INVENTORIES AND COST OF GOODS SOLD

INVENTORIES AND COST OF GOODS SOLD
Chapter 8 INVENTORIES AND COST OF GOODS SOLD Chapter 8: Inventories and cost of goods sold. 2

Goods owned and held for sale to customers
Inventory Defined Inventory Goods owned and held for sale to customers Current asset Inventory includes all goods that a company owns and holds for sale, regardless of where the goods are located when inventory is counted. Inventory is reported as a current asset on the balance sheet.

The Flow of Inventory Costs
BALANCE SHEET Asset Inventory Purchase costs (or manufacturing costs) as goods are sold INCOME STATEMENT Revenue Cost of goods sold Gross profit Expenses Net income Companies that sell inventory report the value of the inventory they have in stock at the end of the period as a current asset on the balance sheet. Companies that sell inventory also have an additional expense item called Cost of Goods Sold on their income statements. The Cost of Goods Sold account represents the cost of the inventory sold during the period to help earn revenue. Cost of Goods Sold is presented as a separate expense item on the income statement. Net Sales minus Cost of Goods Sold equals Gross Profit. Gross Profit is the amount left, after subtracting the cost of inventory sold, to cover all other expenses and a profit.

The Flow of Inventory Costs
In a perpetual inventory system, inventory entries parallel the flow of costs. Remember that in a perpetual inventory system, inventory purchases are recorded by a debit to Inventory and a credit to Accounts Payable. This entry is similar to the entry made when any asset is purchased, such as a truck or land. The cost entry on the sale date requires a debit to Cost of Goods Sold and a credit to Inventory for the cost of the inventory sold.

Which Unit Did We Sell? 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. On the sale date, a natural question arises: What is the unit cost of the inventory being sold? If all the inventory has the same unit cost, then this is not a difficult question to answer. However, in most cases, companies will have identical units of inventory in stock that have different unit costs. Let’s see how to determine the cost of a unit of inventory sold.

Inventory Subsidiary Ledger
A separate subsidiary account is maintained for each item in inventory. In this example, ten laser lights are sold. There are one hundred seventy-five laser lights in stock. Of those in stock, thirty dollars each for one hundred units and fifty dollars each for seventy five units was paid. So, how is the exact cost of the ten units we are selling on September 10th determined? How can we determine the unit cost for the Sept. 10 sale?

Learning Objective In a perpetual inventory system, you are to determine the cost of goods sold using (a) specific identification, (b) average cost, (c) FIFO, and (d) LIFO. You should be able to discuss the advantages and shortcomings of each method. Learning objective number 1 is to determine cost of goods sold in a perpetual inventory system using (a) specific identification, (b) average cost, (c) FIFO, and (d) LIFO. You should be able to discuss the advantages and shortcomings of each method. LO1

Specific Identification
Inventory Cost Flows We use one of these inventory valuation methods to determine cost of inventory sold. Specific Identification Average Cost LIFO FIFO There are four ways to determine the cost of inventory sold: Specific Identification First-in, First-out -- also known as FIFO Last-in, First-out -- also known a LIFO, and Average Cost Now, let’s see how these methods work.

Data for an Illustration
The Bike Company (TBC) Take a minute and review this chart for The Bike Company. This data will be used throughout the perpetual inventory examples to compare results.

When a unit is sold, its specific cost is added to cost of goods sold. First, let’s look at the specific identification method. In this method, the specific cost of each unit that is sold is known. It is most commonly used in businesses that have low sales volume of high dollar items, like car dealerships, exclusive jewelry stores, and custom builders.

On August 14, TBC sold 20 bikes for $130 each. Of the bikes sold 9 originally cost $91 and 11 cost $106. On August 1st and 3rd, TBC purchases inventory. On August 14th, they sell 9 bikes that cost $91 each and 11 bikes that cost $106 each. What is the total cost of goods sold on August 14th?

