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Inventories and the Cost of Goods Sold

Chapter 8

PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin Copyright 2012 The McGraw-Hill Companies, Inc.8-1

The Flow of Inventory Costs


BALANCE SHEET
Purchase costs (or manufacturing costs)

Asset Inventory
as goods are sold

INCOME STATEMENT
Revenue Cost of goods sold Gross profit Expenses Net income

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The Flow of Inventory Costs


In a perpetual inventory system, inventory entries parallel the flow of costs.
GENERAL JOURNAL
Date Account Titles and Explanation Entry on Purchase Date Inventory Accounts Payable Entry on Sale Date Cost of Goods Sold Inventory $$$$ $$$$
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Debit $$$$

Credit

$$$$

Which Unit Did We Sell?


When identical units of inventory have different unit costs, a question naturally arises as to which of these costs should be used in recording a sale of inventory.
GENERAL JOURNAL
Date Account Titles and Explanation Entry on Sale Date Cost of Goods Sold Inventory $$$$ $$$$
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Debit

Credit

Inventory Subsidiary Ledger


A separate subsidiary account is maintained for each item in inventory.

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Data for an Illustration


The Bike Company (TBC)
Cost of Goods Available for Sale Aug. 1 Beg. Inventory 10 units @ Aug. 3 Purchased 15 units @ Aug. 17 Purchased 20 units @ Aug. 28 Purchased 10 units @ Retail Sales of Goods Aug. 14 Sales Aug. 31 Sales $ $ $ $ 91 106 115 119 = = = = $ 910 $ 1,590 $ 2,300 $ 1,190

20 units @ $ 130 = $ 2,600 23 units @ $ 150 = $ 3,450

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Specific Identification
On August 14, TBC sold 20 bikes for $130 each. Of the bikes sold 9 originally cost $91 and 11 cost $106.
Purchases Date Aug. 1 Aug. 3 Aug. 14 Units Unit Cost
91 = $ 106 = $

Total
910 1,590

Cost of Goods Sold Unit Cost Units Total

Inventory Balance Units


10 @ 10 @ $ $

Unit Cost
91 = 91 106 91 106 = $ $

Total
910 2,500

10 @ $ 15 @ $

= $

15 @ $ 9 @ $ 11 @ $ 91 106 = $ 1,985 1 @ $

515

4 @ $

The Cost of Goods Sold for the August 14 sale is $1,985. This leaves 5 units, with a total cost of $515, in inventory: 1 unit that costs $91 and 4 units that cost $106 each.
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Specific Identification
GENERAL JOURNAL
Date Account Titles and Explanation Debit 2,600 2,600 Credit

Aug. 14 Cash Sales

Retail (20 $130)

14 Cost of Goods Sold Inventory

Cost

1,985 1,985

A similar entry is made after each sale.


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Specific Identification
Additional purchases were made on August 17 and 28.
Purchases Unit Cost Units Total
10 15 @ @ $ 91 = = $ 910 $ 106 $ 1,590

Date Aug. 1 Aug. 3 Aug. 14 Aug. 17

Inventory Balance Cost of Goods Sold Unit Unit Cost Total Units Cost Total Units
10 @ 10 @ 15 9 11 @ @ $ 91 = $ 1,985 @ $ $ 91 = 91 $ 910

= $ 2,500

$ 106 $ 91 = $ 515

1 @ 4 @

$ 106

$ 106 $ 91 = $ 2,815

20

$ 115

$ 2,300

1 @ 4 20 @ @

$ 106 $ 115 $ 91

Aug. 28

10

$ 119

$ 1,190

1 @ 4 20 10 @ @ @

$ 106 $ 115 $ 119 $ 106 $ 115 $ 119

= $ 4,005

Aug. 31

1 3 15 4

@ @ @ @

91 = $ 2,610

1 @ 5 6 @ @

$ 106 $ 115 $ 119

= $ 1,395

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Specific Identification
Cost of Goods Sold Unit Cost Units Total Inventory Balance Units
10 @ 10 @ $ $

