Inventory and Cost of Goods Sold

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Inventory and Inventory and Cost of Goods Cost of Goods

SoldSoldAn electronic presentationAn electronic presentation

by Douglas Cloudby Douglas Cloud Pepperdine UniversityPepperdine University

An electronic presentationAn electronic presentation by Douglas Cloudby Douglas Cloud

Pepperdine UniversityPepperdine University

chapterchapter 9

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

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

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

Learning Objectives

ContinuedContinuedContinuedContinued

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4. Compute total inventory acquisition cost.

5. Use the four basic inventory valuation methods: specific identification, average cost, FIFO, and LIFO.

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

Learning Objectives


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Learning Objectives

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

8. Apply the lower-of-cost-or-market (LCM) rule to reflect declines in the market value of inventory.

9. Use the gross profit method to estimate ending inventory.


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10. Determine the financial statement impact of inventory recording errors.

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

Learning Objectives

EXPANDED MATERIAL12. Account for the impact of changing prices on purchase commitments.

13. Record inventory purchase transactions denominated in foreign currencies.

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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

COMPUTEBUY

Raw Materials or Goods for Resale

Value

ADD SELL

Finished Inventory

Ending InventoryCost of

Goods Sold

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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, 1979-2000

Inve

ntor

y as

a P

erce

ntag

e of

T

otal

Ass

ets

1998

Source: Standard and Poor’s Compustat

2000

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Raw Materials

Raw Materials are goods acquired for use in the

production process.

Raw Materials are goods acquired for use in the

production process.Materials that are used

directly in the production of goods are frequently

referred to as direct materials.

Materials that are used directly in the production of goods are frequently

referred to as direct materials.

Materials that are necessary in the

production process but are not directly

incorporated into the product are referred to as

indirect materials.

Materials that are necessary in the

production process but are not directly

incorporated into the product are referred to as

indirect materials.

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Work in Process

Work in process consists of materials partly processed and requiring further work before they can be sold. This inventory includes three cost elements.1. Direct materials

2. Direct labor

3. Manufacturing overhead

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Finished Goods

Finished goods are the manufactured products awaiting sale.

Raw Materials

Raw Materials

Finished Goods

Finished Goods

Cost of Goods Sold

Cost of Goods Sold

Balance Sheet Income Statement

Direct Labor

Work in Process

Work in Process

Manufacturing Overhead

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Summary

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

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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.

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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.

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Purchases of Inventory

Periodic MethodPurchases 3,000

Accounts Payable 3,000

Perpetual MethodInventory 3,000


Inventory Systems

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Sales During the Period

Periodic MethodAccounts Receivable 4,125

Sales 4,125

Perpetual MethodAccounts Receivable 4,125

Sales 4,125Cost of Goods Sold 2,750

Inventory 2,750

Inventory Systems

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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.

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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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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

Goods in Transit

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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.

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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.

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The heading.The heading.

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


Schedule of Cost of Goods Manufactured

24Schedule of Cost of Goods Manufactured


Direct materials:Raw materials $ 21,350Purchases 107,500Cost of raw materials available for use $128,850Less raw materials inventory, Dec. 31 22,350

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


25Schedule of Cost of Goods Manufactured

Manufacturing overhead:Indirect labor $ 40,000Factory supervision 29,000Depr.—factory building and equipment 20,000Light, heat, and power 18,000Factory supplies 15,000Miscellaneous manufacturing overhead 12,055 134,055

Total manufacturing costs $337,405Add work in process inventory, January 1 99,400

$366,805Less work in process inventory, December 31 26,500Cost of goods manufactured $340,305

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Cash Discounts

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

• Example:June 1—purchased merchandise for

$10,000 Terms of payment: 2/10, n/30

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

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Purchase Date

End of Discount Period

$9,800 Owed

$10,000 Owed

Final Payment

Date

10 Days 20 Days

Supplier “Loan” Period

Cash Discounts

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June 1Inventory 9,800


Cash Discounts—Net Method

June 8Accounts Payable 9,800

Cash9,800

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Now, assume that the payment was not

made until June 28.

Now, assume that the payment was not

made until June 28.


