Perpetual Inventory - Freight Costs - Online Tutor, Practice Problems & Exam Prep

Understanding freight costs is essential in accounting, particularly with terms like FOB Shipping Point and FOB Destination. In FOB Shipping Point, ownership transfers to the buyer at the shipping point, making them responsible for shipping costs, which are capitalized into inventory. Conversely, in FOB Destination, the seller retains ownership until delivery, and they incur the shipping expense. This distinction affects journal entries and inventory valuation, ensuring the accounting equation remains balanced. For example, if inventory costs $2,500 and shipping is $35, the total inventory value becomes $2,535.

Perpetual Inventory:Freight Costs (FOB Shipping Point)

Well, goods don't just magically appear in our warehouse, right? There's going to be some sort of delivery cost to get them there. Let's see how the delivery can affect our inventory. Alright. So someone is going to have to pay for the shipping cost, right? There's going to be either the buyer or the seller. Someone is going to have to pay for it, right? So these freight costs, we call them freight costs here in the accounting class and that's just the delivery expense, we call them freight costs. Cool?

So, we're going to have 2 types of situations when we're dealing with freight. The first one is called FOB Shipping Point. FOB stands for Free On Board, okay? You don't really need to know that so much, but it's Free On Board Shipping Point, okay? And this all deals with ownership of the goods, who owns the goods during the delivery, okay? So in this case, in a shipping point notice it says FOB Shipping Point, well, the ownership of the goods changes hands at the shipping point. So this means before it gets onto the delivery truck, it changes hands to the other person, right? So let's see what this means. So in this case, when the ownership changes hands at the shipping point, well, the buyer pays the shipping cost, right? Because they own it during the shipment, right? The ownership changed hands right before it was given to the delivery guy and now it's the buyer who has to pay to put it on the truck and get it to the warehouse. So if you have to pay freight cost to receive your inventory, so if you're the one who's receiving inventory and you're in this situation well, the delivery cost is included in inventory, okay? So this isn't going to just be some sort of delivery expense. We're actually going to what we say capitalize it to the inventory account. And when we say capitalize something, oh, we're going to capitalize this, that means we're just going to turn it into an asset, okay? So in this case, it's going to turn into inventory value. Cool?

So let's see what this says. TOS ordered 500 things at $5 per thing, the terms of the order are FOB Shipping Point. UPS charged $35 for the delivery of these things. Okay, so the first thing we want to think about is who owns the goods during transit right? And this is a shipping point, right? So if we imagine there's going to be in this shipping point, we're going to have the seller's warehouse, then we're going to have the delivery, and then the buyer's warehouse over here, right? So at the FOB shipping point, this is where it changes hands right here. It's changing hands right here, where it leaves the seller and before it gets onto the delivery truck. So that means the seller no longer owns it and the buyer owns it, so the buyer has to pay the shipping costs. Okay? So in this case, we are the buyer so we have to pay the shipping costs. So the first entry we're going to make is the entry for the 500 things at $5 per thing, right, 500 things at $5 per thing, that's 500 times 5, that comes out to 2500, right? So we're going to make an inventory entry to increase that. So we have debit to our inventory for 2500 to increase its value and we're going to credit let's say accounts payable. It didn't tell us if we paid in cash or not, so let's just say it's accounts payable in this situation, it didn't really tell us, it's not a big deal for this question. Okay? So this tells that we owe 2500 for this inventory we received. But we also have to make one more entry for this shipping cost, right? We paid a shipping cost to UPS and that was $35 This $35 is going to increase the value of our inventory. The idea of this basically behind it is we couldn't receive this inventory if we didn't pay this $35 right? If we said, hey we're not paying that delivery fee, well then we're not getting the inventory. So we have to pay this delivery fee if we want the inventory, so it's part of the inventory cost. That's kind of the logic going on here. So what's going to happen is we're going to debit inventory for the $35 and we're going to credit cash or accounts payable depending on how we pay it. Let's say accounts payable again that we're going to owe this $35 to UPS. Okay? So this is the entry for the shipping costs, notice it increased the value of our inventory. So now each unit instead of being worth $5 per thing is going to be worth a little more, right? Because we have to take the shipping cost and spread it out through all these units. So we would have an inventory value after this, inventory went up by 2500 and then inventory went up again by 35 right. So now our total value in inventory is going to be the 2535 right. So if we're going to show our balance sheet it would show inventory with a value of 2535, and in this case, we said that everything was accounts payable. So we had accounts payable of 2500 which is a liability and then the accounts payable to the shipping company for 35. So our equation stays balanced here. Cool? Alright. Let's pause here and then we'll discuss the other type of free onboard shipping. Cool? Let's check it out.

