A lot of times the cost at which a unit of inventory is being carried at is made up of more than just the cost of materials used to produce the actual item. It often includes other costs which are incurred to get the items in place and ready for sale. Some of these other costs included are other improvements or additions, any incoming freight costs and overhead expenses incurred to internally produce the inventory. Companies should aim to be consistent in which costs are being included in inventory. There are also costs that should never be included, such as selling and administrative expenses. This is important as the carrying value of inventory will affect cost of goods sold upon sale, ultimately affecting the company’s bottom line. The value of inventory also affects several other financial ratios, which can be very important if that company is subject to any financial covenants. Furthermore, inventory is often used as one of the bases in determining borrowing availability under any revolving lines of credit.
For companies that produce their inventory and buy only raw materials from outside vendors, this can be relatively straightforward. The carrying value of the finished units would include the portion of materials, labor and overhead used to produce the inventory. This can be calculated ahead of time under a standard costing system, but companies may also choose to use the actual costs of raw materials and labor to calculate the cost of a single unit. For a company that buys its entire inventory for resale, the carrying value is the price that was paid to acquire the unit plus any incoming freight costs. Additionally, any internal work that is completed on purchased inventory needs to be added into the carrying value, along with any modifications or additions to the unit. A company should be able to support all of these costs, and have the proper systems and controls in place in order to track and properly relieve the inventory account when the product is sold.
In preparing for an audit, auditors will generally select a sample of the items in inventory to test the carrying value; however, other methods may be used. For the audit, you will want to be able to support all of the costs being added to the inventory carrying value with invoices from vendors, any internal work orders, bill of materials showing labor incurred in producing manufactured inventory and support for the company’s application of overhead costs to the value of the manufactured inventory. It is important to track these costs in inventory as they may vary from unit to unit. Keeping all records of costs included in inventory organized will help ensure the audit of inventory under your next financial audit goes smoothly.