Cost of Goods Sold and Inventory: Identification and Valuation.

Cost of Cost of Goods Sold Goods Sold

and and Inventory: Inventory: IdentificatioIdentificatio

n and n and ValuationValuation

2

Define inventory for a merchandising business, and identify the different types of inventory for a manufacturing business.

Explain the advantages and disadvantages of both periodic and perpetual inventory systems.

Determine when ownership of goods in transit changes hands and what circumstances require shipped inventory to be kept on the books.

Learning Objectives

3

Compute total inventory acquisition cost. Use the four basic inventory valuation

methods: specific identification, average cost, FIFO, and LIFO.

Explain how LIFO inventory layers are created, and describe the significance of the LIFO reserve.

Learning Objectives

4

Learning Objectives

Choose an inventory valuation method based on the trade-offs among income tax effects, bookkeeping costs, and the impact on the financial statements.

Analyze inventory using financing ratios, and properly compare ratios of different firms after adjusting for differences in inventory valuation methods.

5

Learning Objectives

Use LIFO pools to simplify LIFO calculations.

Compute ending inventory and cost of goods sold using dollar-value LIFO.

EXPANDED MATERIAL

6

LIFO and FIFO in Times of Inflation

Uni

t Cos

t of

Goo

ds S

old

Beginning of Year

End of Year

FIFO assumes the old units are

soldFIFO

LIFO assumes the new units

are soldLIFO

7Time Line of Business Issues Involved With Inventory

BUY

Raw Materials or Goods for Resale

SELL

Finished Inventory

SELL COMPUTE

Ending Inventory and Cost of Goods

Sold

COMPUTEADD

Value

ADDADDADD

8

What Is Inventory?

Inventory designates goods held for sale in the normal course of business and, in the case of a

manufacturer, goods in production or to be placed in production.

Inventory designates goods held for sale in the normal course of business and, in the case of a

manufacturer, goods in production or to be placed in production.

9How Much Inventory Do Companies Have?

0%2%4%6%8%

10%12%14%16%18%

Inventory Levels for the 50 Largest Companies, 1979-1998

Inve

ntor

y as

a P

erce

ntag

e of

T

otal

Ass

ets

1998

Source: Standard and Poor’s Compustat

10

Inventory Types

MerchandiseMerchandiseMerchandiseMerchandise

Balance Sheet Items

IncomeStatement

Items

RetailerCost of Cost of

Goods SoldGoods SoldCost of Cost of

Goods SoldGoods SoldSale

Manufacturer

Raw Raw MaterialsMaterials

Raw Raw MaterialsMaterials

Cost of Cost of Goods SoldGoods Sold

Cost of Cost of Goods SoldGoods Sold

Sale

Finished Goods

Finished Goods

Work in Work in Process Process Work in Work in Process Process

OverheadDirectLabor

11

Periodic Inventory Systems

Cost of Goods Sold is determined and Inventory is adjusted to proper balance at period end.

All purchases of inventoriable merchandise are recorded in the Purchases account.

Ending inventory is determined by physical count of merchandise on hand.

12

Perpetual Inventory Systems

Cost of Goods Sold is determined and Inventory is adjusted to proper balance each time inventory is purchased or sold.

All purchases of inventoriable goods are recorded in the Inventory account.

13

Example: Inventory Systems

Assume:Beginning Inventory 50 units @ $10 $ 500Purchases 300 units @ $10 3,000Sales 275 units @ $15 4,125Ending inventory (physical count) 70 units @ $10 700

Make the journal entries to record the purchases and sales for both the periodic and

perpetual inventory systems.

14


Purchases of Inventory

Periodic MethodPurchases…………………….. 3,000

Accounts Payable…………. 3,000

Perpetual MethodInventory…………………….. 3,000

Accounts Payable…………. 3,000

15


Sales During the Period

Periodic MethodAccounts Receivable………….. 4,125

Sales………………………... 4,125

Perpetual MethodAccounts Receivable………….. 4,125

Sales………………………... 4,125

Cost of Goods Sold…………… 2,750Inventory…………………… 2,750

16

Whose Inventory Is It?

• Goods in Inventory.

• Goods in Transit.– FOB Shipping Point: buyer’s inventory

from time of shipment.

