1. Inventory and Cost of Goods Sold
Chapter 6
Inventory and Cost of Goods Sold
This chapter is divided into 3 parts
Part A: Understanding Inventory and Cost of Goods Sold
Part B: Recording Inventory Transactions
Part C: Other Inventory Reporting Issues 1

2. Inventory
Includes items a company intends for sale to customers clothes at The Limited, shoes at Payless ShoeSource, building supplies at Home Depot, and so on.
Also includes items that are not yet finished products. For instance, lumber at a cabinet manufacturer and rubber at a tire manufacturer are part of inventory because the firm will use them to make a finished product for sale to customers
We report inventory as a current asset in the balance sheet—an asset because it represents a valuable resource the company owns, and current because the company expects to convert it to cash in the near term. At the end of the period, the amount the company reports for inventory is the cost of inventory not yet sold.

3. Understanding Inventory and Cost of Goods Sold
Part A
Understanding Inventory and Cost of Goods Sold
In preceding chapters, we dealt mostly with companies that provide a service. Many companies, though, earn revenues by selling inventory rather than a service. Cost of the inventory that was sold during the period is Cost of goods sold. 3

4. Manufacturing company
LOB1 Trace the flow of inventory costs from manufacturing companies to merchandising companies
Inventory
Merchandise company
Manufacturing company
Many companies, earn revenues by selling inventory rather than a service. These companies are either manufacturing or merchandising companies.
Wholesaler
Retailer
Raw material
Work in
progress
Finished
goods

5. Merchandising Companies
Merchandising companies purchase inventories that are primarily in finished form for resale to customers
Wholesalers resell inventory to retail companies or to professional users.
Retailers purchase inventory from manufacturers or wholesalers and then sell this inventory to end users.
Merchandising companies purchase inventories that are primarily in finished form for resale to customers. These companies may assemble, sort, repackage, redistribute, store, refrigerate, deliver, or install the inventory, but they don’t manufacture it. They simply serve as intermediaries in the process of moving inventory from the manufacturer, the company that actually makes the inventory, to the end user.

6. Manufacturing Companies
Companies manufacture the inventories they sell, rather than buying them from suppliers in finished form.
We classify inventory into three categories
Raw materials inventory: Includes the cost of components that will become part of the finished product but have not yet been used in production.
Work-in-process inventory: Refers to the products that have started the production process but are not yet complete at the end of the period.
Finished goods inventory: Once the manufacturing process is complete, transfer these costs to finished goods inventory.
Raw materials inventory includes the cost of components that will become part of the finished product but have not yet been used in production.
Work-in-process inventory refers to the products that have started the production process but are not yet complete at the end of the period. The cost of work-in-process inventory includes the cost of raw materials used in production, the cost of direct labor that we can trace directly to the goods in process, and an allocated portion of other manufacturing costs, called overhead. Overhead costs include costs to operate the manufacturing facility, depreciation of manufacturing equipment, and many other costs that we cannot directly link to the production of specific inventories.
Once the manufacturing process is complete, we transfer these costs to finished goods inventory.

7. Types of Companies and Flow of Inventory Costs
Raw material
Types of Companies and Flow of Inventory Costs
Flow of Inventory Costs
Manufacturing
Companies
Direct labor
Overhead
Work in process
Products
Merchandising
Finished goods
Service Companies
Services
End users
Raw material
In the slide we see the flow of inventory costs for the three types of companies.
Inventory’s journey begins when manufacturing companies purchase raw materials, hire workers, and incur manufacturing overhead during production. Once the products are finished, manufacturers normally pass inventories to merchandising companies, whether wholesalers or retailers. Merchandising companies then sell inventories to you, the end user. In some cases, manufacturers may sell directly to end users. Some companies provide both services and inventories to customers.
In this chapter, we focus on merchandising companies, both wholesalers and retailers. Still, most of the accounting principles and procedures discussed here also apply to manufacturing companies. We don’t attempt to address all the unique problems of accumulating the direct costs of raw materials and labor and allocating manufacturing overhead. We leave those details for managerial and cost accounting courses and focus instead on the financial reporting implications.

