© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-1 INVENTORIES AND THE COST OF GOODS SOLD Chapter 8

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-2 Inventory Goods owned and held for sale to customers Current asset Current asset Inventory Defined

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-3 INCOME STATEMENT Revenue Cost of goods sold Gross profit Expenses Net income As purchase cost (or manufacturing costs) are incurred as goods are sold BALANCE SHEET Current assets: Inventory $$ $ The Flow of Inventory Costs

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-4 In a perpetual inventory system, inventory entries parallel the flow of costs. The Flow of Inventory Costs

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-5 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. Which Unit Did We Sell?

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-6 A separate subsidiary account is maintained for each item in inventory. How can we determine the unit cost for the Sept. 10 sale? Inventory Subsidiary Ledger

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-7 Specific identification LIFO Average cost FIFO We use one of these inventory valuation methods to determine cost of inventory sold. Inventory Cost Flows

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-8 The Bike Company (TBC) Information for the Following Inventory Examples

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-9 Specific Identification When a unit is sold, the specific cost of the unit sold is added to cost of goods sold.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-10 On August 14, TBC sold 20 bikes for $130 each. Nine bikes originally cost $91 and 11 bikes originally cost $106. On August 14, TBC sold 20 bikes for $130 each. Nine bikes originally cost $91 and 11 bikes originally cost $106. Continue Specific Identification

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-11 The Cost of Goods Sold for the August 14 sale is $1,985, leaving $515 and 5 units in inventory. Continue Let’s look at the entries for the Aug. 14 sale. Specific Identification

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-12 Continue Retail Cost A similar entry is made after each sale. Specific Identification

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-13 Additional purchases were made on August 17 and 28. Costs associated with sales on August 31 were as follows: $91, $106, $115, & $119. Additional purchases were made on August 17 and 28. Costs associated with sales on August 31 were as follows: $91, $106, $115, & $119. Continue Specific Identification Cost of Goods Sold for August 31 = $2,610

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-14 Balance Sheet Inventory = $1,395 Income Statement COGS = $4,595 Specific Identification

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-15 Since specific identification is so easy, can’t we use it all the time? Not really. Specific identification is hard to use when we sell a lot of inventory that has lots of different costs.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-16 Cost of Goods Available for Sale Units on hand on the date of sale ÷ Average-Cost Method When a unit is sold, the average cost of each unit in inventory is assigned to cost of goods sold.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-17 On August 14, TBC sold 20 bikes for $130 each. Continue The average cost per unit must be computed prior to each sale. Average-Cost Method $100 = $2,500  25

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-18 Continue The average cost per unit is $100. Let’s look at the entries for the Aug. 14 sale. Average-Cost Method $100 = $2,500  25

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-19 Continue Retail Cost A similar entry is made after each sale. Average-Cost Method

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-20 Additional purchases were made on August 17 and August 28. On August 31, an additional 23 units were sold. Additional purchases were made on August 17 and August 28. On August 31, an additional 23 units were sold. Continue Average-Cost Method

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-21 $114 = $3,990  35 Average-Cost Method

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-22 $114 = $3,990  35 The average cost per unit is $114. Average-Cost Method

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-23 Income Statement COGS = $4,622 Balance Sheet Inventory = $1,368 $114 × 12 = $1,368 Average-Cost Method

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-24 Costs of Goods Sold Ending Inventory Oldest Costs Recent Costs First-In, First-Out Method (FIFO)

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-25 On August 14, TBC sold 20 bikes for $130 each. Continue The Cost of Goods Sold for the August 14 sale is $1,970, leaving $530 and 5 units in inventory. First-In, First-Out Method (FIFO)

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-26 Retail Cost Continue A similar entry is made after each sale. First-In, First-Out Method (FIFO)

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-27 Additional purchases were made on Aug. 17 and Aug. 28. On August 31, an additional 23 units were sold. Additional purchases were made on Aug. 17 and Aug. 28. On August 31, an additional 23 units were sold. Continue First-In, First-Out Method (FIFO) Cost of Goods Sold for August 31 = $2,600

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-28 Balance Sheet Inventory = $1,420 Income Statement COGS = $4,570 First-In, First-Out Method (FIFO)

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-29 Costs of Goods Sold Ending Inventory Recent Costs Oldest Costs Last-In, First-Out Method (LIFO)

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-30 On August 14, TBC sold 20 bikes for $130 each. Continue Last-In, First-Out Method (LIFO) The Cost of Goods Sold for the August 14 sale is $2,045, leaving $455 and 5 units in inventory.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-31 Continue Retail Cost A similar entry is made after each sale. Last-In, First-Out Method (LIFO)

