COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Inventory and Cost of Goods Sold Chapter 9 S t I c e | S t I c e | S k o u s e n Intermediate Accounting 16E Modified by Ms. Phassawan S.

Learning Objectives 1.Define inventory. 2.Explain the periodic and perpetual inventory system 3.Compute total inventory acquisition cost. 4.Use the four basic inventory valuation methods. 5.Apply the lower-of-cost-or-market (LCM) rule. 6.Use the gross profit method to estimate ending inventory.

Inventory Time Line COMPUTE BUY Raw Materials or Goods for Resale Value ADD SELL Finished Inventory Ending Inventory Cost of Goods Sold

What is Inventory? Items held for resale in the normal course of business. For a manufacturing firm, a broad array of production costs is included as part of the cost of inventory. –The terms raw materials, work in process, and finished goods refer to the inventories of a manufacturing enterprise.

Raw Materials 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 necessary in the production process but are not directly incorporated into the product are referred to as indirect materials.

Work in Process Work in Process (WIP) consists of materials partly processed and requiring further work before they can be sold. The three cost elements that make up WIP are direct materials, direct labor and manufacturing overhead. Direct labor refers to the cost of labor directly identified with goods in production. Manufacturing overhead refers to the proportion of factory overhead assignable to goods in production.

Finished Goods Finished goods are the manufactured products awaiting sale. Raw Materials Finished Goods Cost of Goods Sold Balance Sheet Income Statement Direct Labor Work in Process Manufacturing Overhead

Summary MerchandiseMerchandise Balance Sheet Items Income Statement Items Retailer Cost of Goods Sold Sale Manufacturer Raw Materials Cost of Goods Sold Sale Finished Goods Work in Process Overhead Direct Labor

Learning Objectives 1.Define inventory. 2.Explain the periodic and perpetual inventory system 3.Compute total inventory acquisition cost. 4.Use the four basic inventory valuation methods. 5.Apply the lower-of-cost-or-market (LCM) rule. 6.Use the gross profit method to estimate ending inventory.

Inventory Systems Two types of inventory systems 1.Periodic system- requires a physical count of the inventory periodically, and at the point of sale only records the sale price. –A seller records only the sales price. –A seller has no record of how many units of inventory item have been sold. –The only way to verify what inventory has been sold and what remains is to do a periodic physical count.

Inventory Systems Two types of inventory systems 2. Perpetual system- at point of sale records selling price and type of item sold. Example: a bar code scanning system. –Both selling prices and the type of items sold are recorded for each sale. –The seller knows the number of each items sold and on hand at the time of sale. –The system offers a continuous check and control over inventories.

Differences in Recording Purchases of Inventory- Periodic Purchases3,000 Accounts Payable3,000 Sales During the Period- Periodic Accounts Receivable4,125 Sales4,125 Accounts Receivable4,125 Sales4,125 Cost of Goods Sold2,750 Inventory2,750 Inventory3,000 Accounts Payable3,000 Purchases of Inventory- Perpetual Sales During the Period- Perpetual

Differences in Valuing Cost of Goods Sold Beginning Inventory$ Purchases 3,000 = Cost of Goods available for sale $3,500 - Ending Inventory 700* 750** = Preliminary cost of goods sold (COGS) $2,800$2,750 + Cost of missing inventoryUnknown 50 Reported cost of goods sold$2,800 Periodic System Perpetual System * From count ** From records

The physical count serves to verify the accounting records. There is the difference between the $750 inventory recorded in the books and the $700 physically counted. –A $50 lost in inventory may be as the result of recording errors, shrinkage, breakage, theft, and other causes. Differences in Valuing Cost of Goods Sold

The entry to adjust the perpetual system inventory account for this shrinkage would be: Cost of goods sold 50 Inventory 50 Differences in Valuing Cost of Goods Sold

Learning Objectives 1.Define inventory. 2.Explain the periodic and perpetual inventory system 3.Compute total inventory acquisition cost. 4.Use the four basic inventory valuation methods. 5.Apply the lower-of-cost-or-market (LCM) rule. 6.Use the gross profit method to estimate ending inventory.

