CHAPTER 11 Inventory.

CHAPTER 11 Inventory

Checklist Chapter 11 Inventory Basics
Perpetual vs. Periodic Inventory Systems Perpetual Purchase Transactions Perpetual Sales Transactions and Closing Entries Methods of Valuing Inventory Methods of Estimating Inventory Inventory Ratios

Inventory Inventory represents physical goods purchased/manufactured for resale to a customer.

Why is Inventory Important?
A reader of financial statements needs to know how much gross profit a business is generating to make informed business decisions. Examples include: Pricing policies Purchasing decisions The Cost of Goods Sold is directly linked to the value of inventory used.

Two Types of Inventory Systems
Perpetual inventory system Periodic inventory system

Perpetual Inventory System
When a product is sold, the item is instantly removed from the inventory records and the cost of the product is immediately matched to the sale of the product. Example: Supermarket sales. A barcode is scanned and immediately records the sale of inventory

Perpetual Inventory System
You are already familiar with this system. When an item is sold, the cost of the product is immediately matched to the sale so that the gross profit is known each period. CURRENT ASSETS CASH Jan Feb March SHORT-TERM INVESTMENTS SALES REVENUE SALES REVENUE SALES REVENUE $100 $150 $130 ACCOUNTS RECEIVABLE COST OF GOODS SOLD COST OF GOODS SOLD COST OF GOODS SOLD $20 $40 $60 INVENTORY GROSS PROFIT GROSS PROFIT GROSS PROFIT $80 $90 $70 PREPAID EXPENSES

Periodic Inventory System Example: Restaurant
Under a periodic inventory system the value of inventory and cost of goods sold is not known until it is physically counted. When food is sold, the sale is recorded as revenue. However the cost of goods sold and inventory value is not exactly known. At the end of the period, a physical count of ingredients (ending inventory) will help calculate how much was sold, which is then matched to sales for the period. Quarterly Periods

Inventory Systems - Question
True or False? A perpetual inventory system continually tracks changes in inventory, and matches COGS to revenue as the sale is generated. True False

Inventory Systems - Question
Which inventory system is more costly to implement? Perpetual Periodic

PROPERTY, PLANT & EQUIPMENT
Inventory Purchase Assume for the following transactions, that all inventory purchases were made on account. ACCOUNTS PAYABLE 10,000 CR CASH x BANK LOAN ASSETS BALANCE SHEET ACCOUNTS RECEIVABLE UNEARNED REVENUE INVENTORY 10,000 DR PREPAID EXPENSES PROPERTY, PLANT & EQUIPMENT LIABILITIES RETAINED EARNINGS COMMON STOCK STOCKHOLDERS’ EQUITY JOURNAL ACCOUNT TITLE DEBIT CREDIT Inventory 10,000 Accounts Payable Record purchase of inventory

Purchase Returns Goods that are purchased, often need to be returned.
Reasons can include: Incorrect products Over-shipments Inferior quality products

Purchase Returns Entry to record the return of goods purchased on account to supplier ($300 worth of inventory returned): ACCOUNTS PAYABLE 300 DR CASH x BANK LOAN ASSETS BALANCE SHEET ACCOUNTS RECEIVABLE UNEARNED REVENUE INVENTORY 300 CR PREPAID EXPENSES PROPERTY, PLANT & EQUIPMENT LIABILITIES RETAINED EARNINGS COMMON STOCK STOCKHOLDERS’ EQUITY JOURNAL ACCOUNT TITLE DEBIT CREDIT Accounts Payable 300 Inventory Goods returned to supplier

Purchase Allowances (for Goods that have not been Sold)
Rather than returning goods, a business can offer an allowance. The buyer agrees to keep undesirable goods at a reduced cost. An allowance reduces the value of the inventory purchased and reduces the amount owing to the supplier.

