Chapter 7

Cost of Goods Sold and Inventory

Preview
• Cost principle: determine the value of inventory
• Four inventory costing methods
• The lower of cost or market value (LCM)
• Inventory turnover
• Perpetual and periodic inventory systems

2
Value of Inventory
• Officially define inventory
• Flow of inventory costs for different industries
• How to record inventory purchase costs
• An example of inventory purchase costs
• The nature of COGS: inventory outflow 3
Inventory
• Tangible property owned by the company and
• Held for sale: merchandizers
• To produce new goods for sale: manufacturers

• Merchandizers:
• Goods are purchased for resale
• Cost of inventory: purchasing price
• Manufacturers:
• Buy raw materials
• Direct labor costs and factory overhead expenses
 work-in-process  finished goods
• Cost of inventory: price of raw materials + labor + overhead 4
Flow of Inventory Costs
Merchandiser
Merchandise Cost of
Inventory goods
Sold

Manufacturer

Raw Materials Work-in-process Finished Goods Cost of

Inventory inventory Inventory goods sold

Direct labor costs

Raw materials
Factory overhead 5
Inventory Purchase Costs
• Costs ≥ Price!!
• Invoice Price
• + Freight charges
• + Inspection costs
• + Preparation costs
• + All other costs to get the good ready for sale or use
• − Purchase discounts
• Example: M7-2
• Invoice price + shipping charges + import taxes and duties
• Should not include interests on loans: we do not need to pay the
interests in order to get the good ready for sale or use
6
E7-1
• Goods are in transit from suppliers
• FOB (Free on board): once leave my warehouse, they are yours.
• So goods in transit with terms of FOB should be included in
customer’s inventory and excluded from supplier’s inventory
(revenues are earned)
• Samples temporarily showed on customer’s site
• Not giving to customers. Should be included.
• Goods are in transit to customers, FOB
• Exclude form supplier’s inventory. Have done that correctly.
• Goods are in transit to customers, FOB “destination”
• FOB destination: once arrived destination, they are yours.
• So goods in transit with this term do not belong to customers yet. 7
Should be included.
Nature of Cost of Goods Sold
M7-4
Inventory

$3,213
Beginning inventory $11,042

?
Purchase Cost of goods sold

$2,916
Ending inventory

8
Inventory Costing Methods
• General idea
• Four methods
• A textbook example
• Financial statement effect of costing methods
9
• Managers’ choice
Inventory Costing Methods-
General Idea
• What is the assumed flow of costs?
• Assumed flow ≠ actual flow
• Which units are assumed sold?
• Which units are assumed to remain on hand?

• If we know exactly the costs of each good and exactly which

good is sold:
• Specific identification method
• Otherwise:
• Weighted average method
• First-in first-out method 10
• Last-in first-out method
Specific Identification
• We can identify the costs of every one of the goods
• We can identify which one is sold
• Ex. Jewelry, cars, houses, apartments, lands, etc.

• I/S: Which ones are sold  cost of goods sold

• B/S: Which ones are left in the inventory  ending inventory

11
Weighted Average
• Assume that the goods sold is randomly picked from the
inventory
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝑎𝑎𝑎𝑎𝑎𝑎 𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑓𝑓𝑓𝑓𝑓𝑓 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠
• 𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 =
𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 𝑜𝑜𝑜𝑜 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑓𝑓𝑓𝑓𝑓𝑓 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠

• I/S: Unit cost × number of units sold = Cost of goods sold

• B/S: Unit cost × number of units unsold = Ending inventory

12
FIFO and LIFO
• First-in First out (FIFO): assume that goods sold are taken from
the earliest purchases first
• I/S: Costs of oldest purchase  cost of goods sold
• B/S: Costs of latest purchase  ending inventory

• Last-in First out (LIFO): assume that goods sold are taken from
the latest purchases first
• I/S: Costs of latest purchase  cost of goods sold
• B/S: Costs of earliest purchase  ending inventory