8. LO2 Calculate cost of goods sold
Inventory represents the cost of inventory not sold, while cost of goods sold represents the cost of inventory sold.
Also referred to as cost of sales, cost of merchandise sold, or cost of products sold.
The costs of beginning inventory plus additional purchases make up the cost of goods (or inventory) available for sale.
Let’s think a little more about the relationship between ending inventory in the balance sheet and cost of goods sold in the income statement.
Remember that inventory represents the cost of inventory not sold, while cost of goods sold represents the cost of inventory sold. Thus, we can see that the amount reported for inventory turns into the amount reported for cost of goods sold once the inventory is sold. The costs of beginning inventory plus additional purchases make up the cost of goods (or inventory) available for sale.

9. Relationship between Inventory and Cost of Goods Sold
Inventory represents the cost of inventory not sold, while cost of goods sold represents the cost of inventory sold. Thus, we can see that the amount reported for inventory turns into the amount reported for cost of goods sold once the inventory is sold.
The costs of beginning inventory plus additional purchases make up the cost of goods (or inventory) available for sale.

10. Specific Identification Method
LO3 Determine the cost of goods sold and ending inventory using different inventory cost methods
Inventory cost method
Specific
Identification
First in,
First out
(FIFO)
Last in,
First out
(LIFO)
Average
Cost
Specific Identification Method
To this point, we’ve discussed the cost of inventory without considering how we determine that cost. We do that now by considering four methods for inventory costing.
1. Specific Identification 2. First-In, First-Out (FIFO) 3. Last-In, First-Out (LIFO) 4. Average Cost.
The specific identification method is the method you might think of as the most logical. It matches or identifies each unit of inventory with its actual cost. As you might imagine, though, the specific identification method is practicable only for companies selling unique, expensive products. For example, an automobile has a unique serial number that we can match to an invoice identifying the actual purchase price. Jewelry and pieces of art are other possibilities. For practical reasons, most companies use one of the inventory cost flow assumptions (FIFO, LIFO, or average cost) to determine cost of goods sold and inventory.
This method you might think of as the most logical.
It matches or identifies each unit of inventory with its actual cost.
Practicable only for companies selling unique, expensive products.

11. Inventory Transactions for Mario’s Game Shop
It has 100 units of inventory at the beginning of the year and then makes two purchases during the year—one on April 25 and one on October 19.
There are 1,000 game cartridges available for sale.
During the year, it sells 800 video game cartridges for $10 each. This means that 200 cartridges remain in ending inventory at the end of the year.
Mario’s has 100 units of inventory at the beginning of the year and then makes two purchases during the year—one on April 25 and one on October 19. (Note the different unit costs at the time of each purchase.) There are 1,000 game cartridges available for sale. During the year, Mario’s sells 800 video game cartridges for $10 each. This means that 200 cartridges remain in ending inventory at the end of the year. But which 200? Do they include some of the $2 units from beginning inventory? Are they 200 of the $4 units from the April 25 purchase? Or, do they include some $6 units from the October 19 purchase? We consider these questions in next slides.

12. First-In, First-Out (FIFO)
First units purchased are the first ones sold. Beginning inventory sells first, followed by the inventory from the first purchase during the year, followed by the inventory from the second purchase during the year, and so on.
Mario’s Game Shop, which 800 units were sold?
They were the first 800 units purchased, and that all other units remain in ending inventory.
We assume that all units from beginning inventory (100 units) and the April 25 purchase (300 units) have been sold. For the final 400 units sold, we split the October 19 purchase of 600 units into two groups—400 units assumed sold and 200 units assumed not sold. We calculate cost of goods sold as the units of inventory assumed sold times their respective unit costs. Similarly, ending inventory equals the units assumed not sold times their respective unit costs ($6 in our example).
The amount of cost of goods sold we report in the income statement will be $3,800. The amount of ending inventory in the balance sheet will be $1,200. You may have realized that we don’t actually need to directly calculate both cost of goods sold and inventory. Once we calculate one, the other is apparent. Because the two amounts always add up to the cost of goods available for sale ($5,000 in our example), knowing either amount allows us to subtract to find the other.
Realize, too, that the amounts reported for ending inventory and cost of goods sold do not represent the actual cost of inventory sold and not sold. That’s okay. Companies are allowed to report inventory costs by assuming which units of inventory are sold and not sold, even if this does not match the actual flow.

