6-1

INVENTORIES AND COST OF SALES

Supply Chain Management
Road Map to Excellence….
Corporate Strategy

Where are Inventories?

Competitive Strategy

Supply Chain Strategy

Responsiveness Efficiency

Facilitie Inventor yTransportatio n Information Sourcing Pricing

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Supply Chain Management
Road Map to Excellence….
Corporate Strategy

What are Inventories?

Competitive Strategy

Supply Chain Strategy

Responsiveness Efficiency

Facilitie Inventor yTransportatio n Information Sourcing Pricing

s
Supply Chain Management
Road Map to Excellence….
Corporate Strategy

Reasons for Inventories?

Competitive Strategy

Supply Chain Strategy

Responsiveness Efficiency

Facilitie Inventor yTransportatio n Information Sourcing Pricing

s
Supply Chain Management
Road Map to Excellence….
Corporate Strategy

Reasons against Inventories?

Competitive Strategy

Supply Chain Strategy

Responsiveness Efficiency

Facilitie Inventor yTransportatio n Information Sourcing Pricing

s
Supply Chain Management
Road Map to Excellence….
Corporate Strategy

Types of Inventories?
Competitive Strategy

Supply Chain Strategy

Responsiveness Efficiency

Facilitie Inventor yTransportatio n Information Sourcing Pricing

s
Supply Chain Management
Road Map to Excellence….

Inventory Management
Corporate Strategy

Competitive Strategy

Supply Chain Strategy

Objectives Responsiveness

Facilitie
Efficiency

Inventor yTransportatio n Information Sourcing Pricing

s
Supply Chain Management
Road Map to Excellence….
Corporate Strategy

Inventory
Competitive Strategy

Supply Chain Strategy

Responsiveness Efficiency

Facilitie Inventor yTransportatio Informatio

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• Inventory decisions • Metrics

– Cycle inventory
– Safety inventory
– Seasonal inventory
– Decoupling Inventory
– Level of product availability
– Average inventory
– Units that have been in
stock for more than a
specified period of time
– Fill rate (fraction of orders
that were met on time from
inventory)
– Fraction of time out of stock

Overall tradeoff: Level of inventory versus level of

product availability
How could a grocery retailer use inventory to increase
responsiveness?
 6-9

C1

DETERMINING INVENTORY ITEMS

Merchandise inventory includes all goods that a
company owns and holds for sale, regardless of where
the goods are located when inventory is counted.

Items requiring special attention include:

Goods
Goods in
Damaged or
Transit
Goods on Obsolete
Consignment
 6 - 10

C1

GOODS IN TRANSIT
FOB Shipping Point
Public
Carrier

Seller Buyer

Ownership passes
to the buyer here.

Public
Carrier

Seller FOB Destination Point Buyer

 6 - 11

C1

GOODS ON CONSIGNMENT
Merchandise is included in the inventory of the
consignor, the owner of the inventory.
Thanks for selling my
inventory in your
store.
Consignee

Consignor
 6 - 12

C1

GOODS DAMAGED OR OBSOLETE

Damaged or obsolete goods are not counted in

inventory if they cannot be sold.

Cost should be reduced to net realizable

value if they can be sold.
 6 - 13

C2

DETERMINING INVENTORY COSTS

Include all expenditures necessary to bring an item to
a salable condition and location.

Minus
Discounts Invoice Plus
and Insurance
Allowances
Cost

Plus Import Plus

Duties Plus Storage
Freight
 6 - 14

C2
INTERNAL CONTROLS AND TAKING A
PHYSICAL COUNT
➢ Most companies take a ➢ When the physical count
physical count of does not match the
inventory at least once Merchandise Inventory
each year. account, an adjustment
must be made.

