McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Inventories and the Cost Inventories and the Cost of Goods Soldof Goods SoldChapter 8

8-2

INCOME STATEMENT

Revenue Cost of goods sold Gross profit Expenses Profit

as goods are sold

BALANCE SHEET

Asset Inventory

Purchase costs (or manufacturing

costs)

The Flow of Inventory The Flow of Inventory CostsCosts

8-3

GENERAL JOURNAL

Date Account Titles and ExplanationPR Debit Credit

Entry on Purchase DateInventory $$$$

Accounts Payable $$$$

Entry on Sale DateCost of Goods Sold $$$$

Inventory $$$$

In a perpetual inventory system, inventory entries parallel the flow of costs.

The Flow of Inventory The Flow of Inventory CostsCosts

8-4

When identical units of inventory have different unit costs, a question naturally arises as to which of these costs should be used in recording a sale of inventory.

Which Unit Did We Sell? Which Unit Did We Sell?

8-5

Inventory Subsidiary Inventory Subsidiary LedgerLedger

A separate subsidiary account is maintained for each item in inventory.

How can we determine the unit cost for the 10 Sept. sale?

Item LL002 Primary supplier Electronic CityDescription Laser Light Secondary supplier Electric CompanyLocation Storeroom 2 Inventory level: Min: 25 Max: 200

Purchased Sold Balance

Date UnitsUnitCost Total Units

UnitCost

Cost ofGoodsSold Units

UnitCost Total

Sept. 5 100 30$ 3,000$ 100 30$ 3,000$ 9 75 50 3,750 100 30 3,000

75 50 3,750 10 10 ? ? ? ? ?

? ? ?

8-6

The Bike Company (TBC)

Data for an IllustrationData for an Illustration

8-7

On 14 August, TBC sold 20 bikes for $130 each. Of the bikes sold 9 originally cost $91 and

11 cost $106.

Specific Cost IdentificationSpecific Cost Identification

The Cost of Goods Sold for the 14 August sale is $1,985. This leaves 5 units, with a total cost of $515, in inventory:

1 unit that costs $91 and 4 units that cost $106 each.

Purchases Cost of Goods Sold

Date Units Unit Cost Total Units Unit Cost Total Units

Unit Cost Total

Aug. 1 10 @ 91$ = 910$ 10 @ 91$ = 910$

Aug. 3 15 @ 106$ = 1,590$ 10 @ 91$

15 @ 106$

Aug. 14 9 @ 91$ 1 @ 91$

11 @ 106$ 4 @ 106$

Inventory Balance

= 2,500$

= 515$ = 1,985$

Purchases Cost of Goods Sold

Date Units Unit Cost Total Units Unit Cost Total Units

Unit Cost Total

Aug. 1 10 @ 91$ = 910$ 10 @ 91$ = 910$

Aug. 3 15 @ 106$ = 1,590$ 10 @ 91$

15 @ 106$

Aug. 14 9 @ 91$ 1 @ 91$

11 @ 106$ 4 @ 106$

Inventory Balance

= 2,500$

= 515$ = 1,985$

8-8

Retail (20 × $130)

Cost

A similar entry is made after each sale.

Specific Cost IdentificationSpecific Cost Identification

8-9

Purchases Cost of Goods Sold

Date Units Unit Cost Total Units

Unit Cost Total Units

Unit Cost Total

Aug. 1 10 @ 91$ = 910$ 10 @ 91$ = 910$

Aug. 3 15 @ 106$ = 1,590$ 10 @ 91$

15 @ 106$

Aug. 14 9 @ 91$ 1 @ 91$

11 @ 106$ 4 @ 106$

Aug. 17 20 @ 115$ = 2,300$ 1 @ 91$

4 @ 106$

20 @ 115$

Aug. 28 10 @ 119$ = 1,190$ 1 @ 91$

4 @ 106$

20 @ 115$

10 @ 119$

Aug. 31 1 @ 91$ 1 @ 106$

3 @ 106$ 5 @ 115$

15 @ 115$ 6 @ 119$

4 @ 119$

= 1,395$

= 1,985$

= 2,610$

= 2,815$

= 4,005$

Inventory Balance

= 2,500$

= 515$

Additional purchases were made on 17 and 28 August .