13. Last-In, First-Out (LIFO)
Last units purchased are the first ones sold.
Mario’s, If 800 units were sold, all the 600 units purchased on October 19 were sold, along with 200 units from the April 25 purchase. That leaves 100 of the units from the April 25 purchase and all 100 units from beginning inventory assumed to remain in ending inventory .
Using the last-in, first-out method (LIFO) we assume that the last units purchased (the last in) are the first ones sold (the first out).
In our example for Mario’s Game Shop, If 800 units were sold, we assume all the 600 units purchased on October 19 (the last purchase) were sold, along with 200 units from the April 25 purchase. That leaves 100 of the units from the April 25 purchase and all 100 units from beginning inventory assumed to remain in ending inventory (not sold). Our calculations of cost of goods sold and ending inventory for the LIFO method are shown in the slide.

14. Average Cost Method
Both cost of goods sold and ending inventory consist of a random mixture of all the goods available for sale.
Each unit of inventory has a cost equal to the weighted-average cost of all inventory items.
Notice that the weighted-average cost of each game cartridge is $5, even though none of the game cartridges actually cost $5. However, on average, all the game cartridges cost $5, and this is the amount we use to calculate cost of goods sold and ending inventory under the average cost method.

15. Comparison of Cost of Goods Sold Under The Three Inventory Cost Flow Assumptions
A company purchases three units of inventory and sells two.
FIFO: Inventory is sold in the order purchased.
LIFO: Inventory is sold in the opposite order that we purchased it.
Weighted average cost: Inventory is sold using an average of all inventory purchased.
A company purchases three units of inventory and sells two.
Using FIFO, we assume inventory is sold in the order purchased; that is, the first purchase is sold first and the second purchase is sold second.
Using LIFO, we assume inventory is sold in the opposite order that we purchased it. The last unit purchased is sold first and the second-to-last unit purchased is sold second.
Using average cost, we assume inventory is sold using an average of all inventory purchased.

16. Effects of Managers’ Choice of Inventory
LO4 Explain the financial statement effects and tax effects of inventory cost flow assumptions
Effects of Managers’ Choice of Inventory
Reporting Methods
Why Choose FIFO?
Matches physical flow
for most companies.
Results in higher assets
and net income when
inventory costs are rising.
Has a balance sheet
focus.
Why Choose LIFO?
Results in tax savings.
Has an income statement
focus.
Companies are free to choose FIFO, LIFO, or average cost to report inventory and cost of goods sold. However, because inventory costs generally change over time, this means that the reported amounts for ending inventory and cost of goods sold will not be the same across inventory reporting methods. These differences could cause investors and creditors to make bad decisions if they are not aware of differences in inventory assumptions.
Most companies’ actual physical flow follows FIFO.
FIFO matches physical flow for most companies.
FIFO generally results in higher assets and net income when inventory costs are rising.
FIFO has a balance sheet focus.
If FIFO results in higher total assets and higher net income and produces amounts that most closely follow the actual flow of inventory, why would any company choose LIFO?
The primary benefit of choosing LIFO is tax savings.
LIFO has an income statement focus.

17. Comparison of Inventory Cost Flow Assumptions When Prices Are Rising
A comparison of FIFO, LIFO, and average cost for Mario’s Game Shop is provided below.
When inventory costs are rising, Mario’s Game Shop will report both higher inventory in the balance sheet and higher gross profit (and ultimately, higher net income) in the income statement if it chooses FIFO. The reason is that FIFO assumes the lower costs of the earlier purchases become cost of goods sold first, leaving the higher costs of the later purchases in ending inventory. Managers may want to report higher assets and profitability to increase their bonus compensation, decrease unemployment risk, satisfy shareholders, meet lending agreements, or increase stock price.
As you can see from this illustration, when costs are rising, LIFO will produce the opposite effect. LIFO will report both the lowest inventory and the lowest net income. The average cost method typically produces amounts that fall between the FIFO and LIFO amounts for both cost of goods sold and ending inventory.
Accountants often call FIFO the balance sheet approach because—since FIFO assumes the first purchases sell first—the amount it reports for ending inventory (in the balance sheet) better approximates the current cost of inventory. The ending inventory amount reported under LIFO, in contrast, generally includes “old” inventory costs that do not realistically represent the cost of today’s inventory.

