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# Inventories and the Cost of Goods Sold: Chapter 8

## Accounting for Inventory

Sales revenue is based on sales price Cost of Goods sold is based on cost

Inventory on the balance sheet is based on cost Gross profit is sales revenue minus cost of goods sold

## Accounting for Inventory

Inventory (Balance Sheet) = Number of units of Inventory on hand * Cost per unit of inventory

## *Cost per unit of inventory

Specific Identification

This method can only be used when we can identify the costs for each individual unit. Identification numbers are used to determine which item has been sold. The specific identification method is rarely used.

If the items are homogenous in nature then a cost flow assumption may be used.

## Average Cost Method

A method of valuing all units in inventory at the same average per-unit cost, which is recomputed after every purchase. The average cost method assumes that units are withdrawn from the inventory in random order.

## Perpetual Average Cost

Date Purchased Beg. Inv. 800 x 22.00 = 17,600 1-Sep Sold 600 x 22.000 = Balance \$ 17,600.00 13,200.00 4,400.00

## Perpetual Average Cost

Date Purchased Beg. Inv. 800 x 22.00 = 17,600 1-Sep 3-Sep 300 x 24.00 = 7,200 10-Sep Sold 600 x 300 x 22.000 = 23.200 = Balance \$ 17,600.00 13,200.00 4,400.00 11,600.00 6,960.00 4,640.00

## Perpetual Average Cost

Date Beg. Inv. 1-Sep 3-Sep 10-Sep 15-Sep 21-Sep 29-Sep 30-Sep Purchased 800 x 22.00 = 17,600 600 x 300 x 250 x 200 x 400 x 24.00 = 25.00 = 27.00 = 28.00 = 7,200 300 x 6,250 5,400 11,200 450 x 26.181 = 23.200 = Sold 22.000 = Balance \$ 17,600.00 13,200.00 4,400.00 11,600.00 6,960.00 4,640.00 10,890.00 16,290.00 27,490.00 11,781.45 15,708.55

## Perpetual Average Cost

Date Beg. Inv. 1-Sep 3-Sep 10-Sep 15-Sep 21-Sep 29-Sep 30-Sep Purchased 800 x 22.00 = 17,600 600 x 300 x 250 x 200 x 400 x 24.00 = 25.00 = 27.00 = 28.00 = 7,200 300 x 6,250 5,400 11,200 450 x 26.181 = 23.200 = Sold 22.000 = Balance \$ 17,600.00 13,200.00 4,400.00 11,600.00 6,960.00 4,640.00 10,890.00 16,290.00 27,490.00 11,781.45 15,708.55

Cost of Goods Sold in September Sale Date Units Cost/Unit Total 9/1 600 22.000 \$ 13,200.00 9/10 300 23.200 6,960.00 9/30 450 26.181 11,781.45 Total 1,350 31,941.45

Sum

## Perpetual Average Cost

To record the cash sales on Sep 1 worth \$14,000, cost \$13,200 Cash 14,000

Sales 14,000 To record the sale of one frame Cost of Goods Sold 13,200 Inventory 13,200 To record the cost of one frame sold determined by the average cost method

## First-In, First-Out (FIFO)

The FIFO method assumes that items are sold in the chronological order of their acquisition.
The cost of the oldest inventory items are charged to COGS when goods are sold. The cost of the newest inventory items remain in ending inventory.

## First-In, First-Out (FIFO)

Even though the periodic and the perpetual approaches differ in the timing of adjustments to inventory . . . . . . COGS and Ending Inventory Cost are the same under both approaches.

## First-In, First-Out (FIFO)

Yore Frame, Inc. Frame Inventory
Date Beg. Inventory 9/3 9/15 9/21 9/29 Goods Available for Sale Ending Inventory Cost of Goods Sold Units 800 300 250 200 400 1,950 600 1,350 \$/Unit \$ 22.00 24.00 25.00 27.00 28.00 Total \$ 17,600.00 7,200.00 6,250.00 5,400.00 11,200.00

## First-In, First-Out (FIFO)

Yore Frame, Inc. Frame Inventory
Date Beg. Inventory 9/3 9/15 9/21 9/29 Goods Available for Sale Ending Inventory Cost of Goods Sold Units 800 300 250 200 400 1,950 600 1,350 \$/Unit \$ 22.00 24.00 25.00 27.00 28.00 Total \$ 17,600.00 7,200.00 6,250.00 5,400.00 11,200.00 \$ 47,650.00 16,600.00

