Copyright © 2016 by McGraw-Hill Education

Chapter 7

Inventory and Cost of Goods Sold

PowerPoint Author:Brandy Mackintosh, CA

7-2

Learning Objective 7-1

Describe the issues in managing different types of

inventory.

7-3

The primary goals of inventory managers are to:

1. Maintain a sufficient quantity of inventory to meet customers’ needs

2. Ensure quality meets customers’ expectations and company standards

3. Minimize the costs of acquiring and carrying the inventory

Inventory Management Decisions

7-4

Types of InventoryMerchandisers . . .

Buy finished goods. Sell finished goods.

Manufacturers . . . Buy raw materials. Produce and sell

finished goods.

Raw MaterialsWork in ProcessFinished goods

Merchandise inventory

Materials waiting tobe processed

Partially complete products

Completed products awaiting sale

7-5

Learning Objective 7-2

Explain how to report Inventory and Cost of Goods

Sold.

7-6

Balance Sheet and Income Statement Reporting

7-7

Cost of Goods Sold Equation

Periodic Updating:

Perpetual Updating:

Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold

Beginning Inventory + Purchases – Cost of Goods Sold = Ending Inventory

7-8

Cost of Goods Sold EquationA company has beginning inventory of 5 units that each cost

$10, then purchases 20 units with a cost of $10 each, sells 15 units, and is left with 10 units in ending inventory.

7-9

Learning Objective 7-3

Compute costs using four inventory costing methods.

7-10

Inventory Costing Methods

First-in, first-out(FIFO)

First-in, first-out(FIFO)

Last-in, first-out(LIFO)

Last-in, first-out(LIFO)

Weighted average

Weighted average

Specificidentification

Specificidentification

7-11

Inventory Costing MethodsConsider the following information

This method individually identifies and records the cost of each item sold as part of cost of goods sold. If the items

sold were identified as the ones that cost $70 and $95, the total cost of those items ($70 + 95 = $165) would be

reported as Cost of Goods Sold. The cost of the remaining item ($75) would be reported as Inventory on the balance

sheet at the end of the period.

Specific Identification

May 5$75 cost

May 3$70 cost

May 6$95 costMay 3

May 5May 6May 8

Purchased 1 unit for $70Purchased 1 more unit for $75Purchased 1 more unit for $95Sold 2 units for $125 each

7-12

Inventory Costing Methods

FIFO LIFO Weighted average

May 6$95 cost

May 5$75 cost

May 3$70 cost

May 6$95 cost

May 5$75 cost

May 3$70 cost

So

ld

Sti

ll t

her

e

Income StatementNet SalesCost of Goods SoldGross Profit

$250 145$105

Balance SheetInventory $95

May 6$95 cost

May 5$75 cost

May 3$70 cost

So

ld

Sti

ll t

her

e

Income StatementNet SalesCost of Goods SoldGross Profit

$250 170$ 80

Balance SheetInventory $70

$80per unit

Sold

Still there

$2403 =

Income StatementNet SalesCost of Goods SoldGross Profit

$250 160$ 90

Balance SheetInventory $80

7-13

Inventory Costing Methods

Summary

Cost of Goods Sold (Income Statement)Inventory (Balance Sheet)

FIFO

Oldest costNewest cost

LIFO

Newest costOldest cost

WeightedAverage

Average costAverage cost

Let’s consider a more complex example.

DateOct 1Oct 3Oct 5Oct 6

DescriptionBeginning InventoryPurchasePurchaseSalesEnding Inventory

# of Units103010

(35)15

Cost per Unit$ 7$ 8$10

To calculateTo calculate

Total Cost$ 70

240100

To calculateTo calculate

7-14

Inventory Cost Flow Computations

FIFO

+

-=

beginning Inventorypurchases

cost of goods available for saleending InventoryCost of Goods Sold

10 units x $ 7 = $ 7030 units x $ 8 = 240

10 units x $ 10 = 100

$ 410140

$ 270

(10 units @ $10) + (5 units @ $8)