Unit Cost
91 = 91 106 91 106 91 106 = $ 115 91 106 115 119 106 115 = $ 119 = $ = $ $

Total
910 2,500

= $

15 @ $ 9 @ $ 11 @ $ 91 106 = $ 1,985 1 @ $

515

4 @ $ 1 @ $

4 @ $

2,815

Income Statement
COGS = $4,595

20 @ $ 1 @ $

4 @ $ 20 @ $ 10 @ $

4,005

1 @ $ 3 @ $ 15 @ $ 4 @ $

91 106 115 119 = $ 2,610

1 @

5 @ $ 6 @ $

1,395

Balance Sheet
Inventory = $1,395

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Average-Cost Method
On August 14, TBC sold 20 bikes for $130 each.
Purchases Date Aug. 1 Aug. 3 Aug. 14 Units
10 15 @ @

Unit Cost
$ $ 91 106 = $ = $

Total
910 1,590

Cost of Goods Sold Unit Cost Units Total

Inventory Balance Units


10 @ 25 @

Unit Cost
$ $ $ 91 = 100 100 $ = $ = $

Total
910 2,500 500

20

100

= $

2,000

5 @

The average cost per unit must be computed prior to each sale.

$2,500 25 = $100 avg. cost

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Average-Cost Method
Additional purchases were made on August 17 and August 28. On August 31, an additional 23 units were sold.
Date Aug. 1 Aug. 3 Aug. 14 Aug. 17 Aug. 28 Aug. 31 Purchases Unit Cost Units Total
10 15 @ @ $ 91 = = $ 910 $ 106 $ 1,590 20 20 10 @ @ $ 115 $ 119 = = $ 2,300 $ 1,190 23 @ $ 114 = $ 2,622 @ $ 100 = $ 2,000

Inventory Balance Cost of Goods Sold Unit Unit Cost Total Units Cost Total Units
10 @ 25 @ 5 @ 25 @ 35 @ 12 @ $ 91 = $ 910 $ 100 $ 100 $ 112 $ 114 $ 114 = $ 2,500 = $ 500

= $ 2,800 = $ 3,990 = $ 1,368

$114 = $3,990 35
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Average-Cost Method
Inventory Balance Cost of Goods Sold Unit Unit Cost Total Units Cost Total Units
10 @ 25 @ $ 91 = $ 910 $ 100 $ 100 $ 112 $ 114 $ 114 = $ 2,500 = $ 500

Income Statement
COGS = $4,622

20

$ 100

= $ 2,000

5 @ 25 @ 35 @

= $ 2,800 = $ 3,990 = $ 1,368

23

$ 114

= $ 2,622

12 @

Balance Sheet
Inventory = $1,368

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First-In, First-Out Method (FIFO)


On August 14, TBC sold 20 bikes for $130 each.
Purchases Unit Cost Units Total
10 15 @ @ $ 91 = = $ 910 $ 106 $ 1,590

Date Aug. 1 Aug. 3 Aug. 14

Inventory Balance Cost of Goods Sold Unit Unit Cost Total Units Cost Total Units
10 @ 10 @ 15 10 10 @ @ $ 91 = $ 1,970 5 @ @ $ $ 91 91 = $ = 910

$ 2,500

$ 106 $ 106 = $ 530

$ 106

The Cost of Goods Sold for the August 14 sale is $1,970, leaving 5 units, with a total cost of $530, in inventory.
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First-In, First-Out Method (FIFO)


Additional purchases were made on Aug. 17 and Aug. 28. On August 31, an additional 23 units were sold.
Purchases Unit Cost Units Total
10 15 @ @ $ 91 = = $ 910 $ 106 $ 1,590

Date Aug. 1 Aug. 3 Aug. 14 Aug. 17 Aug. 28

Inventory Balance Cost of Goods Sold Unit Unit Cost Total Units Cost Total Units
10 @ 10 @ 15 10 10 @ @ $ 91 = $ 1,970 5 @ @ $ $ 91 91 = $ = 910