The Cost of Goods Sold for August 14th is $1,985. After this sale, TBC has 5 units in inventory: 1 unit that costs $91 and 3units that cost $106 each. The Cost of Goods Sold for the August 14 sale is $1,985, leaving $515 and 5 units in inventory. Let’s look at the entries for the Aug. 14 sale.

Retail (20 × $130) Part I Remember that in a perpetual inventory system, two entries are required to record a sale. Part II The first entry is to record the sale at retail and involves Cash or Accounts Receivable and Sales. In our example, we debit Cash for $2,600 ( 20 bikes at $130 each), and credit Sales for the same amount. Part III The second entry is to record Cost of Goods Sold at cost and remove the items sold from Inventory. In our case, we debit Cost of Goods Sold for $1,985 and credit Inventory for the same amount. We determined the Cost of Goods Sold amount on the previous screen. We will make a similar set of entries each time we have a sale. Cost A similar entry is made after each sale.

Cost of Goods Sold for August 31 = $2,610 Part I Next, TBC makes a purchase on August 17th and another on August 28th. Part II On August 31st, TBC sell 23 bikes: 1 that cost $91; 3 that cost $106 each; 15 that cost $115 each; and 4 that cost $119 each. How much is the cost of goods sold on August 31st? Part III The Cost of Goods Sold for the August 31st sale is $2,610. After the August 31st sale, TBC has 12 units in inventory: 1 unit that cost $106; 5 units that cost $115 each; and 6 units that cost $119 each. Additional purchases were made on August 17 and 28. Costs associated with sales on August 31 were as follows: $91, $106, $115, & $119.

Income Statement COGS = $4,595 Using the specific identification method, TBC would report Cost of Goods Sold on their August income statement of $4,595 and they would report Ending Inventory on the balance sheet of $1,395. Balance Sheet Inventory = $1,395

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. Because specific identification is impractical to use in most businesses, there are three alternatives that can be used to determine the cost of inventory sold. Let’s look at the Average Cost Method first.

Average-Cost Method When a unit is sold, the average cost of each unit in inventory is assigned to cost of goods sold. When using average cost, assign the average cost of the goods available for sale to cost of goods sold. The average cost is determined by dividing the cost of goods available for sale by the units on hand. Cost of Goods Available for Sale Units on hand on the date of sale ÷

The average cost per unit must be computed prior to each sale.
Average-Cost Method The average cost per unit must be computed prior to each sale. Part I On August 1st and 3rd, TBC purchases inventory. On August 14th, they sell 20 bikes. What is the total cost assigned to the bikes sold on August 14th? Part II First, TBC needs to compute the average cost of the items in inventory. They do this by dividing the cost of goods available for sale of $2,500 by the total units in inventory of 25. The average cost per unit is $100. $2,500  25 = $100 On August 14, TBC sold 20 bikes for $130 each.

The average cost per unit is $100.
Average-Cost Method The average cost per unit is $100. Then, to determine the Cost of Goods Sold for August 14th, multiply the number of units sold by the average cost. This calculation determines that the Cost of Goods Sold for August 14th is $2,000. After this sale, TBC has 5 units in inventory at an average cost of $100 each. $100 = $2,500  25 Let’s look at the entries for the Aug. 14 sale.

A similar entry is made after each sale.
Average-Cost Method Retail Cost The entries to record the August 14th sale using average cost are shown on this slide. A similar entry is made after each sale.

Average-Cost Method Next, TBC makes two purchases on August 17th and August 28th. On August 31st, TBC sell 23 bikes. What is the average cost of the items in inventory on August 31st? Additional purchases were made on August 17 and August 28. On August 31, an additional 23 units were sold.

