Perpetual Inventory - Freight Costs: Videos & Practice Problems

In inventory management and accounting, understanding the implications of freight costs is crucial, particularly in the context of ownership transfer during shipping. Freight costs, also known as delivery expenses, can significantly affect the overall value of inventory. There are two primary scenarios to consider: FOB Shipping Point and FOB Destination.

FOB Shipping Point, which stands for Free On Board Shipping Point, indicates that ownership of the goods transfers from the seller to the buyer at the moment the goods are shipped. This means that the buyer is responsible for the shipping costs incurred during transit. Consequently, these freight costs are not merely treated as an expense; instead, they are capitalized into the inventory account. Capitalizing costs means that they are added to the asset value of the inventory rather than being recorded as a separate expense.

For example, if a company orders 500 items at $5 each under FOB Shipping Point terms, the total cost of the inventory would be calculated as follows:

Inventory Cost = Number of Items × Cost per Item = 500 × 5 = $2,500.

In addition to the inventory cost, if the shipping company charges $35 for delivery, this cost is also added to the inventory value. The rationale is that the buyer cannot receive the inventory without paying for the shipping. Therefore, the total inventory value after including the shipping cost becomes:

Total Inventory Value = Inventory Cost + Shipping Cost = 2,500 + 35 = $2,535.

In accounting entries, the buyer would debit the inventory account for both the cost of the items and the shipping cost, while crediting accounts payable to reflect the liabilities incurred. The entries would look like this:

• Debit Inventory: $2,500 (for the items)
• Debit Inventory: $35 (for shipping)
• Credit Accounts Payable: $2,535 (total liability)

This process ensures that the balance sheet accurately reflects the increased value of inventory due to the shipping costs, maintaining the accounting equation's balance. Understanding these principles is essential for effective inventory management and accurate financial reporting.

When discussing shipping terms, it's essential to understand the distinction between FOB (Free On Board) shipping point and FOB destination. In the case of FOB destination, ownership of the goods transfers from the seller to the buyer only when the goods arrive at the buyer's location. This means that the seller retains responsibility for the goods and any associated shipping costs until delivery is completed.

In this scenario, the seller is accountable for the delivery expenses, which are classified as selling expenses. For instance, if a company orders 500 items at $5 each under FOB destination terms, the seller incurs a shipping cost of $35. Since the seller is responsible for this cost, the buyer does not record any journal entry related to the shipping expense. The only entry the buyer makes is to increase their inventory by the total cost of the items, which is calculated as:

Inventory = Quantity \times Price = 500 \times 5 = 25,100

This results in a debit to inventory for $25,100 and a corresponding credit to accounts payable or cash, depending on the payment method. The shipping cost does not affect the buyer's financial records.

Conversely, if the roles were reversed and the seller had to pay for the shipping, they would record the delivery cost as a selling expense. The journal entry would include a debit to selling expense for $35 and a credit to accounts payable or cash for the same amount. This reflects the seller's obligation to cover the shipping costs.

Overall, understanding these terms is crucial for accurately recording transactions and maintaining balanced financial statements. In the case of FOB destination, the buyer's inventory increases, and their liabilities also rise by the same amount, ensuring that the accounting equation remains balanced.