Purchase Allowances Occurs when the buyer agrees to keep undesirable goods at a reduced cost. For example: Offer a 20% allowance for the company to keep the goods rather than returning them Calculation: $300 potential return x 20% allowance = $60 ACCOUNTS PAYABLE 60 DR CASH x BANK LOAN ASSETS BALANCE SHEET ACCOUNTS RECEIVABLE UNEARNED REVENUE INVENTORY 60 CR PREPAID EXPENSES PROPERTY, PLANT & EQUIPMENT LIABILITIES RETAINED EARNINGS COMMON STOCK STOCKHOLDERS’ EQUITY JOURNAL ACCOUNT TITLE DEBIT CREDIT Accounts Payable 60 Inventory Allowance for damaged goods (20% x $300)

Purchase Allowances - Question
When recording an allowance for inventory that has been purchased from a supplier but not yet sold to customers, what account should the allowance reduce? Inventory Cost of Goods Sold When product is still in inventory, the adjustment must reduce inventory. When the product has been sold, the adjustment is recorded to COGS.

Purchase Discounts Companies often offer discounts
There are two types of purchase discounts Trade discounts Cash discounts

Trade Discounts Given based on volume of goods purchased
For example: Receive 10% discount for ordering 15 or more products Why are trade discounts useful? Encourages more volume of sales

Cash Discounts A cash discount is used to encourage quick payment from the customer Why are cash discounts useful? Encourages quick payment, which increases cash flow Example: 2/10 net 30 A 2% discount if payment is received in 10 days. The remaining amount must be paid within 30 days.

Cash Discounts Example: 2/10, n/30 2% discount is applied if paid within 10 days. Net amount owing is due in 30 days 1. Original purchase of inventory for $4,200 JOURNAL DATE ACCOUNT TITLE DEBIT CREDIT Jan 10 Inventory 4,200 Accounts Payable Purchased goods 2. Make full payment within the 10 day discount period JOURNAL DATE ACCOUNT TITLE DEBIT CREDIT Jan 15 Accounts Payable 4,200 Cash 4,166 Inventory 84 Paid invoice owing less discount received for early payment

Purchase Discounts - Question
If the payment terms of an invoice dated May 1st are shown as “2/10 net 20”, on which date does the discount expire? May 3 May 21 May 11

Freight FOB Shipping Point Indicates that ownership of the items being purchased changes when the goods leave the seller’s place of business. The buyer pays for the shipping costs. FOB Destination Point Indicates that ownership of the items being purchased changes when the goods arrive at the buyer’s place of business. The seller pays for the shipping costs.

Freight Freight –in: Freight-in costs are added to the cost of inventory CASH ACCOUNTS PAYABLE 60 DR BANK LOAN x ASSETS BALANCE SHEET ACCOUNTS RECEIVABLE UNEARNED REVENUE INVENTORY 100 DR PREPAID EXPENSES PROPERTY, PLANT & EQUIPMENT LIABILITIES RETAINED EARNINGS COMMON STOCK STOCKHOLDERS’ EQUITY 100 CR JOURNAL ACCOUNT TITLE DEBIT CREDIT Inventory 100 Cash Record the payment of freight costs

Sales Transactions Adjusting entries relating to sales are, for the most part, a mirror image of those for purchases. This section will address: Reversing entries Tracking merchandise returns Allowances Discounts allowed

Sales (Perpetual Method)
Two entries to record a cash sale under perpetual system: Record the sale Record the COGS CASH ACCOUNTS PAYABLE BANK LOAN x ASSETS BALANCE SHEET ACCOUNTS RECEIVABLE UNEARNED REVENUE INVENTORY PREPAID EXPENSES PROPERTY, PLANT & EQUIPMENT LIABILITIES RETAINED EARNINGS COMMON STOCK STOCKHOLDERS’ EQUITY INCOME STATEMENT SALES REVENUE 1. Record sale 15,000 CR JOURNAL ACCOUNT TITLE DEBIT CREDIT Cash 15,000 Sales Revenue Record sale to customer EXPENSES 15,000 DR COST OF GOODS SOLD 9,000 DR GROSS PROFIT 2. Record the COGS BAD DEBTS MAINTENANCE x x 9,000 CR DEPRECIATION MISCELLANEOUS x x JOURNAL ACCOUNT TITLE DEBIT CREDIT Cost of Goods Sold 9,000 Inventory Record COGS for above sale INCOME TAX PAYROLL x x INSURANCE RENT x x INTEREST TELEPHONE x x NET INCOME (LOSS)

Tracking Returns Customers can frequently return purchased goods. It is important to track customer returns. High return rate could indicate many problems. To track sales returns and allowances a contra-revenue account is used.