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June 28Accounts Payable 9,800Discounts Lost 200

Cash 10,000


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If the invoice has not been paid at the end of the period (assume June 30) and

the discount period has lapsed, the following adjusting entry is made:

June 30Discounts Lost 200

Accounts Payable200

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Cash Discounts—Gross Method

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

• Example:June 1—purchased inventory for $10,000. Terms of payment: 2/10, n/30

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

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June 1Inventory 10,000




Inventory 200Cash 9,800

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

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


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Cash10,000


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Accounts Payable 400 Purchase Returns and Allowances 400

Purchases Returns and Allowances

Periodic Inventory SystemPeriodic Inventory SystemPeriodic Inventory SystemPeriodic Inventory System

Accounts Payable 400 Inventory

400

Perpetual Inventory SystemPerpetual Inventory SystemPerpetual Inventory SystemPerpetual Inventory System

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Inventory Valuation Methods

Specific Identification FIFO

Average Cost

LIFO

Cost Cost Allocation Allocation MethodsMethods

Cost Cost Allocation Allocation MethodsMethods

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Assume:Purchases:

January 1 200 @ $10 $ 2,000March 23 300 @ $12 3,600July 15 500 @ $11 5,500November 6 100 @ $13 1,300Total purchases 1,100 $12,400

Sales 700 @ $15

Assume:Purchases:

January 1 200 @ $10 $ 2,000March 23 300 @ $12 3,600July 15 500 @ $11 5,500November 6 100 @ $13 1,300Total purchases 1,100 $12,400

Sales 700 @ $15

Inventory Valuation Methods

39Frequency of Use of Inventory Valuation Methods

U. S. Companies1979 and 2000

U. S. Companies1979 and 2000

Inventory 1979 2000 2000 Method All Companies All Companies Large Companies

FIFO 75.6% 75.9% 68.6%LIFO 25.8% 15.7% 34.6%Average cost 20.8% 21.4% 32.9%Specific Identification 3.7% 4.5% 3.9%

SOURCE: Standard and Poor’s COMPUSTAT

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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.

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200 units @ $10 per unit

300 units @ $12 per unit500 units @ $11 per unit

Sold 200 units from the January 1 and 500 from the July 15 purchase.



1,100 units

Jan. 1

Mar. 23July 15

Nov. 6

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200 units @ $10 per unitJan. 1

500 units @ $11 per unitJuly 15

43


200 units @ $10 per unitJan. 1

500 units @ $11 per unitJuly 15

= $2,000

= 5,500

Total cost of goods sold $7,500

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300 units @ $12 per unitMar. 23

100 units @ $13 per unitNov. 6

= $3,600

= 1,300

Ending inventory $4,900

Goods Not SoldGoods Not Sold

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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.

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= $ 2,000

= 3,600

= 5,500

= 1,300

$12,400

$12,400 1,100 units = $11.27 per unit (rounded)

Cost of goods sold = $11.27 x 700 = $7,890

Average Cost Method




1,100 units

Jan. 1

Mar. 23July 15

Nov. 6

Ending inventory = $11.27 x 400 = $4,510

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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.

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Jan. 1

Mar. 23July 15

Nov. 6

Sold 200= $2,000

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Jan. 1

Mar. 23July 15

Nov. 6

= $2,000Sold 300= 3,600

50





Jan. 1

Mar. 23July 15

Nov. 6

= $2,000

Sold 200= 3,600= 2,200


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300 units @ $12 per unitMar. 23

100 units @ $13 per unitNov. 6

= $3,600

= 1,300




52

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.

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Jan. 1

Mar. 23July 15

Nov. 6 Sold 100= $1,300


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Jan. 1

Mar. 23July 15

Nov. 6 = $1,300


Sold 500= $5,500

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Jan. 1

Mar. 23July 15

Nov. 6 = $1,300


= $5,500

Sold 100= $1,200


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Jan. 1

Mar. 23



= $2,000

= 2,400


57Comparison of Inventory Methods (Periodic)

Cost of Goods Sold

Ending Inventory

Specific identification $7,500 $4,900

Average cost $7,890 $4,510

FIFO $7,800 $4,600

LIFO $8,000 $4,400

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Perpetual Inventory

Assume:Beginning inventory 100 @ $10 $1,000Purchases:

April 10 80 @ $11 880April 20 70 @ $12 840

Sales:April 18 90 @ $15April 27 50 @ $16

Assume:Beginning inventory 100 @ $10 $1,000Purchases:

April 10 80 @ $11 880April 20 70 @ $12 840

Sales:April 18 90 @ $15April 27 50 @ $16

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FIFO Method—Perpetual

FIFO periodic and FIFO perpetual provide identical

results for cost of goods sold and inventory.

FIFO periodic and FIFO perpetual provide identical

results for cost of goods sold and inventory.

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Apr. 18 Sales (90) units @ $10.44 (940)Apr. 18 Balance 90 units @ $10.44 $ 940Apr. 20 Purchases 70 units @ $12 840Apr. 20 Balance160 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 (556)Apr. 30 Balance110 units @ $11.125 $1,224

$1,780 160

Average Cost Method—Perpetual

Ending inventory, $1,224

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Cost of Goods Sold (140 units) $940 + $556 = $1,496

Average Cost Method—Perpetual

Apr. 18 Sales (90) units @ $10.44 (940)Apr. 18 Balance 90 units @ $10.44 $ 940Apr. 20 Purchases 70 units @ $12 840Apr. 20 Balance160 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

Apr. 27 Sales (50) units @ $11.125 (556)Apr. 30 Balance110 units @ $11.125 $1,224

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

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

LIFO Method—Perpetual

Apr. 10Apr. 20

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Ending inventory………………..