Perpetual Inventory:Freight Costs (FOB Destination)

Alright. So we discussed FOB Shipping Point. Now let's see FOB Destination. Considering what we know about Shipping, what do you think is going to happen here? The ownership is going to change hands at the destination, right? This is a situation just like I drew above. I kinda like what I drew. I had something like this where we have the seller's warehouse, then we have the delivery, and then it gets to the buyer's warehouse over here, right? So in this case, this is where it's changing hands. The seller is going to be responsible; the ownership is in their hands until it arrives at the buyer's warehouse. Alright? So in this case, the seller pays the shipping cost, right? So, if you have to pay freight cost to sell your inventory, this delivery cost is going to be included in selling expenses. So we're thinking about selling our inventory in this case, right?

In the first example, we were purchasing inventory. In this case, we would have the expense if we were selling the inventory, right? If we're the seller, that's when we would have to deal with the expense. If we were a buyer in this situation, well, we don't have to worry about the delivery; the seller has to worry about that. We would make no journal entry about delivery expenses as a buyer. But as a seller, we need to include that delivery cost as a selling expense.

Let's check it out. TOS ordered 500 things at $5 per thing. The terms of the order are FOB destination. UPS charged $35 for the delivery, right? So, in this case, we are purchasing. We are the purchasers, but it's FOB destination, right? We bought these 500 things at $5 a thing and the seller, the person we're buying them from, has to pay the delivery. So that $35 isn't coming out of our pockets, we don't have to make a journal entry there. The only journal entry we would make is for the 500 things at $5 a thing, that's 2500. Right? We would debit our inventory for 2500 to increase it, and we would credit let's say accounts payable, or cash depending on how we paid for this and we would credit it there. Notice that the delivery cost, we have no entry for that $35 because the seller paid for it, it has nothing to do with our books.

Okay? Now, in the situation, I just want to put it out there that if we were the seller and we had to pay the delivery cost, it would make an entry something like this. If we were the seller, this has nothing, this doesn't count in this case, I just want to show you what the entry might look like. We would have a debit to the selling expense — right? The selling expense goes up with a debit for the $35, and then we would have a credit to AP for accounts payable, or to cash if we paid it in cash for $35. That would be if we're the seller. The seller would have this entry on their books.

In this case, we're the buyer and we don't have that entry on our books at all. Okay. So what happens in this situation? We saw that our inventory went up by $2,500 and our liabilities went up by $2,500. So our equation stays balanced, and we're good to go there. Alright, so FOB Shipping Point and FOB destination. Cool, let's move on to the next video.

Here’s what students ask on this topic:

What is the difference between FOB Shipping Point and FOB Destination in accounting?

FOB Shipping Point and FOB Destination are terms that determine when ownership of goods transfers from the seller to the buyer. In FOB Shipping Point, ownership transfers to the buyer when the goods leave the seller's warehouse, making the buyer responsible for shipping costs. These costs are capitalized into inventory. In FOB Destination, ownership transfers when the goods reach the buyer's warehouse, making the seller responsible for shipping costs, which are recorded as selling expenses. This distinction affects journal entries and inventory valuation, ensuring the accounting equation remains balanced.

How do you record freight costs in a perpetual inventory system under FOB Shipping Point?

In a perpetual inventory system under FOB Shipping Point, the buyer is responsible for the freight costs. These costs are capitalized into the inventory value. For example, if you purchase 500 units at $5 each and pay $35 for shipping, you would debit Inventory for $2,535 (500 units * $5 + $35) and credit Accounts Payable or Cash for the same amount. This ensures that the total inventory value reflects both the purchase cost and the shipping cost.

How do you record freight costs in a perpetual inventory system under FOB Destination?

In a perpetual inventory system under FOB Destination, the seller is responsible for the freight costs. These costs are recorded as selling expenses. For example, if you sell 500 units at $5 each and pay $35 for shipping, you would debit Selling Expense for $35 and credit Accounts Payable or Cash for the same amount. The buyer does not record any shipping costs in this scenario, as the seller bears the expense until the goods reach the buyer's warehouse.

Why are freight costs capitalized into inventory under FOB Shipping Point?

Freight costs are capitalized into inventory under FOB Shipping Point because the buyer assumes ownership of the goods at the shipping point and is responsible for getting them to their warehouse. These costs are necessary to acquire the inventory and are therefore included in the inventory's total value. Capitalizing these costs ensures that the inventory is accurately valued on the balance sheet, reflecting all expenses incurred to bring the goods to their intended location.

What journal entries are made for freight costs under FOB Shipping Point and FOB Destination?

Under FOB Shipping Point, the buyer makes the following journal entries: Debit Inventory and Credit Accounts Payable or Cash for the purchase cost, and Debit Inventory and Credit Accounts Payable or Cash for the freight cost. Under FOB Destination, the seller makes the following journal entries: Debit Selling Expense and Credit Accounts Payable or Cash for the freight cost. The buyer does not make any entries for freight costs under FOB Destination, as the seller bears the expense.