The impact of inventories on profit (Deborah Agostino) - YouTube

In this class we will focus on the role of inventories within the income statement.

Inventories of raw materials, work in progress or finished products are really important

because we can find them either in the balance sheet but also in the income statement.

So, what’s the difference? If we have inventories within the balance sheet we can identify,

within a current asset of a balance sheet, the value of inventories at the end of the

period because the balance sheet provides a snapshot of the company in a precise moment of time.

So, if we look at the inventories within the balance sheet we find the value

of inventories at the end of the period. But, we also have inventories within the

income statement but in this case we don’t have the overall value of the inventories that

we have in the warehouse but, in this case, we have the difference, the variation in the

value of the inventories between the beginning of the year and the end of the year.

Let’s try to understand more in detail what does it means. So, how we can recognize the variation

of the inventories within the income statement. We need to think of the initial part of the

income statement itself. So, if you remember, we have, in the income statement, the revenues

minus the cost of sales. This is the income statement by function but it happens the same

if we have the income statement by nature. So, the revenues minus the cost of sales give

rise to what is defined as Gross Profit. So, the revenues and the cost of sales are recognized

by using an accrual logic. So we have that revenues are the revenues which are related

to the selling of the products or rendering of services within the specific year.

While the cost of sales represents the value of resources that are used and absorbed for production

for that specific year. Let’s try to understand what these cost of sales mean.

Assuming that we can represent our production process, so, this is the production process, as a black box.

So we have that at the end of the period we have the finished products.

So, for example, at the end of the year we have some finished products that are sold.

The revenues which are associated to the selling of these finished products enter here.

But, of course in order to realize these finished products the company absorbs some resources.

So, we have as input the purchases of, for example, raw materials,

the purchases of all of the resources so raw materials, components, labour and so on.

These purchases enter, as resources, within the production process.

But, of course, at the beginning of the period,

we don’t have only purchases but we might have also some inventories.

So we can have what is defined as inventories at the beginning of the period.

For example, assuming that at the beginning of the year, the company decides to purchase raw materials

and the value of these purchases of raw materials is equal to 1000€. But, then, we have that

at the beginning of the period, we have some beginning inventories. And we have that the

value of these inventories at the beginning of the year is like 300€.

So, basically, the purchases plus the inventories at the beginning of the period

represents what is available for the company for production.

So, these are the available resources which

are not the resources that are absorbed. So, we need to consider, by adopting the

accrual logic, everything that is absorbed for production. This means that we also need to consider the

fact that at the end of the period the company will realize of course finished products,

but we might also have at the end of the period inventories which, in this case are final inventories.

So, if we go back to our example, assuming that we have, at the end of the period,

inventories at the end of the year which are of 500€,

we will have that the available resources are 1300,

minus the inventories that we have at the end of the period and

we will have that the cost of sales which is, basically, the amount of resources that

have been absorbed for production within the specific financial year, is equal to 800€.

So, if we want to generalize, we can say that the cost of sales, which as I said is defined

by adopting an accrual logic, equals the amount of purchases,

by the company, plus the inventories at the beginning of the period.

Where this amount represents what is available for the company for production.

Minus the inventories at the end of the period. So that we have

considered the overall amount of resources absorbed in the financial year which is the

cost of sales defined by adopting an accrual logic. So, that’s the role of inventories

within the income statement. So, we take into account their delta, their variation of the

overall value. And this is true for the finished products, work in progress and raw materials.

If we have the income statement by function all of the type of inventories are included

within this cost of sales. It is different if we have the income statement by nature

because we will have that the variation of the final inventories enters the amount of

the revenues, while the inventories of raw material enters the cost of sales.