Average-Cost Method $114 = $3,990  35
TBC will divide the cost of goods available for sale of $3,390 by the total units in inventory of 35. The average cost per unit is $114. $114 = $3,990  35

The average cost per unit is $114.
Average-Cost Method The Cost of Goods Sold for August 31st is $2,622. After this sale, TBC has 12 units in inventory at an average cost of $114 each. The average cost per unit is $114. $114 = $3,990  35

Average-Cost Method $114 × 12 = $1,368 COGS = $4,622 Income Statement
Using the weighted average method, TBC would report Cost of Goods Sold on their August income statement of $4,622. And they would report Ending Inventory on the balance sheet of $1,368. Balance Sheet Inventory = $1,368 $114 × 12 = $1,368

First-In, First-Out Method (FIFO)
Oldest Costs Recent Costs Costs of Goods Sold The first-in, first-out method is abbreviated FIFO and pronounced as Fifo. When using FIFO, the older costs are assigned to the units sold. That leaves the more recent costs to be used to value ending inventory. Ending Inventory

The Cost of Goods Sold for the August 14 sale is $1,970, leaving $530 and 5 units in inventory. Part I On August 1st and 3rd, TBC purchases inventory. On August 14th, they sell 20 bikes. What is the total cost assigned to the bikes sold on August 14th? Part II First, TBC assigns the cost of the 10 oldest inventory items purchased on August 1st at $91 each. Now, they need 10 more units, so they move down to the next purchase on August 3rd and include the cost of 10 units from this purchase at $106 each. The Cost of Goods Sold for August 14th is $1,970. After this sale, TBC has 5 units in inventory at a cost of $106 each. On August 14, TBC sold 20 bikes for $130 each.

Retail Cost Here are the entries to record the August 14th sale using FIFO. A similar entry is made after each sale.

Part I TBC makes 2 purchases on August 17th and August 28th. On August 31st, TBC sells 23 bikes. How much is the cost of goods sold on August 31st? Part II First, TBC takes the cost of the 5 remaining units from the August 3rd purchase at $106 each. Then, they move down to the next purchase on August 17th and take the cost of 18 units at $115 dollars each. The Cost of Goods Sold for August 31st is $2,600. After the August 31st sale, TBC has 12 units in inventory: 2 units at $115 each and 10 units at $119 each. Cost of Goods Sold for August 31 = $2,600 Additional purchases were made on Aug. 17 and Aug. 28. On August 31, an additional 23 units were sold.

Income Statement COGS = $4,570 Using the FIFO method, TBC would report Cost of Goods Sold on their August income statement of $4,570. They would report Ending Inventory on the balance sheet of $1,420. Balance Sheet Inventory = $1,420

Last-In, First-Out Method (LIFO)
Recent Costs Oldest Costs Costs of Goods Sold The last-in, first-out method is abbreviated LIFO and pronounced as Lifo. When using LIFO, we assign the most recent costs to the units sold. That leaves the older costs to be used to value ending inventory. Ending Inventory

The Cost of Goods Sold for the August 14 sale is $2,045, leaving $455 and 5 units in inventory. Part I On August 1st and 3rd, TBC purchases inventory. On August 14th, they sell 20 bikes. What is the total cost assigned to the bikes sold on August 14th? Part II First, TBC assigns the cost of the 15 most recent inventory items purchased on August 3rd at $106 each. Now, they need 5 more units, so they move up to the next most recent purchase on August 1st and include the cost of 5 units from this purchase at $91 each. The Cost of Goods Sold for August 14th is $2,045. After this sale, TBC has 5 units in inventory at a cost of $91 each. On August 14, TBC sold 20 bikes for $130 each.

Retail Cost Here are the entries to record the August 14th sale using LIFO. A similar entry is made after each sale.

TBC makes two purchases on August 17th and August 28th. On August 31st, TBC sells 23 bikes. How much is the cost of goods sold on August 31st? Additional purchases were made on Aug. 17 and Aug. 28. On Aug. 31, an additional 23 units were sold.

