Inventories and the Cost of Goods Sold Chapter 8 Chapter 8: Inventories and the Cost of Goods Sold

The Flow of Inventory Costs BALANCE SHEET Asset Inventory Purchase costs (or manufacturing costs) as goods are sold INCOME STATEMENT Revenue Cost of goods sold Gross profit Expenses Net income Inventory includes all goods that a company owns and holds for sale, regardless of where the goods are located when inventory is counted. Inventory is reported as a current asset on the balance sheet. Companies that sell inventory report the value of the inventory they have in stock at the end of the period as a current asset on the balance sheet. Companies that sell inventory also have an additional expense item called Cost of Goods Sold on their income statements. The Cost of Goods Sold account represents the cost of the inventory sold during the period to help earn revenue. Cost of Goods Sold is presented as a separate expense item on the income statement. Net Sales minus Cost of Goods Sold equals Gross Profit. Gross Profit is the amount left, after subtracting the cost of inventory sold, to cover all other expenses and a profit.

Which Unit Did We Sell? 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. On the sale date, a natural question arises: What is the unit cost of the inventory being sold? If all the inventory has the same unit cost, then this is not a difficult question to answer. However, in most cases, companies will have identical units of inventory in stock that have different unit costs. Let’s see how to determine the cost of a unit of inventory sold.

Data for an Illustration The Bike Company (TBC) Take a minute and review this chart for The Bike Company. This data will be used throughout the perpetual inventory examples to compare results.

Specific Identification On August 14, TBC sold 20 bikes for $130 each. Of the bikes sold 9 originally cost $91 and 11 cost $106. When using the specific identification method, the specific cost of each unit that is sold is known. It is most commonly used in businesses that have low sales volume of high dollar items, like car dealerships, exclusive jewelry stores, and custom builders. On August 1st and 3rd, TBC purchases inventory. On August 14th, they sell 9 bikes that cost $91 each and 11 bikes that cost $106 each. The Cost of Goods Sold for August 14th is $1,985. After this sale, TBC has 5 units in inventory: 1 unit that costs $91 and 4 units that cost $106 each. The Cost of Goods Sold for the August 14 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.

Average-Cost Method $114 = $3,990  35 Additional purchases were made on August 17 and August 28. On August 31, an additional 23 units were sold. Next, TBC makes two purchases on August 17th and August 28th. On August 31st, TBC sells 23 bikes. To determine the average cost of the inventory items, TBC will divide the cost of goods available for sale of $3,990 by the total units in inventory of 35. The average cost per unit is $114. The units on hand (35) is determined by taking the total units purchased (55) and subtracting the units sold (20). The Cost of Goods Sold for August 31st is $2,622. After this sale, TBC has 12 units in inventory at an average cost of $114 each.   $114 = $3,990  35

First-In, First-Out Method (FIFO) On August 14, TBC sold 20 bikes for $130 each. The Cost of Goods Sold for the August 14 sale is $1,970, leaving 5 units, with a total cost of $530, in inventory. When using the First-in, First-out (FIFO) method, the older costs are assigned to the units sold. That leaves the more recent costs to be used to value ending inventory. On August 1st and 3rd, TBC purchases inventory. On August 14th, they sell 20 bikes. Using FIFO, first TBC assigns the cost of the 10 oldest inventory items purchased on August 1st at $91 each. Now, they need 10 more units, so they move down to the next purchase on August 3rd and include the cost of 10 units from this purchase at $106 each. The Cost of Goods Sold for August 14th is $1,970. After this sale, TBC has 5 units in inventory at a cost of $106 each.

Last-In, First-Out Method (LIFO) On August 14, TBC sold 20 bikes for $130 each. When using the Last-in, First-out (LIFO) method, we assign the most recent costs to the units sold. That leaves the older costs to be used to value ending inventory. On August 1st and 3rd, TBC purchases inventory. On August 14th, they sell 20 bikes. Using LIFO, first TBC assigns the cost of the 15 most recent inventory items purchased on August 3rd at $106 each. Now, they need 5 more units, so they move up to the next most recent purchase on August 1st and include the cost of 5 units from this purchase at $91 each. The Cost of Goods Sold for August 14th is $2,045.   After this sale, TBC has 5 units in inventory at a cost of $91 each. The Cost of Goods Sold for the August 14 sale is $2,045, leaving 5 units, with a total cost of $455, in inventory.

