condition as to salability, and they are ruled with two money columns. The tags are numbered on both parts consecutively and are charged out to the various departments, as many being issued as there are classes or compartments of goods. As the count is made of a certain class of goods, a tag is attached to the compartment or other storage place as evidence that the count has been made, after which the lower portion is torn off and sent to the office. Any missing numbers indicate omissions in the count. If the card has been lost, the duplicate still attached to its compartment will indicate the count. After all cards are accounted for, the duplicates are detached and the goods covered by them are then released for sale or other use. In taking the inventory it is especially important that where goods are below normal as to salability, their estimated per cent of normal condition be noted on the tag. This gives a basis for valuing and should show the amount of deterioration and its cause.

Perpetual Inventory

The use of a perpetual inventory system is quite general in some lines. Its operation requires almost as careful a record of stock as is made of cash, i.e., not only must all receipts be recorded but all disbursements as well. In a trading concern this record usually takes the form of a stock book of some sort, to which entry is made, as to quantities only, from the purchase and sales invoices, the balance shown at any time being the stock remaining on hand. The application of the unit value gives the value of the entire stock and so makes possible monthly statements of approximate condition. In a factory, a separate stores ledger may be operated, carrying an account with every kind of material used. This ledger is controlled by the Raw Material or Stores account on the general ledger. Entry to the stores ledger accounts is made from the purchase invoices for receipts, and from formal requisitions drawn on the stores-keeper for disbursements, i.e., for the issuance of material. The stores ledger may record not only quantities but also values, so that its balance should be the value of the stores on hand. This is possible because the material is drawn out at cost price.

Oftentimes, for retail concerns, instead of the stock book method, the percentage method of book inventories described in Volume I, page 506, gives more satisfactory results when sufficient past experience can be drawn from.

Necessity of Physical Count. It must not be assumed that a perpetual inventory system obviates the necessity of taking a physical inventory, for it does not. All that it accomplishes is to secure a closer supervision over stock between inventory times and to make possible the showing of approximate results at interim periods. Where operated, it is possible to take the physical inventory piecemeal, although there is a marked advantage in taking a complete inventory periodically. The piecemeal method means that any department can do its stock-taking during a slack time without regard to the time when other departments take theirs. Thus there is less interference with the regular conduct of business. It must be borne in mind, however, that the physical inventory is just as essential as ever because of the many inaccuracies that tend to creep into the perpetual inventory system, and furthermore because of loss, theft, over-measure, and so on, which throw the book record out of agreement with the actual count.