Inventories and Cost of Goods Sold

Inventories and Cost of Goods Sold
Chapter 7 Inventories and Cost of Goods Sold PowerPoint Authors: Brandy Mackintosh Lindsay Heiser Chapter 7: Inventories and Cost of Goods Sold.

Describe the issues in managing different types of inventory.
Learning Objective 7-1 Describe the issues in managing different types of inventory. Learning objective number 7-1 is to describe the issues in managing different types of inventory.

Inventory Management Decisions
The primary goals of inventory managers are to: 1. Maintain a sufficient quantity to meet customers’ needs 2. Ensure quality meets customers’ expectations and company standards 3. Minimize the costs of acquiring and carrying the inventory As an inventory manager you must be sure there are sufficient quantities on hand to meet customer needs. Additionally, you must ascertain that the quality of your inventory meets customers’ expectations and your own company’s standards, and you must control the cost of acquiring and storing inventory.

Types of Inventory Merchandisers . . . Buy finished goods.
Sell finished goods. Manufacturers . . . Buy raw materials. Produce and sell finished goods. Raw Materials Work in Process Finished goods Merchandise inventory Materials waiting to be processed Partially complete products Completed products awaiting sale Part I Merchandising companies purchase finished goods from suppliers for resale to customers. Manufacturing companies purchase raw materials from suppliers and produce and sell finished goods to customers. Part II Manufacturing companies report three types of inventory on their balance sheets: raw materials, work in process and finished goods. Merchandising companies do not have to distinguish between raw materials, work in process, and finished goods. They report one inventory number on their balance sheet labeled merchandise inventory. Part III Raw materials are the materials used to make the product. Work in process consists of units of product that are partially complete, but will require further work to be saleable to customers. Finished goods consists of units of product that have been completed, but not yet sold to customers. We focus on merchandise inventory, but be aware that the concepts we cover apply equally to manufacturers’ inventory.

Explain how to report Inventory and Cost of Goods Sold.
Learning Objective 7-2 Explain how to report Inventory and Cost of Goods Sold. Learning objective number 7-2 is to explain how to report inventory and cost of goods sold.

Balance Sheet and Income Statement Reporting
Part I Normally, Inventory is reported in the current asset section of the Balance Sheet because it will be converted into cash within one year. Part II When a company sells goods, it removes their cost from the Inventory account and reports the cost on the Income Statement as the expense Cost of Goods Sold. Cost of Goods sold is deducted from Net Sales to obtain Gross Profit.

Cost of Goods Sold Equation
BI + P – CGS = EI National Outfitters’ beginning inventory was $4,800. During the period, the company purchased inventory for $10,200. The cost of goods sold for the period is $9,000. Compute the ending inventory. Cost of Goods Sold Calculation + = - Beginning Inventory Purchases Cost of Goods Available for Sale Cost of Goods sold Ending Inventory $ 4,800 10,200 15,000 9,000 $ 6,000 Part I The Cost of Goods Sold calculation starts with Beginning Inventory (BI). To Beginning Inventory we add the amount of inventory purchased (P) during the period and then subtract Cost of Goods Sold (CGS) to get the Ending Inventory (EI) National Outfitters’ Beginning Inventory was $4,800. During the period, the company purchased inventory for $10,200. The Cost of Goods Sold for the period is $9,000. Compute the Ending Inventory. Part II Beginning Inventory plus Purchases equal cost of goods available for sale. We then subtract Cost of Goods Sold from cost of goods available of sale to get Ending Inventory.

Cost of Goods Sold Equation
beginning Inventory $4,800 purchases $10,000 + goods available for sale $15,000 ending Inventory $6,000 Still Here (Balance Sheet) Cost of Goods Sold $9,000 Sold (Income Statement) Part I A company starts with its beginning Inventory and then purchases additional inventory during the period. Part II When we add beginning Inventory and purchases together, we get goods available for sale. The amount represents all the inventory that we could possibly sell during the period. Part III The Inventory that is sold from goods available for sale is placed into Cost of Goods Sold. Part IV If we do not sell all the goods available for sale, we place the unsold Inventory in ending Inventory. Ending Inventory represents Inventory that is still on hand.

Compute costs using four inventory costing methods.
Learning Objective 7-3 Compute costs using four inventory costing methods. Learning objective number 7-3 is to compute costs using four inventory costing methods.

Inventory Costing Methods
Specific identification First-in, first-out (FIFO) Last-in, first-out (LIFO) When we purchase inventory items at various prices, we must decide how we will associate cost with the item sold. For example, we may purchase several inventory items for $10 each. The next time we need to purchase the same item, the cost may have risen to $11 each. When we sell any of these items we must decide if we will use the $10 cost or the $11 cost, or some other cost between the two. The four cost flow methods we will look at in this presentation include specific identification, first-in, first-out, also called FIFO, last-in, first-out, also called LIFO, and weighted average cost. Weighted average

Consider the following information May 6 $95 cost May 3 May 5 May 6 May 8 Purchased 1 unit for $70 Purchased 1 more unit for $75 Purchased 1 more unit for $95 Sold 2 units for $125 each May 5 $75 cost May 3 $70 cost Specific Identification This method individually identifies and records the cost of each item sold as part of cost of goods sold. If the items sold were identified as the ones that cost $70 and $95, the total cost of those items ($ = $165) would be reported as Cost of Goods Sold. The cost of the remaining item ($75) would be reported as Inventory on the balance sheet at the end of the period. The specific identification method individually identifies and records the cost of each item sold as part of cost of goods sold. This method requires accountants to keep track of the purchase cost of each item. In the example just given, if the items sold were identified as the ones that cost $70 and $95, the total cost of those items ($ = $165) would be reported as Cost of Goods Sold. The cost of the remaining item ($75) would be reported as Inventory on the balance sheet at the end of the period. The specific identification method is used primarily to account for individually expensive and unique items. Toll Brothers, the country’s leading builder of luxury homes, reports the costs of home construction using the specific identification method. Car Max, a national auto dealership, also uses specific identification.