$ 2,500

$ 106 $ 106 $ 106 $ 115 $ 106 $ 115 $ 119 $ 115 $ 119


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530

$ 106 5 @ 20 @ = $ 2,830

20

$ 115

$ 2,300

10

$ 119

$ 1,190

5 @ 20 10 @ @

= $ 4,020

Aug. 31

5 18

@ @

$ 106 $ 115

= $ 2,600

2 @ 10 @

= $ 1,420

First-In, First-Out Method (FIFO)


Inventory Balance Cost of Goods Sold Unit Unit Cost Total Units Cost Total Units
10 @ 10 @ 15 10 10 @ @ $ 91 = $ 1,970 5 @ @ $ $ 91 91 = $ = 910

$ 2,500

$ 106 $ 106 $ 106 $ 115 $ 106 $ 115 $ 119 $ 115 $ 119 = $ 1,420 = $ 4,020 = $ 530

$ 106 5 @ = $ 2,830

Income Statement
COGS = $4,570
5 18 @ @ $ 106 $ 115

20

5 @ 20 10 @ @

= $ 2,600

2 @ 10 @

Balance Sheet
Inventory = $1,420

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Last-In, First-Out Method (LIFO)


On August 14, TBC sold 20 bikes for $130 each.
Date Aug. 1 Aug. 3 Aug. 14 Purchases Unit Cost Units Total
10 15 @ @ $ 91 = = $ 910 $ 106 $ 1,590

Inventory Balance Cost of Goods Sold Unit Unit Cost Total Units Cost Total Units
10 @ 10 @ 15 15 5 @ @ $ 106 $ 91 = $ 2,045 5 @ @ $ $ 91 91 = $ = 910

$ 2,500

$ 106 $ 91 = $ 455

The Cost of Goods Sold for the August 14 sale is $2,045, leaving 5 units, with a total cost of $455, in inventory.

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Last-In, First-Out Method (LIFO)


Additional purchases were made on Aug. 17 and Aug. 28. On Aug. 31, an additional 23 units were sold.
Purchases Unit Cost Units Total
10 15 @ @ $ 91 = = $ 910 $ 106 $ 1,590

Date Aug. 1 Aug. 3 Aug. 14 Aug. 17 Aug. 28

Inventory Balance Cost of Goods Sold Unit Unit Cost Total Units Cost Total Units
10 @ 10 @ 15 15 5 @ @ $ 106 $ 91 5 @ 20 @ $ 91 = $ 2,755 = $ 2,045 5 @ @ $ $ 91 91 = $ = 910

$ 2,500

$ 106 $ 91 = $ 455

20

$ 115

$ 2,300

$ 115 $ 91 = $ 3,945

10

$ 119

$ 1,190

5 @ 20 10 @ @

$ 115 $ 119 $ 91

Aug. 31

10 13

@ @

$ 119 $ 115

= $ 2,685

5 @ 7 @

= $ 1,260
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$ 115

Last-In, First-Out Method (LIFO)


Inventory Balance Cost of Goods Sold Unit Unit Cost Total Units Cost Total Units
10 @ 10 @ 15 15 5 @ @ $ 106 $ 91 5 @ $ 91 = $ 2,755 = $ 2,045 5 @ @ $ $ 91 91 = $ = 910

$ 2,500

$ 106 $ 91 = $ 455

Income Statement
COGS = $4,730

20

$ 115 $ 91 = $ 3,945

5 @ 20 10 @ @

$ 115 $ 119 $ 91

10 13

@ @

$ 119 $ 115

= $ 2,685

5 @ 7 @

Balance Sheet
= $ 1,260

$ 115

Inventory = $1,260

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Valuation Valuation Method Method Specific Specific identification identification

Average Average cost cost

First-in, First-in, First-out First-out (FIFO) (FIFO)

