8-1

Chapter

8
INVENTORIES AND
COST OF GOODS SOLD

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 8-2

Inventory Defined

Inventory

Goods owned Current

and held for sale asset
to customers

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 8-3

The Flow of Inventory Costs

BALANCE SHEET

Purchase costs (or

Asset
manufacturing Inventory
costs)

as goods
INCOME STATEMENT are sold
Revenue
Cost of goods sold
Gross profit
Expenses
Net income
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 8-4

The Flow of Inventory Costs

In a perpetual inventory system, inventory entries
parallel the flow of costs.

GENERAL JOURNAL
P
Date Account Titles and Explanation R Debit Credit
Entry on Purchase Date
Inventory $$$$
Accounts Payable $$$$

Entry on Sale Date

Cost of Goods Sold $$$$
Inventory $$$$
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 8-5

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.

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 8-6

Inventory Subsidiary Ledger

A separate subsidiary account is maintained

for each item in inventory.
Item LL002 Primary supplier Electronic City
Description Laser Light Secondary supplier Electric Company
Location Storeroom 2 Inventory level: Min: 25 Max: 200
Purchased Sold Balance
Cost of
Unit Unit Goods Unit
Date Units Cost Total Units Cost Sold Units Cost Total
Sept. 5 100 $ 30 $ 3,000 100 $ 30 $ 3,000
Sept. 9 75 50 3,750 100 30 3,000
75 50 3,750
Sept. 10 10 ? ? ? ? ?
? ? ?

How can we determine the unit cost for the Sept. 10 sale?
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 8-7

Inventory Cost Flows

We use one of these inventory valuation
methods to determine cost of inventory sold.

r age
Ave st
Co
FIFO

LIFO
Specific
Identification

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 8-8

Data for an Illustration

The Bike Company (TBC)

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 8-9

Specific Identification

When a unit
is sold, its
specific cost is
added to cost of
goods sold.

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 8-10

Specific Identification

On August 14, TBC sold 20 bikes for $130 each.

Of the bikes sold 9 originally cost $91 and
11 cost $106.

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 8-11

Specific Identification

The Cost of Goods Sold for the August 14 sale is

$1,985, leaving $515 and 5 units in inventory.

Let’s look at the entries for the Aug. 14 sale.

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 8-12

Specific Identification

Retail (20 × $103)

Cost

A similar entry is made after each sale.

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 8-13

Specific Identification

Cost of Goods
Sold for
August 31 =
$2,610
Additional purchases were made on August 17 and 28.
Costs associated with sales on August 31 were as follows: 1 @ $91,
3 @ $106, 15 @ $115, & 4 @ $119.

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 8-14

Specific Identification

Income Statement
COGS = $4,595

Balance Sheet
Inventory = $1,395 1 @ $ 106 = $ 106
5 @ $ 115 = 575
6 @ $ 119 = 714
End. Inv. © The$McGraw-Hill
1,395 Companies, Inc., 2008
McGraw-Hill/Irwin
 8-15

Specific Identification
Since specific
identification is so
easy, can’t we use it
Not really. Specific all the time?
identification is hard to use
when we sell a lot of inventory
that has lots of different costs.

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 8-16

Average-Cost Method

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

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 8-17

Average-Cost Method

The average cost per unit

must be computed prior
to each sale. $2,500  25 = $100

On August 14, TBC sold 20 bikes for $130 each.

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 8-18

Average-Cost Method

The average cost per

unit is $100. $100 = $2,500  25

Let’s look at the entries

for the Aug. 14 sale.
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McGraw-Hill/Irwin
 8-19

Average-Cost Method

Retail

Cost

A similar entry is made after each sale.

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 8-20

Average-Cost Method

Additional purchases were made on August 17

and August 28.
On August 31, an additional 23 units were sold.

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 8-21

Average-Cost Method

$114 = $3,990  35

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 8-22

Average-Cost Method

The average cost per $114 = $3,990  35

unit is $114.

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 8-23

Average-Cost Method

Income Statement
COGS = $4,622

Balance Sheet
Inventory = $1,368
$114 × 12 = $1,368
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 8-24

First-In, First-Out Method (FIFO)

Oldest Costs of
Costs Goods Sold

Recent Ending
Costs Inventory

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 8-25

First-In, First-Out Method (FIFO)

The Cost of Goods Sold for the August 14 sale is $1,970,

leaving $530 and 5 units in inventory.