FIFO LIFO Weighted average May 6 $95 cost May 5 $75 cost May 3 $70 cost May 6 $95 cost May 5 $75 cost May 3 $70 cost May 6 $95 cost May 5 $75 cost May 3 $70 cost Sold Still there Income Statement Net Sales Cost of Goods Sold Gross Profit $250 145 $105 Balance Sheet Inventory $95 Sold Still there Income Statement Net Sales Cost of Goods Sold Gross Profit $250 170 $ 80 Balance Sheet Inventory $70 $80 per unit Sold Still there $240 3 = Income Statement Net Sales Cost of Goods Sold Gross Profit $250 160 $ 90 Balance Sheet Inventory $80 Part I Here we see the three purchases. Note that the purchases amounts are the same for each cost flow method. Next we will see the differences in Cost of Goods Sold and ending Inventory for each of the three cost flow methods, beginning with FIFO. Part II First-in, first-out (FIFO) assumes that the inventory costs flow out in the order the goods are received. The earliest items received, the $70 and $75 units received on May 3 and 5, become the $145 Cost of Goods Sold on the income statement and the remaining $95 unit received on May 6 becomes ending Inventory on the balance sheet. Part III Last-in, first-out (LIFO) assumes that the inventory costs flow out in the opposite of the order the goods are received. The latest items received, the $95 and $75 units received on May 6 and 5, become the $170 Cost of Goods Sold on the income statement, and the remaining $70 unit received on May 3 becomes ending Inventory on the balance sheet. Part IV Weighted average uses the weighted average of the costs of goods available for sale for both the cost of each item sold and those remaining in inventory. The average of the costs [($ ) divided by 3 = $80] is assigned to the two items sold totaling $160 Cost of Goods Sold and to the one item in ending Inventory ($80).

Summary Cost of Goods sold (Income Statement) Inventory (Balance sheet) FIFO Oldest cost Newest cost LIFO Weighted Average Average cost Let’s consider a more complex example. Date Oct 1 Oct 3 Oct 5 Oct 6 Description Beginning Inventory Purchase Sales Ending Inventory # of Units 10 30 (35) 15 Cost per Unit $ 7 $ 8 $10 To calculate Total Cost $ 240 100 Part I The oldest costs are in Cost of Goods Sold and the newest costs are in Inventory using the FIFO method. The oldest costs are in Inventory and the newest costs are in Cost of Goods sold using the LIFO method. Weighted average is a middle-of-the-road method. Part II Now that you’ve seen how these cost flow assumptions work and that they actually make a difference in a company’s balance sheet and income statement, we are ready for a more complex example. So, let’s assume that during the first week of October American Eagle entered into the following transactions for its Henley T-shirt product line. All sales were made at a selling price of $15 per unit. These sales occurred after American Eagle made two batches of T-shirt purchases, which were added to beginning Inventory.

Inventory Cost Flow Computations
FIFO + - = beginning Inventory purchases cost of goods available for sale ending Inventory Cost of Goods Sold units x $ = $ 70 units x $ = units x $ = $ 410 140 $ 270 (10 $10) + (5 $8) (10 $7) + (25 $8) Part I Cost of goods available for sale of $410 equals the dollar amount of beginning Inventory plus dollar amount of the two purchases. Part II The first-in, first-out (FIFO) method assumes that the costs of the newer goods are included in the cost of the ending Inventory (all 10 units from the 10-unit purchase at $10 plus 5 units remaining from the 30-unit purchase at $8 equals a total of $140). Part III The cost of the oldest goods (the first in to Inventory) are the first ones sold (the first out of Inventory). So to calculate the cost of the 35 units sold, use the costs of the first-in (oldest) goods (all 10 units from beginning Inventory at $7 plus 25 units of the 30-unit purchase at $8 equals a total of $270). Part IV You will notice that ending Inventory and Cost of Goods Sold when added together equal the cost of goods available for sale.

LIFO + - = beginning Inventory purchases cost of goods available for sale ending Inventory Cost of Goods Sold units x $ = $ 70 units x $ = units x $ = $ 410 110 $ 300 (10 $7) + (5 $8) (10 $10) + (25 $8) Part I Cost of goods available for Sale of $410 equals the dollar amount of beginning Inventory plus dollar amount of the two purchases. Part II The last-in, first-out (LIFO) method assumes that the costs of the older goods are included in the cost of the ending Inventory (all 10 units from beginning Inventory at $7 plus 5 units remaining from the 30-unit purchase at $8 equals a total of $110). Part III The cost of the newest goods (the last in to Inventory) are the first ones sold (the first out of Inventory). So to calculate the cost of the 35 units sold, use the costs of the last-in (newest) goods (10 units at $10 plus 25 of the 30 units at $8 equals a total of $300). Part IV You will notice that ending Inventory and Cost of Goods Sold when added together equal the cost of goods available for sale.

