Inventories Generally, 2 types of inventories: Merchandise (for sale) inventory Processing Inventory...

Inventories

Generally, 2 types of inventories:

Merchandise (for sale) inventory

Processing Inventory

• Raw Materials Inventory• Work In Process Inventory

InventoriesWhen to Include Items?

Include items in inventory when ownership transfers.

FOB (Free-on-Board):

• Specifies where ownership transfers.• Shipping Point: when delivered to carrier.• Destination: when delivered from carrier to recipient.

InventoriesWhen to Include Items?

Consignment:

• Provide product to marketing agent (shopkeeper) to sell.• Marketing agent receives commission for sale.• Marketing agent does not take ownership.• Original owner retains ownership.

Inventories

Generally, 2 ways to keep track of inventory:

Perpetual (real-time) tracking

• Updates as items leave and arrive• e.g. Supermarket Scanners

Periodic tracking or counting

• Inventory counted at regular intervals• Usually involves a hand-count• Inventory sold is “backed-into” by looking at changes in inventory balance

InventoriesPeriodic Inventory System

We take end of period count of inventory and compareto beginning inventory + newly purchased inventory to compute Cost of Goods Sold.

Information needed:

• Beginning Inventory• Purchases• Ending Inventory

InventoriesPeriodic Inventory System

Beginning Inventory = $15

$5 $5 $5

$5 $5

Purchases = $10

Cost of GoodsAvailable for Sale= BI + Purchases= $25

InventoriesPeriodic Inventory System

Ending Inventory = $5

$5

Cost of Goods Sold = Cost of Goods Available for Sale – EI= $25 - $5= $20

InventoriesPeriodic Inventory System

$5 $5 $5

$5 $5

Available for Sale$25

Let’s take another look…

InventoriesPeriodic Inventory System

$5 $5 $5

$5 $5Ending Inv $5

Available for Sale$25

InventoriesPeriodic Inventory System

$5

Sold$20

Available for Sale $25Ending Inv ($5)COGS $20 (or stolen)

InventoriesPeriodic Inventory System—Inventory Errors

• Inventory Errors in a Periodic System directly hit Net Income.• These errors affect 2 periods.• The error in the first period is reversed in the second period.

- i.e., if Net Income is overstated in period 1, it will be understated in period 2.

InventoriesPeriodic Inventory System—Inventory Errors

Period 1 Period 2

Beg Inventory+ Purchases= CoG Avail for Sale- Ending Inventory= Cost of Goods Sold

Sales Revenue- Cost of Goods Sold= Net Income

Beg Inventory+ Purchases= CoG Avail for Sale- Ending Inventory= Cost of Goods Sold

Sales Revenue- Cost of Goods Sold= Net Income

InventoriesPeriodic Inventory System—Inventory Errors

Period 1 Period 2

Beg Inventory+ Purchases= CoG Avail for Sale- Ending Inventory= Cost of Goods Sold

Sales Revenue- Cost of Goods Sold= Net Income

Beg Inventory+ Purchases= CoG Avail for Sale- Ending Inventory= Cost of Goods Sold

Sales Revenue- Cost of Goods Sold= Net Income

Assume we accidentally OVERCOUNT (overstate) 1st pd Ending Inv.

InventoriesPeriodic Inventory System—Inventory Errors

Period 1 Period 2

Beg Inventory+ Purchases= CoG Avail for Sale- Ending Inventory= Cost of Goods Sold

Sales Revenue- Cost of Goods Sold= Net Income

Beg Inventory+ Purchases= CoG Avail for Sale- Ending Inventory= Cost of Goods Sold

Sales Revenue- Cost of Goods Sold= Net Income

(Too big)(Too small)

InventoriesPeriodic Inventory System—Inventory Errors

Period 1 Period 2

Beg Inventory+ Purchases= CoG Avail for Sale- Ending Inventory= Cost of Goods Sold

Sales Revenue- Cost of Goods Sold= Net Income

Beg Inventory+ Purchases= CoG Avail for Sale- Ending Inventory= Cost of Goods Sold

Sales Revenue- Cost of Goods Sold= Net Income

(Too small)

(Too small)(Too big)

(Too big)

InventoriesPeriodic Inventory System—Inventory Errors

Period 1 Period 2

Beg Inventory+ Purchases= CoG Avail for Sale- Ending Inventory= Cost of Goods Sold

Sales Revenue- Cost of Goods Sold= Net Income

Beg Inventory+ Purchases= CoG Avail for Sale- Ending Inventory= Cost of Goods Sold