– FOB Destination: seller’s inventory until receipt by buyer.

• Goods on Consignment: inventory of the consignor, not the consignee.

17

Goods in Transit

Quality

Produce

Goods being shipped are included in inventory of buyer while in transit.

Goods being shipped are included in inventory of buyer while in transit.

FOB Shipping PointFOB Shipping PointFOB Shipping PointFOB Shipping Point

Seller Buyer

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Goods in Transit

FOB DestinationFOB DestinationFOB DestinationFOB Destination

Quality

Produce

Goods being shipped are included in inventory of seller until received by buyer.

Goods being shipped are included in inventory of seller until received by buyer.

Seller Buyer

19

Goods on Consignment

Title to goods sold on consignment remains with the shipper until

their sale or use by the dealer or customer.

Title to goods sold on consignment remains with the shipper until

their sale or use by the dealer or customer.

20

What Is Inventory Cost?

• Inventory Cost is all expenditures related to inventory acquisition, preparation, and placement for sale.

• Trade Discounts

– Convert the catalog price to the actual price.

– Record inventory at discounted price.

• Cash Discounts

– Granted for payment of invoices within a limited time period.

– Record inventory using the net method or gross method.

21

Cash Discounts--Net Method

• Records inventory net of any purchase (cash) discounts.

• Example:

June 1--purchased inventory for $100

Terms of payment: 2/10, n/30

Assuming a perpetual inventory method, record the purchase of the inventory and payment on June 8.

22

June 1Inventory.............................. 98

Accounts Payable.....…..... 98


23

June 1Inventory.............................. 98

Accounts Payable.....…..... 98June 8Accounts Payable................ 98

Cash.........................…..... 98


24


Now, assume that the payment was not

made until June 28.

Now, assume that the payment was not

made until June 28.

25

June 28Accounts Payable..............…. 98Discounts Lost…………….. 2

Cash..............................…. 100


26

Cash Discounts--Gross Method

• Record inventory at gross cost; discounts are recorded only if taken.

• Example:

June 1--purchased inventory for $100

Terms of payment: 2/10, n/30

Assuming a perpetual inventory method, record the purchase of the inventory and payment on June 8.

27

June 1Inventory.............................. 100

Accounts Payable.....…..... 100


28

June 1Inventory.............................. 100

Accounts Payable.....…..... 100June 8Accounts Payable................ 100

Inventory……………….. 2Cash.........................…..... 98


29

Again, assume that the payment was not made until June 28.

Again, assume that the payment was not made until June 28.


30

June 28Accounts Payable..............…. 100

Cash..............................….100


31

Cost of Goods Manufactured

The heading.The heading.

Bartlett CorporationSchedule of Cost of Goods ManufacturedFor the Year Ended December 31, 2002

Bartlett CorporationSchedule of Cost of Goods ManufacturedFor the Year Ended December 31, 2002

32


Direct materials:Raw materials inventory, January 1, 2002 $ 21,350Purchases 107,500Cost of raw materials available for use $128,850Less: Raw materials inventory, December 31, 2002 22,350

Raw materials used in production $106,500Direct labor 96,850

ContinuedContinuedContinuedContinued

33


Manufacturing overhead:Indirect labor $40,000Factor supervision 29,000Depreciation---factory buildings and equipment 20,000Light, heat, and power 18,000Factory supplies 15,000Miscellaneous mfg. overhead 12,055 134,055

Total manufacturing costs $337,405Add: Work in process, Jan. 1, 2002 29,400

$366,805Less: Work in process, Dec. 31, 2002 26,500Cost of goods manufactured $340,305

34

Impact of Cash Discounts

Purchase Date

End of Discount Period

$9,800 Owed

$10,000 Owed

Final Payment

Date

10 Days 20 Days

Supplier “Loan” Period

35

Inventory Cost Flow Methods

Cost Cost Allocation Allocation MethodsMethods

Specific Identification FIFO

Average Cost

LIFO

Actual Cost Cost Pools Dollar Value

36Frequency of Use of Inventory Valuation Methods

U. S. Companies1979 and 1998

U. S. Companies1979 and 1998

Inventory 1979 1998 1998 Method All Companies All Companies Large Companies

FIFO 75.6% 82.9% 72.6%LIFO 25.8% 12.5% 33.0%Average cost 20.8% 15.7% 30.0%Specific Identification 3.7% 3.2% 2.6%

37

Specific Identification Method

Assigns the actual cost of the asset to Inventory and Cost of Goods Sold.