Weighted Average Description beginning Inventory purchase cost of goods available for sale # of Units 10 30 50 Cost per Unit $ 7 $ 8 $10 Total Cost $ 240 100 $ 410 Part I Cost of goods available for sale of $410 equals the dollar amount of beginning Inventory plus dollar amount of the two purchases. Fifty units are available for sale. Part II The weighted average unit cost is equal to the cost of goods available for sale divided by the number of units available for sale. Part III The weighted average unit cost is equal to $410 divided by 50 units, $8.20 per unit. Cost of Goods Sold and ending Inventory are both calculated using the same weighted average cost per unit. Weighted Average Cost Cost of goods Available for Sale Number of Units Available for Sale = Weighted Average Cost $ units = = $8.20 per unit

Weighted Average + - = Beginning Inventory Purchases Cost of Goods Available for Sale Ending Inventory Cost of Goods Sold units x $ = $ 70 units x $ = units x $ = $ 410 123 $ 287 15 $8.20 35 $8.20 Part I Cost of Goods Available for Sale of $410 equals the dollar amount of Beginning Inventory plus dollar amount of the two purchases. Part II Ending Inventory of 15 units at the weighted average unit cost $8.20 is equal to $123. Part III Cost of Goods Sold of 35 units at the weighted average unit cost $8.20 is equal to $287. Part IV You will notice that ending Inventory and Cost of Goods Sold when added together equal the cost of goods available for sale.

Financial Statement Effects
Effects on the Income Statement Sales Cost of Goods Sold Gross Profit Operating Expenses Income from Operations Other Revenue (Expenses) Income before Income Tax Expense Income Tax Expense (30%) Net Income Effects on the Balance Sheet Inventory Weighted Average $ 287 238 125 113 20 133 40 $ $ LIFO 300 225 100 120 36 $ $ FIFO 270 255 130 150 45 $ $ The costing methods differ only in the way they split the cost of goods available for sale between Ending Inventory and Cost of Goods Sold. If a cost goes into Inventory, it doesn’t go into Cost of Goods Sold. So, the method that assigns the highest cost to Ending Inventory will assign the lowest cost to Cost of Goods Sold (and vice versa).

Depending on whether costs are rising or falling, different methods have different effects on the financial statements. When costs are rising, as they are in our example, FIFO produces a higher inventory value (making the balance sheet appear to be stronger) and a lower cost of goods sold (resulting in a higher gross profit, which makes the company look more profitable). When costs are falling, these effects are reversed; FIFO produces a lower ending inventory value and a higher cost of goods sold—a double whammy. These are not “real” economic effects, however, because the same number of units is sold or held in ending inventory under either method.

Advantages of Methods Weighted Average First-In, First-Out Last-In, First-Out Smoothes out price changes. Ending inventory approximates current replacement cost. Better matches current costs in cost of goods sold with revenues. Many companies use weighted average cost because it tends to smooth out changes in price paid for inventory items. If a company uses FIFO, we can conclude that inventory on the balance sheet is stated at an amount very close to its replacement cost. Using LIFO does a good job of matching current costs with current revenue, and may tend to give an income amount that reflects current costs and selling prices.

Tax Implications and Cash Flow Effects
Effects on the Income Statement Sales Cost of Goods Sold Gross Profit Operating Expenses Income from Operations Other Revenue (Expenses) Income before Income Tax Expense Income Tax Expense (30%) Net Income Effects on the Balance Sheet Inventory Weighted Average $ 287 238 125 113 20 133 40 $ $ LIFO 300 225 100 120 36 $ $ FIFO 270 255 130 150 45 $ $ Let’s revisit our Income Statements and Balance Sheets for the three cost flow methods. Given the financial statement effects, you might wonder why a company would ever use the LIFO method that produces a lower inventory amount and a higher Cost of Goods Sold. But remember that a higher Cost of Goods Sold results in a lower Income and correspondingly lower Income Tax Expense. When faced with increasing costs per unit a company that uses FIFO will have a higher Income Tax Expense. This income tax effect is a real cost, in the sense that the company will actually have to pay more income taxes in the current year, thereby reducing the company’s cash. Companies are not allowed to alternate between FIFO and LIFO to report better financial results, depending on whether unit costs are rising or declining during the period. Doing so would make it difficult to compare financial results across periods. Consistency over time allows for better comparisons. A change in method is allowed only if it will improve the accuracy with which the company’s financial results and financial position are measured, and is generally a one-time change. Tax rules also limit the methods that can be used. In the United States, the LIFO Conformity Rule requires that if LIFO is used on the income tax return, it also must be used in financial statement reporting.

Reporting inventory at the lower of cost or market.
Learning Objective 7-4 Reporting inventory at the lower of cost or market. Learning objective number 7-4 is to reporting inventory at the lower of cost or market.

Lower of Cost or Market The value of inventory can fall below its recorded cost for two reasons: it’s easily replaced by identical goods at a lower cost, or it’s become outdated or damaged. When the value of inventory falls below its recorded cost, the amount recorded for inventory is written down to its lower market value. This is known as the lower of cost or market (LCM) rule. Part I Regardless of the inventory costing method used, all companies must report inventory at lower of cost or market. When the value of ending inventory falls because of lower replacement costs or outdated items, we should report the inventory at its market value rather than the higher cost amount. Think about the computer industry. We used to think that a twenty megabyte hard drive was big, now we measure the storage capacity of hard drives in gigabytes. If you have several 250 megabyte hard drives in inventory, you would not be able to sell them for the cost you paid. Today, such a hard drive is considered way too small to be of much use. Think about what has happened to the floppy disk. These days, several computer manufacturers do not even include floppy disks in their standard systems. Part II When we write down inventory from cost to market, we recognize a loss that will appear on the income statement.