Sales Return and Sales Allowance - Difference
Occurs when undesirable products are returned to the seller Sales Allowance Occurs when the customer decides to keep such undesirable products at a reduced price.

Sales Returns & Allowances
In order to keep track of returns and allowances use a contra revenue account Sales Returns Undesirable product is returned to seller Sales Allowances Customer decides to keep undesirable products at a reduced price INCOME STATEMENT SALES REVENUE SALES RETURNS AND ALLOWANCES EXPENSES COST OF GOODS SOLD GROSS PROFIT DEPRECIATION MISCELLANEOUS x x MARKETING SALARIES x x INSURANCE RENT x x INTEREST TELEPHONE x x NET INCOME (LOSS)

Sales Returns and Allowances Example: Sales Return
How should you record a merchandise return assuming $4,000 worth of goods (i.e. its cost) were sold for $6,000? CASH ACCOUNTS PAYABLE 60 DR BANK LOAN x ASSETS BALANCE SHEET ACCOUNTS RECEIVABLE 6,000 CR UNEARNED REVENUE INVENTORY 4,000 DR PREPAID EXPENSES PROPERTY, PLANT & EQUIPMENT LIABILITIES RETAINED EARNINGS COMMON STOCK STOCKHOLDERS’ EQUITY 100 CRdsdx100 INCOME STATEMENT 1. Record sales return from client SALES REVENUE SALES RETURNS AND ALLOWANCES 6,000 DR JOURNAL ACCOUNT TITLE DEBIT CREDIT Sales Returns & Allowances 6,000 Accounts Receivable Record sales return EXPENSES COST OF GOODS SOLD 4,000 CR GROSS PROFIT 2. Restock inventory returned from client DEPRECIATION MISCELLANEOUS x x INCOME TAX PAYROLL x x JOURNAL ACCOUNT TITLE DEBIT CREDIT Inventory 4,000 Cost of Goods Sold Restock returned inventory INSURANCE RENT x x INTEREST TELEPHONE x x NET INCOME (LOSS)

Sales Returns and Allowances Example: Sales Allowance
A company sold $2,000 of goods on account. How should a sales allowance of $100 be recorded? CASH ACCOUNTS PAYABLE BANK LOAN x ASSETS BALANCE SHEET ACCOUNTS RECEIVABLE 100 CR UNEARNED REVENUE INVENTORY PREPAID EXPENSES PROPERTY, PLANT & EQUIPMENT LIABILITIES RETAINED EARNINGS COMMON STOCK STOCKHOLDERS’ EQUITY INCOME STATEMENT SALES REVENUE SALES RETURNS AND ALLOWANCES 100 DR EXPENSES JOURNAL ACCOUNT TITLE DEBIT CREDIT Sales Returns & Allowances 100 Accounts Receivable Record sales return COST OF GOODS SOLD GROSS PROFIT DEPRECIATION MISCELLANEOUS x x INCOME TAX PAYROLL x x Notice that there is no change to COGS because the goods are not returned. INSURANCE RENT x x INTEREST TELEPHONE x x NET INCOME (LOSS)

Sales Discount On March 1st,Dorval sold $4,000 of services with payment terms of 2/10 net 30. On March 5th, Dorval received payment. How should Dorval record the receipt of payment? CASH ACCOUNTS PAYABLE 60 DR BANK LOAN x ASSETS BALANCE SHEET ACCOUNTS RECEIVABLE 3,920 CR UNEARNED REVENUE INVENTORY 100 DR PREPAID EXPENSES PROPERTY, PLANT & EQUIPMENT LIABILITIES RETAINED EARNINGS COMMON STOCK STOCKHOLDERS’ EQUITY 3,920 DR INCOME STATEMENT SALES REVENUE SALES DISCOUNT 80 DR EXPENSES COST OF GOODS SOLD What is the sales discount amount? $4,000 x 2% = $80 GROSS PROFIT DEPRECIATION MISCELLANEOUS JOURNAL ACCOUNT TITLE DEBIT CREDIT Cash 3,920 Sales Discount 80 Accounts Receivable 4,000 Record payment less discounts owed x x INCOME TAX PAYROLL x x INSURANCE RENT x x INTEREST TELEPHONE x x NET INCOME (LOSS)