What Is Inventory Cost? Inventory costs comprise of all expenditures both direct and indirect, relating to acquisition, preparation, and placement for sale. Discounts can change the total inventory costs. 1.Trade Discounts 2.Cash Discounts

What Is Inventory Cost? 1.Trade Discounts Convert the catalog price to the actual price. Record inventory at discounted price. 2.Cash Discounts Granted for payment of invoices within a limited time period. Record inventory using the net method or gross method.

Net Method 6/1 (at a time of purchase) Inventory 9,800 A/P 9,800 6/8 (paid within disc. period) A/P 9,800 Cash 9,800 6/28 (paid beyond disc. period) A/P9,800 Discounts Lost200 Cash10,000 6/30 (not paid ’til end of month) Discounts Lost 200 A/P 200 6/1 (at a time of purchase) Inventory 10,000 A/P 10,000 6/8 (paid within disc. period) A/P 10,000 Inventory 200 Cash 9,800 6/28 (paid beyond disc. period) A/P 10,000 Cash10,000 Gross Method On June 1, Purchased merchandise for $10,000; 2/10, n/30;

Purchase Returns and Allowances Adjustments are also made when goods are damaged or not lesser in quality than ordered. Sometimes the customer returns the goods. Accounts Payable 400 Purchase Returns & Allowances 400 Periodic Inventory System Accounts Payable 400 Inventory 400 Perpetual Inventory System

Schedule of Cost of Goods Manufactured Bartlett Corporation Schedule of Cost of Goods Manufactured For the Year Ended December 31, 2005 Direct materials: Raw materials $ 21,350 Purchases 107,500 Cost of raw materials available for use 128,850 Less raw materials inventory, Dec ,350 Raw materials used in production $106,500 Direct labor 96,850 Manufacturing overhead :

Schedule of Cost of Goods Manufactured Manufacturing overhead: Indirect labor$ 40,000 Factory supervision29,000 Depr.—factory building and equipment 20,000 Light, heat, and power18,000 Factory supplies15,000 Miscellaneous manufacturing overhead 12, ,055 Total manufacturing costs $337,405 Add work in process inventory, January 1 99,400 $366,805 Less work in process inventory, December 31 26,500 Cost of goods manufactured $340,305

Learning Objectives 1.Define inventory. 2.Explain the periodic and perpetual inventory system 3.Compute total inventory acquisition cost. 4.Use the four basic inventory valuation methods. 5.Apply the lower-of-cost-or-market (LCM) rule. 6.Use the gross profit method to estimate ending inventory.

Inventory Valuation Methods Specific Identification FIFO Average Cost LIFO Cost Allocation Methods

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.

Inventory Valuation Method Assume : Purchases: January $10$ 2,000 March $123,600 July $115,500 November 6 $13 1,300 Total purchases 1,100$12,400 $15 Assume : Purchases: January $10$ 2,000 March $123,600 July $115,500 November 6 $13 1,300 Total purchases 1,100$12,400 $15

Specific Identification Method $10 per unit $12 per unit $11 per unit Sold 200 units from the January 1 and 500 from the July 15 purchase. $13 per unit 1,100 units Jan. 1 Mar. 23 July 15 Nov. 6 ANS. Total cost of goods sold$7,500 Ending inventory $4,900

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.

Average Cost Method $10 per unit $12 per unit $11 per unit $13 per unit 1,100 units Jan. 1 Mar. 23 July 15 Nov. 6 = $ 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 Ending inventory = $11.27 x 400 = $4,510

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.

FIFO Method $10 per unit $12 per unit $11 per unit $13 per unit Jan. 1 Mar. 23 July 15 Nov. 6 Total cost of goods sold$7,800 Ending Inventory$4,600

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.