Lower of Cost or Market 1,000 items @ $165 1,000 items @ $150
Leather coats Vintage jeans Cost per $165 20 Market Value per Item $150 25 LCM Quantity 1,000 400 Total Lower of cost or Market $150,000 8,000 Total cost $165,000 Write- down $15,000 1,000 $150 400 $20 1 Analyze Liabilities Assets = Stockholders’ Equity + Inventory $15,000 Cost of Goods Sold (+E) $15,000 Part I American Eagle’s ending Inventory includes two items whose replacement costs have recently changed: leather coats and vintage jeans. The replacement costs of these items can be used as estimates of market value and compared to the original recorded cost per unit. You then take the lower of those two amounts (the lower of cost or market) and multiply it by the number of units on hand. The result ($150,000 for leather coats and $8,000 for vintage jeans) is the amount at which the Inventory should be reported after all adjustments have been made. Part II Because the market value of the 1,000 leather coats ($150) is lower than the recorded cost ($165), the recorded amount for ending Inventory should be written down by $15 per unit ($165 - $150). If American Eagle has 1,000 units in Inventory, the total write-down should be $15,000 ($15 × 1,000). Because the market value of the vintage jeans ($25) is higher than the original cost ($20) no write-down is necessary. The vintage jeans remain on the books at their cost of $20 per unit ($8,000 in total). Their value should not be increased based on the higher replacement cost because GAAP requires that they be reported at the lower of cost or market. Most companies report their Inventory write-down expense as Cost of Goods Sold, even though the written-down goods may not have been sold. This reporting is appropriate because writing down goods that haven’t yet sold is a necessary cost of carrying the goods that did sell. By recording the write-down in the period in which a loss in value occurs, companies better match their revenues and expenses of that period. 2 Record dr Cost of Goods Sold (+E, -SE) cr Inventory (-A) 15,000

Lower of Cost or Market When the maker of Blackberry devices, Research in Motion (RIM), recently announced a $485 million LCM write-down on its inventory of first generation PlayBooks, investors reacted by selling their shares in the company. Within just one day of the announcement, the company’s stock price fell by 9.2%, to only $17 per share. Investors knew the write-down signaled bad news for the tablet. Because investors and analysts view an inventory LCM write-down as a sign of inventory management problems, some executives go out of their way to avoid them. The failure to follow inventory LCM rules is one of the most common types of financial statement misstatements.

Learning Objective 7-5 Analyze and record inventory purchases, transportation, returns and allowances, and discounts. Learning objective number 7-5 is to analyze and record inventory purchases, transportation, returns and allowances, and discounts.

Recording Inventory Transactions
We will now look at the accounting for purchases, transportation costs, purchase returns and allowances, and purchase discounts. We will record all inventory-related transactions in the Inventory account. We will now look at the accounting for purchases, transportation costs, purchase returns and allowances, and purchase discounts. We will record all inventory-related transactions in the Inventory account. This approach is generally associated with a perpetual inventory system because it maintains an up-to-date balance in the Inventory account at all times. An alternative approach, which maintains separate accounts for purchases, transportation costs, and so on, is generally used in a periodic inventory system and is demonstrated in Supplement 7C at the end of this chapter.

Inventory Purchases American Eagle Outfitters purchases $10,500 of vintage jeans on credit. 1 Analyze Liabilities Assets = Stockholders’ Equity + Inventory (+A) +$10,500 Accounts Payable (+L) $10,500 Part I American Eagle Outfitters purchases $10,500 of vintage jeans on credit. Part II The transaction would affect the accounting equation by increasing assets by $10,500 and increasing Liabilities by $10,500. Part III We would record the transaction by debiting Inventory for $10,500 and crediting Accounts Payable for $10,500. 2 Record dr Inventory (+A) cr Accounts Payable (+L) 10,500

Transportation Cost American Eagle pays $400 cash to a trucker who delivers the $10,500 of vintage jeans to one of its stores. 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (-A) $400 Inventory (+A) $400 Part I The inventory that American Eagle purchases must be shipped from suppliers to American Eagle. If the terms are FOB shipping point, the purchaser pays for the shipping. If the terms are FOB destination, the seller pays for the shipping. When the purchaser pays for the shipping, the additional cost of transporting the goods (called freight-in) is added to the Inventory account. Assume that American Eagle pays $400 cash to a trucker who delivers the $10,500 of vintage jeans to one of its stores. Part II In general, a purchaser should include in the Inventory account any costs needed to get the inventory into a condition and location ready for sale. The transaction would affect the accounting equation by decreasing cash by $400 and increasing Inventory by $400. Part III We would record the transaction by debiting Inventory for $400 and crediting Cash for $400. 2 Record dr Inventory (+A) cr Cash (-A) 400