Last-in, Last-in, First-out First-out (LIFO) (LIFO)

Inventory Inventory Valuation Valuation Methods: Methods: A A Summary Summary Costs Costs Allocated Allocated to: to: Cost of Goods Cost of Goods Sold Inventory Comments Sold Inventory Comments Actual cost of Actual cost of units Parallels Actual cost of Actual cost of units Parallels physical physical flow flow the units sold remaining Logical method when the units sold remaining Logical method when units units are are unique unique May May be be misleading misleading for for identical units identical units Number of units Number of units on Number of units Number of units on Assigns Assigns all all units units the the same same sold times the hand times the average unit cost sold times the hand times the average unit cost average Current average unit unit cost cost average average unit unit cost cost Current costs costs are are averaged averaged in with older costs in with older costs Cost of earliest Cost of most Cost Cost of earliest Cost of most Cost of of goods goods sold sold is is based based purchases on recently on older costs purchases on recently on older costs hand prior to the purchased units Inventory hand prior to the purchased units Inventory valued valued at at current current sale costs sale costs May May overstate overstate income income during during periods of rising prices; periods of rising prices; may may increase income taxes due increase income taxes due Cost Cost Cost Cost of of most most Cost of of earliest earliest Cost of of goods goods sold sold shown shown at at recently purchases recent prices recently purchases recent prices purchased units (assumed still in Inventory purchased units (assumed still in Inventory shown shown at at old old (and (and inventory) perhaps out of date) costs inventory) perhaps out of date) costs Most Most conservative conservative method method during during periods periods of of rising rising prices; often results prices; often results in in lower lower income taxes income taxes
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The Principle of Consistency


Once a company has adopted a particular accounting method, it should follow that method consistently rather than switch methods from one year to the next.
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Taking a Physical Inventory


The primary reason for taking a physical inventory is to adjust the perpetual inventory records for unrecorded shrinkage losses, such as theft, spoilage, or breakage.

GENERAL JOURNAL
Date Account Titles and Explanation Inventory Debit $$$$ $$$$ Credit

Dec. 31 Cost of Goods Sold

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LCM and Other Write-Downs of Inventory


Obsolescence Reduces the value of the inventory.

Lower of Cost or Market (LCM)

Adjust inventory value to the lower of historical cost or current replacement cost (market).
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LCM and Other Write-Downs of Inventory


LCM Applied on the Basis of . . . Cost Bicycles: Boy's bicycles Girls bicycles Junior bicycle Total Bicycle accessories: Training wheels Headlamps Protective helmets Gloves Kneepads Total Total inventory $ 4,200 3,800 5,700 $ 13,700 $ 485 312 700 245 195 $ 1,937 $ 15,637 Market $ 4,600 3,100 5,000 $ 12,700 $ 525 400 600 212 145 $ 1,882 $ 14,582 Individual Items 4,200 3,100 5,000 12,700 485 312 600 212 145 $ 14,054 1,882 $ 14,582 $ 14,582 Inventory Category Total Inventory

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Goods In Transit
A sale should be recorded when title to the merchandise passes to the buyer.
F.O.B. shipping point title passes to buyer at the point of shipment. F.O.B. destination point title passes to buyer at the point of destination.
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Year End

Periodic Inventory Systems


In a periodic inventory system, inventory entries are as follows.
GENERAL JOURNAL
Date Account Titles and Explanation Entry on Purchase Date Purchases Accounts Payable $$$$ $$$$ Debit Credit

Note that an entry is not made to inventory.