First, TBC takes the cost of the 10 units from the most recent purchase on August 28th at $119 each. Then, they move up to the next most recent purchase on August 17th and take the cost of 13 units at $115 each. The Cost of Goods Sold for August 31st is $2,685. After the August 31st sale, TBC has 12 units in inventory: 5 units at $91 each and 7 units at $115 each. Cost of Goods Sold for August 31 = $2,685

Income Statement COGS = $4,730 Using LIFO, TBC would report Cost of Goods Sold of $4,730 on their August income statement. They would report Ending Inventory on the balance sheet of $1,260. Balance Sheet Inventory = $1,260

This slide provides a summary of some of the key differences among the four inventory valuation methods. Take a few minutes to review it.

SO… COMPANIES CAN MANIPULATE INCOME STATEMENTS AND PAY LESS TAXES USING LIFO AND BOOST THE BALANCE SHEET USING FIFO BUT YOU SHOULD USE THE SAME METHOD CONSTANTLY!!!

The Principle of Consistency
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 limits companies’ ability to switch accounting methods from period to period. The goal of this principle is to provide users with financial statements prepared using consistent accounting principles from one period to the next. This allows users to more easily make comparisons from period to period. However, a company doesn’t have to use the same accounting principle forever. If a company has a good reason to change accounting principles, they can.

To explain the need for taking a physical inventory.
Learning Objective To explain the need for taking a physical inventory. Learning objective number 2 is to explain the need for taking a physical inventory. LO2

Taking a Physical Inventory
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. Most companies take a physical count of inventory at least once a year. Theoretically, the physical count should match the number of items in the inventory records. In reality, this is not the case. The physical count does not match the records due to spoilage, breakage, damage, obsolescence, and theft. The physical count helps get records up to date to reflect what is actually on hand. Remember from Chapter 6 that when a physical count identifies inventory shrinkage, an entry is made to debit Cost of Goods Sold and credit Inventory. This entry increases Cost of Goods Sold, an expense account, and decreases the Inventory account.

Goods In Transit 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. FOB stands for Free On Board. FO B terms designate when titles pass and who pays transportation costs. If the shipping terms are Free On Board shipping point, that means ownership transfers from the seller to the buyer when the seller provides the goods to the carrier. It also means that the buyer will pay the transportation cost. On the other hand, if the shipping terms are Free On Board destination, that means ownership transfers from the seller to buyer when the buyer receives the goods. It also means that the seller will pay the transportation cost. If goods are shipped FOB Shipping Point and the goods are in transit at year end, then the buyer owns the goods in transit and will pay the transportation costs. In this case, the transportation cost will be added to the merchandise inventory account. Year End

Learning Objective In a periodic inventory system, you are to determine the cost of goods sold using (a) specific identification, (b) average cost, (c) FIFO, and (d) LIFO. Learning objective number 4 is to determine cost of goods sold in a periodic inventory system using (a) specific identification, (b) average cost, (c) FIFO, and (d) LIFO. LO4

Periodic Inventory Systems
In a periodic inventory system, inventory entries are as follows. Recall that in a periodic inventory system, purchases of inventory are recorded with a debit to Purchases, not Inventory, and a credit to Accounts Payable. Note that an entry is not made to inventory.

In a periodic inventory system, inventory entries are as follows. Remember that in a periodic inventory system, a sale of inventory requires only one entry: a debit to Accounts Receivable and a credit to Sales for the retail amount of the sale. The cost entry that was made under the perpetual inventory system is not required because the periodic system does not attempt to keep the Inventory and Cost of Good Sold accounts up to date.

The inventory on hand and the cost of goods sold for the year are not determined until year-end. Remember that because the periodic system does not maintain a cost of goods sold account, cost of goods sold must be calculated at the end of the period.

We use one of these inventory valuation methods in a periodic inventory system. Specific identification LIFO Average cost FIFO Now let’s see how to use the inventory valuation methods in a periodic inventory system.

Information for the Following Inventory Examples
Take a minute to review this chart for Computers, Incorporated. This data will be used throughout the periodic inventory examples and to compare the results at the end.

