INVENTORY AND OVERHEAD Chapter Eighteen McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning unit objectives LU 18-1: Assigning Costs to Ending Inventory - Specific Identification; Weighted Average; FIFO; LIFO List the key assumptions of each inventory method. Calculate the cost of ending inventory and cost of goods sold for each inventory method. LU 18-2: Retail Method; Gross Profit Method; Inventory Turnover; Distribution of Overhead Calculate the cost ratio and ending inventory at cost for the retail method. Calculate the estimated inventory using the gross profit method. Explain and calculate inventory turnover. Explain overhead; allocate overhead according to floor space and sales. 18-

Inventory Systems Perpetual Inventory System – Keeps a running account of inventory by updating with each transaction. Periodic Inventory System – Relies on a physical count of inventory done periodically.

Blue Company Inventory Information Number of Cost Total Units Purchased per Unit Cost Beginning inventory 40 $8 $320 First purchase (April 1) 20 9 180 Second purchase (May 1) 20 10 200 Third purchase (Oct. 1) 20 12 240 Fourth purchase (Dec. 1) 20 13 260 Goods available for sale 120 $1,200 Units sold 72 Units in ending inventory 48 Step 1

Specific Identification Method Beg Inv. 4/1 5/1 10/1 12/1 Step 1. Calculate the cost of goods (merchandise available for sale). Step 2. Calculate the cost of ending inventory. Step 3. Calculate the cost of goods sold (Step 1 -- Step 2).

Specific Identification Method Cost per Unit Total Cost 20 units from April 1 $ 9 $180 20 units from Oct. 1 12 240 8 units from Dec. 1 13 104 Cost of ending inventory $524 Step 2 Cost of goods -- Cost of ending = Cost of available for sale inventory goods sold $1,200 -- $524 = $676 Step 3

Weighted-Average Method Beg Inv. 4/1 5/1 10/1 12/1 Step 1. Calculate the average unit cost. Step 2. Calculate the cost of ending inventory. Step 3. Calculate the cost of goods sold (Step 1 -- Step 2).

Weighted-Average Method Number of Cost Total Units Purchased per Unit Cost Beginning inventory 40 $ 8 $320 First purchase (April 1) 20 9 180 Second purchase (May 1) 20 10 200 Third purchase (Oct. 1) 20 12 240 Fourth purchase (Dec. 1) 20 13 260 Goods available for sale 120 $1,200 Units sold 72 Units in ending inventory 48 Weighted average = Total cost of goods available for sale unit cost Total number of units available for sale $1,200 120 = = $10 Average cost of ending inventory: 48 units at $10 = $480 Cost of goods sold = $1,200 -- $480 = $720

First-In, First-Out Method Beg Inv. 4/1 5/1 10/1 12/1 Step 1. List the units to be included in the ending inventory and their costs. Step 2. Calculate the cost of ending inventory. Step 3. Calculate the cost of goods sold (Step 1 -- Step 2).

First-In, First-Out Method Number of Cost Total Units Purchased per Unit Cost Beginning inventory 40 $ 8 $320 First purchase (April 1) 20 9 180 Second purchase (May 1) 20 10 200 Third purchase (Oct. 1) 20 12 240 Fourth purchase (Dec. 1) 20 13 260 Goods available for sale 120 $1,200 Units sold 72 Units in ending inventory 48 20 units from Dec. 1 at $13 $260 20 units from Oct. 1 at $12 240 8 units from May 1 at $10 80 48 units in ending inventory $580 Goods available for sale -- Cost of ending inventory = Cost of goods sold $1,200 -- $580 = $620

Last-In, First-Out Method Beg Inv. 4/1 5/1 10/1 12/1 Step 1. List the units to be included in the ending inventory and their costs. Step 2. Calculate the cost of ending inventory. Step 3. Calculate the cost of goods sold (Step 1 -- Step 2).