Good internal controls over count include:

1. Pre-numbered inventory tickets.
2. Counters have no inventory responsibility.
3. Counts confirm existence, amount, and
quality of inventory item.
4. Second count is taken.
5. Manager confirms all items counted.
 6 - 15

C2 INVENTORY COSTING UNDER

A PERPETUAL SYSTEM

Inventory
affects . . .
Balance Income
Sheet Statement

The matching
principle requires
matching costs
with sales.
 6 - 16

C2

INVENTORY COST FLOW ASSUMPTIONS

Management decisions in accounting for inventory
involve the following:
1. Items included in inventory and their costs.
2. Costing method (specific identification, FIFO, LIFO,
or weighted average).
3. Inventory system (perpetual or periodic).
4. Use of market values or other estimates.
 6 - 17

P1

INVENTORY COST FLOW ASSUMPTIONS

First-In, First-Out Assumes costs flow in the order
(FIFO) incurred.

Last-In, First-Out Assumes costs flow in the

(LIFO) reverse order incurred.

Weighted Assumes costs flow at an

Average average of the costs available.
 6 - 18

P1

INVENTORY COSTING ILLUSTRATION

Here is information about the mountain bike inventory of Trekking
for the month of August.
 6 - 19

P1

SPECIFIC IDENTIFICATION
 6 - 20

P1 SPECIFIC IDENTIFICATION

Income Statement
Cost of Goods Sold Balance Sheet Inventory
 6 - 21

P1

SPECIFIC IDENTIFICATION
Here are the entries to record the purchases and sales. The
numbers in red are determined by the cost flow assumption used.

All purchases and sales are made on credit.

The selling price of inventory was as follows:
8/14 $130
8/31 150
 6 - 22

P1

FIRST-IN, FIRST-OUT (FIFO)

Oldest Cost of
Costs Goods Sold

Recent Ending
Costs Inventory
 6 - 23

P1

FIRST-IN, FIRST-OUT (FIFO)

 6 - 24

P1

FIRST-IN, FIRST-OUT (FIFO)

 6 - 25

P1

FIRST-IN, FIRST-OUT (FIFO)

Here are the entries to record the purchases and sales entries. The
numbers in red are determined by the cost flow assumption used.

All purchases and sales are made on credit.

The selling price of inventory was as follows:
8/14 $130
8/31 150
 6 - 26

P1

LAST-IN, FIRST-OUT (LIFO)

Recent Cost of
Costs Goods Sold

Oldest Ending
Costs Inventory
 6 - 27

P1

LAST-IN, FIRST-OUT (LIFO)

 6 - 28

P1

LAST-IN, FIRST-OUT (LIFO)

 6 - 29

P1

LAST-IN, FIRST-OUT (LIFO)

Here are the entries to record the purchases and sales entries. The
numbers in red are determined by the cost flow assumption used.

All purchases and sales are made on credit.

The selling price of inventory was as follows:
8/14 $130
8/31 150
 6 - 30

P1

WEIGHTED AVERAGE
When a unit is sold, the average
cost of each unit in inventory is
assigned to cost of goods sold.
Cost of Goods Units on hand
Available for ÷ on the date of
Sale sale
 6 - 31

P1

WEIGHTED AVERAGE
 6 - 32

P1

WEIGHTED AVERAGE
 6 - 33

P1

WEIGHTED AVERAGE
 6 - 34

P1

WEIGHTED AVERAGE
Here are the entries to record the purchases and sales entries for Trekking.
The numbers in red are determined by the cost flow assumption used.

All purchases and sales are made on credit.

The selling price of inventory was as follows:
8/14 $130
8/31 150
 6 - 35

A1
FINANCIAL STATEMENT EFFECTS
OF COSTING METHODS
Because prices change, inventory methods nearly always
assign different cost amounts.
 6 - 36

A1 FINANCIAL STATEMENT EFFECTS

OF COSTING METHODS

Advantages of Methods

Weighted First-In, Last-In,

Average First-Out First-Out

Ending inventory Better matches

Smoothes out approximates current costs in cost
price changes. current of goods sold with
replacement cost. revenues.
 6 - 37

A1

TAX EFFECTS OF COSTING METHODS

The Internal Revenue Service (IRS) identifies several

acceptable inventory costing methods for reporting
taxable income.

