Saint Mary’s University

CHAPTER FIVE
Inventory and Cost of goods
sold

Compiled by: Alem Hagos (Phd)

 Part I
Introduction
1.1 Inventory of Wholesalers and Retailers
 Purchased in finished form
 Resold without transformation
 Classified as “Merchandise
Inventory” on balance sheet
 INVENTORY
INVENTORY BASICS
BASICS
 In the balance sheet of merchandising and
manufacturing companies, inventory is
frequently the most significant current asset.
 In the income statement, inventory is vital in
determining the results of operations for a
particular period.
 Gross profit (net sales - cost of goods sold)
is closely watched by management,
owners, and other interested
parties.
 DETERMINING
DETERMINING INVENTORY
INVENTORY
QUANTITIES
QUANTITIES
 In order to prepare financial statements, it is necessary
to determine the number of units of inventory
owned by the company at the statement date, and to
value them.
 The determination of inventory quantities involves

 taking a physical inventory of goods on hand, and

 determining the ownership of goods.

 Taking a physical inventory involves counting,

weighing, or measuring each kind of inventory on hand.
 DETERMINING
DETERMINING OWNERSHIP
OWNERSHIP OF
OF
CONSIGNED
CONSIGNED GOODS
GOODS

 Under a consignment arrangement,

the holder of the goods (called the
consignee) does not own the goods.
 Ownership remains with the shipper
of the goods (consignor) until the
goods are actually sold to a
customer.
 Consigned goods should be included
in the consignor’s inventory, not the
consignee’s inventory.
Owned by a consignor; do not

count in our (consignee) Consignee Company

1.2 Condensed Income Statement for a
Merchandiser

Net sales $100,000

Cost of goods sold
60,000
Gross profit $ 40,000
Selling and administrative expenses
29,300
Net income before tax $ 10,700
Income tax expense
4,280
Net income $ 6,420
 FORMULA FOR COST OF GOODS SOLD

Cost of Cost of
Beginning +
Goods _ Ending = Goods
Inventory Inventory
Purchased Sold
 1.3 How companies keep track of their
inventory

1. Perpetual inventory system

2. Periodic inventory system

 Perpetual
Perpetual vs.
vs. Periodic
Periodic
Inventory
Inventory Accounting
Accounting
Perpetual
 Updates inventory and cost of goods sold
after every purchase and sales transaction
Periodic
 Delays updating of inventory and cost of
goods sold until end of the period
 Misstates inventory during the period
 Under the periodic method, all goods
purchased during the year are assumed to
be available for the first sale, regardless of
date of purchase.
Perpetual Inventory Systems
Inventory records
are
updated after
each purchase or
sale
 Point-of-sale terminals have improved
the ability of mass merchandisers to
maintain perpetual systems
 Company knows the cost of sales and
ending inventory figure from their books
Periodic Inventory
Inventory Systems
records are
updated
periodically
based on
physical
inventory counts
Reduces record keeping but also
decreases the ability to track theft,
breakage, etc., and prepare interim
financial statements
The Cost of Goods Sold
Model
Beginning inventory $ 15,000
+ Cost of goods purchased 63,000
= Cost of goods available for sale
78,000
– Ending inventory
(18,000)
= Cost of goods
“Pool” sold
of goods $ 60,000
An increase in ending
available to sell inventory means more
was bought than sold
during the period
 1.4 Purchase of inventory on
account
• Cash discount
Credit Terms and Sales
Discounts

n/30 Payment due 30 days from invoice

date

1/10, n/30 Deduct 1% of invoice amount if

paid within 10 days; otherwise full
invoice amount is due in 30 days

2/10, n/30 Deduct 2% of invoice amount if

paid within 10 days; otherwise full
invoice
amount is due in 30 days
 EXAMPLE
• On July 16, the company purchased
Merchandise inventory on account
for $500. Term: 1/10, n/30.
Dr Cr
Purchases 500
A/P 500
 Recording Purchase
Discounts
On July 25, the company paid for the purchase, less
discount.
Accounts Payable 500
Cash 495
Purchase Discounts
5
To record payment within discount
period to supplier who offers 1%
purchase discount.