Specific Cost IdentificationSpecific Cost Identification

8-10

Balance Sheet Inventory = $1,395

Specific Cost IdentificationSpecific Cost IdentificationCost of Goods Sold

Units Unit Cost Total Units

Unit Cost Total

10 @ 91$ = 910$

10 @ 91$

15 @ 106$

9 @ 91$ 1 @ 91$

11 @ 106$ 4 @ 106$

1 @ 91$

4 @ 106$

20 @ 115$

1 @ 91$

4 @ 106$

20 @ 115$

10 @ 119$

1 @ 91$ 1 @ 106$

3 @ 106$ 5 @ 115$

15 @ 115$ 6 @ 119$

4 @ 119$

Inventory Balance

= 2,500$

= 515$

= 1,395$

= 1,985$

= 2,610$

= 2,815$

= 4,005$

Income StatementCOGS = $4,595

8-11

Purchases Cost of Goods Sold

Date Units Unit Cost Total Units Unit Cost Total Units Unit Cost Total

Aug. 1 10 @ 91$ = 910$ 10 @ 91$ = 910$

Aug. 3 15 @ 106$ = 1,590$ 25 @ 100$ = 2,500$

Aug. 14 20 @ 100$ = 2,000$ 5 @ 100$ = 500$

Inventory Balance

Weighted Average Cost Weighted Average Cost MethodMethod

The weighted average cost per unit must be

computed prior to each sale.

On 14 August, TBC sold 20 bikes for $130 each. On 14 August, TBC sold 20 bikes for $130 each.

$2,500 25 = $100 avg. cost

8-12

Purchases Cost of Goods Sold

Date Units Unit Cost Total Units

Unit Cost Total Units

Unit Cost Total

Aug. 1 10 @ 91$ = 910$ 10 @ 91$ = 910$

Aug. 3 15 @ 106$ = 1,590$ 25 @ 100$ = 2,500$

Aug. 14 20 @ 100$ = 2,000$ 5 @ 100$ = 500$

Aug. 17 20 @ 115$ = 2,300$ 25 @ 112$ = 2,800$

Aug. 28 10 @ 119$ = 1,190$ 35 @ 114$ = 3,990$

Aug. 31 23 @ 114$ = 2,622$ 12 @ 114$ = 1,368$

Inventory Balance

$114 = $3,990 35

Additional purchases were made on 17 August and 28 August. On 31 August, an additional 23 units

were sold.

Weighted Average Cost Weighted Average Cost MethodMethod

8-13

Income StatementCOGS = $4,622

Balance Sheet Inventory = $1,368

Cost of Goods Sold

Units Unit Cost Total Units

Unit Cost Total

10 @ 91$ = 910$

25 @ 100$ = 2,500$

20 @ 100$ = 2,000$ 5 @ 100$ = 500$

25 @ 112$ = 2,800$

35 @ 114$ = 3,990$

23 @ 114$ = 2,622$ 12 @ 114$ = 1,368$

Inventory Balance

Weighted Average Cost Weighted Average Cost MethodMethod

8-14

Purchases Cost of Goods Sold

Date Units Unit Cost Total Units

Unit Cost Total Units

Unit Cost Total

Aug. 1 10 @ 91$ = 910$ 10 @ 91$ = 910$

Aug. 3 15 @ 106$ = 1,590$ 10 @ 91$

15 @ 106$

Aug. 14 10 @ 91$

10 @ 106$ @ 106$

Inventory Balance

= 2,500$

= 1,970$ = 530$ 5

On 14 August, TBC sold 20 bikes for $130 each. On 14 August, TBC sold 20 bikes for $130 each.

The Cost of Goods Sold for the 14 August sale is $1,970, leaving 5 units, with a total cost of $530, in inventory.

First-In, First-Out Method First-In, First-Out Method (FIFO)(FIFO)

8-15

Additional purchases were made on 17 Aug. and 28 Aug. On 31 August, an additional 23 units were sold.