This slide provides a summary of some of the key differences among the four inventory valuation methods. Take a few minutes to review it.

Taking a Physical Inventory 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. Most companies take a physical count of inventory at least once a year. Theoretically, the physical count should match the number of items in the inventory records. In reality, this is not the case. The physical count does not match the records due to spoilage, breakage, damage, obsolescence, and theft. The physical count helps get records up to date to reflect what is actually on hand. Remember from Chapter 6 that when a physical count identifies inventory shrinkage, an entry is made to debit Cost of Goods Sold and credit Inventory. This entry increases Cost of Goods Sold, an expense account, and decreases the Inventory account.

LCM and Other Write-Downs of Inventory Reduces the value of the inventory. Obsolescence Adjust inventory value to the lower of historical cost or current replacement cost (market). Lower of Cost or Market (LCM) Before reporting a value for Inventory on the balance sheet, companies consider any needed reductions for obsolescence. They also make sure to adjust the inventory value to the lower of cost or market. Cost is determined using one of the methods just discussed: specific identification, FIFO, LIFO or average cost. Market is defined as the current replacement price of the inventory. Reporting inventory at the lower of cost or market follows the conservatism principle by not overstating the value of assets.

LCM and Other Write-Downs of Inventory We can apply the lower-of-cost-or-market rule to individual inventory items, the categories of inventory items, or to the total inventory. At TBC we have two broad categories of inventory items – Bicycles and Bicycle accessories. You can see the inventory items that are in each category. Let’s begin by applying LCM to the individual inventory items. When we apply the rule to individual items, we compare the cost and market of each item and select the lower. For example, for the Boy’s Bicycles total cost is $4,200 and total market value is $4,600, so we will select the lower amount, which is cost. We complete the process for all the other items in inventory. Inventory will be carried on the balance sheet at $14,054. We have two major categories of inventory items at TBC. If we apply LCM by inventory categories, we will compare the total cost of Bicycles to total Market for Bicycles. Under this approach, inventory will be carried at $14,582. Part IV Finally, we can apply LCM to the entire inventory. Using this approach we compare total cost of $15,637, to total market of $14,582, and select the lower – market of $14,582. Inventory will be shown on the balance sheet at $14,582.

Periodic Inventory Systems In a periodic inventory system, inventory entries are as follows. Recall that in a periodic inventory system, purchases of inventory are recorded with a debit to Purchases, not Inventory, and a credit to Accounts Payable. Note that an entry is not made to inventory.

Information for the Following Inventory Examples Now let’s see how to use the inventory valuation methods in a periodic inventory system. Take a minute to review this chart for Computers, Incorporated. This data will be used throughout the periodic inventory examples and to compare the results at the end.

Specific Identification Cost of Goods Sold $9,725 - $6,400 = $3,325 First, let’s look at the specific identification method. Remember that in this method, the specific cost of each unit in inventory is known. At the end of the period, inventory is counted and cost is determined. Computers, Incorporated, counted 1,200 mouse pads with a cost of $6,400. This is enough information to determine Cost of Goods Sold for the year. To calculate Cost of Goods Sold for the period, start with Goods Available for Sale of $9,725 dollars and subtract Ending Inventory, based on the physical count, of $6,400.

Average-Cost Method Avg. Cost $9,725  1,800 = $5.40278 Ending Inventory Avg. Cost $5.40278 1,200 = $6,483 Cost of Goods Sold Avg. Cost $5.40278 600 = $3,242 When using average cost, assign the average cost of the goods available for sale to cost of goods sold. The average cost is determined by dividing the cost of goods available for sale for the period by the units available for sale for the period. First, determine the average cost by taking Goods Available for Sale for the period and divide it by the number of units available for sale during the period. In this example, this calculation would be $9,725 divided by 1,800 units. The average cost is 5.40278 dollars. To determine Ending Inventory, take the number of units in inventory and multiply by the average cost. To determine Cost of Goods Sold, take the number of units sold and multiply by the average cost.

First-In, First-Out Method (FIFO) Ending Inventory is $6,575. The Cost of Goods Sold value for the 600 units sold is determined using the first costs in. Start with the beginning inventory and account for all 600 units. The Cost of Goods Sold is $3,150. As a double check, when you add together the Ending Inventory and the Cost of Goods Sold, you should get the Cost of Goods Available for Sale.