($ 500 × 1% = $5 discount)
Cost of Goods Purchased
 Cost of Goods Purchased:

= invoice price-(Purchase returns and

allowances

Purchase discounts)+Transportation in
 Inventory Costs
Included

 Any freight costs incurred by buyer

 Cost of insurance for inventory in
transit
 Cost of storing inventory before
selling
 Excise and sales taxes
 1.5 Shipping cost: FOB
Destination Point

Seller Buyer

Title
passes at
destination
 No sale or purchase until inventory reaches its
destination
 Seller responsible for inventory while in transit
1.5 Shipping cost: FOB Shipping
Point

Seller Buyer

Title
passes when
shipped
 Both sale and purchase recorded upon shipment
 Buyer responsible for inventory while in transit
Analysis of Profitability

Of
particular
interest
to current and
potential
investors
Gross
Profit %

LO4
 Daisy’s Profitability

Net sales $100,0

Cost of goods sold 60,000
Gross profit $ 40,000

Gross profit ratio = 40%

Gross Profit Ratio = Gross Profit
Net Sales
(How many cents on every $ of sales are left
over after covering the cost of the product)
 Part II
Inventory Costing Method

 How to determine the cost of

inventory left on hand and cost of
inventory sold in a period
 ALLOCATION
ALLOCATION OF
OF
INVENTORIABLE
INVENTORIABLE COSTS
COSTS

Ending
Beginning Inventory
Inventory (Balance
Sheet)
Cost of Goods
Available for
Sale
Goods Cost of
Purchased Goods Sold
during the (Income
year Statement)
Inventory Valuation and Income
Measurement

Value Value
assigned toWhen Sold = expensed
inventory as cost of
on balance goods sold
sheet on income
statement

LO5
Detailed Costing Method
Example
What’re the cost of goods sold and
ending inventory?
Beginning inventory, Jan. 1: 500 units (unit cost $10)
Inventory purchases:
Date Units Unit Cost
1/20 300 $ 11
4/8 400 12
9/5 200 13
12/12 100 14
Total purchases 1,000 units
Ending inventory, Dec. 31: 600 units
Inventory Costing Methods
(in a period of inflation)

Four costing methods available:

Specific Weighted
Identification Average

First-in, First-out Last-in, First-out

(FIFO) (LIFO)
LO6
 USING
USING ACTUAL
ACTUAL PHYSICAL
PHYSICAL
FLOW
FLOW COSTING
COSTING

 The specific identification method tracks

the actual physical flow of the goods.
 Each item of inventory is marked,
tagged, or coded with its specific unit
cost.
 It is most frequently used when the
company sells a limited variety of high
unit-cost items.
 Specific Identification
Method

Step 1: Identify the specific

units in
inventory at the end of
the year
and their costs.
 When a company’s inventory
consists of many high-priced, low-
turnover goods the record keeping
necessary to use specific identification
is more practical.
 Specific Identification
Method
Units in ending inventory:
Date purchased Units Cost
Total Cost
1/20 100 $11
$1,100
4/8 300 12
3,600
Units × Cost = Total
9/5 200 13
cost
2,600
 Specific Identification
Method

Step 2:
cost of goods sold = cost of
goods available for sale –
ending inventory
= 17,100 – 7,300 = 9,800

* Few companies use this

method
 USING
USING ASSUMED
ASSUMED COST
COST
FLOW
FLOW METHODS
METHODS

Other cost flow methods are

allowed since specific
identification is often impractical.
These methods assume flows of
costs that may be unrelated to the
physical flow of goods.
Cost flow assumptions:
1. First-in, first-out (FIFO).
2. Average cost.
3. Last-in, first-out (LIFO).
 AVERAGE
AVERAGE COST
COST
 The average cost method assumes that the goods
available for sale are homogeneous.
 The allocation of the cost of goods available for
sale is made on the basis of the weighted average
unit cost incurred.
 The weighted average unit cost is then applied to
the units sold to determine the cost of goods sold
and to the units on hand to determine the ending
inventory.
Weighted Average Method