13
P7-2: Q4
• Even if the sales are dated, we still may not know which units were
sold.
• Suppose we knew (Q4):
• 90 units of goods were sold, 2/5 of which (=36) were from beginning
inventory (unit price was $4) and 3/5 (=54) were from purchase in
January (unit price was $2.7)
• Cost of goods sold: 36*$4 + 54*$2.7 = $289.8
• 630 units of goods were sold, 294 (= 330-36) from whatever we have
left from the beginning inventory (unit price was $4), 336 (=630-294)
from the purchase in May (unit price was $5)
• Cost of goods sold: 294*$4 + 336*$5 = $2,856
• Total cost of goods sold = $2,856+$289.8=$3,145.8
• Beginning inventory is sold out, 176 (=230-54) units were left from
purchase in January, and 54 (=390-336) units were left from purchase
in May 14
• Ending inventory = 176*$2.7 + 54*5 = $745.2
P7-2: Q3
• Suppose we do not know exactly which goods were sold.
• Assume that goods are randomly selected from inventory to
sell. We use the weighted average to determine the costs and
the ending inventory.
• Total costs of goods available for sale = 330*$4 + 230* $2.7 + 390*$5
= $3,891
• Total units available for sale = 330+230+390 = 950
• Weighted average unit price = $3,891 / 950=$4.10
• Cost of goods sold = (90+630) * $4.1 = $2,948.97
• Units in ending inventory = beginning + purchase – sold
 330 + (230+390) – (90+630) = 230
Value of ending inventory = units in ending inventory × weighted
average unit price = 230*$4.1 = $942.03 15
P7-2: Q1
• Suppose we do not know exactly which goods were sold.
• Assume that goods sold are taken from the earliest purchases
first
• Sold 90+630 = 720 units
• Beginning inventory is 330 units, not enough. (need 390 more)
• First purchase (in January) is 230, not enough. (need 160 more)
• Second purchase (in May) is 390, enough. (only takes 160 out)
• So ending inventory has 390 – 160 = 230 units left. These are
assumed to be from the purchase in May (unit price $5).
• Ending inventory = 230*$5 = $1,150.
• Beginning inventory (330*$4) + purchases (230*$2.7+390*$5) –
cost (?) = Ending inventory ($1,150).
16
• Cost of goods sold = $2,741.
P7-2: Q2
• Suppose we do not know exactly which goods were sold.
• Assume that goods sold are taken from the latest purchases
first
• Sold 90+630 = 720 units
• Second purchase (in May) is 390, not enough. (need 330 more)
• First purchase (in January) is 230, not enough. (need 100 more)
• Beginning inventory is 330 units, enough. (only takes 100 out)
• So ending inventory has 330 – 100 = 230 units left. These are
assumed to be from the beginning inventory (unit price $4).
• Ending inventory = 230*$4 = $920.
• Beginning inventory (330*$4) + purchases (230*$2.7+390*$5) –
cost (?) = Ending inventory ($920).
17
• Cost of goods sold = $2,971.
 Financial Statement Effects of
Costing Methods
FIFO LIFO Weighted average

If unit cost of •COGS: Lowest •COGS: Highest •COGS: middle

inventories is •Ending Inventory: •Ending Inventory: •Ending Inventory:
rising over the fiscal Highest Lowest middle
period
If unit cost of •COGS: Highest •COGS: Lowest •COGS: middle
inventories is •Ending Inventory: •Ending Inventory: •Ending Inventory:
declining over the Lowest Highest middle
fiscal period
Benefits/Costs FIFO correctly values LIFO matches revenues
inventories at the end and COGS well, but Smoothes out price
of fiscal period, but tends to understate or changes.
tends to understate or overstate ending
overstate cost of goods inventory (compared
18
sold to the current
replacement costs)
Managers Choice of Inventory Costing
Methods
Net Income Effects Income Tax Effects
• If costs are lower, • If costs are higher, pre-
earnings are higher tax income is lower and
so tax expense is lower

IFRS, HK, Canada, Australia, Singapore prohibit LIFO in

the financial reporting.

19
Lower of Cost or Market

• The idea of the lower of cost or market (LCM)

• An example of iPhone 1
• Textbook example 20
Valuation at Lower of Cost or Market
• Ending inventory reported at min{historical cost, market value}
• Market value = ?
(A) Replacement cost: for same goods with the same quality
If we buy exactly the same goods now, how much do we have
to pay for them?
(B) Net realizable value: for same goods, quality has declined.
If we sell the goods now, how much can we sell them for? And
how much sales expenses we have to incur to sell them?
NET realized value = sales price – additional expenses to sell
• If market value < historical cost, then:
• Recognize a holding loss (Cost of goods sold) Conservative
= historical cost – market value
• If market value ≥ historical cost, then:
• Do nothing else. Keep recording the costs of inventory as usual. 21
Example
• Apple Inc. started selling the first generation of iPhone
(iPhone 1) on June 29, 2007. Original prices were:
• 4GB: US$499 (≈ HKD$3,842) (+ 2-year contract with A&T&)
• 8GB: US$599 (≈ HKD$4,612) (+ 2-year contract with A&T&)
• On September 5, 2007, Apple discontinued the 4GB model
and reduced the price of the 8GB model to US$399.
• Suppose the ending inventory is as follows:
Cost Quantity Market Price
4GB $300 1 million $100
8GB $350 2 million $399
• It needs to do an adjustment:
Cost of goods sold 200,000,000 22
Inventory 200,000,000
 E7-11
Item Quantity Historical Replacement Write-off Total
cost cost Per unit write-off
A 55 $20 $17
B 85 35 45
C 15 53 57
D 75 30 35
E 355 15 10
Total

