1. Inventories Generally, 2 types of inventories: Merchandise (for sale) inventory Processing Inventory Raw Materials Inventory Work In Process Inventory

2. Inventories When to Include Items? Include items in inventory when ownership transfers. FOB (Free-on-Board): Specifies where ownership transfers. Shipping Point: when delivered to carrier. Destination: when delivered from carrier to recipient.

3. Inventories When to Include Items? Consignment: Provide product to marketing agent (shopkeeper) to sell. Marketing agent receives commission for sale. Marketing agent does not take ownership. Original owner retains ownership.

4. Inventories Generally, 2 ways to keep track of inventory: Perpetual (real-time) tracking Updates as items leave and arrive e.g. Supermarket Scanners Periodic tracking or counting Inventory counted at regular intervals Usually involves a hand-count Inventory sold is backed-into by looking at changes in inventory balance

5. Inventories Periodic Inventory System We take end of period count of inventory and compare to beginning inventory + newly purchased inventory to compute Cost of Goods Sold. Information needed: Beginning Inventory Purchases Ending Inventory

6. Inventories Periodic Inventory System Beginning Inventory = $15 $5 Purchases = $10 Cost of Goods Available for Sale = BI + Purchases = $25

7. Inventories Periodic Inventory System Ending Inventory = $5 $5 Cost of Goods Sold = Cost of Goods Available for Sale – EI = $25 - $5 = $20

8. Inventories Periodic Inventory System $5 Available for Sale $25 Lets take another look…

9. Inventories Periodic Inventory System $5 Ending Inv $5 Available for Sale $25

10. Inventories Periodic Inventory System $5 Sold $20 Available for Sale $25 Ending Inv($5) COGS$20 (or stolen)

11. Inventories Periodic Inventory SystemInventory Errors Inventory Errors in a Periodic System directly hit Net Income. These errors affect 2 periods. The error in the first period is reversed in the second period. - i.e., if Net Income is overstated in period 1, it will be understated in period 2.

12. Inventories Periodic Inventory SystemInventory Errors Period 1Period 2 Beg Inventory + Purchases = CoG Avail for Sale - Ending Inventory = Cost of Goods Sold Sales Revenue - Cost of Goods Sold = Net Income Beg Inventory + Purchases = CoG Avail for Sale - Ending Inventory = Cost of Goods Sold Sales Revenue - Cost of Goods Sold = Net Income

13. Inventories Periodic Inventory SystemInventory Errors Period 1Period 2 Beg Inventory + Purchases = CoG Avail for Sale - Ending Inventory = Cost of Goods Sold Sales Revenue - Cost of Goods Sold = Net Income Beg Inventory + Purchases = CoG Avail for Sale - Ending Inventory = Cost of Goods Sold Sales Revenue - Cost of Goods Sold = Net Income Assume we accidentally OVERCOUNT (overstate) 1 st pd Ending Inv.

14. Inventories Periodic Inventory SystemInventory Errors Period 1Period 2 Beg Inventory + Purchases = CoG Avail for Sale - Ending Inventory = Cost of Goods Sold Sales Revenue - Cost of Goods Sold = Net Income Beg Inventory + Purchases = CoG Avail for Sale - Ending Inventory = Cost of Goods Sold Sales Revenue - Cost of Goods Sold = Net Income (Too big) (Too small)

15. Inventories Periodic Inventory SystemInventory Errors Period 1Period 2 Beg Inventory + Purchases = CoG Avail for Sale - Ending Inventory = Cost of Goods Sold Sales Revenue - Cost of Goods Sold = Net Income Beg Inventory + Purchases = CoG Avail for Sale - Ending Inventory = Cost of Goods Sold Sales Revenue - Cost of Goods Sold = Net Income (Too small) (Too big)

16. Inventories Periodic Inventory SystemInventory Errors Period 1Period 2 Beg Inventory + Purchases = CoG Avail for Sale - Ending Inventory = Cost of Goods Sold Sales Revenue - Cost of Goods Sold = Net Income Beg Inventory + Purchases = CoG Avail for Sale - Ending Inventory = Cost of Goods Sold Sales Revenue - Cost of Goods Sold = Net Income (Too big)