18. LIFO Reserve
Choice between FIFO and LIFO results in different amounts for ending inventory and cost of goods sold.
It complicates the investment decisions of stockholders.
Due to financial statement effects of different inventory methods, companies that choose LIFO must report what’s called their LIFO reserve.
It is the additional amount of inventory a company would report if it used FIFO instead of LIFO.
Companies that have been using LIFO for a long time or that have seen dramatic increases in inventory costs, the LIFO reserve can be substantial.
The effect of the LIFO reserve for Lone Star Technologies, which uses LIFO to account for most of its inventory follows.
If Lone Star Technologies had used FIFO instead of LIFO, reported inventory amounts would have been $135.1 million greater and $169.6 million greater in 2005 and 2006, respectively. The magnitude of these effects can have a significant influence on investors’ decisions.
Many companies, like Lone Star Technologies, choose inventory reporting methods in order to get the best of both worlds. Assuming costs are rising, they use LIFO to report lower taxable income and pay lower taxes. They also disclose, in the footnotes to the financial statements, the higher inventory and income amounts that would have occurred if they had reported using FIFO.
Companies can choose whichever inventory method they prefer, even if the method does not match the actual physical flow of goods. However, once it chooses a method, the company is not allowed to frequently change to another one.

19. Recording Inventory Transactions
Part B
Recording Inventory Transactions
To this point in the chapter, we have talked about purchases and sales of inventories and how to track their costs. But we haven’t discussed how to record inventory transactions. Companies record inventory transactions with either a perpetual inventory system or a periodic inventory system 19

20. Perpetual Inventory System Periodic Inventory System
LO5 Explain the differences between a perpetual inventory system and a periodic inventory system
Perpetual Inventory System
It maintains a continual—or perpetual—record of inventory purchased and sold.
A continual tracking of inventory has the advantage of helping a company to better manage its inventory levels.
Periodic Inventory System
It does not continually modify inventory amounts, but instead periodically adjusts for purchases and sales of inventory at the end of the reporting period based on a physical count of inventory on hand.
As a practical matter, most companies with the help of scanners and bar codes keep track of their inventory units using a perpetual system but report inventory in the balance sheet and cost of goods sold in the income statement using a periodic system.

21. Inventory Information for Incredible Electronics for 2010
To record inventory transactions under the perpetual system and periodic system. We keep the amount of inventory small to make the calculations easy, but both systems can be applied to inventory of any size. Consider the given information below during 2010:
For ease of comparison, we record transactions for the perpetual system and periodic system side-by-side. At the end of the example, you’ll see that both inventory systems result in identical amounts being reported. The difference between the two systems is in the timing of recording inventory and cost of goods sold.
In certain situations, using a periodic system instead of a perpetual system will cause balances in the inventory account (and cost of goods sold account) to differ. We look at why this could occur in Appendix A to this chapter.

22. Perpetual inventory system Periodic Inventory system
Inventory Purchases
Perpetual inventory system
Debit inventory when we purchase inventory .
Credit cash if the purchase was paid in cash or, credit accounts payable if the purchase was on account, increasing total liabilities.
Periodic Inventory system
Debit purchases account instead of inventory.
We use the purchases account to temporarily track increases in inventory. We close this account to cost of goods sold at the end of the period.
FOB shipping point
Title passes when the seller ships the inventory, not when the buyer receives it.
FOB destination
Title would not transfer to the buyer and the purchase transaction would not be recorded until the shipped inventory reached its destination.
The buyer records the purchase when title to the inventory transfers from the seller. This often takes place immediately as the seller hands the goods to the buyer. However, in some cases the goods must be shipped. In this case, there is a delay between when the seller releases the goods and the buyer receives the goods. The time at which title of the shipped inventory transfers to the buyer depends on the shipping terms—FOB shipping point or FOB destination.
FOB shipping point means Title passes when the seller ships the inventory, not when the buyer receives it. The fact that a buyer does not have physical possession of the inventory does not prevent title of the inventory from being transferred. In contrast,If the inventory were shipped FOB destination, then title would not transfer to the buyer and the purchase transaction would not be recorded until the shipped inventory reached its destination.