Sales Returns and Allowances - Question
True or False? When a customer returns a product, an entry to cost of goods sold is not required. True False

Sales Discount - Question
An invoice in the amount of $100 is dated April 1, with payment terms “2/15 net 25”. If it is paid on April 20, what is the total discount? $0 (i.e. no discount) $2 $15 $25

For the Period Ended mm/dd/yy
Income Statement The multistep income statement can be prepared based on the sales transactions that have occurred: Sample Company Income Statement For the Period Ended mm/dd/yy Separate tracking allows for separate reporting

For the Period Ended mm/dd/yy
Gross Profit Margin When a company tracks sales returns and discounts separately, gross profit margin is calculated using net sales (not sales revenue). Sample Company Income Statement For the Period Ended mm/dd/yy

Closing Entries in a Perpetual Inventory System
Step 1: Adjust Inventory* *Assuming shrinkage = $200 (i.e. the balance in the inventory account was $200 more than the physical count)

ABC Inc.* Adjusted Trial Balance For the Period Ended mm/dd/yy Step 2: Close revenue accounts *A corporation

ABC Inc. Adjusted Trial Balance For the Period Ended mm/dd/yy Step 3: Close expense and debit balance accounts New additions to the usual list

Step 4: Close income summary to retained earnings* *The debit and credit amount for this entry is equal to the net income for the period. Income summary is closed to retained earnings since ABC Inc. is a corporation.

Four Methods of Valuing Inventory
Specific Identification First-In-First-Out (FIFO) Weighted Average Cost Last-In-First- Out (LIFO)

Specific Identification
When items are sold, they can be specifically identified. For example: 3 products are ordered at different times and prices. Each unit has its own serial number and can be specifically identified. When 2 units are sold, the sales are specifically identified Sales $50 $52 $51 Cost of Goods sold = $102 Ending Inventory = $50+$50+$51+$51 = $202 Opening inventory

First-In First-Out (FIFO)
Identifies the value of inventory that was delivered first, as the ones to be sold first.

Purchased Jan 1st Purchased Jan 5th Purchased Jan 7th $50 Suppose you placed 3 orders for a product at different times and prices. $50 $51 $51 $52 $50 $150 $102 $52 $50 Management wants oldest inventory sold first. Therefore when a sale is made, the product that is first in, is the product that is first out. $50 Sold Cost of Goods Sold = 2 x $50 = $100

$50 Management wants oldest inventory sold first. Therefore when a sale is made, the product that is first in, is the product that is first out. $50 Sold Cost of Goods Sold = 2 x $50 = $100 The Cost of Goods Sold for the sale is matched to the cost of the first item purchased in inventory (Jan 1st ). The Ending Inventory is made up of the last items purchased. Ending Inventory = = $204 (4 units) $50 $51 $52

Weighted Average Cost Calculates the value of inventory using an average cost for all units of inventory.

Weighted Average Cost $51 $50 $52 Total Cost of Goods Available for Sale ($150 + $102+ $52 ) Weighted Average Cost per unit Total number of units available for Sale (6 units) = $304 = $50.67 average Calculate the Cost of Goods Sold and the Value of Ending Inventory using the Weighted Average Cost method. Cost of Goods Sold = 2 x $50.67 = $101 Ending Inventory = 4 x $50.67 = $203

Last-In First-Out (LIFO)
Identifies the value of inventory that was delivered last, as the ones to be sold first.

Last in First out (LIFO) (2 items were sold)
Purchased Jan 1st Purchased Jan 5th Purchased Jan 7th $50 Suppose you placed 3 orders for a product at different times and prices. $50 $51 $51 $52 $50 $150 $102 $52 $50 Inventory that is purchased last is sold first. $50 Sold Cost of Goods Sold = = $103

Last in First out (LIFO) (2 items were sold)
$50 Inventory that is purchased last is sold first. $50 Sold Cost of Goods Sold = = $103 The Cost of Goods Sold for the sale is matched to the cost of the last items purchased in inventory (Jan 1st ). The Ending Inventory is made up of first items purchased Ending Inventory = = $201 (4 units) $50 $51

The Effect of Different Valuation Methods
Significantly affecting company’s financial records Changing the value of COGS 4 inventory methods produced different results Summary of Results* Inventory Method Inventory Value Specific Identification $202 FIFO $203 Weighted Average Cost $204 LIFO *Although the values shown above are not materially different from one another, in the real world, they often are. This is because large companies often deal with millions of units and dollars worth of inventory. Once a method of valuing inventory is chosen it must be consistently followed according to GAAP rules.