17. Inventories Periodic Inventory SystemInventory Errors Period 1Period 2 Beg Inventory + Purchases = CoG Avail for Sale - Ending Inventory = Cost of Goods Sold Sales Revenue - Cost of Goods Sold = Net Income Beg Inventory + Purchases = CoG Avail for Sale - Ending Inventory = Cost of Goods Sold Sales Revenue - Cost of Goods Sold = Net Income (Too big)

18. Inventories Periodic Inventory SystemInventory Errors Period 1Period 2 Beg Inventory + Purchases = CoG Avail for Sale - Ending Inventory = Cost of Goods Sold Sales Revenue - Cost of Goods Sold = Net Income Beg Inventory + Purchases = CoG Avail for Sale - Ending Inventory = Cost of Goods Sold Sales Revenue - Cost of Goods Sold = Net Income (Too big) (Too small)

19. Inventories Periodic Inventory SystemInventory Errors Period 1Period 2 Beg Inventory + Purchases = CoG Avail for Sale - Ending Inventory = Cost of Goods Sold Sales Revenue - Cost of Goods Sold = Net Income Beg Inventory + Purchases = CoG Avail for Sale - Ending Inventory = Cost of Goods Sold Sales Revenue - Cost of Goods Sold = Net Income (Too big) (Too small)(Too big) Note the reversal in the 2 nd period.

20. Inventories Valuing inventory stock (determining COGS) A common problem is that inventory is often brought in with different cost layers. Different methods to value inventory: Specific Identification: each item tracked at actual value Average Cost Method: use weighted average cost of items First-in-First-Out Last-in-First-Out

21. Inventories Average Cost Method AmountUnit CostValue 100$5$500 200$6$1,200 200$7$1,400 500$3,100 Sell 300 units: Average cost = $3,100 / 500 = $6.20 per unit Cost of Goods Sold = $6.20 x 300 units = $1,860

22. Inventories Average Cost Method AmountUnit CostValue 100$5$500 200$6$1,200 200$7$1,400 500$6.20 $3,100 Sell 300 units: Average cost = $3,100 / 500 = $6.20 per unit After Sale, 200 units left. Unit cost now adjusted to $6.20. 200$1,240

23. Inventories Average Cost Method AmountUnit CostValue 200$6.20$1,240 (new purchase) 100$6.50$650 300$1,890 Any new purchases create new layers and a new average will be computed. $1,890 / 300 = $6.30 per unit

24. Inventories FIFO Method AmountUnit CostValue 100$5$500 200$6$1,200 200$7$1,400 Sell 250 units: 100 x $5 = $500 150 x $6 = $900 COGS = $1,400 These layers are depleted first. (Top down).

25. Inventories LIFO Method AmountUnit CostValue 100$5$500 200$6$1,200 200$7$1,400 Sell 250 units: 200 x $7 = $1,400 50 x $6 = $300 COGS = $1,700 These layers are depleted first. (Bottom up.)

26. Inventories Differences in Methods Weighted Average has least potential for manipulation LIFO has highest COGS (lowest Net Income) during rising inflation FIFO has the lowest COGS (highest Net Income) during rising inflation Specific Identification may be the most accurate

27. Inventories Problems with LIFO LIFO Liquidation is an issue when, due to high demand, a firm using LIFO has to dip deep into its inventory. When this happens, many of the earlier (cheaper) layers get liquidated. This forces the firm to match revenues against cheaper, and likely less accurate costs. One potential remedy is the Dollar Value LIFO Method

28. Inventories Dollar Value LIFO To use Dollar Value LIFO, you only need to know two things: Ending Value of Total Inventory The rate of inflation From these, you back out the layers of inventory

29. Inventories Dollar Value LIFO 1999 Ending Inventory Value 2000 Ending Inventory Value $200,000$299,000 $99,000 increase in value Is this increase in value due to purchases of new inventory or due to inflation? Both!

30. Inventories Dollar Value LIFO 1999 Ending Inventory Value 2000 Ending Inventory Value $200,000$299,000 To find out actual inventory purchases, we need to deflate (discount) the 2000 Ending Inventory back to 1999 price levels. This effectively wipes away the inflation effect to give us the true purchases effect.