On August 14, TBC sold 20 bikes for $130 each.

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 8-26

First-In, First-Out Method (FIFO)

Retail

Cost

A similar entry is made after each sale.

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 8-27

First-In, First-Out Method (FIFO)

Additional purchases were made on Aug. 17 and Aug. 28.

Cost of
On Goods
August 31,Sold for August
an additional 31 sold.
23 units were = $2,600

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 8-28

First-In, First-Out Method (FIFO)

Income Statement
COGS = $4,570

Balance Sheet
2 @ $ 115 = $ 230
10 @ $ 119 = 1,190
Inventory = $1,420
End. Inv. $ 1,420

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 8-29

Last-In, First-Out Method (LIFO)

Recent Costs of
Costs Goods Sold

Oldest Ending
Costs Inventory

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 8-30

Last-In, First-Out Method (LIFO)

The Cost of Goods Sold for the August 14 sale is

$2,045, leaving $455 and 5 units in inventory.

On August 14, TBC sold 20 bikes for $130 each.

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 8-31

Last-In, First-Out Method (LIFO)

Retail

Cost

A similar entry is made after each sale.

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 8-32

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.

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 8-33

Last-In, First-Out Method (LIFO)

Cost of Goods Sold for August 31 = $2,685

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 8-34

Last-In, First-Out Method (LIFO)

Income Statement
COGS = $4,730

Balance Sheet 5 @ $ 91 = $ 455

Inventory = $1,260 7 @ $ 115 = 805
End. Inv. $ 1,260

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 Inventory Valuation Methods: A Summary 8-35
Costs Allocated to:
Valuation Cost of Goods
Method Sold Inventory Comments
Specific Actual cost of Actual cost of units Parallels physical flow
identification the units sold remaining Logical method when units
are unique
May be misleading for
identical units
Average cost Number of units Number of units on Assigns all units the same
sold times the hand times the average unit cost
average unit cost average unit cost Current costs are averaged
in with older costs
First-in, First-out Cost of earliest Cost of most Cost of goods sold is based
(FIFO) purchases on recently on older costs
hand prior to the purchased units Inventory valued at current
sale costs
May overstate income during
periods of rising prices; may
increase income taxes due
Last-in, First-out Cost of most Cost of earliest Cost of goods sold shown at
(LIFO) recently purchases recent prices
purchased units (assumed still in Inventory shown at old (and
inventory) perhaps out of date) costs
Most conservative method
during periods of rising
prices; often results in lower
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income taxes Companies, Inc., 2008
 8-36

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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 8-37
Just-In-Time (JIT) Inventory
Systems

This inventory arrived

just in time for us to use
it in the manufacturing
process.

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 8-38

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.

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 8-39

LCM and Other Write-Downs

of Inventory

Reduces the value

Obsolescence
of the inventory.

Lower of Cost Adjust inventory

or Market value to the lower
(LCM) of historical cost or
current
replacement cost
(market).

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 8-40

LCM and Other Write-Downs

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

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 8-41

Goods In Transit

A sale should be recorded when title to

the merchandise passes to the buyer.

F.O.B. F.O.B.
shipping destination
point  title point  title
passes to passes to
buyer at the Year buyer at the
point of End point of
shipment. destination.
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 8-42

Periodic Inventory Systems

In a periodic inventory system, inventory entries
are as follows.

Note that an entry is not

made to inventory.
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 8-43

Periodic Inventory Systems

In a periodic inventory system, inventory entries
are as follows.

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 8-44

Periodic Inventory Systems

The inventory on
hand and the cost
of goods sold for
the year are not
determined until
year-end.

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 8-45

Periodic Inventory Systems

We use one of these inventory valuation
methods in a periodic inventory system.