The Effect of Different Valuation Methods
Other Conclusions: In times where product cost are increasing, FIFO will result in the highest value of ending inventory and LIFO will result in the highest value of cost of goods sold. While specific identification provides the true value of ending inventory and cost of goods sold, it is costly to implement and therefore not practical for items of small value.

Inventory Valuation Methods - Question
Company ABC manufactures identical steel nails for construction. What inventory method is the most logical to use? Specific Identification Weighted Average Cost First in First Out (FIFO) Last in First Out (LIFO) Applies an average cost to all its inventory.

Inventory Valuation Methods - Question
What inventory method is most suitable to value used cars at a dealership? Specific Identification Weighted Average Cost First in First Out (FIFO) Last in First Out (LIFO) Values specific items individually. Example: High value items such as cars, houses and diamonds.

Controls Related to Inventory
Use controls to comply with plans, policies, procedures, regulations and laws Use controls to safeguard inventory Physically protect assets. The facilities storing the inventory must be easily accessible for shipping, but also needs to protect against theft. Use alarm systems, security guards and/or inventory custodian Use controls to ensure the economical and efficient use of resources

Ethics and Inventory What kind of impact does inventory have on a business? Inflating closing inventory reduces the cost of goods sold and increases profit for the current year. Inventory values significantly effect financial statements and profitability of companies. For this reason, manipulating inventory is illegal. It is management’s ethical responsibility to ensure manipulation does not happen. Inventory fraud can happen from the top down and also from the bottom up.

Estimating Inventory In a perpetual inventory system, a company can track the cost of an inventory item from purchase to sale. Therefore, at any given point in time, a company can value their inventory, cost of goods sold and ending inventory. However, when a periodic system is used, accountants do not have this information. Accountants estimate the value of inventory using two methods: Gross Profit Method Retail Method

Basic Calculations To calculate a line item, you need two pieces of information. Sales 125,000 Cost of Goods Sold Opening Inventory 5,000 Purchases 65,000 Cost of Goods Available for Sale 70,000 Closing Inventory 50,000 20,000 Gross Profit ?

Estimating Inventory - Question
What is the value of cost of goods available for sale? Sales 125,000 Cost of Goods Sold Opening Inventory 5,000 Purchases 65,000 Cost of Goods Available for Sale Closing Inventory 50,000 Gross Profit 70,000 55,000 60,000 70,000 195,000

What is the value of closing inventory? Sales 125,000 Cost of Goods Sold Opening Inventory 5,000 Purchases 65,000 Cost of Goods Available for Sale 70,000 Closing Inventory 20,000 Gross Profit 50,000 50,000 55,000 75,000 90,000

What is the value of gross profit given a gross profit margin of 50% Sales 100,000 Cost of Goods Sold Opening Inventory 5,000 Purchases 65,000 Cost of Goods Available for Sale 70,000 Closing Inventory Gross Profit 50% 50,000 70,000 50,000 65,000 None of the above

Inventory Valuation at the Lower of Cost or Market
GAAP Principle of Conservatism asserts the use of the accounting method that produces the lowest value for assets must always be used Lower of Cost or Market (LCM) principle must be used when valuing inventory When inventory is sold below cost, it is the selling price that is used to value inventory, not the purchase price Inventory items can never be valued at more than their purchase price We will demonstrate how this is done by using Elan’s Camera Shop as an example. The chart on the next slide details the cost and selling price of all their inventory.