First-In, First-Out Method First-In, First-Out Method (FIFO)(FIFO)

Purchases Cost of Goods Sold

Date Units Unit Cost Total Units

Unit Cost Total Units

Unit Cost Total

Aug. 1 10 @ 91$ = 910$ 10 @ 91$ = 910$

Aug. 3 15 @ 106$ = 1,590$ 10 @ 91$

15 @ 106$

Aug. 14 10 @ 91$

10 @ 106$

Aug. 17 20 @ 115$ = 2,300$ 5 @ 106$

20 @ 115$

Aug. 28 10 @ 119$ = 1,190$ 5 @ 106$

20 @ 115$

10 @ 119$

Aug. 31 5 @ 106$ 2 @ 115$

18 @ 115$ 10 @ 119$

@ 106$

= 2,830$

= 4,020$

= 2,600$ = 1,420$

Inventory Balance

= 2,500$

= 1,970$ = 530$ 5

8-16

First-In, First-Out Method First-In, First-Out Method (FIFO)(FIFO)

Cost of Goods Sold

Units Unit Cost Total Units

Unit Cost Total

10 @ 91$ = 910$

10 @ 91$

15 @ 106$

10 @ 91$

10 @ 106$

5 @ 106$

20 @ 115$

5 @ 106$

20 @ 115$

10 @ 119$

5 @ 106$ 2 @ 115$

18 @ 115$ 10 @ 119$

@ 106$

= 2,830$

= 4,020$

= 2,600$ = 1,420$

Inventory Balance

= 2,500$

= 1,970$ = 530$ 5

Balance SheetInventory = $1,420

Income StatementCOGS = $4,570

8-17

Inventory Valuation Methods: A SummaryCosts Allocated to:

ValuationMethod

Cost of GoodsSold Inventory Comments

Specific Actual cost of Actual cost of units Parallels physical flowcostidentification

the units sold remaining Logical method when unitsare uniqueMay be misleading foridentical units

Weightedaverage cost

Number of unitssold times the

Number of units onhand times the

Assigns all units the sameaverage unit cost

average unit cost average unit cost Current costs are averagedin with older costs

First-in, First-out(FIFO)

Cost of earliestpurchases on

Cost of mostrecently

Cost of goods sold is basedon older costs

hand prior to thesale

purchased units Inventory valued at currentcostsMay overstate profit duringperiods of rising prices; mayincrease income taxes due

8-18

Once a company has adopted a particular

accounting method, it should follow that

method consistentlyrather than switch methods from one year to the next.

The Principle of The Principle of ConsistencyConsistency

8-19

The primary reason for taking a physical inventory is to adjust the perpetual inventory

records for unrecorded shrinkage losses, such as theft, spoilage, or breakage.

Taking a Physical Taking a Physical InventoryInventory

8-20

Reduces the value of the inventory.Obsolescence

Adjust inventory value to the lower

of historical cost or net realizable value

(NRV).

Lower of Cost and

Net Realizable Value (LCNRV)

LCNRV and Other Write-LCNRV and Other Write-Downs of InventoryDowns of Inventory

8-21

LCNRV and Other Write-LCNRV and Other Write-Downs of InventoryDowns of Inventory

Cost Market Individual

Items InventoryCategory

TotalInventory

Bicycles: Boy's bicycles 4,200$ 4,600$ 4,200 Girls bicycles 3,800 3,100 3,100 Junior bicycle 5,700 5,000 5,000 Total 13,700$ 12,700$ 12,700 Bicycle accessories: Training wheels 485$ 525$ 485 Headlamps 312 400 312 Protective helmets 700 600 600 Gloves 245 212 212 Kneepads 195 145 145 Total 1,937$ 1,882$ 1,882 Total inventory 15,637$ 14,582$ 14,054$ 14,582$ 14,582$

LCNRV Applied on the Basis of . . .

8-22

Year End

A sale should be recorded when title to the goods passes to the buyer.

F.O.B. shipping

point title passes to

buyer at the point of

shipment.

F.O.B. F.O.B. destination destination pointpoint title passes to

buyer at the point of

destination.

Goods In TransitGoods In Transit

8-23

In a periodic inventory system, inventory entries are as follows.

Note that an entry is not made to inventory.

Periodic Inventory Periodic Inventory SystemsSystems

8-24

In a periodic inventory system, inventory entries are as follows.