Specific Average
identification cost

FIFO LIFO
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 8-46
Information for the Following
Inventory Examples
Computers, Inc.
Mouse Pad Inventory
Date Units $/Unit Total
Beginning
Inventory 1,000 $ 5.25 $ 5,250.00
Purchases:
Jan. 3 300 5.30 1,590.00
June 20 150 5.60 840.00
Sept. 15 200 5.80 1,160.00
Nov. 29 150 5.90 885.00
Goods
Available
for Sale 1,800 $ 9,725.00
Ending
Inventory 1,200 ?
Cost of
Goods Sold
McGraw-Hill/Irwin 600 ?
© The McGraw-Hill Companies, Inc., 2008
 8-47

Specific Identification

By reviewing actual
purchase invoices,
Computers, Inc. determines
that the 1,200 mouse pads
on hand at year-end have
an actual total cost of
$6,400.
Determine the cost of
goods sold for the year.

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 8-48

Specific Identification
Computers, Inc.
Mouse Pad Inventory
Date Units $/Unit Total
Beginning
Inventory 1,000 $ 5.25 $ 5,250.00
Purchases:
Jan. 3 300 5.30 1,590.00
June 20 150 5.60 840.00
Sept.
Cost15 200
of Goods Sold 5.80 1,160.00
Nov. 29 150 5.90 885.00
$9,725 -
Goods $6,400 = $3,325
Available
for Sale 1,800 $ 9,725.00
Ending
Inventory 1,200 $ 6,400.00
Cost of
Goods Sold 600 $ 3,325.00
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 8-49

Average-Cost Method

The average cost is

calculated at year-
end as follows:

Total Cost of Total Number

Goods of Units
Available for
÷ Available for
Sale Sale

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 8-50

Average-Cost Method
Computers, Inc.
Mouse Pad Inventory
Avg. Cost $9,725  1,800 =
Date Units $/Unit Total
$5.40278 Beginning
Ending Inventory Inventory 1,000 $ 5.25 $ 5,250.00
Avg. Cost $5.40278 1,200 = Purchases:
$6,483 Jan. 3 300 5.30 1,590.00
June 20 150 5.60 840.00
Cost of Goods Sold
Sept. 15 200 5.80 1,160.00
Avg. Cost $5.40278 600 =
Nov. 29 150 5.90 885.00
$3,242 Goods
Available
for Sale 1,800 $ 9,725.00
Ending
Inventory 1,200
1,200 $ 6,483.00
?
Cost of
Goods Sold 600 $ 3,242.00
?

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 8-51

First-In, First-Out Method (FIFO)

Oldest Costs of
Costs Goods Sold

Recent Ending
Costs Inventory

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 8-52

First-In, First-Out Method (FIFO)

Computers, Inc.
Remember: Mouse Pad Inventory
Start with the Date Units $/Unit Total
11/29 purchase Beginning
Inventory 1,000 $ 5.25 $ 5,250.00
and then add Purchases:
other purchases Jan. 3 300 5.30 1,590.00
June 20 150 5.60 840.00
until you reach Sept. 15 200 5.80 1,160.00
the number of Nov. 29 150 5.90 885.00
units in ending Goods
Available
inventory. for Sale 1,800 $ 9,725.00
Ending
Inventory 1,200 ?
Cost of
Goods Sold 600 ?

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 8-53

First-In, First-Out Method (FIFO)

Cost of
Date Beg. Inv. Purchases End. Inv. Goods Sold
1,000@$5.25 600@$5.25
400@$5.25
Jan. 3 300@$5.30 300@$5.30
June 20 150@$5.60 150@$5.60
Sept. 15 200@$5.80 200@$5.80
Nov. 29 150@$5.90 150@$5.90
Units 1,200
150 600

Now, we have allocated

Costs $6,575 $3,150
the cost to allNow,
1,200 let’s
units complete the
Cost in
of ending inventory.
Goods Available table.
for Sale $9,725

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 8-54

First-In, First-Out Method (FIFO)

Computers, Inc.
Completing Mouse Pad Inventory
the table Date
Beginning
Units $/Unit Total

summarizes Inventory 1,000 $ 5.25 $ 5,250.00

Purchases:
the Jan. 3 300 5.30 1,590.00
computations June 20 150 5.60 840.00
Sept. 15 200 5.80 1,160.00
just made. Nov. 29 150 5.90 885.00
Goods
Available
for Sale 1,800 $ 9,725.00
Ending
Inventory 1,200 $ 6,575.00
Cost of
Goods Sold 600 $ 3,150.00

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 8-55

Last-In, First-Out Method (LIFO)