Lower of Cost or Market Applied at Three Levels
Lower of Cost or Market Example Description Category Cost Selling Price Individual Total Film Type 1 Supplies $100 $90 Film Type 2 500 520 Total Supplies 600 610 Camera A Cameras 1,000 Camera B 2,000 2,200 Total Cameras 3,000 3,200 Accessory 1 Accessories 2,900 Accessory 2 4,000 3,500 Total Accessory 7,000 6,400 $10,600 $10,210 $90 500 $600 1,000 2,000 3,000 2,900 3,500 6,400 $9,990 $10,000 $10,210

Lower of Cost or Market Transaction
The cost of the inventory is over-stated by $610. To adjust this amount, the following journal entry should be recorded. JOURNAL ACCOUNT TITLE DEBIT CREDIT Cost of Goods Sold 610 Inventory To adjust inventory to LCM on an individual item basis

Gross Profit Method Based on previous years, a figure of 50% for gross profit margin will be used to estimate inventory. Three steps of estimating closing inventory What is the value of Gross Profit? 1 Sales 100,000 Cost of Goods Sold Opening Inventory 4,000 Given Purchases 65,000 Cost of goods available for Sale 69,000 Closing Inventory Gross Profit 50% = Sales x Gross Profit Margin = 100,000 x 50% = 50,000 2 What is the value of COGS? = Sales – Gross Profit =100,000 – 50,000 =50,000 ? 19,000 3 ? 50,000 2 ? 50,000 1 3 What is the value of closing inventory? Use 50% Gross Profit Margin = Cost of goods available for sale – COGS = Inventory minus what was sold = 69,000 – 50,000 = 19,000

What is the value of closing inventory using a 45% Gross Profit Margin? Sales 125,000 Cost of Goods Sold Opening Inventory 5,000 Given Purchases 65,000 Cost of Goods Available for Sale ? Closing Inventory ? Gross Profit 1,875 -8,750 1,250 None of the above

Estimating Inventory - Solution
Sales 125,000 Cost of Goods Sold Opening Inventory 5,000 Given Purchases 65,000 Cost of Goods Available for Sale Closing Inventory Gross Profit Use 45% Gross Profit Margin 1 Gross Profit: = Sales x 45% Gross Profit Margin 2 4 70,000 1,250 5 COGS = Sales – gross profit 3 68750 3 56,250 45% 2 1 Cost of goods available for sale = Opening inventory + purchases 4 Closing Inventory = COGS available for sale – COGS 5

Gross Margin Method If gross margin varies significantly from year to year, using a historical average of Gross Profit Margin to estimate ending inventory may be inaccurate. The second method of estimating inventory is the Retail Method.

Retail Method Retail businesses track both the selling price and the purchase cost of goods sold. Purchase cost Selling Price This information provides another way to estimate ending inventory.

Estimating Ending Inventory
Suppose a retail store wants to estimate the cost of ending inventory using the information shown below. Cost Retail Beginning Inventory $70,000 140,000 Purchases 240,000 480,000 Cost of Goods Available for Sale $ 310,000 620,000 Net Sales $ 400,000 Ending Inventory First step: calculate the retail value of ending inventory $220,000 ? Subtract net sales from the retail value of goods available for sale.

Second step: calculate the cost-to-retail ratio Cost Retail Beginning Inventory $70,000 140,000 Purchases 240,000 480,000 Cost of Goods Available for Sale $ 310,000 620,000 Net Sales $ 400,000 Ending Inventory 220,000 Second step: calculate the cost-to-retail ratio. Cost of Goods Available for Sale at cost $ 310,000 50% 620,000 Cost Goods Available for Sale at retail

Third step: Estimate the cost of ending inventory using cost-to-retail ratio. Cost Retail Beginning Inventory $70,000 140,000 Purchases 240,000 480,000 Cost of Goods Available for Sale $ 310,000 620,000 Net Sales $ 400,000 Ending Inventory 220,000 Third step: Apply the cost-to-retail ratio of 50%. ? $110,000 Ending Inventory (cost) = cost-to-retail ratio x retail value = 50% x $220,000 = $110,000

Using the retail method of valuing inventory, what is the value of ending inventory at cost? 50% cost-to-retail, Closing inventory $50,000 62.5% cost-to-retail, Closing inventory $62,500 55% cost-to-retail, inventory $55,000 None of the above Cost Retail Beginning Inventory $60,000 120,000 Purchases 50,000 80,000 Goods Available for Sale $ 110,000 200,000 Net Sales $ 100,000 Ending Inventory $55,000 ? 100,000

Retail Method A store's cost-to-retail ratio may vary significantly from one type of item to another. If the items that actually sold have a cost-to-retail ratio that differs significantly from the simple ratio used in the calculation, the estimate will be inaccurate.

