Determining Purchase Cost and Calculating Cost of Inventory
Inventory is one of the key costs associated with running a business. Managing inventory requires constant vigilance to ensure that the right amount of product is available at the right cost. The purchase price of inventory is one factor that influences this balance.
Other factors, such as the cost of production and freight costs may also influence the inventory cost.
This article will help you in determining the purchase price and calculating the cost of inventory. You’ll also see step by step journal entries to get you started.
What is purchase price?
The purchase price is the price tag on an item, or the amount of money a company pays for an item. The purchase amount can be found on a product’s packaging or on the website where the product is sold. This amount only includes the price of the product and any sales tax associated with the cost of the product.
When should purchase be recorded?
Under the cash method of accounting, purchases should be recorded when the company receives goods or services in exchange for cash or other assets.
The transaction should be recognized as an expense in the accounting period in which the company receives the goods or services. This means the purchase price will be recorded under cost of goods sold in the income statement.
Under the accrual method, purchases should be recorded when the company pays for the item. This is true even if the company did not receive the product yet. It is defined, under the generally accepted accounting principles, that the purchase price, following the accrual method, is recognized when the transaction is made, not when it’s paid for.
Payments made on credit, also known as accounts payable, will live on the balance sheet.
Is purchase cost of inventory?
The purchase price is one measure of the cost of inventory. However, it’s not the only cost to consider when evaluating inventory costs. Other costs, such as storage and maintenance, should also be taken into account.
Is Inventory and Purchase Price the same?
Inventory and purchase price are not the same. Inventory refers to the items that a company has on hand, while purchase is the act of buying items for resale or use in a business. The two terms are related, as a company’s inventory will usually grow when it makes more purchases, but they are not interchangeable.
The purchase amount plays a part of the cost of inventory but their total cost are determined differently. Inventory items factor in more expenses than the purchase price.
How do you record purchases and inventory?
Purchases and inventory are typically recorded using a double-entry bookkeeping system. This means that each purchase or sale is recorded as both a decrease (or increase) in assets and an increase (or decrease) in liabilities. This ensures that the total amount of assets and liabilities remains the same.
When a company records a purchase, it debits an asset account called “Inventory” and credits either Accounts Payable or cash.
The image below shows a debit to inventory and a credit to cash. Since both accounts are considered assets, we will credit the asset account that is leaving our possession; In this case it is cash. This is because the entry below represents a purchase of inventory with a cash payment.
Let’s dig deeper.
If a company buys a computer on credit for $3,500, it would debit Inventory and credit Accounts Payable. This is because the company purchased the computer on credit. Unlike the example above, accounts payable is a liability because it is payment for a future date. The liability account will be credited to represent an increase in accounts payable.
Let’s look at an example journal entry below:
When a company sell goods, it credits the account that corresponds to the good that was sold and debits Cash or Accounts Receivable (whichever is applicable). See journal entry below:
Do I debit inventory or purchases?
Debiting inventory refers to recording a decrease in the value of inventory items due to the sale of products. This decrease is matched with an increase in revenue, which is also recorded.
The total value of the inventory decreases as products are sold, and this decrease is matched with an increase in revenue.
Purchases, on the other hand, refer to recording an increase in the value of the inventories due to goods bought by the company.
How do you calculate inventory purchase price?
Inventory purchase price is the cost of purchasing inventory for a business. This includes the cost of the inventory itself, as well as any tax associated with the purchase.
To calculate inventory purchase price, businesses will need to know the cost of the inventory itself, as well as any associated shipping or handling costs.
There are several options when calculating the cost of inventory. The most common are First In, First Out (FIFO), Last In, First Out (LIFO), and the weighted average cost.
Many companies are reporting inventory cost as the weighted average amount. This means that their inventory valuation is determined by the weighted average cost. In other words, the dollar amount is not determined by the actual cost of the purchase. This is usually done to avoid complex reporting.
Calculating inventories on finished goods are calculated differently. This process takes the prices of raw materials, direct labor, and freight costs and add it against the process to produce that item. This is also known as calculating cost of goods sold.
Costs of Goods Sold equation:
COGS = Beginning Inventory – Ending Inventory + Purchases
What are the differences between purchase price and cost of inventory?
A business’s “cost of inventory” refers to the money an organization spends on raw materials, labor, and other associated costs to bring a product to market. “Purchase price” is the amount of money a business pays for an item. It’s important to understand these two factors so you can calculate a company’s true profit.
How to Determine your Selling Costs
To price your product correctly, you must determine your net realizable value (NRV). Net realizable value is the estimated selling price of a good or service, less the cost to complete and sell the good or service.
This metric is used to help businesses determine whether they should hold or sell a particular inventory item. The lower the net realizable value, the less likely it is that a business will make a profit on that item.
See Net Realizable Value equation below:
NRV = Expected selling price or Inventory market value – Total production and associated selling costs.
Purchase price and inventory are different costs associated with the price of a merchandise ready for production or resale. Although the price of a purchase is included in the cost of inventory, it is much more simple. It is the amount of the product with any associated tax.
Inventory cost is more complex as companies factor in the purchase price with shipping, direct labor, and any other amounts associated with manufacturing the product.
The financial statements that are mainly related to the two is the income statement and balance sheet.