Last-In, First-Out Method Number of Cost Total Units Purchased per Unit Cost Beginning inventory 40 $8 $320 First purchase (April 1) 20 9 180 Second purchase (May 1) 20 10 200 Third purchase (Oct. 1) 20 12 240 Fourth purchase (Dec. 1) 20 13 260 Goods available for sale 120 $1,200 Units sold 72 Units in ending inventory 48 40 units from beginning inventory at $8 $320 8 units from Apr. 1 at $9 72 48 units in ending inventory $392 Goods available for sale -- Cost of ending inventory = Cost of goods sold $1,200 -- $392 = $808

Summary

Estimating Inventory – Retail Method Step 1. Calculate the cost of goods available for sale at cost and retail. Step 2. Calculate a cost ratio using the following formula: Cost of goods available for sale at cost Cost of goods available for sale at retail Step 3. Deduct net sales from cost of goods available for sale at retail. Step 4. Multiply the cost ratio by the ending inventory at retail.

Estimating Inventory – Retail Method Cost Retail Beginning inventory $4,000 $6,000 Net purchases during month 2,300 3,000 Cost of goods available for sale (Step 1) $6,300 $9,000 Less net sales for month (Step 3) 4,000 Ending inventory at retail $5,000 Cost ratio ($6,300/$9,000) (Step 2) 70% Ending inventory at cost ($5,000 x .70) (Step 4) $3,500

Estimating Inventory – Gross Profit Method Example: Assuming the following, calculate the estimated inventory. Gross profit on sales 30% Beginning inventory, Jan. 1, 2013 $20,000 Net purchases 8,000 Net sales at retail for Jan. 12,000 Step 1. Calculate the cost of goods available for sale (Beginning inventory + Net purchases). Step 2. Multiply the net sales at retail by the complement of the gross profit rate. This is the estimated cost of goods sold. Step 3. Calculate the cost of estimated ending inventory (Step 1 -- Step 2).

Estimating Inventory – Gross Profit Method Beginning inventory, June 1, 2013 $20,000 Net purchases 8,000 Cost of goods available for sale (Step 1) $28,000 Less estimated cost of good sold: Net sales at retail $12,000 Cost percentage (100% - 30%) (Step 2) x .70 Estimated cost of goods sold - 8,400 Estimated ending inventory, Jan. 30, 2013 (Step 3) $19,600

Inventory Turnover Net sales Inventory turnover at retail = Inventory turnover is the number of times inventory is replaced during a specific time. Net sales Average inventory at retail Inventory turnover at retail = Cost of goods sold Average inventory at cost Inventory turnover at cost =

Inventory Turnover Net sales $32,000 Cost of goods sold $22,000 Beginning inventory at retail 11,000 Beginning inventory at cost 7,500 Ending inventory at retail 8,900 Ending inventory at cost 5,600 Average inventory = Beginning inventory + Ending inventory 2 $32,000 $11,000 + $8,900 2 $32,000 $9,950 At retail = = = 3.22 $22,000 $7,500 + $5,600 2 $22,000 $6,550 Usually higher due to theft, spoilage, markdowns, etc. At cost = = = 3.36

Calculating the Distribution of Overhead by Floor Space Step 1. Calculate the total square feet in all departments. Step 2. Calculate the ratio for each department based on floor space. Step 3. Multiply each department’s floor space ratio by the total overhead.

Calculating the Distribution of Overhead by Floor Space Roy Company Department A - 6,000 square feet Department B - 3,000 square feet Department C - 1,000 square feet Overhead of $90,000 Floor Space Ratio Department A 6,000 6,000 = 60% 10,000 Department B 3,000 3,000 = 30% Department C 1,000 1,000 = 10% Step 1 & 2 Department A .60 x $90,000 = $54,000 Department B .30 x $90,000 = $27,000 Department C .10 x $90,000 = $ 9,000

Calculating the Distribution of Overhead by Sales Step 1. Calculate the total sales in all departments. Step 2. Calculate the ratio for each department based on sales . Step 3. Multiply each department’s sales ratio by the total overhead.

Calculating the Distribution of Overhead by Sales Morse Company distributes its overhead expenses based on the sales of its departments. For example, last year Morse’s overhead expenses were $60,000. Sales of its two departments were as follows, along with its ratio calculation. Sales Ratio Department A $80,000 $ 80,000 = .80 $100,000 Department B 20,000 $20,000 = .20 $100,000 $100,000 Department A .80 x $60,000 = $48,000 Department B .20 x $60,000 = $12,000 $60,000 Total overhead expenses