What Costs Are Included in Inventory?

Inventory represents a significant asset for many businesses, encompassing goods available for sale, materials used in production, and items in the process of being manufactured. The value assigned to this asset on a company’s balance sheet is determined by the costs incurred to bring it to its current condition and location. This valuation directly influences the calculation of the Cost of Goods Sold (COGS) on the income statement, which in turn affects reported profitability.

The accounting standards that govern inventory costing, such as the Generally Accepted Accounting Principles (GAAP) in the United States, provide a framework for this process. These principles ensure that financial statements are consistent and comparable across different companies. A precise calculation of inventory costs is necessary for accurate financial reporting and business analysis.

Direct Costs of Inventory

Direct costs are expenditures that can be specifically and easily traced to the production of individual units of inventory. U.S. GAAP, under rules like Accounting Standards Codification 330, mandates the inclusion of these costs in the inventory’s value on the balance sheet. This ensures that the asset’s carrying amount reflects the direct investment made to acquire or produce it.

Direct materials are the raw materials and components that become an integral part of the finished product. For a furniture manufacturer, this would include the wood, screws, and varnish used to create a table. For a bakery, it would be the flour, sugar, and eggs that go into a cake. The cost recorded for these materials includes the purchase price from the supplier, any freight-in charges to transport the materials to the factory, and any applicable sales taxes or import duties.

Another component of direct costs is direct labor. This category includes the wages and benefits paid to employees who are physically involved in converting raw materials into a finished product. Examples include the machine operator on an assembly line or the artisan hand-finishing a piece of jewelry. Costs such as payroll taxes and fringe benefits for these specific employees are also considered part of direct labor.

Indirect Costs of Inventory

Indirect costs, often referred to as manufacturing or factory overhead, are expenses necessary for production that cannot be feasibly traced to a single unit. Under the full absorption costing method required by U.S. GAAP, these indirect production costs must be allocated to the units produced during a period.

The allocation of indirect costs involves collecting them in a cost pool and then systematically assigning them to inventory using a predetermined rate. This rate is often based on an activity measure like direct labor hours, machine hours, or direct labor cost. For example, if a factory incurs $100,000 in total indirect costs and operates for 10,000 machine hours, an overhead rate of $10 per machine hour would be used. A product requiring two machine hours to complete would be allocated $20 of indirect costs.

Common examples of indirect costs include the depreciation of manufacturing equipment, rent or property taxes on the factory building, and factory utilities like electricity and water. The salaries of factory supervisors, quality control inspectors, and maintenance personnel are also indirect costs. Other includable costs are factory supplies not directly part of the product, such as lubricants for machinery. For tax purposes, IRS Section 263A often requires a broader range of indirect costs to be capitalized into inventory than what is required for financial reporting.

Costs Excluded from Inventory

Certain business expenses are explicitly excluded from the cost of inventory and are not carried as an asset on the balance sheet. These are classified as period costs and are recognized as expenses on the income statement in the period they are incurred. Separating these from product costs is a requirement under GAAP.

Selling expenses are one category of excluded costs. These are incurred to market and deliver products to the end customer. Examples include advertising campaigns, salaries and commissions for the sales team, costs of operating a retail store, and freight-out or shipping costs to transport finished goods to customers.

General and administrative (G&A) expenses are another group of costs excluded from inventory. These are related to the overall management of the company and are not linked to manufacturing operations. This category includes the salaries of corporate executives, accounting and legal fees, and rent for the corporate headquarters. Office supplies, depreciation on office equipment, and other expenses related to non-production departments fall under G&A costs. Interest expense is also generally treated as a period cost rather than an inventory cost, except in very specific circumstances involving long production periods.