Step 1: Calculate the cost of

goods
available for sale.
 Weighted Average
Method
Date purchased Units Cost
Total cost
Beg. inventory 500
$10 $ 5,000
1/20 300 11
3,300
4/8 400
12 4,800
9/5 200
 Weighted Average Method

Step 2: Divide the cost of

goods available
for sale by the total units
to

:
determine the weighted
average
cost per unit.
Weighted Average Method

Cost of Goods Available for Sale

Units Available for Sale

$17,100
= $11.40/unit
1,500
 Weighted Average Method

Step 3: Calculate ending

inventory and cost of goods
sold by multiplying the
weighted average cost per unit
by the number of units in
ending inventory and the

×
number of units sold.
Avg. # of
Cost Units
 Weighted Average Method

ALLOCATE TO
Ending
Cost of
Inventory
Goods Sold
Units on hand 600
Units sold
900
Weighted average cost ×
$11.40 $ 11.40
Total cost of goods
available of $17,100 allocated: $6,840
$10,260
 FIFO
FIFO
The FIFO method assumes that the
earliest goods purchased are the first to
be sold.
Often reflects the actual physical flow of
merchandise.
Under FIFO, the costs of the earliest
goods purchased are the first to be
recognized as cost of goods sold. The
costs of the most recent goods purchased
are recognized as the ending inventory.
First-in, First-out (FIFO)
Method
Step 1: Assign the cost of the
beginning
inventory to cost of goods
sold
The first-in, first-out cost flow method
requires that the cost of the items
purchased first be assigned to Cost of
Goods Sold.

1st
in
 First-in, First-out (FIFO)
Method
ALLOCATE TO
Ending Cost of
Units Cost Inventory Goods Sold
1/1 500 $10 $5,000
1/20 300 $11
4/8 400 $12
9/5 200 $13
12/12 100 $14
 First-in, First-out (FIFO)
Method
Step 2:Continue to work forward until
you assign the total number of
units sold during the period to
cost of goods sold. Allocate the
remaining costs to ending
inventory.
3rd etc.
2nd
First-in, First-out (FIFO)
Method
ALLOCATE TO
Ending
Cost of
Units Cost Inventory
Goods Sold
1/1 500 $10 $5,000
1/20 300 $11 3,300
4/8 300 / 100 $12 $3,600
1,200
9/5 200 $13 2,600
 LIFO

The LIFO method assumes that the

latest goods purchased are the first
to be sold and that the earliest
goods purchased remain in ending
inventory.
Seldom coincides with the actual
physical flow of inventory.
Last-in, First-out (LIFO)
Method
Step 1: Assign the cost of the last
units purchased to cost
of goods sold.
The last-in, first-out cost flow method
requires that the cost of the items
purchased last be assigned to Cost of
Goods Sold.

1st
in
Last-in, First-out (LIFO)
Method
ALLOCATE TO
Ending
Cost of
Units Cost Inventory
Goods Sold
1/1 500 $10
1/20 300 $11
4/8 400 $12
9/5 200 $13
12/12 100 $14 $1,400
Last-in, First-out (LIFO)
Method
Step 2: Work backwards until
you assign the total number of
units sold during the period to
cost of goods sold (allocate
the remaining costs to ending
inventory).