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-32 Continue Last-In, First-Out Method (LIFO) Additional purchases were made on Aug. 17 and Aug. 28. On Aug. 31, an additional 23 units were sold. Additional purchases were made on Aug. 17 and Aug. 28. On Aug. 31, an additional 23 units were sold.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-33 Continue Last-In, First-Out Method (LIFO) Cost of Goods Sold for August 31 = $2,685

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-34 Balance Sheet Inventory = $1,260 Income Statement COGS = $4,730 Last-In, First-Out Method (LIFO)

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-35

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-36 Once a company has adopted a particular accounting method, it should follow that method consistently, rather than switch methods from one year to the next. The Principle of Consistency

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-37 This inventory arrived just in time for us to use it in the manufacturing process. Just-In-Time (JIT) Inventory Systems

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-38 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. Taking a Physical Inventory

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-39 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) LCM and Other Write-Downs of Inventory

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-40 Year End A sale should be recorded when title to the merchandise passes to the buyer. F.O.B. shipping point  title passes to buyer at the point of shipment. F.O.B. destination point  title passes to buyer at the point of destination. Goods In Transit

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-41 In a periodic inventory system, inventory entries are as follows. Note that an entry is not made to inventory. Periodic Inventory Systems

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-42 In a periodic inventory system, inventory entries are as follows. Periodic Inventory Systems

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-43 The inventory on hand and the cost of goods sold for the year are not determined until year-end. Periodic Inventory Systems

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-44 Specific identification LIFO Average cost FIFO We use one of these inventory valuation methods in a periodic inventory system. Periodic Inventory Systems

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-45 Information for the Following Inventory Examples

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-46 By reviewing actual purchase invoices, Computers, Inc. determines that the 1,200 mouse pads on hand at year-end have an actual total cost of $6,400. Determine the cost of goods sold for the year. Specific Identification

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-47 Cost of Goods Sold $9,725 - $6,400 = $3,325 Cost of Goods Sold $9,725 - $6,400 = $3,325 Specific Identification

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-48 Total Cost of Goods Available for Sale Total Number of Units Available for Sale ÷ The average cost is calculated at year- end as follows: Average-Cost Method

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-49 Avg. Cost $9,725  1,800 = $ Average-Cost Method Ending Inventory Avg. Cost $  1,200 = $6,483 Ending Inventory Avg. Cost $  1,200 = $6,483 Cost of Goods Sold Avg. Cost $  600 = $3,242 Cost of Goods Sold Avg. Cost $  600 = $3,242

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-50 Costs of Goods Sold Ending Inventory Oldest Costs Recent Costs First-In, First-Out Method (FIFO)

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-51 Remember: Start with the 11/29 purchase and then add other purchases until you reach the number of units in ending inventory. First-In, First-Out Method (FIFO)

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-52 Now, let’s complete the table. First-In, First-Out Method (FIFO) Now, we have allocated the cost to all 1,200 units in ending inventory.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-53 Completing the table summarizes the computations just made. First-In, First-Out Method (FIFO)

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-54 Costs of Goods Sold Ending Inventory Recent Costs Oldest Costs Last-In, First-Out Method (LIFO)

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-55 Remember: Start with beginning inventory and then add other purchases until you reach the number of units in ending inventory. Last-In, First-Out Method (LIFO)

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-56 Last-In, First-Out Method (LIFO) Now, we have allocated the cost to all 1,200 units in ending inventory. Next, let’s complete the table.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-57 Completing the table summarizes the computations just made. Last-In, First-Out Method (LIFO)

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-58 An error in ending inventory in a year will result in the same error in the beginning inventory of the next year. Importance of an Accurate Valuation of Inventory

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-59 For interim financial statements, we may need to estimate ending inventory and cost of goods sold.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-60  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.  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. The Gross Profit Method

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-61 In March of 2005, ChemCo’s inventory was destroyed by fire. ChemCo’s normal gross profit ratio is 30% of net sales. At the time of the fire, ChemCo showed the following balances: The Gross Profit Method

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-62 The Gross Profit Method × 70%   

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-63 The Retail Method The retail method of estimating inventory requires that management determine the value of ending inventory at retail prices. In March of 2005, ChemCo’s inventory was destroyed by fire. At the time of the fire, ChemCo’s management collected the following information:

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-64 The Retail Method ChemCo would follow the steps below to estimate their ending inventory using the retail method.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-65 Measures how quickly a company sells its merchandise inventory. A ratio that is low compared to competitors suggests inefficient use of assets. Average Inventory = (Beg. Inv. + End. Inv.) ÷ 2 Financial Analysis

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-66 Measures how many days on average it takes to sell its inventory. Financial Analysis

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-67 Remember that identical companies that use different inventory methods (e.g., FIFO and LIFO) will have different inventory turnover ratios. Accounting Methods Can Affect Financial Ratios

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 8-68 End of Chapter 8