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. First, let’s look at the specific identification method. Remember that in this method, the specific cost of each unit in inventory is known. At the end of the period, inventory is counted and cost is determined. Computers, Incorporated, counted 1,200 mouse pads with a cost of $6,400. This is enough information to determine Cost of Goods Sold for the year.

Cost of Goods Sold $9,725 - $6,400 = $3,325 To calculate Cost of Goods Sold for the period, start with Goods Available for Sale of $9,725 dollars and subtract Ending Inventory, based on the physical count, of $6,400.

The average cost is calculated at year-end as follows:
Average-Cost Method The average cost is calculated at year-end as follows: Total Cost of Goods Available for Sale Total Number of Units Available for Sale When using average cost, assign the average cost of the goods available for sale to cost of goods sold. The average cost is determined by dividing the cost of goods available for sale for the period by the units available for sale for the period. Let’s see how this works. ÷

Average-Cost Method Avg. Cost $9,725  1,800 = $5.40278
Ending Inventory Avg. Cost $ 1,200 = $6,483 Cost of Goods Sold Avg. Cost $ 600 = $3,242 Part I First, determine the average cost by taking Goods Available for Sale for the period and divide it by the number of units available for sale during the period. In this example, this calculation would be $9,725 divided by 1,800 units. The average cost is dollars. Part II To determine Ending Inventory, take the number of units in inventory and multiply by the average cost. To determine Cost of Goods Sold, take the number of units sold and multiply by the average cost.

Oldest Costs Recent Costs Costs of Goods Sold When using FIFO, assign the older costs to the units sold. That leaves the more recent costs to be used to value ending inventory. Ending Inventory

Remember: Start with the 11/29 purchase and then add other purchases until you reach the number of units in ending inventory. For Computers, Incorporated, there are 1,200 units in Ending Inventory. To determine their cost using FIFO, start with the most recent purchase and then add other purchases until 1,200 units are accounted for. Let’s see how this works.

Part I Start with the November 29th purchase of 150 units. Part II Add the units from the September 15th purchase, the June 20th purchase, the January 3rd purchase, and 400 units from the beginning inventory. This accounts for all 1,200 units on hand. The cost of these units is determined by taking the units times their respective cost amount. Part III Ending Inventory is $6,575. The Cost of Goods Sold value for the 600 units sold is determined using the first costs in. Start with the beginning inventory and account for all 600 units. The Cost of Goods Sold is $3,105. As a double check, when you add together the Ending Inventory and the Cost of Goods Sold, you should get the Cost of Goods Available for Sale. Now, we have allocated the cost to all 1,200 units in ending inventory. Now, let’s complete the table.

Completing the table summarizes the computations just made. Here is the completed table using FIFO in a periodic inventory valuation system.

Recent Costs Oldest Costs Costs of Goods Sold When using LIFO, assign the most recent costs to the units sold. That leaves the older costs to be used to value ending inventory. Ending Inventory

Remember: Start with beginning inventory and then add other purchases until you reach the number of units in ending inventory. For Computers, Incorporated, there are units in Ending Inventory. To determine their cost using LIFO, start with the beginning inventory and then add other purchases until 1,200 units are accounted for. Let’s see how this works.

Part I Start with the beginning inventory of 1,000 units. Part II Add 200 units from the January 3rd purchase. This accounts for all 1,200 units on hand. The cost of these units is determined by taking the units times their respective cost amount. Part III Ending Inventory is $6,310. The Cost of Goods Sold value for the 600 units sold is determined using the last costs in. Start with the November 29th purchase of 150 units. Then add the units from the September 15th purchase, the June 20th purchase, and 100 units from the January 3rd purchase. The Cost of Goods Sold is $3,415. As a double check, when Ending Inventory and the Cost of Goods Sold are added together, they should equal the Cost of Goods Available for Sale. Now, we have allocated the cost to all 1,200 units in ending inventory. Next, let’s complete the table.