## First-In, First-Out (FIFO)

Yore Frame, Inc. Frame Inventory
Date Beg. Inventory 9/3 9/15 9/21 9/29 Goods Available for Sale Ending Inventory Cost of Goods Sold Units 800 300 250 200 400 1,950 600 1,350 \$/Unit \$ 22.00 24.00 25.00 27.00 28.00 Total \$ 17,600.00 7,200.00 6,250.00 5,400.00 11,200.00

## First-In, First-Out (FIFO)

Yore Frame, Inc. Frame Inventory
Date Beg. Inventory 9/3 9/15 9/21 9/29 Goods Available for Sale Ending Inventory Cost of Goods Sold Units 800 300 250 200 400 1,950 600 1,350 \$/Unit \$ 22.00 24.00 25.00 27.00 28.00 Total \$ 17,600.00 7,200.00 6,250.00 5,400.00 11,200.00 \$ 47,650.00 16,600.00 \$ 31,050.00

Last-In, First-Out
The LIFO method assumes that the newest items are sold first, leaving the older units in inventory.
The cost of the newest inventory items are charged to COGS when goods are sold. The cost of the oldest inventory items remain in inventory.

Last-In, First-Out
Unlike FIFO, using the LIFO method may result in COGS and Ending Inventory Cost that differ under the periodic and perpetual approaches.

Last-In, First-Out

## These are the first 600 units acquired.

Last-In, First-Out
Yore Frame, Inc. Frame Inventory
Date Beg. Inventory 9/3 9/15 9/21 9/29 Goods Available for Sale Ending Inventory Cost of Goods Sold Units 800 300 250 200 400 1,950 600 1,350 \$/Unit \$ 22.00 24.00 25.00 27.00 28.00 Total \$ 17,600.00 7,200.00 6,250.00 5,400.00 11,200.00 \$ 47,650.00 13,200.00

Last-In, First-Out
Yore Frame, Inc. Frame Inventory
Date Beg. Inventory 9/3 9/15 9/21 9/29 Goods Available for Sale Ending Inventory Cost of Goods Sold Units 800 300 250 200 400 1,950 600 1,350 \$/Unit \$ 22.00 24.00 25.00 27.00 28.00 Total \$ 17,600.00 7,200.00 6,250.00 5,400.00 11,200.00

## These are the last \$ 47,650.00 1,350 units 13,200.00 acquired.

Last-In, First-Out
Yore Frame, Inc. Frame Inventory
Date Beg. Inventory 9/3 9/15 9/21 9/29 Goods Available for Sale Ending Inventory Cost of Goods Sold Units 800 300 250 200 400 1,950 600 1,350 \$/Unit \$ 22.00 24.00 25.00 27.00 28.00 Total \$ 17,600.00 7,200.00 6,250.00 5,400.00 11,200.00 \$ 47,650.00 13,200.00 \$34,450.00

## When Prices Are Rising . . .

FIFO Matches low (older) costs with current (higher) sales. Inventory is valued at approximate replacement cost. Results in higher taxable income. LIFO Matches high (newer) costs with current (higher) sales. Inventory is valued based on low (older) cost basis. Results in lower taxable income.

Principle of Consistency

Once a company has adopted a particular method it should follow that method consistently. If a change is to be made the reasons for the change and the effects of the change on the company's net income must be disclosed.

## Just in Time Inventory Systems

A technique designed to minimize a companys investment in inventory This method increases efficiency

In a manufacturing company purchases are received just before starting production The manufactured goods are completed in time for sales orders

## Taking a Physical Inventory

Perpetual inventory records are adjusted for unrecorded shrinkage losses, such as theft, spoilage, or breakage The physical inventory is taken at the end of the year

## Recording Shrinkage Losses

8 units purchased Nov 2 @100 150 units purchased Dec 10 @ 115 Total (158 units)

## \$800 17,250 \$18,050

A year end physical count shows only 148 units on hand The loss in 10 units is to be adjusted

## Recording Shrinkage Losses

8 units purchased Nov 2 @100 150 units purchased Dec 10 @ 115 Total (158 units) \$800 17,250 \$18,050