Purchase Returns and Allowances
American Eagle returned some of the vintage jeans to the supplier and received a $500 reduction in the balance owed. 1 Analyze Liabilities Assets = Stockholders’ Equity + Inventory (-A) $500 Accounts Payable (-L) $500 Part I When goods purchased from a supplier arrive in damaged condition or fail to meet specifications, the buyer can (1) return them for a full refund or (2) keep them and ask for a cost reduction, called an allowance. Either way, these purchase returns and allowances are accounted for by reducing the cost of the inventory and either recording a cash refund or by reducing the liability owed to the supplier. Assume, for example, that American Eagle returned some of the vintage jeans to the supplier and received a $500 reduction in the balance owed. Part II The transaction would affect the accounting equation by decreasing Inventory by $500 and decreasing Accounts Payable by $500. Part III We would record the transaction by debiting Accounts Payable for $500 and crediting Inventory for $500. 2 Record dr Accounts Payable (-L) cr Inventory (-A) 500

Purchase Discounts American Eagle’s vintage jeans purchase for $10,500 had terms of 2/10, n/30. Recall that American Eagle returned inventory costing $500 and received a $500 reduction in its Accounts Payable. American Eagle paid within the discount period. 1 Analyze Liabilities Assets = Stockholders’ Equity + Cash (-A) $9,800 Inventory (-A) $200 Accounts Payable (-L) -10,000 Part I When inventory is bought on credit, terms such as “2/10, n/30” may be specified. From the purchaser’s perspective, these terms mean that the purchaser is allowed to deduct a 2 percent purchase discount if payment is made within 10 days of the date of purchase, otherwise the purchase cost (net of any returns or allowances) is due within 30 days of the purchase date. Assume, for example, that American Eagle’s purchase of vintage jeans for $10,500 occurred with terms 2/10, n/30. The initial purchase would be accounted for as shown earlier, by recording a $10,500 increase in Inventory (with a debit) and a $10,500 increase in Accounts Payable (with a credit). American Eagle returned inventory costing $500 and received a $500 reduction in its Accounts Payable. Consequently, American Eagle owed the supplier $10,000 for the purchase. Multiplying this balance by the 2 percent discount, we find that American Eagle’s purchase discount is $200 (2% × $10,000 = $200), which means that American Eagle has to pay only $9,800 ($10,000 - $200 = $9,800). Part II Multiplying the $10,000 Accounts Payable balance by the 2 percent discount, we find that American Eagle’s purchase discount is $200, which means that American Eagle has to pay only $9,800 ($10,000 - $200 = $9,800). The transaction would affect the accounting equation by decreasing Cash by $9,800, decreasing Inventory by $200, and decreasing Accounts Payable by $10,000. Part III We would record the transaction by debiting Accounts Payable for $10,000, crediting Cash for $9,800, and crediting Inventory for $200. 2 Record dr Accounts Payable (-L) cr Cash (-A) cr Inventory (-A) 9,800 200 10,000

Summary of Inventory Transactions
Part I Here you see a summary of how inventory transactions affect the Inventory account on the balance sheet. Part II This is an alternate form of the computation of goods available.

Learning Objective 7-6 Evaluate inventory management by computing and interpreting the inventory turnover ratio. Learning objective number 7-6 is to evaluate inventory management by computing and interpreting the inventory turnover ratio.

Inventory Turnover Analysis
Part I As a company buys goods, its inventory balance goes up; as it sells goods, its inventory balance goes down. This process of buying and selling, which is called inventory turnover, is repeated over and over during each accounting period for each line of products. Part II The method most analysts use to evaluate such changes is called inventory turnover analysis. Analysts can assess how many times, on average, inventory has been bought and sold during the period by calculating the inventory turnover ratio (Cost of Goods Sold divided by Average Inventory). A higher ratio indicates that inventory moves more quickly from purchase to sale, reducing storage and obsolescence costs and tying up less money in inventory. Rather than evaluate the number of times inventory turns over during the year, some analysts prefer to think in terms of the length of time (in days) required to sell inventory. Converting the inventory turnover ratio to the number of days needed to sell the inventory is easy. You simply divide 365 days by the inventory turnover ratio to get the days to sell. More efficient purchasing and production techniques as well as high product demand will boost the inventory turnover ratio. A sudden decline in the inventory turnover ratio may signal an unexpected drop in demand for the company’s products or sloppy inventory management.

Comparison to Benchmarks
Inventory turnover ratios and the number of days to sell can be helpful in comparing different companies’ inventory management practices. For merchandisers, inventory turnover refers to buying and selling goods, whereas for manufacturers, it refers to producing and delivering inventory to customers. These differences are reflected the company comparisons on the screen. McDonald’s has a turnover ratio of 49.1, which means it takes about 7–8 days to sell its entire food inventory (including the stuff in its freezers). The motorcycles at Harley-Davidson hog more time, as indicated by its inventory turnover ratio of 8.5, which equates to about 43 days to produce and sell. American Eagle’s inventory turned over only 5.7 times during the year, which is just once every 64 days.

FIFO, LIFO, and Weighted Average in a Perpetual Inventory System
Supplement 7A FIFO, LIFO, and Weighted Average in a Perpetual Inventory System Supplement 7A: FIFO, LIFO, and Weighted Average in a Perpetual Inventory System.

Perpetual Inventory System
This is the same information that we used earlier in the chapter to illustrate a periodic inventory system. The only difference is that we have assumed the sales occurred on October 4, prior to the final inventory purchase. To Illustrate a perpetual inventory system, we will use the same information that we used earlier in the chapter to illustrate a periodic inventory system. The only difference is that we have assumed the sales occurred on October 4, prior to the final inventory purchase.