23
Inventory Turnover

• The formula and the concept

• Textbook example
24
Inventory Turnover
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
• 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 =
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝐺𝐺𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
=
𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 + 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖
2
• Suppose beginning inventory is 1 unit @ $1
Bought Sold (units) Inventory turnover
1 @ $1 1 1  inventory was sold once
2 @ $1 2 2  inventory was sold twice
N @ $1 N N  inventory was sold N times
3 @ $1 1 0.5  inventory was sold ? times
• A higher ratio indicates that inventory moves faster (i.e.,
goods are sold faster). 25
E7-14
• Sale 1/21/2015 and 1/27/2015: 40+25=65 units
• FIFO: turnover = 2.40
• Step 1, beginning inventory: 19 units. Need 46 units more.
• Step 2, first purchase: 25 units. Need 21 units more.
• Step 3, second purchase: 50 units. Take 21 units out.
• Ending inventory: 50-21=29 units from second purchase (@ $19) = $551
• Cost of goods sold: beginning + purchase – ending
= $304 + ($325+$925) – $551 = $1,028
• LIFO: turnover = 3.91
• Step 1, second purchase: 50 units. Need 15 units more.
• Step 2, first purchase: 25 units. Take 15 units out.
• Ending inventory: beginning inventory ($228) + 10 (= 25-15) units from first
purchase (@ $13) = $358
• Cost of goods sold: beginning + purchase – ending = $228 + ($325+$950) –
$358 = $1,145
• FIFO ending inventory reflects the increasing unit price  more 26
conservative
Perpetual and Periodic
Inventory
• The definition of perpetual and periodic inventory systems
• Comparison of the two systems
• An example using weighted average cost method 27
Perpetual and Periodic Inventory Systems

• Perpetual inventory system:

• Inventory record is continuously updated by purchases and sales
• Provides up-to-date inventory balance and cost of goods sold
• Periodic inventory system:
• Quantity in the ending inventory: walk into the warehouse and
count
• Value of the ending inventory: assume that the all sales over the
period happen after all purchases over the period and then find
out the correct unit prices
• Then calculate cost of goods sold as follows:
Cost of goods sold = beginning inventory + purchases – ending
inventory
28
Perpetual and Periodic Inventory Systems
Inventory System

Item Perpetual System Periodic System

Carried over Carried over from
Beginning Inventory
from prior period prior period
Accumulated in Accumulated in
Add: Purchases the Inventory the Purchases
account account
Perpetual record Measured at end
updated at every of period by
Less: Ending Inventory
sale physical
inventory count
Measured at Computed as a
every sale based residual amount
Cost of Goods Sold
on perpetual at end of period
record
29
 Perpetual vs. Periodic: weighted average cost method
Transactions Perpetual system Periodic system

Beginning: 10*$5= $50 10*$5= $50

10 units @ $5/per unit
Jan 3, buy Inventory available for sale Additional purchase
10 units @ $8/per unit =50+10*$8=130 =10*$8=$80
Average unit cost=
$130/20=$6.5/per unit
January 15, Sell 15 units COGS=$6.5*15=$97.5
Inventory available for sale
=$6.5*5=$32.5
January 20, Buy Inventory available for sale Additional purchase
20 units @ $7/per unit =32.5+20*$7=172.5 =20*$7=$140
Average unit cost=
$172.5/25=$6.9/per unit
January 31, Sell 10 units COGS=$6.9*10=$69 Total inventory available for sale=
Ending inventory 50+80+140=$270
=$6.9*15=$103.5 average unit cost=$270/40=$6.75
Total COGS Ending inventory
=97.5+69=$166.5 =15*$6.75=$101.25 30
Total COGS=270-101.25=$168.75
Summary Quiz
A. FIFO, LIFO, and Weighted average differ by the assumed flow of
costs.
B. Under LIFO, if new purchases are usually more than goods sold,
the oldest inventory would remain in the ending inventory forever.
C. If the unit prices are decreasing, the ending inventory under LIFO
would be higher than the ending inventory under FIFO.
D. LIFO matches revenues and cost of goods sold better than FIFO.
E. If the current market price of inventory is higher than the
historical costs, we should increase inventory value to reflect the
current market condition.
F. If some inventory becomes obsolete and resulting in a reduction
in the market price, we should record a Loss on the Income
Statement.
G. If the unit prices are increasing, the LIFO cost of goods sold would
be higher in the periodic inventory system than in the perpetual
inventory system. 31
H. The costs of inventory is the purchase price of the inventory.