Provides a highly objective method of matching costs because cost flow exactly matches physical goods flow.

Is almost impossible to implement cost effectively.

38

Specific IdentificationSpecific Identification

100 units @ $10 per unitApr. 1

Apr. 10

Apr. 20

80 units @ $11 per unit70 units @ $12 per unit

Sold 80 units from the beginning inventory, 40 units from the April 10 purchase, and 20

units from the April 20 purchase.

39

20 units @ $10 per unit


Sold 80 units from the beginning inventory, 40 units from the April 10 purchase, and 20

units from the April 20 purchase.

Apr. 1

Apr. 10

Apr. 20

Beg. Inv. + Purchases - End. Inv. = Cost of Goods Sold

Ending inventory…………….

= $ 200

= 440

= 600

$1,240

$1,000 + $1,720 - $1,240 = $1,480

Specific IdentificationSpecific Identification

40

Average Cost Method

• Assigns the same average cost to each unit sold and each item in inventory.

• For Periodic Inventory, the unit cost is the weighted average for the entire period.

• For Perpetual Inventory, the unit cost is computed as a moving average, which changes with each new purchase of goods.

41

= $1,000

= 880

= 840

$2,720


Apr. 10

Apr. 20


Sold 140 units during April.

250 units


$1,000 + $1,720 - $1,197 = $1,523

$2,720 250 units = $10.88$10.88 x 110 units = ending inventory of $1,197

Average Cost Method--Periodic

42

Apr. 18 Sales -90 units @ $10.44 -940Apr. 18 Balance 90 units @ $10.44 $ 940Apr. 20 Purchases 70 units @ $12 840Apr. 20 Balance 160 units @ $11.125 $1,780

Apr. 1 Beginning Inventory 100 units @ $10 $1,000Apr. 10 Purchases 80 units @ $11 880Apr. 10 Balance 180 units @ $10.44 $1,880

$1,880 180Apr. 27 Sales -50 units @ $11.125 -556Apr. 30 Balance 110 units @ $11.125 $1,224

$1,780 160Cost of Goods Sold (140 units) $940 + $556 $1,496Ending Inventory (110 units @ $11.125) $1,224

Average Cost Method--Perpetual

43

First-in, First-out (FIFO) Method

Assigns historical unit cost to Cost of Goods Sold in the order the costs are incurred.

Provides a close match between physical product flow and product cost flow.

Results in the same inventory valuation and Cost of Goods Sold regardless of whether perpetual or periodic inventory is used.

44

Last-in, First-out (LIFO) Method

Assigns the most recent historical costs to Cost of Goods Sold and the oldest costs to Inventory.

Is used primarily to minimize taxable income.

Results in differences between Cost of Goods Sold and Inventory for perpetual inventory versus periodic inventory.

45


Apr. 10

Apr. 20


Sold 140 units during April.


Sold 0

Sold 70

Sold all70 units @ $12 per unit

Periodic Inventory SystemPeriodic Inventory System



46



Apr. 10

Apr. 20

80 units @ $11 per unit10 units @ $11 per unit70 units @ $12 per unit0 units @ $12 per unit

Ending inventory………………..

= $1,000

= 110

= 0

$1,110

$1,000 + $1,720 - $1,110 = $1,610

Periodic Inventory SystemPeriodic Inventory System


47

100 units @ $10 per unit90 units @ $10 per unitApr. 1

Apr. 10

Apr. 20

80 units @ $11 per unit Purchased 8070 units @ $12 per unit

Perpetual Inventory SystemPerpetual Inventory System

20 units @ $12 per unitSold 8080 units @ $11 per unit0 units @ $11 per unit

Sold 10

Purchased 70Sold 50

Beginning inventory


48

Apr. 1

Apr. 10

Apr. 20Ending inventory………………..