(10 units @ $7) + (25 units @ $8)

7-15

Inventory Cost Flow Computations

LIFO

+

-=

beginning Inventorypurchases

cost of goods available for saleending InventoryCost of Goods Sold

10 units x $ 7 = $ 7030 units x $ 8 = 240

10 units x $ 10 = 100

$ 410110

$ 300

(10 units @ $7) + (5 units @ $8)

(10 units @ $10) + (25 units @ $8)

7-16

Inventory Cost Flow Computations

Weighted Average

WeightedAverage Cost

=Cost of goods Available for Sale

Number of Units Available for Sale

WeightedAverage Cost

=$410

50 units= $8.20 per unit

Description

beginning Inventorypurchasepurchasecost of goods available for sale

# of Units

1030

1050

Cost per Unit

$ 7$ 8$10

Total Cost

$ 70240

100$ 410

7-17

Inventory Cost Flow Computations

Weighted Average

+

-=

Beginning InventoryPurchases

Cost of Goods Available for SaleEnding InventoryCost of Goods Sold

10 units x $ 7 = $ 7030 units x $ 8 = 240

10 units x $ 10 = 100

$ 410123

$ 287

15 units @ $8.20

35 units @ $8.20

7-18

Financial Statement Effects

Effects on the Income Statement

SalesCost of Goods Sold

Gross Profit

Operating ExpensesIncome from OperationsOther Revenue (Expenses)

Income before Income Tax ExpenseIncome Tax Expense (30%)

Net Income

Effects on the Balance Sheet

Inventory

WeightedAverage

$ 525287

238

12511320

13340

$ 93

$ 123

LIFO

$ 525300

225

12510020

12036

$ 84

$ 110

FIFO

$ 525270

255

12513020

15045

$ 105

$ 140

7-19

Financial Statement Effects

7-20

Tax Implications and Cash Flow Effects

Effects on the Income Statement

SalesCost of Goods Sold

Gross Profit

Operating ExpensesIncome from OperationsOther Revenue (Expenses)

Income before Income Tax ExpenseIncome Tax Expense (30%)

Net Income

Effects on the Balance Sheet

Inventory

WeightedAverage

$ 525287

238

12511320

13340

$ 93

$ 123

LIFO

$ 525300

225

12510020

12036

$ 84

$ 110

FIFO

$ 525270

255

12513020

15045

$ 105

$ 140

7-21

Learning Objective 7-4

Report inventory at thelower of cost or market.

7-22

The value of inventory can fall below its recorded cost for two reasons:

1. it’s easily replaced by identical goods at a lower cost, or

2. it’s become outdated or damaged.

The value of inventory can fall below its recorded cost for two reasons:

1. it’s easily replaced by identical goods at a lower cost, or

2. it’s become outdated or damaged.

Lower of Cost or Market

When the value of inventory falls below its recorded cost, the amount recorded for

inventory is written down to its lower market value. This is known as the lower of

cost or market (LCM) rule.

When the value of inventory falls below its recorded cost, the amount recorded for

inventory is written down to its lower market value. This is known as the lower of

cost or market (LCM) rule.

7-23

Lower of Cost or Market

Item

Leather coatsVintage jeans

CostperItem

$16520

MarketValue

per Item

$15025

LCMperItem

$15020

Quantity

1,000400

Total Lowerof cost

or Market

$150,0008,000

Totalcost

$165,0008,000

Write-down

$15,0000

1,000 items @ $165

2 Record

Cost of Goods Sold Inventory 15,000

15,000

1,000 items @ $150 400 items @ $201 Analyze

LiabilitiesAssets = Stockholders’ Equity+

Inventory -$15,000 Cost of GoodsSold (+E) -$15,000

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Lower of Cost or Market

7-25

Learning Objective 7-5

Evaluate inventory management by computing

and interpreting the inventory turnover ratio.

7-26

Inventory Turnover Analysis

7-27

Comparison to Benchmarks

Copyright © 2016 by McGraw-Hill Education

Supplement 7A

FIFO, LIFO, and Weighted Average in a Perpetual Inventory System

7-29

Learning Objective 7-S1

Compute inventory costs in perpetual systems.