Completing the table summarizes the computations just made. Here is the completed table using LIFO in a periodic inventory valuation system.

Learning Objective To estimate the cost of goods sold and ending inventory by the gross profit method and by the retail method. Learning objective number 6 is to estimate the cost of goods sold and ending inventory by the gross profit method and by the retail method. LO6

For interim financial statements, we may need to estimate ending inventory and cost of goods sold.
It is expensive and time consuming to take a physical count of inventory. As a result, in interim financial statements, most companies estimate ending inventory and cost of goods sold. Using this estimate helps avoid having to shut down production or close the doors to the business to do a physical count. Let’s look at two methods used to estimate inventory for interim financial statements.

The Gross Profit Method
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. When using the gross profit method, follow these three steps. First, determine the Cost of Goods Available for Sale. This can be done using accounting data. Second, estimate Cost of Goods Sold by multiplying Net Sales by the cost ratio. The cost ratio is based on past history of the company. Third, deduct the Cost of Goods Sold estimate from the Cost of Goods Available for Sale to determine Ending Inventory. Let’s look at an example of the Gross Profit Method.

In March of 2007, Matrix Company’s inventory was destroyed by fire. Matrix normal gross profit ratio is 30% of net sales. At the time of the fire, Matrix showed the following balances: In March of 2007, Matrix’s inventory was destroyed by fire. Past history shows that Matrix’s normal Gross Profit ratio is 30% of Net Sales. Here are some other balances in Matrix’s accounting records: Sales were $31,500; Sales Returns were $1,500; Beginning Inventory was $12,000, and the Net Cost of Goods Purchased was $20,500. Let’s estimate the amount of the inventory lost in the fire.

× 70% Step 1 Step 2 Part I First, determine the Cost of Goods Available for Sale. This is calculated by adding Beginning Inventory and the Net Cost of Goods Purchased. The Cost of Goods Available for Sale is $32,500. Part II Second, estimate Cost of Goods Sold by multiplying Net Sales by the cost ratio. To accomplish this, remember that Net Sales minus Cost of Goods Sold equals Gross Profit. Since the Gross Profit ratio is 30%, then the Cost of Goods Sold Ratio has to be 70%. Net Sales is calculated as Sales minus Sales Returns and Sales Discounts. In this problem, there are only Sales Returns. Seventy percent of $30,000 is $21,000, which is the estimate of the Cost of Goods Sold. Part III Third, deduct the Cost of Goods Sold estimate from the Cost of Goods Available for Sale to determine Ending Inventory, which in this case is $11,500. Step 3

To compute the inventory turnover rate and explain its uses.
Learning Objective To compute the inventory turnover rate and explain its uses. Learning objective number 7 is to compute the inventory turnover rate and explain its uses. LO7

Measures how quickly a company sells its merchandise inventory.
Financial Analysis Measures how quickly a company sells its merchandise inventory. The Inventory Turnover Rate measures how quickly a company sells its inventory. A ratio that is low compared to competitors suggests inefficient use of assets. To calculate this ratio, take Cost of Goods Sold and divide by Average Inventory. Average Inventory = (Beginning Inventory + Ending Inventory) ÷ 2 A ratio that is low compared to competitors suggests inefficient use of assets.

Measures how many days on average it takes to sell its inventory.
Financial Analysis Measures how many days on average it takes to sell its inventory. The Average Number of Days to Sell Inventory ratio measures how many days on average it takes to sell inventory. It is calculated as Number of Days in the Year divided by Inventory Turnover. 97 97

Accounting Methods Can Affect Financial Ratios
Remember that identical companies that use different inventory methods (e.g., FIFO and LIFO) will have different inventory turnover ratios. Remember that using different accounting principles, such as FIFO and LIFO, can make a difference in the ratios between two comparable companies. 97 97

End of Chapter 8 End of Chapter 8. 4

INVENTORIES AND COST OF GOODS SOLD

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