31. Inventories Dollar Value LIFO 1999 Ending Inventory Value 2000 Ending Inventory Value $200,000$299,000 If price index is 15%, the discount multiplier is: 1 1.15 = 0.8696 $260,000 x 0.8696

32. Inventories Dollar Value LIFO 1999 Ending Inventory Value 2000 Ending Inventory Value $200,000$299,000 $260,000 x 0.8696 $60,000 of actual inventory increase (stated at year 1999 price levels)

33. Inventories Dollar Value LIFO Year[a] Ending Value [b] Disc. Multiplier [1/Price Index] [c] = [a] x [b] Ending Value (Base Year $) [d] Real Increase in Inventory (Base Year $) [e] New Layer at inflated cost 1999 (Base) 200,000---200,000---200,000 2000 2001

34. Inventories Dollar Value LIFO Year[a] Ending Value [b] Disc. Multiplier [1/Price Index] [c] = [a] x [b] Ending Value (Base Year $) [d] Real Increase in Inventory (Base Year $) [e] New Layer at inflated cost 1999 (Base) 200,000---200,000---200,000 2000299,000 2001

35. Inventories Dollar Value LIFO Year[a] Ending Value [b] Disc. Multiplier [1/Price Index] [c] = [a] x [b] Ending Value (Base Year $) [d] Real Increase in Inventory (Base Year $) [e] New Layer at inflated cost 1999 (Base) 200,000---200,000---200,000 2000299,0001/1.15 2001

36. Inventories Dollar Value LIFO Year[a] Ending Value [b] Disc. Multiplier [1/Price Index] [c] = [a] x [b] Ending Value (Base Year $) [d] Real Increase in Inventory (Base Year $) [e] New Layer at inflated cost 1999 (Base) 200,000---200,000---200,000 2000299,0000.8696260,000 2001

37. Inventories Dollar Value LIFO Year[a] Ending Value [b] Disc. Multiplier [1/Price Index] [c] = [a] x [b] Ending Value (Base Year $) [d] Real Increase in Inventory (Base Year $) [e] New Layer at inflated cost 1999 (Base) 200,000---200,000---200,000 2000299,0000.8696260,00060,000 2001 This is the real increase reinflated = 60,000 x 1.15 = 69,000

38. Inventories Dollar Value LIFO Year[a] Ending Value [b] Disc. Multiplier [1/Price Index] [c] = [a] x [b] Ending Value (Base Year $) [d] Real Increase in Inventory (Base Year $) [e] New Layer at inflated cost 1999 (Base) 200,000---200,000---200,000 2000299,0000.8696260,00060,00069,000 2001

39. Inventories Dollar Value LIFO Year[a] Ending Value [b] Disc. Multiplier [1/Price Index] [c] = [a] x [b] Ending Value (Base Year $) [d] Real Increase in Inventory (Base Year $) [e] New Layer at inflated cost 1999 (Base) 200,000---200,000---200,000 2000299,0000.8696260,00060,00069,000 2001360,0001/1.20 Assume a price index of 120 percent in this year.

40. Inventories Dollar Value LIFO Year[a] Ending Value [b] Disc. Multiplier [1/Price Index] [c] = [a] x [b] Ending Value (Base Year $) [d] Real Increase in Inventory (Base Year $) [e] New Layer at inflated cost 1999 (Base) 200,000---200,000---200,000 2000299,0000.8696260,00060,00069,000 2001360,0000.8333300,000

41. Inventories Dollar Value LIFO Year[a] Ending Value [b] Disc. Multiplier [1/Price Index] [c] = [a] x [b] Ending Value (Base Year $) [d] Real Increase in Inventory (Base Year $) [e] New Layer at inflated cost 1999 (Base) 200,000---200,000---200,000 2000299,0000.8696260,00060,00069,000 2001360,0000.8333300,00040,000

42. Inventories Dollar Value LIFO Year[a] Ending Value [b] Disc. Multiplier [1/Price Index] [c] = [a] x [b] Ending Value (Base Year $) [d] Real Increase in Inventory (Base Year $) [e] New Layer at inflated cost 1999 (Base) 200,000---200,000---200,000 2000299,0000.8696260,00060,00069,000 2001360,0000.8333300,00040,00048,000 This is the real increase reinflated = 40,000 x 1.20 = 48,000

43. Inventories Dollar Value LIFO Year[e] New Layer at inflated cost 1999 (Base) 200,000 200069,000 200148,000 This is how the inventory would be layered on the books.