1st
in
Last-in, First-out (LIFO)
Method
ALLOCATE TO
Ending
Cost of
Units Cost Inventory
Goods Sold
1/1 500 $10 $5,000
1/20 100 / 200 $11 1,100
$ 2,200
4/8 400 $12
4,800
9/5 200 $13
 Comparison of Costing
Methods
Cost of Goods
Ending Goods Availab
Inventory Sold le for
Sale
Specific
Identificati $7,300 $ $17,1
on
Weighted 9,800 00
Average 6,840 10,260
FIFO 7,600 9,500 17,10
17,000
0
LIFO 6,100 11,000 17,100
Comparison of Costing
Methods
Weighted
Average FIFO L
In periods of rising prices:

Highest cost of goods sold? X

Lowest cost of goods sold? X
Highest gross profit? X
Lowest net income? X
Lowest income taxes? X
LO7
Comparison of Costing
Methods
Weighted
Average FIFO L
In periods of declining prices:

Highest cost of goods sold? X

Lowest cost of goods sold? X
Highest gross profit? X
Lowest net income? X
Lowest income taxes? X
LO7
 INCOME
INCOME STATEMENT
STATEMENT
EFFECTS
EFFECTS
 In periods of rising prices, FIFO
reports the highest net income,
LIFO the lowest and average cost
falls in the middle.
 The reverse is true when prices are
falling.
 When prices are constant, all cost
flow methods will yield the same
results.
 BALANCE
BALANCE SHEET
SHEET EFFECTS
EFFECTS

FIFO produces the best balance

sheet valuation since the inventory
costs are closer to their current, or
replacement, costs.
 LIFO Conformity Rule
 In general, companies can use one
accounting method for financial
reporting purpose and use a different
method for tax purpose.
 Accounting choice should be made
based on which method produces most
useful information.
 USING
USING INVENTORY
INVENTORY COST
COST
FLOW
FLOW METHODS
METHODS
CONSISTENTLY
CONSISTENTLY
A company needs to use its chosen cost
flow method consistently from one
accounting period to another.
Such consistent application enhances
the comparability of financial
statements over successive time
periods.
When a company adopts a different
cost flow method, the change and its
effects on net income should be
disclosed in the financial statements.
 INVENTORY
INVENTORY ERRORS
ERRORS -- INCOME
INCOME
STATEMENT
STATEMENT EFFECTS
EFFECTS

Both beginning and ending inventories

appear on the income statement.
The ending inventory of one period
automatically becomes the beginning
inventory of the next period.
Inventory errors affect the
determination of cost of goods
sold and net income.
 EFFECTS OF INVENTORY ERRORS ON
CURRENT YEAR’S INCOME
STATEMENT

Understate beginning inventory Understated Overstated

Overstate beginning inventory Overstated Understated
Understate ending inventory Overstated Understated
Overstate ending inventory Understated Overstated

An error in ending inventory of the current period

will have a reverse effect on net income of the next
accounting period.
 ENDING INVENTORY ERROR – BALANCE
SHEET EFFECTS

The effect of ending inventory errors on

the balance sheet can be determined by
using the basic accounting equation:

Assets = Liabilities + Owner’s Equity

Overstated Overstated None

Overstated Understated Understated None
Understated
 LCM
(for your information
• If only)
inventory’s market value has fallen
below the cost, the inventory must
be reported at the lower market
value, and a loss must be recorded.
VALUING
VALUING INVENTORY
INVENTORY AT
AT THE
THE LOWER
LOWER OF
OF
COST
COST AND
AND MARKET
MARKET

 When the value of inventory is

lower than the cost, the
inventory is written down to its
market value.
 This is known as the lower of
cost and market (LCM) method.
 Market is defined as
replacement cost or net
realizable value.
 ILLUSTRATION ALTERNATIVE LOWER OF COST
AND MARKET (LCM) RESULTS

Cost Market LCM

Television sets
Consoles $ 60,000 $ 55,000
Portables 45,000 52,000
Total 105,000 107,000
Video equipment
Recorders 48,000 45,000
Movies 15,000 14,000
Total 63,000 59,000
Total inventory $ 168,000 $ 166,000 $ 166,000

The common practice is to use total

inventory rather than individual items or
major categories in determining the LCM