Inventory Ratios What is the purpose of analyzing inventory ratios? A company can measure how well inventory is being managed by using inventory ratios. Too much inventory means capital is tied up. Too little inventory means that customer demand is not being met.

Inventory Ratios Inventory turnover = Cost of Goods Sold Average Inventory* *Note* When insufficient information is available to calculate averages, use ending the inventory. Inventory turnover ratio: Estimates how many times a year a company is selling inventory.

Inventory Ratios - Question
What is the formula for Inventory Turnover? Inventory / COGS Avg. Inventory / COGS COGS / Inventory COGS / Avg. Inventory Inventory Turnover COGS Avg. Inventory = Average Beginning inventory + Ending Inventory 2

What is the inventory turnover ratio for company ABC? 0.11 0.10 10.00 11.11 Beginning Inventory $100,000 Ending Inventory $80,000 Cost of goods sold $1,000,000 Inventory Turn over COGS 1,000,000 = = = 11.11 Avg. Inventory 90,000 This means company ABC on average sells inventory 11 times a year

Which company has a better inventory turnover? Company A Company B Company A Beginning Inventory $45,000 Ending Inventory $65,000 Cost of goods sold $275,000 Inventory Turnover Ratio 5 Company B Beginning Inventory $150,000 Ending Inventory $200,000 Cost of goods sold $1,400,000 Inventory Turnover Ratio 8

A low inventory turnover rate could mean a company is overstocking their inventory. True or false? True False A low inventory rate of say 3 times per year means a company sells out inventory 3 times per year (not often). This could mean the company is overstocking inventory depending on the industry. Inventory cost money to hold. Companies need to pay attention to this ratio and stock the correct amount of inventory.

Inventory Days on Hand The inventory turnover ratio measures the number of times a company sells its inventory during the year. Inventory Days on Hand estimates how many days it takes to move items out of inventory. In other word's, how many days inventory will last given the current rate of sales. # of days in fiscal period 365 Inventory Days on Hand = Inventory Turnover Avg. Inventory or x 365 Cost of Goods Sold

What is the formula for Inventory Days on Hand? 365 / Average Sales 365 / Inventory Turnover Inventory Turnover / 365 Sales / 365

What is the Inventory Days on Hand for company XYZ? 0.04 days 19.01 days 22.26 days 25.56 days Beginning Inventory $26,000 Ending Inventory $35,000 Average inventory $30,500 Cost of goods sold $500,000 Inventory Days on Hand Average Inventory = x 365 = COGS 30,500 = x 365 = 22.26 days 500,000 This means company ABC on average sells out their inventory every days.

Which company sells inventory quicker? Company A Company B Company A Inventory Turnover Ratio 5 Cost of goods sold 600,000 Inventory Days on Hand Inventory Days on Hand = 365 / 5 =73 Company B Inventory Turnover Ratio 8 Cost of goods sold 400,000 Inventory Days on Hand Inventory Days on Hand = 365/8 = 45.6 This means company A on average sells out inventory every 73 days compared to Company B who sells out every 45.6 days

A manager at Company ABC has performed a ratio analysis to determine how effective inventory is being managed. He has found a decreasing trend in inventory days on hand and is very worried that capital is being tied up in overstocking. Are his worries justified? Yes No Inventory Days on Hand estimates how many days it takes to move items out of inventory. A decreasing trends means stock is being sold more quickly. If inventory days on hand gets too low, however, the manager should be worried that they are under- stocking inventory.

Do you think a very high inventory turnover is always good? Yes No A very high inventory may result in lack of customer service, stock-outs, increased purchasing costs. Its all in the balance. Hence the importance of trend and forecast analysis.

Application of Ratio Analysis
Simply memorizing equations and calculating a ratio is not as critical as understanding what the ratio demonstrates. Yearly trends determine the direction a company is moving towards, allowing managers to draw sound conclusions. Always try to ask “so what?” What is the implication of a ratio? What is the trend? How does this effect profitability? What changes can be made to improve these ratios?

End of Chapter 11

CHAPTER 11 Inventory.

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CHAPTER 11 Inventory.

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