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Periodic Inventory Systems


In a periodic inventory system, inventory entries are as follows.
GENERAL JOURNAL
Date Account Titles and Explanation Entry on Sale Date No entry to inventory. Accounts Receivable Sales $$$$ $$$$ Debit Credit

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Information for the Following Inventory Examples


Date Beginning Inventory Purchases: Jan. 3 June 20 Sept. 15 Nov. 29 Goods Available for Sale Ending Inventory Cost of Goods Sold Computers, Inc. Mouse Pad Inventory Units $/Unit 1,000 $ 300 150 200 150 5.25 5.30 5.60 5.80 5.90 Total

$ 5,250.00 1,590.00 840.00 1,160.00 885.00

1,800 1,200 600

$ 9,725.00 ? ?
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Specific Identification
Date Beginning Inventory 1,000 $ 5.25 Purchases: Jan. 3 300 5.30 June 20 150 5.60 Sept. 15 200Sold5.80 Cost of Goods Nov. 29 150 5.90 Goods $9,725 $6,400 = $3,325 Available for Sale 1,800 Computers, Inc. Mouse Pad Inventory Units $/Unit Total

$ 5,250.00 1,590.00 840.00 1,160.00 885.00

$ 9,725.00 $ 6,400.00 $ 3,325.00


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Ending Inventory Cost of Goods Sold

1,200 600

Average-Cost Method
Avg. Cost $9,725 1,800 = $5.40278
Ending Inventory Avg. Cost $5.40278 1,200 = $6,483 Cost of Goods Sold Avg. Cost $5.40278 600 = $3,242
Date Beginning Inventory Purchases: Jan. 3 June 20 Sept. 15 Nov. 29 Goods Available for Sale Ending Inventory Cost of Goods Sold Computers, Inc. Mouse Pad Inventory Units $/Unit 1,000 $ 300 150 200 150 5.25 5.30 5.60 5.80 5.90 Total $ 5,250.00 1,590.00 840.00 1,160.00 885.00

1,800 1,200 1,200 600

$ 9,725.00 $ 6,483.00 ? $ 3,242.00 ?


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First-In, First-Out Method (FIFO)


Date Beginning Inventory Purchases: Jan. 3 June 20 Sept. 15 Nov. 29 Goods Available for Sale Ending Inventory Cost of Goods Sold Computers, Inc. Mouse Pad Inventory Units $/Unit 1,000 $ 300 150 200 150 5.25 5.30 5.60 5.80 5.90 Total $ 5,250.00 1,590.00 840.00 1,160.00 885.00

Remember: Start with the Nov. 29 purchase and then add other purchases until you reach the number of units in ending inventory.

1,800 1,200 600

$ 9,725.00 ? ?
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First-In, First-Out Method (FIFO)


Date Beg. Inv. Purchases 1,000@$5.25 300@$5.30 150@$5.60 200@$5.80 150@$5.90 End. Inv. 400@$5.25 300@$5.30 150@$5.60 200@$5.80 150@$5.90 1,200 150 Cost of Goods Sold 600@$5.25

Jan. 3 June 20 Sept. 15 Nov. 29 Units

600

Now, we have allocated a cost to all 1,200 units in ending inventory.

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First-In, First-Out Method (FIFO)


Date Beg. Inv. Purchases 1,000@$5.25 300@$5.30 150@$5.60 200@$5.80 150@$5.90 End. Inv. 400@$5.25 300@$5.30 150@$5.60 200@$5.80 150@$5.90 1,200 150 $6,575 $9,725
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Cost of Goods Sold 600@$5.25

Jan. 3 June 20 Sept. 15 Nov. 29 Units Costs

600 $3,150

Cost of Goods Available for Sale

First-In, First-Out Method (FIFO)


Completing the table summarizes the computations just made.
Date Beginning Inventory Purchases: Jan. 3 June 20 Sept. 15 Nov. 29 Goods Available for Sale Ending Inventory Cost of Goods Sold Computers, Inc. Mouse Pad Inventory Units $/Unit 1,000 $ 300 150 200 150 5.25 5.30 5.60 5.80 5.90 Total $ 5,250.00 1,590.00 840.00 1,160.00 885.00

1,800 1,200 600

$ 9,725.00 $ 6,575.00 $ 3,150.00


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Last-In, First-Out Method (LIFO)