= $ 900

= 0

= 240

$1,140

$1,000 + $1,720 - $1,140 = $1,580

Perpetual Inventory SystemPerpetual Inventory System



80 units @ $11 per unit70 units @ $12 per unit20 units @ $12 per unit80 units @ $11 per unit0 units @ $11 per unit

49

Inventory Turnover

Appropriateness of inventory size and Appropriateness of inventory size and position can be measured by calculating position can be measured by calculating the the Inventory Turnover RatioInventory Turnover Ratio..

Appropriateness of inventory size and Appropriateness of inventory size and position can be measured by calculating position can be measured by calculating the the Inventory Turnover RatioInventory Turnover Ratio..

Inventory Turnover:

Cost of Goods Sold ÷ Average Inventory

50

Example: Inventory Turnover

Determine the inventory turnover.

• Cost of Goods Sold $1,000• Beginning Inventory $ 90• Ending Inventory $ 110


51



$1,000

($90 + $110)/2= 10

Example: Inventory Turnover

52Number of Days’ Sales in Inventory

$1,000

($90 + $110)/2= 10

36510

Number of days’ sales in inventory is 36.5

53

Example--Dollar-Value LIFO

1. Compute ending inventory at ending prices.

2. Compute beginning inventory at ending prices.

3. Compute the difference. An increase represents a new LIFO layer.

4. LIFO ending inventory is beginning inventory at base-year prices plus the new LIFO layer.

54

Assuming 1999 is the first year Harry’s Hardware, Inc. uses dollar-value LIFO, the following slides illustrate the calculations for 2000, 2001, and 2002 ending inventory.


55

Assume the following inventory data for Harry’s:

Inventory

Year (nominal) Price Index

1999 $ 76 1.0

2000 $ 108 1.2

2001 $ 90 1.5

2002 $ 255 1.7


56

Inv @ Dollar-Inv @ Base Base Value

EoY EoY Year Year Layer LIFOYear Cost Index Cost Layers Index Cost

1999 $ 76 ÷1.0 = $ 76 $ 76 x 1.0 = $ 76.0


Ending Ending inventoryinventoryDVLifoDVLifo

19991999


19991999

57



2000 $108

1999 $ 76 ÷1.0 = $ 76 $ 76 x 1.0 = $ 76.0


58



2000 $108 ÷1.2 = $ 901999 $ 76 ÷1.0 = $ 76 $ 76 x 1.0 = $ 76.0


59



2000 $108 ÷1.2 = $ 901999 $ 76 ÷1.0 = $ 76 $ 76 x 1.0 = $ 76.0

$ 76 x 1.0 = $ 76.0 14 x 1.2 = 16.8


Ending inventory (DV Lifo, 2000) $ 92.8

60



2001 $ 90 ÷1.5 = $ 60 $ 60 x 1.0 = $ 60.0


2000 $108 ÷1.2 = $ 901999 $ 76 ÷1.0 = $ 76 $ 76 x 1.0 = $ 76.0

$ 76 x 1.0 = $ 76.0 14 x 1.2 = 16.8

Ending inventory (DV Lifo, 2000) $ 92.8

ContinuedContinuedContinuedContinued

61

2002 $255 ÷1.7 = $150 $ 60 x 1.0 = $ 60.090 x 1.7 = 153.0



2001 $ 90 ÷1.5 = $ 60 $ 60 x 1.0 = $ 60.0


Ending inventory (DV Lifo, 2002) $213.0Ending Ending inventoryinventoryDVLifoDVLifo

20012001


20012001

62

LIFO Advantages

Advantages:

• Matches current costs with current revenues.

• Excludes inventory holding gains from gross profit.

• Income tax deferral.

63

Disadvantages:• Does not correspond with the physical flow

of goods.• Potential LIFO liquidation can draw old

costs into cost of goods sold.• Ending inventory balance can be much

lower than current replacement cost.

LIFO Disadvantages

64

FIFO Advantages

Advantages:

• Corresponds with physical flow of goods.

• Ending inventory balance is close to current replacement cost.

65

Disadvantages:

• Matches older costs with current revenues.

• Inventory holding gains and losses are part of gross profit.

• No income tax deferral.

FIFO Disadvantages

66

The EndThe End

Cost of Goods Sold and Inventory: Identification and Valuation.

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