7-30

Perpetual Inventory System

Date Description # of Units Cost per Unit Total CostOct 1 Beginning Inventory 10 7$ 70$ Oct 3 Purchase 30 8$ 240$ Oct 4 Sales (35) To calculate To calculateOct 5 Purchase 10 10$ 100$

Ending Inventory 15 To calculate To calculate

This is the same information that we used earlier in the chapter to illustrate a periodic inventory system. The only difference is that we have assumed the sales occurred on

October 4, prior to the final inventory purchase.

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FIFO (First-in, First-Out)

7-32

LIFO (Last-in, First-Out)

7-33

Weighted Average Cost

$310 ÷ 40 units= $7.75 per unit

7-34

Financial Statement Effects

Summary of Perpetual Inventory System Cost Flow Assumptions on Financial Statements

Copyright © 2016 by McGraw-Hill Education

Supplement 7B

The Effects of Errors in Ending Inventory

7-36

Learning Objective 7-S2

Determine the effects of inventory errors.

7-37

The Effects of Errors in Ending InventoryCost of Goods Sold Equation

BI + P – EI = CGS

Errors in EndingInventory will affect

the Balance Sheet andthe Income Statement.

Assume that Ending Inventory was overstated in Year 1 by$10,000 due to an error that was not discovered until Year 2.

Year 1

+-

=

Beginning InventoryPurchasesEnding Inventory

Cost of Goods Sold

AccurateAccurateOverstated $10,000

Understated $10,000

7-38

The Effects of Errors in Ending Inventory

Now let’s examine the effects of theYear 1 Ending Inventory Error on Year 2.

Assume that Ending Inventory was overstated in Year 1 by$10,000 due to an error that was not discovered until Year 2.

Year 2

+-

=

Beginning InventoryPurchasesEnding Inventory

Cost of Goods Sold

Overstated $10,000AccurateAccurate

Overstated $10,000

Copyright © 2016 by McGraw-Hill Education

Chapter 7Solved Exercises

M7-6, M7-7, E7-5, E7-10, E7-13

7-40

M7-6 Calculating Cost of Goods Available for Sale, Ending Inventory, Sales, Cost of Goods Sold, and Gross Profit under Periodic FIFO, LIFO, and Weighted Average CostGiven the following information, calculate cost of goods available for sale and ending inventory, then sales, cost of goods sold, and gross profit, under (a) FIFO, (b) LIFO, and (c) weighted average. Assume a periodic inventory system is used.

7-41

M7-6 Calculating Cost of Goods Available for Sale, Ending Inventory, Sales, Cost of Goods Sold, and Gross Profit under Periodic FIFO, LIFO, and Weighted Average Cost

a. FIFO Beginning Inventory 50 units x $10 = $ 500+ Purchase 250 units x $13 = $3,250 Cost of Goods Available for Sale $3,750 - Ending Inventory (200 x $13) = $2,600 = Cost of Goods Sold (50 x $10) + (50 x $13) $1,150

7-42

M7-6 Calculating Cost of Goods Available for Sale, Ending Inventory, Sales, Cost of Goods Sold, and Gross Profit under Periodic FIFO, LIFO, and Weighted Average Cost

b. LIFO Beginning Inventory 50 units x $10 = $ 500+ Purchase 250 units x $13 = $3,250 Cost of Goods Available for Sale $3,750 - Ending Inventory (50 x $10) + (150 x $13) = $2,450 = Cost of Goods Sold (100 x $13) $1,300

7-43

WeightedAverage Cost =

$3,750300 units = $12.50 per unit

M7-6 Calculating Cost of Goods Available for Sale, Ending Inventory, Sales, Cost of Goods Sold, and Gross Profit under Periodic FIFO, LIFO, and Weighted Average Cost

c. Weighted Average Beginning Inventory 50 units x $10 = $ 500+ Purchase 250 units x $13 = $3,250 Cost of Goods Available for Sale $3,750 - Ending Inventory (200 x $12.50) = $2,500 = Cost of Goods Sold (100 x $12.50) $1,250