23. Freight Charges
Under the perpetual system, we add the cost of freight-in to inventory.
Under the periodic system, it also eventually becomes part of the cost of inventory, but we initially record it in a separate freight-in account. Like purchases, the freight-in account is closed to cost of goods sold at the end of the period.
The cost of inventory includes all costs necessary to get the inventory ready for sale. A common cost to get the inventory ready for sale is the cost to transport inventory to the company, commonly referred to as freight-in. Under the perpetual system, we add the cost of freight-in to inventory. Under the periodic system, it also eventually becomes part of the cost of inventory, but we initially record it in a separate freight-in account. Like purchases, the freight-in account is closed to cost of goods sold at the end of the period.
Typically, the party that has title during shipment is the party responsible for paying the shipping cost.

24. Purchase Returns
Under the perpetual system, the company records the purchase returns as a reduction in both inventory and accounts payable.
Under the periodic system, the company credits an account called purchase returns, a contra purchases account, instead of inventory. Purchase returns is a temporary account that will be closed to (and become part of) cost of goods sold at the end of the period.
Occasionally, a company will find inventory items to be unacceptable for some reason—damaged perhaps or maybe different from what it ordered. In those cases, the company returns the items to the supplier and receives a reduction in the amount owed. Under the perpetual system, the company records the purchase returns as a reduction in both inventory and accounts payable.
If it’s using a periodic system, the company credits an account called purchase returns, a contra purchases account, instead of inventory. Purchase returns is a temporary account that will be closed to (and become part of) cost of goods sold at the end of the period.

25. Purchase Discounts
Digital Wholesale, offers terms 2/10, n/30 for purchases on account, and Incredible Electronics takes advantage of the discount. Incredibles’ purchases on account were $55,000, purchases returns were $5,000, the balance of account payable is $50,000. Subtracting the 2% purchase discount, Incredible owes only $49,000.
Incredible Electronics reduces its inventory balance by the amount of the discount. The true cash price for inventory is $49,000, not $50,000.
The company will record the discount in purchase discounts.
Purchase discounts, like returns, is a temporary account that will be closed to cost of goods sold at the end of the period.
Let’s assume that Incredible Electronics’ supplier, Digital Wholesale, offers terms 2/10, n/30 for purchases on account, and Incredible Electronics takes advantage of the discount. Incredible Electronics’ purchases on account were $55,000, but remember, purchases returns were $5,000, so the balance of the account payable is $50,000. Subtracting the 2% purchase discount ($1,000 = $50,000 x 2%), Incredible owes Digital Wholesale only $49,000.
Using a perpetual system, Incredible Electronics reduces its inventory balance by the amount of the discount. The true cash price for inventory is $49,000, not $50,000.
Using a periodic system, the company will record the discount in purchase discounts, a contra purchases account. Purchase discounts, like purchase returns, is a temporary account that will be closed to (and become part of) cost of goods sold at the end of the period.

26. Inventory Sales
Incredible sales $80,000. What is the cost of this inventory?
Cost of goods sold = $53,000 ($61,000 - $8000).
Record cost of goods sold of $53,000 only when using perpetual system.
Periodic system we record the reduction in inventory and increase in cost of goods sold only periodically, as part of the period-end adjustment.
Inventory sales for Incredible Electronics total $80,000. This is the price it charges to customers. But what is the cost of this inventory (cost of goods sold) to Incredible Electronics? Since we know the cost of ending inventory equals $8,000, we can use the following formula to determine the cost of goods sold:
By subtracting the $8,000 ending inventory from the $61,000 cost of goods available for sale, we see that the cost of goods sold is $53,000.
We record sales revenue at the time of sale under both the perpetual and the periodic inventory systems. However, we record the cost of goods sold of $53,000 at the time of sale only when we are using the perpetual system. This system maintains a continual record of the inventory balance.
Under the periodic system, on the other hand, we record the reduction in inventory and increase in cost of goods sold only periodically, as part of the period-end adjustment.