Last-In, First-Out Method (LIFO) Start with the beginning inventory of 1,000 units. Add 200 units from the January 3rd purchase. This accounts for all 1,200 units on hand. The cost of these units is determined by taking the units times their respective cost amount. Ending Inventory is $6,310. The Cost of Goods Sold value for the 600 units sold is determined using the last costs in. Start with the November 29th purchase of 150 units. Then add the units from the September 15th purchase, the June 20th purchase, and 100 units from the January 3rd purchase. The Cost of Goods Sold is $3,415. As a double check, when Ending Inventory and the Cost of Goods Sold are added together, they should equal the Cost of Goods Available for Sale.

Importance of an Accurate Valuation of Inventory Take a few minutes to review this chart. It shows the impact of inventory errors. For example, an understated Ending Inventory will result in an overstatement of Cost of Goods Sold, an understatement of Gross Profit, and an understatement of Net Income. On the Balance Sheet it will result in understated Ending Inventory and understated Owner’s Equity. An error in the valuation of ending inventory affects not only the financial statements of the current year but also the income statement for the following year. The ending inventory in one year becomes the beginning inventory in the following year. An understatement of the beginning inventory results in an understatement of the cost of goods sold and, therefore, an overstatement of gross profit and net income in the following year. Notice that the original error has exactly the opposite effects on the net incomes of the two successive years. For this reason, inventory errors are said to be “self-correcting” over a two-year period.

The Gross Profit Method Determine cost of goods available for sale. Estimate cost of goods sold by multiplying the net sales by the cost ratio. Deduct cost of goods sold from cost of goods available for sale to determine ending inventory. It is expensive and time consuming to take a physical count of inventory. As a result, in interim financial statements, most companies estimate ending inventory and cost of goods sold. Using this estimate helps avoid having to shut down production or close the doors to the business to do a physical count. Let’s look at two methods used to estimate inventory for interim financial statements: the gross profit method and the retail method. When using the gross profit method, follow these three steps. First, determine the Cost of Goods Available for Sale. This can be done using accounting data. Second, estimate Cost of Goods Sold by multiplying Net Sales by the cost ratio. The cost ratio is based on past history of the company. Third, deduct the Cost of Goods Sold estimate from the Cost of Goods Available for Sale to determine Ending Inventory.

The Gross Profit Method × 70% Step 1 Step 2 First, determine the Cost of Goods Available for Sale. This is calculated by adding Beginning Inventory and the Net Cost of Goods Purchased. The Cost of Goods Available for Sale is $32,500. Second, estimate Cost of Goods Sold by multiplying Net Sales by the cost ratio. To accomplish this, remember that Net Sales minus Cost of Goods Sold equals Gross Profit. Since the Gross Profit ratio is 30%, then the Cost of Goods Sold Ratio has to be 70%. Net Sales is calculated as Sales minus Sales Returns and Sales Discounts. In this problem, there are only Sales Returns. Seventy percent of $30,000 is $21,000, which is the estimate of the Cost of Goods Sold. Third, deduct the Cost of Goods Sold estimate from the Cost of Goods Available for Sale to determine Ending Inventory, which in this case is $11,500. Step 3

The Retail Method Matrix would follow the steps below to estimate their ending inventory using the retail method. First, we need to determine the cost ratio. This is calculated by dividing Goods Available for Sale at Cost by Goods Available for Sale at Retail. Matrix’s cost ratio is 65%. Next, take Matrix’s ending inventory at retail of $22,000 and multiply it by the cost ratio to arrive at Estimated Ending Inventory at cost. For Matrix, this is $14,300.

(Beginning Inventory + Ending Inventory) ÷ 2 Financial Analysis (Beginning Inventory + Ending Inventory) ÷ 2 Inventory Turnover measures how quickly a company sells its inventory. A ratio that is low compared to competitors suggests inefficient use of assets. To calculate this ratio, take Cost of Goods Sold and divide by Average Inventory. The Average Number of Days to Sell Inventory ratio measures how many days on average it takes to sell inventory. It is calculated as Number of Days in the Year divided by Inventory Turnover.

End of Chapter 8 End of chapter 8.