7-44

M7-6 Calculating Cost of Goods Available for Sale, Ending Inventory, Sales, Cost of Goods Sold, and Gross Profit under Periodic FIFO, LIFO, and Weighted Average Cost

FIFO LIFO Weighted AvgSales (100 units at $15) $1,500 $1,500 $1,500Cost of Goods Sold 1,150 1,300 1,250 Gross Profit $ 350 $ 200 $ 250

7-45

M7-7 Calculating Cost of Goods Available for Sale, Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Weighted Average Cost (Periodic Inventory)Aircard Corporation tracks the number of units purchased and sold throughout each accounting period, but applies its inventory costing method at the end of each period as if it uses a periodic inventory system. Given the following information, calculate the cost of goods available for sale, endinginventory, and cost of goods sold, if Aircard uses (a) FIFO, (b) LIFO, or (c) weighted average cost.

7-46

M7-7 Calculating Cost of Goods Available for Sale, Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Weighted Average Cost (Periodic Inventory)

Goods Available for Sale – same for all methodsUnits Unit Total

Cost CostBeginning Inventory 2,000 $40 $ 80,000+ Purchase (July 13) 6,000 $44 264,000+ Purchase (July 25) 8,000 $50 400,000 Goods Available for Sale 16,000 $744,000

7-47

M7-7 Calculating Cost of Goods Available for Sale, Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Weighted Average Cost (Periodic Inventory)

a. FIFO Ending Inventory (7,000 units x $50) = $350,000

Cost of Goods Sold (2,000 units x $40)(6,000 units x $44)(1,000 units x $50) = $394,000

b. LIFO Ending Inventory (2,000 units x $40)

(5,000 units x $44) = $300,000

Cost of Goods Sold (8,000 units x $50)(1,000 units x $44) = $444,000

7-48

M7-7 Calculating Cost of Goods Available for Sale, Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Weighted Average Cost (Periodic Inventory)

c. Weighted Average Average Unit Cost $744,000 / 16,000 = $46.50

Ending Inventory (7,000 units x $46.50) = $325,500

Cost of Goods Sold (9,000 units x $46.50) = $418,500

7-49

E7-5 Calculating Cost of Ending Inventory and Cost of Goods Sold under Periodic FIFO, LIFO, and Weighted AverageOahu Kiki tracks the number of units purchased and sold throughout each accounting period but applies its inventory costing method at the end of each month, as if it uses a periodic inventory system. Assume Oahu Kiki’s records show the following for the month of January. Sales totaled 240 units.

Required:1. Calculate the number and cost of goods available for sale.

Goods Available for Sale – same for all methodsUnits Unit Total

Cost CostBeginning Inventory 120 $80 $ 9,600+ Purchase (Jan 15) 380 $90 34,200+ Purchase (Jan 24) 200 $110 22,000 Goods Available for Sale 700 $65,800

7-50

E7-5 Calculating Cost of Ending Inventory and Cost of Goods Sold under Periodic FIFO, LIFO, and Weighted AverageAssume Oahu Kiki’s uses a periodic inventory system, which shows the following for the month of January. Sales totaled 240 units.

Required:2. Calculate the number of units in ending inventory.

Units in Ending Inventory = Units Available – Units Sold

Units in Ending Inventory = 700 – 240 = 460 units

7-51

E7-5 Calculating Cost of Ending Inventory and Cost of Goods Sold under Periodic FIFO, LIFO, and Weighted AverageAssume Oahu Kiki’s uses a periodic inventory system, which shows the following for the month of January. Sales totaled 240 units.

Required:3. Calculate the cost of ending Inventory and Cost of Goods Sold using the (a) FIFO, (b) LIFO, and (c) weighted average cost methods.

a. FIFO ending Inventory (200 units x $110)

(260 units x $ 90) = $45,400

Cost of Goods Sold (120 units x $80)(120 units x $90) = $20,400

7-52

E7-5 Calculating Cost of Ending Inventory and Cost of Goods Sold under Periodic FIFO, LIFO, and Weighted AverageAssume Oahu Kiki’s uses a periodic inventory system, which shows the following for the month of January. Sales totaled 240 units.