27. Period End Adjustment It is needed only under the periodic system.
The entry serves the following purposes:
Adjusts the balance of inventory to its proper ending balance.
Records the cost of goods sold for the period to match inventory costs with the related revenues.
Closes (or zeros out) the temporary purchases accounts (purchases, freight-in, returns, and discounts).
Notice that cost of goods sold is recorded for $53,000, the same amount as that recorded under the perpetual system during the year. The beginning balance of inventory ($10,000) is eliminated and the ending balance ($8,000) is established. The temporary accounts are closed to zero.

28. LO6 Prepare a multiple-step income statement
Sales and purchases of inventory are most important set of transactions , companies report revenues and expenses from these separately from other revenues and expenses.
It makes easier for investors and other financial statement users to determine the profitability of a company’s inventory transactions.
Use the information for Incredible to calculate gross profit on the sale and purchase of inventory.
We discussed the calculation of net sales in Chapter 5. The difference between net sales of inventory ($74,000) and the cost of that inventory ($53,000) equals gross profit ($21,000).
While gross profit is a key profitability measure used to evaluate the performance of a merchandising company, investors consider other measures of profitability as well.

29. Multiple-step Income Statement
After gross profit, we see that the next item reported is selling, general, and administrative expenses, often referred to as operating expenses. We discussed several types of operating expenses in earlier chapters—wages, utilities, advertising, supplies, rent, insurance, and bad debts. These costs are normal for operating most companies. Operating income is what we call gross profit reduced by these operating expenses.
Combining operating income with nonoperating revenues and expenses yields income before income taxes. For Incredible Electronics, the amount of nonoperating revenues exceeds the amount of nonoperating expenses, so income before income taxes is higher than operating income. Next, the company’s bottom-line net income is the result of subtracting income tax expense from income before income taxes. At the bottom line, net income represents the difference between all revenues and all expenses for the period. We re-examine the multiple-step income statement in Chapter 12 and discuss additional income statement activities such as discontinued operations and extraordinary items.

30. Other Inventory Reporting Issues
Part C
Other Inventory Reporting Issues
What happens if the value of inventory falls below its original cost before a company can sell it? For example, think about the store where you usually buy your clothes. You’ve probably noticed the store selling leftover inventory at deeply discounted prices after the end of each selling season to make room for the next season’s clothing line. The value of the company’s old clothing inventory has likely fallen below its original cost. Is it appropriate to report the reduced-value inventory at its original cost? 30

31. LO7 Apply the lower-of-cost-or-market rule for inventories
When the value of inventory falls below its cost, companies are required to report inventory at the lower market value. And it is considered to be the replacement cost .
Once it has determined both the cost and market value of inventory, Inventory is reported at the lower of the two amounts
In other words, what is the cost to replace the inventory item in its identical form? The cost of inventory is the amount initially recorded in the accounting records based on methods we discussed in the previous section, specifically FIFO, LIFO, average cost, or specific identification. Once it has determined both the cost and market value of inventory, the company reports ending inventory in the balance sheet at the lower of the two amounts. This is known as the lower-of-cost-or-market rule (LCM) to valuing inventory.
To see how we apply the lower-of-cost-or-market method to inventory amounts, assume Mario’s Game Shop sells FunStation 2 and FunStation 3.

32. Calculating the Lower of Cost or Market
Mario’s reports the FunStation 2 in ending inventory at market value.
The 15 FunStation 2s were originally reported in inventory at their cost of $4,500.
To reduce the inventory from that original cost of $4,500 to its lower market value of $3,000, Mario records the following year-end adjustment.
The write-down of inventory has the effect not only of reducing total assets, but also of reducing net income and retained earnings.
FunStation 3 inventory, on the other hand, remains on the books at its original cost of $8,000 (= $400 x 20), since cost is less than market value. Mario’s doesn’t need to make any adjustment for these inventory items.
After adjusting inventory to the lower-of-cost-or-market, the store calculates its ending inventory balance.

