Reporting and Interpreting Cost of Goods Sold and Inventory Chapter 7 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc.

McGraw-Hill/Irwin Slide 2 Understanding the Business Provide sufficient quantities of high- quality inventory. Minimize the costs of carrying inventory. Primary Goals of Inventory Management

McGraw-Hill/Irwin Slide 3 Items Included in Inventory Inventory TangibleHeld for Sale Used to Produce Goods or Services Merchandise Inventory Raw Materials Inventory Work in Process Inventory Finished Goods Inventory

McGraw-Hill/Irwin Slide 4 Costs Included in Inventory Purchases cost principle The cost principle requires that inventory be recorded at the price paid or the consideration given. Invoice Price Freight Inspection Costs Preparation Costs

McGraw-Hill/Irwin Slide 5 Flow of Inventory Costs Merchandise Purchases Cost of Goods Sold Merchandise Inventory Merchandiser Raw Materials Raw Materials Inventory Work in Process Inventory Finished Goods Inventory Cost of Goods Sold Manufacturer Direct Labor Factory Overhead

McGraw-Hill/Irwin Slide 6 Nature of Cost of Goods Sold Beginning Inventory Purchases for the Period Ending Inventory (Balance Sheet) Goods Available for Sale Cost of Goods Sold (Income Statement) Beginning inventory + Purchases = Goods Available for Sale Goods Available for Sale – Ending inventory = Cost of goods sold Beginning inventory + Purchases = Goods Available for Sale Goods Available for Sale – Ending inventory = Cost of goods sold

McGraw-Hill/Irwin Slide 7 Inventory Costing Methods Total Dollar Amount of Goods Available for Sale Ending Inventory Cost of Goods Sold Inventory Costing Method Inventory Costing Methods 1.Specific Identification 2.First-in, First-out 3.Last-in, First-out 4.Weighted Average

McGraw-Hill/Irwin Slide 8 Specific Identification When units are sold, the specific cost of the unit sold is added to cost of goods sold and deducted from inventory When units are sold, the specific cost of the unit sold is added to cost of goods sold and deducted from inventory

McGraw-Hill/Irwin Slide 9 Cost Flow Assumptions The choice of an inventory costing method is not always based on the physical flow of goods on and off the shelves. LIFO FIFO Weighted Average

McGraw-Hill/Irwin Slide 10 First-In, First-Out Method Cost of Goods Sold Oldest Costs Ending Inventory Recent Costs

Under the first-in, first-out (FIFO) method The first costs into inventory are the first costs out to cost of goods sold Ending inventory is based on the cost of the latest purchases INVENTORY COSTING METHODS

McGraw-Hill/Irwin Slide 12 Last-In, First-Out Method Ending Inventory Cost of Goods Sold Oldest Costs Recent Costs

Under the last-in, first-out (LIFO) method The last costs into inventory are the first costs out to cost of goods sold Ending inventory consists of the oldest costs--those of beginning inventory and the earliest purchases of the period INVENTORY COSTING METHODS

McGraw-Hill/Irwin Slide 14 Average Cost Method When a unit is sold, the average cost of each unit in inventory is assigned to cost of goods sold. Cost of Goods Available for Sale Number of Units Available for Sale ÷

Inventory Value Effects FIFO ending inventory is highest because it is priced at the most recent costs, which are the highest LIFO ending inventory is lowest because it is priced at the oldest costs, which are the lowest When inventory unit costs are increasing

FIFO ending inventory is lowest because it is priced at the most recent costs, which are the lowest LIFO is highest because it is priced at the oldest costs, which are the highest Inventory Value Effects When inventory unit costs are decreasing

McGraw-Hill/Irwin Slide 17 Financial Statement Effects of Costing Methods Advantages of Methods Better matches current costs in cost of goods sold with revenues. Ending inventory approximates current replacement cost. First-In, First-Out Last-In, First-Out Smooths out price changes. Weighted Average

McGraw-Hill/Irwin Slide 18 Managers Choice of Inventory Methods Net Income Effects Managers prefer to report higher earnings for their companies. Income Tax Effects Managers prefer to pay the least amount of taxes allowed by law as late as possible. LIFO Conformity Rule If last-in, first-out is used on the income tax return, it must also be used to calculate inventory and cost of goods sold for financial statements.

McGraw-Hill/Irwin Slide 19 Valuation at Lower of Cost or Market Ending inventory is reported at the lower of cost or market (LCM). Replacement Cost The current purchase price for identical goods. The company will recognize a holding loss in the current period rather than the period in which the item is sold. This practice is conservative.

McGraw-Hill/Irwin Slide 20 Valuation at Lower of Cost or Market

McGraw-Hill/Irwin Slide 21 Inventory Turnover Cost of Goods Sold = Average Inventory Inventory Turnover Average Inventory is... (Beginning Inventory + Ending Inventory) ÷ 2 Average Inventory is... (Beginning Inventory + Ending Inventory) ÷ 2 This ratio reflects how many times average inventory was produced and sold during the period. A higher ratio indicates that inventory moves more quickly thus reducing interest, storage and obsolescence costs.

Deckers Receivables Turnover was 7.6.Deckers Receivables Turnover was 7.6. This ratio indicates the average time it takes a business to sell its inventory. Inventory Days 365 Inventory Turnover Inventory Days =

McGraw-Hill/Irwin Slide 23 Inventory Methods and Financial Statement Analysis U.S. public companies using LIFO also report beginning and ending inventory on a FIFO basis if the FIFO values are materially different.

McGraw-Hill/Irwin Slide 24 Perpetual and Periodic Inventory Systems Provides up-to-date inventory records. Provides up-to-date cost of sales records. PerpetualSystemPerpetualSystem In a periodic inventory system, ending inventory and cost of goods sold are determined at the end of the accounting period based on a physical count.

McGraw-Hill/Irwin Slide 25 Comparison of Perpetual and Periodic Inventory Systems Periodic Inventory System

McGraw-Hill/Irwin Slide 26 Comparison of Perpetual and Periodic Inventory Systems Perpetual Inventory System

McGraw-Hill/Irwin Slide 27 Perpetual and Periodic Inventory Systems

McGraw-Hill/Irwin Slide 28 Errors in Measuring Ending Inventory

© 2008 The McGraw-Hill Companies, Inc. End of Chapter 7