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

= $ 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

LIFO Method—Perpetual

Apr. 1

Apr. 10Apr. 20

64Size of LIFO Reserve for Selected U.S. Companies

General Motors $10,034 $1,814

Sears Roebuck 4,912 590

Ford 6,191 905

ExxonMobil 7,904 4,200

Deere & Co. 1,506 1,004

General Electric 8,565 676

ReportedReported LIFO LIFOLIFO LIFO Company Name Inventory ReserveCompany Name Inventory Reserve

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FIFO Advantages

Advantages:• Usually corresponds with physical

flow of goods.• Ending inventory balance agrees

closely with current replacement cost.

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Disadvantages:• Can cause older costs to be matched with

current revenues.• Inventory holding gains and losses are

included as part of gross profit.• Yields higher taxable income in times of

inflation if inventory levels are stable or increasing.

FIFO Disadvantages

67

LIFO Advantages

Advantages:• Matches current costs with current revenues.• Excludes inventory holding gains from gross

profit.• Yields lower taxable income in times of inflation

if inventory levels are stable or increasing.

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Disadvantages:• Usually does not correspond with the physical flow

of goods.• Potential LIFO liquidation means old cost in LIFO

layers can be drawn in to cost of goods sold.• Ending inventory balance can be much lower than

current replacement cost.• LIFO liquidation can result in greatly increased tax

payments when inventory levels decline.

LIFO Disadvantages

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Lower of Cost or Market

The term “market” in lower of cost or market means replacement cost.

The term “market” in lower of cost or market means replacement cost.

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Replacement Cost


Ceiling: Estimated selling price – normal selling costsCeiling: Also known as the

net realizable value

Floor: Net realizable value – a normal profit margin

Market

Historical Costcompare

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$0.70


Ceiling: $0.80

Floor: $0.55

$0.70

$0.65

LCM = $0.65LCM = $0.65LCM = $0.65LCM = $0.65

Market

Historical Cost

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$0.60


Ceiling: $0.80

Floor: $0.55

$0.60

$0.65

LCM = $0.60LCM = $0.60LCM = $0.60LCM = $0.60

Market

Historical Cost

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$0.50


Ceiling: $0.80

Floor: $0.55

$0.55

$0.65

LCM = $0.55LCM = $0.55LCM = $0.55LCM = $0.55Click on the

button to skip LCM

examples

Market

Historical Cost

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$0.45

Ceiling: $0.80

Floor: $0.55

$0.55

$0.50

LCM = $0.50LCM = $0.50LCM = $0.50LCM = $0.50


Market

Historical Cost

75

$0.85

Ceiling: $0.80

Floor: $0.55

$0.80

$0.75

LCM = $0.75LCM = $0.75LCM = $0.75LCM = $0.75


Market

Historical Cost

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$1.00

Ceiling: $0.80

Floor: $0.55

$0.80

$0.90

LCM = $0.80LCM = $0.80LCM = $0.80LCM = $0.80


Market

Historical Cost

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Gross Profit Method

Beginning inventory, January 1 $25,000

Sales, January 1–January 31 50,000

Purchases, January 1–January 31 40,000

Historical gross profit percentage

Last year 40 %

Two years ago 37

Three years ago 42

Last year’s 40% is considered a good estimate.Last year’s 40% is considered a good estimate.

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Gross Profit Method

Sales (actual) $50,000 100 %

Cost of goods sold (estimate) 30,000 60 %

Gross profit (estimate) $20,000 40 %Beginning inventory (actual) $25,000

+ Purchases (actual) 40,000

– Cost of goods available forsale (actual) $65,000

– Ending inventory (estimate) 35,000

= Cost of goods sold (estimate) $30,000

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Gross Profit Method

Sales (actual) $50,000 100 %







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Gross Profit Method

Sales (actual) $50,000 100 %







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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

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Determine the inventory turnover.

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


Inventory Turnover

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$1,000

($90 + $110)/2= 10

Inventory Turnover

84Number of Days’ Sales in Inventory

$1,000

($90 + $110)/2= 10

36510

Number of days’ sales in inventory is 36.5

85Number of Days’ Sales in Inventory

IBM 31.4 daysDell 5.7 daysGeneral Motors 28.2 daysFord 19.4 daysNike 90.5 daysReebok. 82.9 days

Wal-Mart 46.9 daysKmart 74.6 days

Number of Days’Number of Days’ Company Sales in InventoryCompany Sales in Inventory

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The EndThe End

chapter 9chapter 9

Inventory and Cost of Goods Sold

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