Required:3. Calculate the cost of ending inventory and cost of goods sold using the (a) FIFO, (b) LIFO, and (c) weighted average cost methods.

b. LIFO Ending Inventory (120 units x $80)

(340 units x $90) = $40,200

Cost of Goods Sold (200 units x $110)( 40 units x $ 90) = $25,600

7-53

E7-5 Calculating Cost of Ending Inventory and Cost of Goods Sold under Periodic FIFO, LIFO, and Weighted AverageAssume Oahu Kiki’s uses a periodic inventory system, which shows the following for the month of January. Sales totaled 240 units.

Required:3. Calculate the cost of ending inventory and cost of goods sold using the (a) FIFO, (b) LIFO, and (c) weighted average cost methods.

c. Weighted Average Average Unit Cost $65,800 / 700 units = $94

Ending Inventory (460 units x $94) = $43,240

Cost of Goods Sold (240 units x $94) = $22,560

7-54

E7-10 Reporting Inventory at Lower of Cost or MarketPeterson Furniture Designs is preparing the annual financial statements dated December 31. Ending inventory information about the five major items stocked for regular sale follows:

Required:1. Complete the two columns of the table and then compute the amount that should be reported for the ending inventory using the LCM rule applied to each item.

$1,500Total $11,900 $10,400

Item

Alligator Armoires

Bear Bureaus

Cougar Beds

Dingo Cribs

Elephant Dressers

Qty

50

75

10

30

400

Total Cost

x $30 = $1,500

x $40 = $3,000

x $50 = $ 500

x $30 = $ 900

x $15 = $6,000

Total Market

x $24 = $1,200

x $40 = $3,000

x $52 = $ 520

x $30 = $ 900

x $12 = $4,800

LCM Per Item LCM Valuation

$24

40

50

30

12

$1,200

3,000

500

900

4,800

7-55

E7-10 Reporting Inventory at Lower of Cost or MarketPeterson Furniture Designs is preparing the annual financial statements dated December 31. Ending inventory information about the five major items stocked for regular sale follows:

Required:2. Prepare the journal entry that Peterson Furniture Designs would record on December 31 to write-down its inventory to LCM.

Cost of Goods Sold 1,500 Inventory 1,500

7-56

E7-13 Analyzing and Interpreting the Inventory Turnover RatioPolaris Industries Inc. is the biggest snowmobile manufacturer in the world. It reported the following amounts in its financial statements (in millions):

Required:1. Calculate to one decimal place the inventory turnover ratio and average days to sell inventory for 2012, 2011, and 2010.

*7.1 = $2,280 ÷ $320 **7.0 = $1,900 ÷ $270 ***7.0 = $1,460 ÷ $210

2012 2011 2010 InventoryTurnoverRatio

Days toSell

=

=

Cost of Goods SoldAverage Inventory

365 DaysInventory Turnover

=

=

7.1* 7.0** 7.0***

51.4 52.1 52.1

Times per year

days

7-57

E7-13 Analyzing and Interpreting the Inventory Turnover RatioPolaris Industries Inc. is the biggest snowmobile manufacturer in the world. It reported the following amounts in its financial statements (in millions):

Required:2. Comment on any trends, and compare the effectiveness of inventory managers at Polaris to inventory managers at its main competitor, Arctic Cat, where inventory turns over 5.4 times per year in 2012 (67.6 days to sell).

Both companies use the same inventory costing method (FIFO).

The inventory turnover ratio reflects how many times average inventory was acquired and sold during the year. The inventory turnover ratio for Polaris Industries has been consistent throughout 2010 to 2012. Polaris is performing better than Arctic Cat, where the inventory turnover is 5.4 times per year or every 67.6 days.

7-58

End of Chapter 7