LIFO Method $10 per unit $12 per unit $11 per unit $13 per unit Jan. 1 Mar. 23 July 15 Nov. 6 Total cost of goods sold$8,000 Ending inventory$4,400

Perpetual Inventory Assume : Beginning $10$1,000 Purchases: April $11880 April $12840 Sales: April $15 April $16 Assume : Beginning $10$1,000 Purchases: April $11880 April $12840 Sales: April $15 April $16

FIFO Method- Perpetual DatePurchaseSalesBalance unit$/unitTotalunit$/unitTotalunit$/unitTotal 4/ ,000 4/ , / / /

LIFO Method- Perpetual DatePurchaseSalesBalance unit$/unitTotalunit$/unitTotalunit$/unitTotal 4/ ,000 4/ , / / /

Average Method- Perpetual DatePurchaseSalesBalance unit$/unitTotalunit$/unitTotalunit$/unitTotal 4/ ,000 4/ ,880 4/ / ,780 4/ ,224

Learning Objectives 1.Define inventory. 2.Explain the periodic and perpetual inventory system 3.Compute total inventory acquisition cost. 4.Use the four basic inventory valuation methods. 5.Apply the lower-of-cost-or-market (LCM) rule. 6.Use the gross profit method to estimate ending inventory.

Lower of Cost or Market “market” means replacement cost (entry cost) = cost that would be acquired to replace an existing asset, e.g. the purchase price of the product plus all other costs incurred in the acquisitions of good. As the selling prices (exit value) do not always respond immediately and in proportion to changes in replacement costs, the ceiling and floor constraints are placed on the use of replacement cost as the measure of market value of inventory.

Exhibit 9-17: Market value = Replacement cost, constrained by the ceiling and the floor Selling price Less normal selling cost Ceiling Market value range Floor Less normal profit Replacement cost Condition: Market value > Floor, < Ceiling, and = RC when RC is between floor and ceiling

ItemCostFloorRCCeilingMarketLCM A$0.65$0.55$0.70$0.80 B C D E F Lower of Cost or Market $0.70$

ItemUnitscostMarketLCM Indi.CategoryTotal inventory Category A A1,000$650$700 B1, C1, ,000 1,9501,850 Category B D1, E1, F1, ,000 2,150 Total6,000 $4,100$4,000 $ $3,850 $1,850 2,150 $4,000

Lower of Cost or Market The journal entry to record the write down of the inventory based on (1)Individual item basis Loss from decline in value of inventory 250 Inventory 250 **loss = shown as a separate item on the I/S or part of COGS.

Lower of Cost or Market The journal entry to record the write down of the inventory based on (2) Category/Entire inventory basis Loss from decline in value of inventory 100 Allowance for decline in value of inventory 100 Cost of goods sold 100 (when company sells its entire existing inventory)

Learning Objectives 1.Define inventory. 2.Explain the periodic and perpetual inventory system 3.Compute total inventory acquisition cost. 4.Use the four basic inventory valuation methods. 5.Apply the lower-of-cost-or-market (LCM) rule. 6.Use the gross profit method to estimate ending inventory.

Gross Profit Method Inventory estimation techniques are used to generate inventory values when a physical inventory count is not practical. The gross profit method is based on the observation that the relationship between sales and cost of goods sold is usually fairly stable.

Gross Profit Method Exhibit 9-18: Two-step process Estimated COGS Estimated Gross Profit Sales (actual) Estimated COGS Estimated Ending Inventory Cost of goods available for sale (Actual) (1) (2)

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 year40% Two years ago37 Three years ago42 Last year’s 40% is considered a good estimate.

Gross Profit Method Sales (actual)$50,000100% 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 for sale (actual)$65,000 –Ending inventory (estimate) 35,000 =Cost of goods sold (estimate)$30,000

Gross Profit Method Sales (actual)$50,000100% Cost of goods sold (estimate) 29,000 58% Gross profit (estimate)$21,000 42% Beginning inventory (actual)$25,000 +Purchases (actual) 40,000 –Cost of goods available for sale (actual)$65,000 –Ending inventory (estimate) 36,000 =Cost of goods sold (estimate)$29,000

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