Remember: Start with beginning inventory and then add other purchases until you reach the number of units in ending inventory.
Date Beginning Inventory Purchases: Jan. 3 June 20 Sept. 15 Nov. 29 Goods Available for Sale Ending Inventory Cost of Goods Sold Computers, Inc. Mouse Pad Inventory Units $/Unit 1,000 $ 300 150 200 150 5.25 5.30 5.60 5.80 5.90 Total $ 5,250.00 1,590.00 840.00 1,160.00 885.00

1,800 1,200 600

$ 9,725.00 ? ?
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Last-In, First-Out Method (LIFO)


Date Jan. 3 June 20 Sept. 15 Nov. 29 Units Costs Cost of Goods Available for Sale Beg. Inv. Purchases End. Inv. 1,000@$5.25 1,000@$5.25 300@$5.30 200@$5.30 150@$5.60 200@$5.80 150@$5.90 1,200 1,000 $6,310 $9,725
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Cost of Goods Sold

100@$5.30 150@$5.60 200@$5.80 150@$5.90 600 100 $3,415

Last-In, First-Out Method (LIFO)


Completing the table summarizes the computations just made.
Date Beginning Inventory Purchases: Jan. 3 June 20 Sept. 15 Nov. 29 Goods Available for Sale Ending Inventory Cost of Goods Sold Computers, Inc. Mouse Pad Inventory Units $/Unit 1,000 $ 300 150 200 150 5.25 5.30 5.60 5.80 5.90 Total $ 5,250.00 1,590.00 840.00 1,160.00 885.00

1,800 1,200 600

$ 9,725.00 $ 6,310.00 $ 3,415.00


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International Financial Reporting Standards

International accounting standards prohibit the use of LIFO.

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Importance of an Accurate Valuation of Inventory

8-39

The Gross Profit Method


1. Determine cost of goods available for sale. 2. Estimate cost of goods sold by multiplying the net sales by the cost ratio. 3. Deduct cost of goods sold from cost of goods available for sale to determine ending inventory.

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The Gross Profit Method


In March of 2011, Matrix Companys inventory was destroyed by fire. Matrix normal gross profit ratio is 30% of net sales. At the time of the fire, Matrix showed the following balances:
Sales $ 31,500 Sales returns 1,500 Beginning Inventory 12,000 Net cost of goods purchased 20,500

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The Gross Profit Method


Estimating Inventory The Gross Profit Method Goods Available for Sale: $ 12,000 Step Beginning Inventory 1 Net cost of goods purchased 20,500 Goods available for sale $ 32,500 Less estimated cost of goods sold: Sales $ 31,500 Step Less sales returns (1,500) 70% 2 Net sales $ 30,000 Estimated cost cost ofof goods goods sold sold (21,000) Step Estimated 3 Estimated March inventory loss $ 11,500
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The Retail Method


The retail method of estimating inventory requires that management determine the value of ending inventory at retail prices.
In March of 2011, Matrix Companys inventory was destroyed by fire. At the time of the fire, Matrixs management collected the following information:
Information for Matrix Company The Retail Method Goods available for sale at cost Goods available for sale at retail Physical count of ending inventory priced at retail $ 32,500 50,000 22,000
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The Retail Method


Matrix would follow the steps below to estimate their ending inventory using the retail method.
Estimating Inventory The Retail Method a b c d e Goods available for sale at cost Goods available for sale at retail Cost ratio [a b] Physical count of ending inventory priced at retail Estimated ending inventory at cost [ c d] $ 32,500 50,000 65% 22,000 $ 14,300

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Financial Analysis
Inventory Turnover = Cost of Goods Sold Average Inventory

(Beginning Inventory + Ending Inventory) 2

Average Days to Sell Inventory

365 Inventory Turnover

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Financial Analysis
Receivables Turnover = Net Sales Average Accounts Receivable

(Beginning Receivables + Ending Receivables) 2

365 Average Days to = Collect Receivables Receivables Turnover

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End of Chapter 8

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