Periodic Inventory Periodic Inventory SystemsSystems

8-25

Computers Co.Mouse Pad Inventory

Date Units $/Unit TotalBeginningInventory 1,000 5.25$ 5,250.00$ Purchases:3 Jan. 300 5.30 1,590.00 20 June 150 5.60 840.00 15 Sept. 200 5.80 1,160.00 29 Nov. 150 5.90 885.00 GoodsAvailablefor Sale 1,800 9,725.00$

EndingInventory 1,200 ?

Cost ofGoods Sold 600 ?

Information for the Following Information for the Following Inventory ExamplesInventory Examples

8-26

Computers Co.Mouse Pad Inventory

Date Units $/Unit TotalBeginningInventory 1,000 5.25$ 5,250.00$ Purchases:3 Jan. 300 5.30 1,590.00 20 June 150 5.60 840.00 15 Sept. 200 5.80 1,160.00 29 Nov. 150 5.90 885.00 GoodsAvailablefor Sale 1,800 9,725.00$

EndingInventory 1,200 6,400.00$

Cost ofGoods Sold 600 3,325.00$

Cost of Goods Sold$9,725 - $6,400 = $3,325

Specific Cost IdentificationSpecific Cost Identification

8-27

Computers, Inc.Mouse Pad Inventory

Date Units $/Unit TotalBeginning Inventory 1,000 5.25$ 5,250.00$ Purchases:Jan. 3 300 5.30 1,590.00 June 20 150 5.60 840.00 Sept. 15 200 5.80 1,160.00 Nov. 29 150 5.90 885.00 Goods Available for Sale 1,800 9,725.00$

Ending Inventory 1,200 ?

Cost of Goods Sold 600 ?

WAC $9,725 1,800 = $5.40278

Weighted Average Cost Weighted Average Cost MethodMethod

Computers Co.Mouse Pad Inventory

Date Units $/Unit TotalBeginning Inventory 1,000 5.25$ 5,250.00$ Purchases:3 Jan. 300 5.30 1,590.00 20 June 150 5.60 840.00 15 Sept. 200 5.80 1,160.00 29 Nov. 150 5.90 885.00 Goods Available for Sale 1,800 9,725.00$

Ending Inventory 1,200 6,483.00$

Cost of Goods Sold 600 3,242.00$

Ending InventoryWAC $5.40278 1,200 =

$6,483Cost of Goods Sold

WAC $5.40278 600 = $3,242

8-28

Remember: Start with the 29 Nov purchase and then add other purchases until you reach the

number of units in ending inventory.

First-In, First-Out Method First-In, First-Out Method (FIFO)(FIFO)

Computers Co.Mouse Pad Inventory

Date Units $/Unit TotalBeginningInventory 1,000 5.25$ 5,250.00$ Purchases:3 Jan. 300 5.30 1,590.00 20 June 150 5.60 840.00 15 Sept. 200 5.80 1,160.00 29 Nov. 150 5.90 885.00 GoodsAvailablefor Sale 1,800 9,725.00$

EndingInventory 1,200 ?

Cost ofGoods Sold 600 ?

8-29

Date Beg. Inv. Purchases End. Inv.Cost of

Goods Sold

29 Nov. 150@$5.90 150@$5.90Units 150

Now, let’s complete the table.

First-In, First-Out Method First-In, First-Out Method (FIFO)(FIFO)

Date Beg. Inv. Purchases End. Inv.Cost of

Goods Sold1,000@$5.25 600@$5.25

400@$5.253 Jan. 300@$5.30 300@$5.3020 June 150@$5.60 150@$5.6015 Sept. 200@$5.80 200@$5.8029 Nov. 150@$5.90 150@$5.90Units 1,200 600

Now, we have allocated the cost to all 1,200 units in ending

inventory.

Date Beg. Inv. Purchases End. Inv.Cost of

Goods Sold1,000@$5.25 600@$5.25

400@$5.253 Jan. 300@$5.30 300@$5.3020 June 150@$5.60 150@$5.6015 Sept. 200@$5.80 200@$5.8029 Nov. 150@$5.90 150@$5.90Units 1,200 600

Costs $6,575 $3,150

Cost of Goods Available for Sale $9,725

8-30

Completing the table

summarizes the

computations just made.