FIFO (First-in, First-Out)
Part I The first-in, first-out (FIFO) method assumes that the oldest goods (the first in to inventory) are the first ones sold (the first out of inventory). So to calculate the cost of the 35 units sold, use the costs of the first-in (oldest) goods (10 units at $7 plus 25 of the 30 units at $8 equals a total of $270). Part II The costs of the newer goods are included in the cost of the Ending Inventory (5 units remaining from the 30 units at $8 plus 10 units at $10 equals a total of $140). Part III Here you see the periodic computations for comparison. Using the periodic system, a physical count of ending inventory is used to compute the Ending Inventory balance. As you can see, FIFO yields identical amounts under perpetual and periodic.

LIFO (Last-in, First-Out)
Part I The last-in, first-out (LIFO) method assumes that the newest goods (the last in to inventory) as of the date of the sale are the first ones sold (the first out of inventory). So to calculate the cost of the 35 units sold, use the costs of the last-in (newest) goods as of the October 4 sale (30 $8 plus 5 of the 10 $7 from Beginning Inventory equals a total of $275). Part II The costs of the older goods (5 units remaining from the 10 units of Beginning $7 equals $35) plus the October 5 purchase (10 $10 equals $100) are included in the cost of the ending inventory ($35 + $100 = $135). Part III Here you see the periodic computations for comparison. Notice that LIFO–Perpetual calculates Cost of Goods Sold using the cost of goods last-in at the time of the sale, whereas LIFO–Periodic uses the cost of goods last-in at the end of the period.

Weighted Average Cost $310 ÷ 40 units = $7.75 per unit Part I
In a perpetual inventory system, the weighted average cost must be calculated each time a sale is recorded by dividing the total cost of the goods available for sale, at the time of the sale, by the number of units available for sale. The weighted average cost at the time of sale on October 4 is calculated by dividing $310 by the 40 units available for sale on October 4 ($310 ÷ 40 units = $7.75 per unit). This cost is then multiplied by the number of units sold to calculate Cost of Goods Sold (35 units × $7.75 per unit = $271.25). Part II The remaining 5 units are also valued at the same weighted average cost (5 units × $7.75 per unit = $38.75). Additional inventory purchases on October 5 ($100) are added to these inventory costs to calculate the cost of Ending Inventory ($ $100 = $138.75). The new weighted average cost per unit after the October 5 purchase is $ ($ ÷ 15 units = $9.25 per unit). Notice the change in weighted average cost from $7.75 to $9.25 per unit. Because the weighted average unit cost changes, weighted average perpetual is also called the moving average method. Part III Here you see the periodic computations for comparison. Notice that the weighted average unit cost is computed only once in a periodic system, at the end of the period.

Summary of Perpetual Inventory System Cost Flow Assumptions on Financial Statements Here you see a summary of the financial statement effects of using a perpetual inventory system with FIFO, LIFO, or weighted average cost methods. These methods differ only in the way they split the cost of goods available for sale between ending inventory and cost of goods sold. If a cost goes into Cost of Goods Sold, it must be taken out of Inventory. The method that assigns the highest cost to cost of goods sold assigns the lowest cost to ending inventory (and vice versa).

The Effects of Errors in Ending Inventory
Supplement 7B The Effects of Errors in Ending Inventory Supplement 7B: The Effects of Errors in Ending Inventory.

Errors in Ending Inventory will affect the Balance Sheet and the Income Statement. Cost of Goods Sold Equation BI + P – CGS = EI Assume that Ending Inventory was overstated in 2012 by $10,000 due to an error that was not discovered until 2013. Part I Errors in inventory can significantly affect both the Balance Sheet and the Income Statement. As the cost of goods sold equation (BI + P – CGS = EI) indicates, a direct relationship exists between ending inventory and cost of goods sold because items not in the ending inventory are assumed to have been sold. Any errors in ending inventory will affect the balance sheet (current assets) and the income statement (Cost of Goods Sold, Gross Profit, and Net Income). The effects of inventory errors are felt in more than one year because the ending inventory for one year becomes the beginning inventory for the next year. Part II To determine the effects of inventory errors on the financial statements in both the current year and the following year, let’s assume that ending inventory was overstated in 2012 by $10,000 due to an error that was not discovered until Because Cost of Goods Sold was understated, Gross Profit and Income before Income Tax Expense would be overstated by $10,000 in The 2012 ending inventory becomes the 2013 beginning inventory, so even if 2013 ending inventory is calculated correctly, the error in 2012 creates an error in 2013. 2012 + - = Beginning Inventory Purchases Ending Inventory Cost of Goods Sold Accurate Overstated $10,000 Understated $10,000

Now let’s examine the effects of the 2012 Ending Inventory Error on 2013. Assume that Ending Inventory was overstated in 2012 by $10,000 due to an error that was not discovered until 2013. Part I Now let’s examine the effects of the 2012 Ending Inventory Error on 2013. Part II Because Cost of Goods Sold is overstated in 2013, that year’s Gross Profit and Income before Income Tax Expense would be understated by the same amount in Notice that the Cost of Goods Sold is understated in 2012 overstated in Over the two years, these errors offset one another. Inventory errors will “self-correct” like this only if ending inventory is accurately calculated at the end of the following year and adjusted to that correct balance. 2013 + - = Beginning Inventory Purchases Ending Inventory Cost of Goods Sold Overstated $10,000 Accurate

Recording Inventory Transactions in a Periodic System
Supplement 7C Recording Inventory Transactions in a Periodic System Supplement 7C: Recording Inventory Transaction in a Periodic System.