33. Inventory turnover ratio
LO8 Analyze management of inventory using the inventory turnover ratio and gross profit ratio
If managers purchase too much inventory, the company runs the risk of the inventory becoming obsolete and market value falling below cost.
Analysts as well as managers often use the inventory turnover ratio to evaluate a company’s effectiveness in managing its investment in inventory.
Investors often rely on the gross profit ratio to determine the core profitability of a company’s operations.
Inventory turnover ratio is cost of goods sold divided by average inventory. It shows the number of times the firm sells its average inventory balance during a reporting period.
Inventory turnover ratio shows the number of times the firm sells its average inventory balance during a reporting period. The more frequently a business is able to sell or “turn over” its average inventory balance, the less the company needs to invest in inventory for a given level of sales. Other things equal, a higher ratio indicates greater effectiveness of a company in managing its investment in inventory.
Inventory turnover ratio =
Cost of goods sold
Average inventory
Average days in inventory =
365
Inventory turnover ratio

34. Analyze the inventory of Best Buy and Sharper Image Corporation
We can analyze the inventory of Best Buy and Sharper Image Corporation by calculating these ratios for both companies.
Best Buy sells a large volume of commonly purchased products.
Sharper Image sells a variety of high-end specialty products, including electronics, toys and other home and personal care products that typically are not carried by most other retailers.
Below are relevant amounts for each company.
Best Buy sells a large volume of commonly purchased products. In contrast, Sharper Image sells a variety of high-end specialty products, including electronics, toys, travel accessories, office furniture, and other home and personal care products that typically are not carried by most other retailers.

35. Computation of the Inventory Turnover Ratio
The turnover ratio is more than twice as high for Best Buy. On average, it takes Sharper Image an additional 73 days to sell its inventory. If the two companies had the same business strategies, this would be strong evidence that Best Buy has superior management of inventory. In this case, though, the difference in inventory turnover more likely is related to the type of products the two stores sell. Specialty items are not expected to sell as quickly. As we see next, Sharper Image offsets its relatively low inventory turnover with a relatively high profit margin per unit sold.
The turnover ratio is more than twice as high for Best Buy. On average, it takes Sharper Image an additional 73 days to sell its inventory.

36. LO8 Analyze management of inventory using the inventory turnover ratio and gross profit ratio
Gross profit ratio: Important indicator of the company’s successful management of inventory.
Gross profit ratio =
Gross profit
Net sales
Measures the amount by which the sale price of inventory exceeds its cost per dollar of sales.
Higher the ratio, higher is the “markup” a company is able to achieve on its inventories.
The gross profit ratio measures the amount by which the sale price of inventory exceeds its cost per dollar of sales. The higher the ratio, the higher is the “markup” a company is able to achieve on its inventories. Best Buy and Sharper Image report the following information.

37. Calculation of Gross Profit Ratio for Best buy and Sharper Image
For Best Buy, the gross profit ratio is 25% This means
that for every $1 of sales revenue, the company spends
$0.75 on inventory, resulting in a gross profit of $0.25.
We saw earlier that Sharper Image’s inventory turnover is about half that of Best Buy. But, we see now that Sharper Image makes up for that lower turnover with a profit margin about twice that of Best Buy. The products Best Buy sells are familiar goods, and competition from companies like Circuit City, Dell, Target, and Wal-Mart for these high-volume items keeps sale prices low compared to costs. Because Sharper Image specializes in unique lower-volume products, there is less competition, allowing greater price markups.
As products become more highly specialized, gross profit ratios typically increase even further.
For Sharper Image gross profit ratio is 49%

38. LO9 Calculate inventory amounts using FIFO and LIFO under a perpetual inventory system
We can calculate the amount of ending inventory by one of several methods.
We saw in Part B, the periodic and perpetual inventory systems determine when to report inventory transactions
Mario’s Game Shop. It sold 800 games to customers. Modify it by giving exact dates for the sale of the 800 games—250 on July 17 and 550 on December 15. The chronological order of inventory transactions follows.
We now calculate cost of goods sold and ending inventory for both FIFO and LIFO using a periodic inventory system and then a perpetual inventory system. It’s important to remember that the periodic system considers inventory transactions only at the end of the period, whereas the perpetual system maintains a continual record of inventory transactions.