If LIFO is used for tax

purposes, the IRS requires
it be used in financial
statements.
 6 - 38

A1 CONSISTENCY IN USING COSTING

METHODS

The consistency principle requires a

company to use the same accounting
methods period after period so that financial
statements are comparable across periods.
 6 - 39

P2

LOWER OF COST OR MARKET

Inventory must be reported at market value
when market is lower than cost.

Defined as current Can be applied three ways:

(1) separately to each
replacement cost
individual item.
(not sales price).
(2) to major categories of
Consistent with assets.
the conservatism (3) to the whole inventory.
principle.
 6 - 40

P2

LOWER OF COST OR MARKET

A motor sports retailer has the following
items in inventory:
Per Unit
Units on Total
Inventory Items Hand Cost Market Total Cost Market
Cycles:
Roadster 20 $ 8,000 $ 7,000 $ 160,000 $ 140,000
Sprint 10 5,000 6,000 50,000 60,000
Off-Road
Trax-4 8 5,000 6,500 40,000 52,000
Blazer 5 9,000 7,000 45,000 35,000
Totals $ 295,000
 6 - 41

P2

LOWER OF COST OR MARKET

Here is how to compute lower of cost or
market for individual inventory items.

LCM Applied
to
Units on Total
Inventory Items Hand Total Cost Market Items
Cycles:
Roadster 20 $ 160,000 $ 140,000 $ 140,000
Sprint 10 50,000 60,000 50,000
Off-Road
Trax-4 8 $ 40,000 $ 52,000 40,000
Blazer 5 45,000 35,000 35,000
Totals $ 295,000 $ 265,000
 6 - 42

A2 FINANCIAL STATEMENT EFFECTS OF

INVENTORY ERRORS
Income Statement Effects
Inventory Error Cost of Goods Sold Net Income
Understate ending inventory Overstated Understated
Understate beginning inventory Understated Overstated
Overstate ending inventory Understated Overstated
Overstate beginning inventory Overstated Understated
 6 - 43

A2 FINANCIAL STATEMENT EFFECTS OF

INVENTORY ERRORS
Balance Sheet Effects
Inventory Error Assets Equity
Understate ending inventory Understated Understated
Overstate ending inventory Overstated Overstated
 6 - 44

A3

INVENTORY TURNOVER
Shows how many times a company turns over its inventory
during a period. Indicator of how well management is
controlling the amount of inventory available.

Inventory Cost of goods sold

Turnover = Avg. inventory

Average
Inventory = (Beg. Inv. + End Inv.) ÷ 2
 6 - 45

A3

DAYS’ SALES IN INVENTORY

Reveals how much inventory is available in

terms of the number of days’ sales.

Days' Sales in Ending Inventory

Inventory = Cost of goods sold
×365
 6 - 46

GLOBAL VIEW
Items and Costs Making Up Inventory
Both U.S. GAAP and IFRS include in inventory all items that a company owns
and holds for sale and include in the cost expenditures necessary to bring those
items to a salable condition and location.

Assigning Costs to Inventory

Both U.S. GAAP and IFRS allow companies to use specific identification, FIFO,
and Weighted Average. IFRS does not currently allow use of LIFO.

Estimating Inventory Costs

Both U.S. GAAP and IFRS require companies to write down inventory when its
value falls below recorded cost. U.S. GAAP prohibits any later increase in
value. IFRS does allow reversals of write downs up to the original acquisition
cost. Neither allow inventory to be adjusted upward beyond the original cost.
 6 - 47

P3 APPENDIX 6A: INVENTORY COSTING

UNDER A PERIODIC SYSTEM

LIFO computation of COGS

and ending inventory under
a periodic system.
 6 - 48

P4 APPENDIX 6B:
INVENTORY ESTIMATION METHODS
Inventory sometimes requires estimation for interim statements or
if some casualty such as fire or flood makes taking a physical
count impossible.

Retail Inventory Method Gross Profit Method