A local cell phone dealer stocks and sells one item. The following events occurred in the past year: Businesses using a periodic inventory system update inventory records only at the end of the accounting period. Unlike a perpetual inventory system, a periodic system does not track the cost of goods sold during the accounting period. This supplement illustrates typical journal entries made when using a periodic inventory system. We will record purchase and sale transactions using a periodic system and then compare the periodic systems with a perpetual system. We will record these events assuming the company uses a periodic inventory system and then compare the periodic inventory system to a perpetual inventory system.

Periodic Inventory System Perpetual Inventory System Part I In a periodic inventory system, we record purchases with a debit to Purchases, while in a perpetual inventory system, the debit is to Inventory. Otherwise the purchase entry is the same. Part II When goods are sold, we debit Accounts Receivable and credit Sales Revenue both in a periodic system and in a perpetual system. To keep the inventory balance up to date in a perpetual system, we record an additional entry to reduce the inventory when goods are sold. We debit Cost of Goods Sold and credit Inventory.

Periodic Inventory System Part I Since the Inventory account is not up to date in a periodic system, and Cost of Goods Sold has not been recorded, we need to count the Ending Inventory and use the Cost of Goods Sold equation to determine Cost of Goods Sold. Using the equations to solve for Cost of Goods Sold, we find that Cost of goods sold equals Beginning Inventory plus Purchases less Ending Inventory. ($4,800 + $10,200 - $6,000 = $9,000) Part II In the first end-of-year adjustment entry, we close the balance in the Purchases account with a credit, close the Beginning Inventory balance with a credit, and debit Cost of Goods Sold. This entry transfers Beginning Inventory and Net Purchases to Cost of Goods Sold, effectively treating all goods as if they were sold. In the second end-of-year adjustment entry, we debit Inventory for the ending balance that we determined from the physical count and credit Cost of Goods Sold. This entry adjusts the Cost of Goods Sold by subtracting the amount of Ending Inventory still on hand, recognizing that not all goods were sold. As a result of the two entries, the Inventory balance is $6,000 and cost of Goods Sold is $9,000. Part III Since Inventory and Cost of Goods Sold balances are kept up to date with each purchase and sale transaction during the period using a perpetual inventory system, no end-of-period adjustment entries are required. A physical inventory count is still necessary using a perpetual inventory system to assess the accuracy of the perpetual records and identify theft and other forms of shrinkage. Any shrinkage would be recorded by reducing the Inventory account and increasing an expense account (such as Inventory Shrinkage or Cost of Goods Sold) BI + P – CGS = EI End-of-year adjustment entries are not required using a perpetual inventory system.

Summary of the Effects on the Accounting Equation Periodic Inventory System Perpetual Inventory System A summary of the effects of the journal entries on the accounting equation shows that total effects and the resulting financial statements are identical. Only the timing and nature of the entries differ.

Chapter 7 Solved Exercises
M7-6, M7-7, E7-2, E7-5, E7-10, E7-17 Chapter 7 Solved Exercises: M7-6, M7-7, E7-3, E7-5, E7-10, E7-17

M7-6 Calculating Cost of Goods Available for Sale, Ending Inventory, Sales, Cost of Goods Sold, and Gross Profit under Periodic FIFO, LIFO, and Weighted Average Cost Given the following information, calculate cost of goods available for sale and ending inventory, then sales, cost of goods sold, and gross profit, under (a) FIFO, (b) LIFO, and (c) weighted average. Assume a periodic inventory system is used. M7-6 Calculating Cost of Goods Available for Sale, Ending Inventory, Sales, Cost of Goods Sold, and Gross Profit under Periodic FIFO, LIFO, and Weighted Average Cost Given the information on the screen, calculate cost of goods available for sale and ending inventory, then sales, cost of goods sold, and gross profit, under (a) FIFO, (b) LIFO, and (c) weighted average. Assume a periodic inventory system is used.

M7-6 Calculating Cost of Goods Available for Sale, Ending Inventory, Sales, Cost of Goods Sold, and Gross Profit under Periodic FIFO, LIFO, and Weighted Average Cost FIFO Beginning Inventory 50 units x $10 = $ 500 + Purchase units x $13 = $3,250 Cost of Goods Available for Sale $3,750 - Ending Inventory (200 x $13) = $2,600 = Cost of Goods Sold (50 x $10) + (50 x $13) $1,150 Part I The FIFO method. Cost of Goods Available for Sale is the sum of the Beginning Inventory and the July 13 purchase (50 $10) + (250 $13) = $3,750. Part II The FIFO method assumes the oldest units are sold first and the newest units remain in Ending Inventory. The Ending Inventory is 200 $13 = $2,600. Part III Cost of Goods Sold is (50 $10) + (50 $13) = $1,150.