First-In, First-Out Method First-In, First-Out Method (FIFO)(FIFO)

Computers Co.Mouse Pad Inventory

Date Units $/Unit TotalBeginningInventory 1,000 5.25$ 5,250.00$ Purchases:3 Jan. 300 5.30 1,590.00 20 June 150 5.60 840.00 15 Sept. 200 5.80 1,160.00 29 Nov. 150 5.90 885.00 GoodsAvailablefor Sale 1,800 9,725.00$

EndingInventory 1,200 6,575.00$

Cost ofGoods Sold 600 3,150.00$

8-31

Errors in Measuring InventoryBeginning Inventory Ending Inventory

Effect on Income Statement Overstated Understated Overstated UnderstatedGoods Available for Sale + - NE NECost of Goods Sold + - - +Gross Profit - + + -Profit - + + -Effect on Balance SheetEnding Inventory NE NE + -Retained Earnings - + + -An error in ending inventory in a year will result in the

same error in the beginning inventory of the next year.

Importance of an Accurate Importance of an Accurate Valuation of InventoryValuation of Inventory

8-32

The Gross Profit MethodThe Gross Profit Method1. Determine cost of

goods available for sale.

2. Estimate cost of goods sold by multiplying the net sales by the cost ratio.

3. Deduct cost of goods sold from cost of goods available for sale to determine ending inventory.

8-33

The Gross Profit MethodThe Gross Profit MethodIn March 2010, Matrix Company’s inventory was destroyed by fire.

Matrix normal gross profit ratio is 30% of net sales. At the time of the fire,

Matrix showed the following balances:

Sales 315,000$ Sales returns 15,000 Beginning Inventory 120,000 Net cost of goods purchased 205,000

8-34

Goods Available for Sale: Beginning Inventory 120,000$ Net cost of goods purchased 205,000 Goods available for sale 325,000$ Less estimated cost of goods sold: Sales 315,000$ Less sales returns (15,000) Net sales 300,000$ Estimated cost of goods sold (210,000) Estimated March inventory loss 115,000$

Estimating Inventory The Gross Profit Method

Goods Available for Sale: Beginning Inventory 120,000$ Net cost of goods purchased 205,000 Goods available for sale 325,000$ Less estimated cost of goods sold: Sales 315,000$ Less sales returns (15,000) Net sales 300,000$ Estimated cost of goods sold (21,000) Estimated March inventory loss 304,000$

Estimating Inventory The Gross Profit Method

The Gross Profit MethodThe Gross Profit Method

Goods Available for Sale: Beginning Inventory 120,000$ Net cost of goods purchased 205,000 Goods available for sale 325,000$ Less estimated cost of goods sold: Sales 315,000$ Less sales returns (15,000) Net sales 300,000$ Estimated cost of goods sold (210,000) Estimated March inventory loss 115,000$

Estimating Inventory The Gross Profit Method

× × 70%70%

Step 1

Step 2

Step 3

8-35

The Retail MethodThe Retail MethodThe retail method of estimating inventory requires that management determine the value of ending inventory at retail prices.

Goods available for sale at cost 325,000$ Goods available for sale at retail 500,000 Physical count of ending inventory priced at retail 220,000

The Retail Method

In March of 2009, Matrix Company’s inventory was destroyed by fire. At the time of the fire, Matrix’s management collected the following information:

8-36

The Retail MethodThe Retail Method

a Goods available for sale at cost 325,000$ b Goods available for sale at retail 500,000 c Cost ratio [a b] 65%d Physical count of ending inventory priced at retail 220,000 e Estimated ending inventory at cost [ c d] 143,000$

Estimating Inventory The Retail Method

Matrix would follow the steps below to estimate their ending inventory using the retail method.

8-37

(Beginning Inventory + Ending Inventory) ÷ 2

Financial AnalysisFinancial AnalysisCost of Goods SoldAverage Inventory

=Inventory Turnover

365Inventory Turnover

Average Days to Sell Inventory

=

8-38

Financial AnalysisFinancial Analysis

(Beginning Receivables + Ending Receivables) ÷ 2

Net SalesAverage Accounts Receivable=Receivables

Turnover

365Receivables Turnover

Average Days to Collect Receivables

=

8-39

End of Chapter 8End of Chapter 8