Recent Costs of
Costs Goods Sold

Oldest Ending
Costs Inventory

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 8-56

Last-In, First-Out Method (LIFO)

Computers, Inc.
Remember: Start Mouse Pad Inventory
with beginning Date
Beginning
Units $/Unit Total

inventory and Inventory 1,000 $ 5.25 $ 5,250.00

Purchases:
then add other Jan. 3 300 5.30 1,590.00
purchases until June 20 150 5.60 840.00
Sept. 15 200 5.80 1,160.00
you reach the Nov. 29 150 5.90 885.00
number of units Goods
Available
in ending for Sale 1,800 $ 9,725.00

inventory. Ending
Inventory 1,200 ?
Cost of
Goods Sold 600 ?

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 8-57

Last-In, First-Out Method (LIFO)

Cost of
Date Beg. Inv. Purchases End. Inv. Goods Sold
1,000@$5.25 1,000@$5.25
Jan. 3 300@$5.30 200@$5.30
100@$5.30
June 20 150@$5.60 150@$5.60
Sept. 15 200@$5.80 200@$5.80
Nov. 29 150@$5.90 150@$5.90
Units 1,000
1,200 100
600

Now, we have allocated

Costs $6,310 $3,415
Next, let’s
the cost to all 1,200 units complete the
Cost in
of ending inventory.
Goods Available for Sale $9,725
table.

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 8-58

Last-In, First-Out Method (LIFO)

Completing the Computers, Inc.
Mouse Pad Inventory
table Date Units $/Unit Total
Beginning
summarizes the Inventory 1,000 $ 5.25 $ 5,250.00
computations Purchases:
Jan. 3 300 5.30 1,590.00
just made. June 20 150 5.60 840.00
Sept. 15 200 5.80 1,160.00
Nov. 29 150 5.90 885.00
Goods
Available
for Sale 1,800 $ 9,725.00
Ending
Inventory 1,200 $ 6,310.00
Cost of
Goods Sold 600 $ 3,415.00

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 8-59
Importance of an Accurate
Valuation of Inventory
Errors in Measuring Inventory
Beginning Inventory Ending Inventory
Effect on Income Statement Overstated Understated Overstated Understated
Goods Available for Sale + - NE NE
Cost of Goods Sold + - - +
Gross Profit - + + -
Net Income - + + -
Effect on Balance Sheet
Ending Inventory NE NE + -
Retained Earnings - + + -

An error in ending inventory in a year will result in the

same error in the beginning inventory of the next year.
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 8-60

For interim financial

statements, we may
need to estimate ending
inventory and cost of
goods sold.

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 8-61

The Gross Profit Method

 Determine cost of goods

available for sale.
 Estimate cost of goods sold by
multiplying the net sales by the
cost ratio.
 Deduct cost of goods sold
from cost of goods available
for sale to determine ending
inventory.

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 8-62

The Gross Profit Method

In March of 2007, Matrix Company’s
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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 8-63

The Gross Profit Method

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

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 8-64

The Retail Method

The retail method of estimating inventory requires
that management determine the value of ending
inventory at retail prices.

In March of 2007, Matrix Company’s inventory was

destroyed by fire. At the time of the fire, Matrix’s
management collected the following information:

Information for Matrix Company

The Retail Method
Goods available for sale at cost $ 32,500
Goods available for sale at retail 50,000
Physical count of ending inventory priced at retail 22,000

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 8-65

The Retail Method

Matrix would follow the steps below to estimate

their ending inventory using the retail method.

Estimating Inventory
The Retail Method
a Goods available for sale at cost $ 32,500
b Goods available for sale at retail 50,000
c Cost ratio [a b] 65%
d Physical count of ending inventory priced at retail 22,000
e Estimated ending inventory at cost [ c d] $ 14,300

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 8-66

Financial Analysis

Measures how quickly a company

sells its merchandise inventory.

Average Inventory = (Beginning Inventory + Ending Inventory) ÷ 2

A ratio that is low compared to competitors

suggests inefficient use of assets.
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 8-67

Financial Analysis

Measures how many days on

average it takes to sell its
inventory.

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 8-68
Accounting Methods Can Affect
Financial Ratios

Remember that identical

companies that use different
inventory methods (e.g., FIFO
and LIFO) will have different
inventory turnover ratios.

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