M7-6 Calculating Cost of Goods Available for Sale, Ending Inventory, Sales, Cost of Goods Sold, and Gross Profit under Periodic FIFO, LIFO, and Weighted Average Cost b. LIFO Beginning Inventory 50 units x $10 = $ 500 + Purchase units x $13 = $3,250 Cost of Goods Available for Sale $3,750 - Ending Inventory (150 x $13) + (50 x $10) = $2,450 = Cost of Goods Sold (100 x $13) $1,300 Part I The LIFO method. Cost of Goods Available for Sale is the sum of the Beginning Inventory and the July 13 purchase (50 $10) + (250 $13) = $3,750. Notice that Cost of Goods Available for Sale using LIFO is the same as FIFO. Part II The LIFO method assumes the newest units are sold first and the oldest units remain in Ending Inventory. The Ending Inventory is (150 $13) + (50 $10) = $2,450. Part III Cost of Goods Sold is 100 $13 = $1,300.

c. Weighted Average Weighted Average Cost = $3,750 300 units
M7-6 Calculating Cost of Goods Available for Sale, Ending Inventory, Sales, Cost of Goods Sold, and Gross Profit under Periodic FIFO, LIFO, and Weighted Average Cost c. Weighted Average Beginning Inventory 50 units x $10 = $ 500 + Purchase units x $13 = $3,250 Cost of Goods Available for Sale $3,750 - Ending Inventory (200 x $12.50) = $2,500 = Cost of Goods Sold (100 x $12.50) $1,250 Part I The Weighted Average method. Cost of Goods Available for Sale is the sum of the Beginning Inventory and the July 13 purchase (50 $10) + (250 $13) = $3,750. Notice that Cost of Goods Available for Sale using Weighted Average is the same as LIFO and FIFO. Part II The weighted average unit cost is the Cost of Goods Available for Sale ($3,750) divided by the number of units available for sale (300). The result is $12.50 per unit. Part III. The Ending Inventory is 200 $12.50 = $2,500. Part IV Cost of Goods sold is 100 $12.50 = $1,250. Weighted Average Cost = $3, units = $12.50 per unit

M7-6 Calculating Cost of Goods Available for Sale, Ending Inventory, Sales, Cost of Goods Sold, and Gross Profit under Periodic FIFO, LIFO, and Weighted Average Cost FIFO LIFO Weighted Avg Sales (100 units at $15) $1,500 $1,500 $1,500 Cost of Goods Sold 1, , ,250 Gross Profit $ $ $ 250 We subtract Cost of Goods Sold as previously computed from Sales to obtain Gross Profit.

M7-7 Calculating Cost of Goods Available for Sale, Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Weighted Average Cost (Periodic Inventory) Aircard Corporation tracks the number of units purchased and sold throughout each accounting period, but applies its inventory costing method at the end of each period as if it uses a periodic inventory system. Given the following information, calculate the cost of goods available for sale, ending inventory, and cost of goods sold, if Aircard uses (a) FIFO, (b) LIFO, or (c) weighted average cost. M7-7 Calculating Cost of Goods Available for Sale, Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Weighted Average Cost (Periodic Inventory) Aircard Corporation tracks the number of units purchased and sold throughout each accounting period, but applies its inventory costing method at the end of each period as if it uses a periodic inventory system. Given the following information, calculate the cost of goods available for sale, ending inventory, and cost of goods sold, if Aircard uses (a) FIFO, (b) LIFO, or (c) weighted average cost.

Goods Available for Sale – same for all methods Units Unit Total
M7-7 Calculating Cost of Goods Available for Sale, Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Weighted Average Cost (Periodic Inventory) Goods Available for Sale – same for all methods Units Unit Total Cost Cost Beginning Inventory 2,000 $40 $ 80,000 + Purchase (July 13) 6,000 $ ,000 + Purchase (July 25) 8,000 $ ,000 Goods Available for Sale 16, $744,000 The number of units available for sale and the Cost of Goods Available for Sale are the same for all methods. Cost of Goods Available for Sale is the sum of the Beginning Inventory, the July 13 purchase, and the July 25 purchase (2,000 $40) + (6,000 $44) + (8,000 $50) = $744,000.

M7-7 Calculating Cost of Goods Available for Sale, Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Weighted Average Cost (Periodic Inventory) a. FIFO Ending Inventory (7,000 units x $50) = $350,000 Cost of Goods Sold (2,000 units x $40) (6,000 units x $44) (1,000 units x $50) = $394,000 b. LIFO Ending Inventory (2,000 units x $40) (5,000 units x $44) = $300,000 Cost of Goods Sold (8,000 units x $50) (1,000 units x $44) = $444,000 Part I The FIFO Method. The FIFO method assumes the oldest units are sold first and the newest units remain in Ending Inventory. The Ending Inventory is 7,000 $50 = $350,000. Cost of Goods Sold is (2,000 $40) + (6,000 $44) + (1,000 $50) = $394,000. Part II The LIFO method. The LIFO method assumes the newest units are sold first and the oldest units remain in Ending Inventory. The Ending Inventory is (2,000 $40) + (5,000 $44) = $300,000. Cost of Goods Sold is (8,000 $50) + $44) = $444,000.

M7-7 Calculating Cost of Goods Available for Sale, Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Weighted Average Cost (Periodic Inventory) c. Weighted Average Average Unit Cost $744,000 / 16,000 = $46.50 Ending Inventory (7,000 units x $46.50) = $325,500 Cost of Goods Sold (9,000 units x $46.50) = $418,500 The Weighted Average method. The weighted average unit cost is the Cost of Goods Available for Sale ($744,000) divided by the number of units available for sale (16,000). The result is $46.50 per unit. The Ending Inventory is 7,000 $46.50 = $325,500. Cost of Goods sold is 9,000 $46.50 = $418,500.

End of Chapter 7 End of chapter 7.

Inventories and Cost of Goods Sold

Similar presentations

Presentation on theme: "Inventories and Cost of Goods Sold"— Presentation transcript:

Similar presentations

About project

Feedback

Log in

Auth with social network:

Inventories and Cost of Goods Sold

Similar presentations

Presentation on theme: "Inventories and Cost of Goods Sold"— Presentation transcript:

Similar presentations

About project

Feedback