## FIFO: 8 units @100 + 2 units @115=\$1,030 LIFO: 10 units @115= \$1150

Lower-of-Cost-or-Market Rule

In addition to shrinkage losses the inventory may become obsolete or unsalable A write down of inventory reduces both the inventory balance as well as the net income Report inventory at the lower of its historical cost or market (replacement) value If the replacement cost falls below its historical cost, write down the value of the inventory, the difference in the amounts will be debited to COGS

## Matching Revenues and COGS

The sales revenue and COGS relating to sales transactions occurring near year end are recorded in the same accounting period. If goods are in transit:
FOB shipping- the title passes to the buyer at the point of shipment FOB destination- the title passes to the buyer at the destination point

## Periodic Inventory Systems

At the end of the year all goods on hand are counted and priced at cost The ending inventory is used to calculate COGS for the year

Inventory at the beginning of the year Add: Purchases during the year Cost of goods available during the year Less: Inventory at the end of the year Cost of goods sold

## Specific Identification- assuming 12 units have a total cost of \$1,240

cost per # of units unit Beg inventory March1 10 5 \$80 90 total cost \$800 450 COG available for sale Less: Ending Inventory COGS \$3,000 1,240 \$1,760

July 1
Oct 1 Dec 1 Available for sale Units in ending inventory

5
5 5 30

100
120 130

500
600 650 \$3,000

(12)

Units sold

18

Average cost
cost per # of units unit Beg inventory March1 10 5 \$80 90 total cost \$800 450

## COGS= 3,000/ 30 =\$100(cost per unit) Ending Inventory = 12*100 =\$1,200

July 1
Oct 1 Dec 1 Available for sale Units in ending inventory

5
5 5 30

100
120 130

500
600 650 \$3,000

(12)

Units sold

18

FIFO
cost per # of units unit Beg inventory March1 10 5 \$80 90 total cost \$800 450

## Ending Inventory= (5*130)+(5*120)+(2*100) = \$1,450 COGS= 3,000- 1,450 = \$1,550

July 1
Oct 1 Dec 1 Available for sale Units in ending inventory

5
5 5 30

100
120 130

500
600 650 \$3,000

(12)

Units sold

18

LIFO
cost per # of units unit Beg inventory March1 10 5 \$80 90 total cost \$800 450

## Ending Inventory = (10*80) + (2*90) = \$980 COGS= 3,000-980 = \$2,020

July 1
Oct 1 Dec 1 Available for sale Units in ending inventory

5
5 5 30

100
120 130

500
600 650 \$3,000

(12)

Units sold

18

## The Tax Advantage of LIFO

FIFO LIFO Sales COGS Gross profit Operating expenses Income before taxes Income tax expense (40%) \$800 (340) 460 (260) \$200 \$ 80 \$800 (460) \$340 (260) \$ 80 \$ 32

## Inventory Errors Affect Two Years

An error in the valuation of inventory affects the financial statements of the current year as well as the income statement of the next year
Year of the Error Beginning Inventory Cost of Goods available for sale Ending Inventory COGS NE NE U O Following Year U U NE U

Gross Profit
Net Income Owners Equity at year end

U
U U

O
O NE

## Gross Profit Method

Step 1. Start with beginning inventory and add net purchases to get cost of goods available for sale. Step 2. To estimate cost of goods sold first subtract the gross profit on sales from 100% to get the cost percentage. Step 3. Second take net sales at retail and multiple by cost percentage this will give you estimated cost of goods sold. Step 4. Subtract estimated cost of goods sold from cost of goods available for sale to get estimated ending inventory.

## Gross Profit Method

Morrison Pet Supply Company Gross Profit Method For the Year Ended December 31, 2010 Beginning inventory \$40,000 Add: Net purchases 5,000 Cost of goods available for sale \$45,000 Estimated cost of goods sold: Net sales at retail ( \$17,000 Cost percentage (100% 35%) X .65) Less: Estimated cost of goods sold 11,050 Estimated ending inventory \$33,950

## The Retail Method

The retail method is similar to the gross profit method. The difference between the two is that the retail method uses the cost ratio of the current year rather than the previous period. In order to use this method the company must keep track of the cost of goods available for sale and the retail sales price assigned to the goods

Cont
Cost of goods available for sale= \$40,000 Retail price= \$100,000 Cost ratio = 40,000/100,000 = 40%

Inventory Management
Inventory = turnover ratio

## Average Inventory= (Beginning inventory + Ending inventory)/ 2

This ratio measures how many times a companys inventory has been sold and replaced during the year.

Length of the operating cycle- The shorter the cycle, the better it is for the company