39. FIFO with Perpetual System
FIFO AND LIFO WITH PERIODIC SYSTEM
FIFO, the first 800 units purchased for the period are those we assume were sold first. LIFO the last 800 units purchased for the period are those we assume were sold first.
FIFO WITH PERPETUAL SYSTEM
First units sold at the time of the sale, consistent with the perpetual systems approach to continually recording transactions.
By comparing amounts in the slide, we see that cost of goods sold and ending inventory do not differ depending on whether FIFO is computed using a periodic system or perpetual system. As we see next, this is not the case for LIFO.

40. LIFO with Perpetual System
Last units purchased at the time of the sale are the ones were sold first.
What are the last 250 units purchased at the time of the July 17 sale?
What are the last 550 units purchased at the time of the December 15 sale?
At the time of the July 17 sale, the last 250 units purchased are those we assume are sold first. These items consist of 250 units purchased on April 25. For the December 15 sale, the last 550 units purchased were those from the October 19 purchase. This means that at the end of the period, 50 units of the October 19 purchase, 50 units of the April 25 purchase, and all 100 units of beginning inventory remain.
Using LIFO, the amounts reported for cost of goods sold and ending inventory differ depending on whether we use a periodic or a perpetual system. This is also true for the average cost method.
In practice, though, very few companies use LIFO or the average cost method with a perpetual system. Companies that use LIFO use a procedure known as dollar-value LIFO.

41. LO10 Determine the financial statement effects of inventory errors
Errors can unknowingly occur in inventory amounts if there are mistakes in a physical count of inventory or in the pricing of inventory quantities.
The formula for cost of goods sold, follows
Notice that an error in calculating ending inventory, an asset in the balance sheet, causes an error in calculating cost of goods sold, an expense in the income statement. Since cost of goods sold is misstated, gross profit will be misstated as well but in the opposite direction. This is true because gross profit equals sales minus cost of goods sold.
The amount of ending inventory this year is the amount of beginning inventory next year. An error in ending inventory this year will create an error in beginning inventory next year.
Notice that ending inventory is subtracted in calculating cost of goods sold in year 1 (the year of the inventory error). That same amount becomes beginning inventory in the following year and is added in calculating cost of goods sold. Because of this, an error in calculating ending inventory in the current year will automatically affect cost of goods sold in the following year in the opposite direction .

42. Determine the financial statement effects of inventory errors
Summary of Effects of Inventory Error in the Current Year.
Relationship between Cost of Goods Sold in the Current Year
and the Following Year
Notice that an error in calculating ending inventory, an asset in the balance sheet, causes an error in calculating cost of goods sold, an expense in the income statement. Since cost of goods sold is misstated, gross profit will be misstated as well but in the opposite direction. This is true because gross profit equals sales minus cost of goods sold.
The amount of ending inventory this year is the amount of beginning inventory next year. An error in ending inventory this year will create an error in beginning inventory next year.
Notice that ending inventory is subtracted in calculating cost of goods sold in year 1 (the year of the inventory error). That same amount becomes beginning inventory in the following year and is added in calculating cost of goods sold. Because of this, an error in calculating ending inventory in the current year will automatically affect cost of goods sold in the following year in the opposite direction .

43. Inventory Amounts Correct Inventory Amounts
Incorrect Inventory Amounts
Now, assume the company mistakenly reports ending inventory in 2010 as $400, instead of $500. The effect of the mistake is shown in the slide.
Notice three things. First, the amount reported for inventory is correct by the end of the second year, $800. This is true even if the company never discovered its inventory mistake in 2010.
Second, the total amount reported for cost of goods sold over the two-year period from 2010 to 2011 is the same whether the error occurs or not, $6,800. That’s because the overstatement to cost of goods sold of $100 in 2010 is offset by an understatement of $100 in This also means that the inventory error affects gross profit in each of the two years but the combined two-year gross profit amount is unaffected.
Third, if the combined two-year gross profit is correct, then retained earnings will also be correct by the end of Thus, the inventory error in 2010 has no effect on the accounting equation at the end of Assets (inventory) and stockholders’ equity (retained earnings) are correctly stated.

44. End of chapter 6