Sales Revenue- Cost of Goods Sold= Net Income

(Too big)

(Too big)

InventoriesPeriodic Inventory System—Inventory Errors

Period 1 Period 2

Beg Inventory+ Purchases= CoG Avail for Sale- Ending Inventory= Cost of Goods Sold

Sales Revenue- Cost of Goods Sold= Net Income

Beg Inventory+ Purchases= CoG Avail for Sale- Ending Inventory= Cost of Goods Sold

Sales Revenue- Cost of Goods Sold= Net Income

(Too big)

(Too big)

(Too big)

InventoriesPeriodic Inventory System—Inventory Errors

Period 1 Period 2

Beg Inventory+ Purchases= CoG Avail for Sale- Ending Inventory= Cost of Goods Sold

Sales Revenue- Cost of Goods Sold= Net Income

Beg Inventory+ Purchases= CoG Avail for Sale- Ending Inventory= Cost of Goods Sold

Sales Revenue- Cost of Goods Sold= Net Income

(Too big)

(Too big)(Too small)

InventoriesPeriodic Inventory System—Inventory Errors

Period 1 Period 2

Beg Inventory+ Purchases= CoG Avail for Sale- Ending Inventory= Cost of Goods Sold

Sales Revenue- Cost of Goods Sold= Net Income

Beg Inventory+ Purchases= CoG Avail for Sale- Ending Inventory= Cost of Goods Sold

Sales Revenue- Cost of Goods Sold= Net Income

(Too big)

(Too small)(Too big)

Note the reversal in the 2nd period.

InventoriesValuing inventory stock (determining COGS)

A common problem is that inventory is often brought in with different cost layers.

Different methods to value inventory:

• Specific Identification: each item tracked at actual value• Average Cost Method: use weighted average cost of items• First-in-First-Out• Last-in-First-Out

InventoriesAverage Cost Method

Amount Unit Cost Value

100 $5 $500

200 $6 $1,200

200 $7 $1,400

500 $3,100

Sell 300 units:

Average cost = $3,100 / 500 = $6.20 per unit

Cost of Goods Sold = $6.20 x 300 units = $1,860

InventoriesAverage Cost Method

Amount Unit Cost Value

100 $5 $500

200 $6 $1,200

200 $7 $1,400

500 $6.20 $3,100

Sell 300 units:

Average cost = $3,100 / 500 = $6.20 per unit

After Sale, 200 units left. Unit cost now adjusted to $6.20.

200 $1,240

InventoriesAverage Cost Method

Amount Unit Cost Value

200 $6.20 $1,240

(new purchase)

100 $6.50 $650

300 $1,890

Any new purchases create new layers and a new average will be computed.

$1,890 / 300 = $6.30 per unit

InventoriesFIFO Method

Amount Unit Cost Value

100 $5 $500

200 $6 $1,200

200 $7 $1,400

Sell 250 units:

100 x $5 = $500150 x $6 = $900COGS = $1,400

These layers are depleted first. (Top down).

InventoriesLIFO Method

Amount Unit Cost Value

100 $5 $500

200 $6 $1,200

200 $7 $1,400

Sell 250 units:

200 x $7 = $1,40050 x $6 = $300COGS = $1,700 These layers are

depleted first. (Bottom up.)

InventoriesDifferences in Methods

• Weighted Average has least potential for manipulation• LIFO has highest COGS (lowest Net Income) during rising inflation• FIFO has the lowest COGS (highest Net Income) during rising inflation• Specific Identification may be the most accurate

InventoriesProblems with LIFO

• LIFO Liquidation is an issue when, due to high demand, a firm using LIFO has to dip deep into its inventory.• When this happens, many of the earlier (cheaper) layers get liquidated.• This forces the firm to match revenues against cheaper, and likely less accurate costs.• One potential remedy is the Dollar Value LIFO Method

InventoriesDollar Value LIFO

• To use Dollar Value LIFO, you only need to know two things:• Ending Value of Total Inventory• The rate of inflation• From these, you “back out” the layers of inventory

InventoriesDollar Value LIFO

1999 Ending Inventory Value

2000 Ending Inventory Value

$200,000 $299,000

$99,000 increase in value

Is this increase in value due to purchases of new inventory or due to inflation?

Both!

InventoriesDollar Value LIFO

1999 Ending Inventory Value

2000 Ending Inventory Value

$200,000 $299,000

To find out actual inventory purchases, we need to deflate (discount) the 2000 Ending Inventory back to 1999 price levels.

This effectively wipes away the inflation effect to give us the true purchases effect.

InventoriesDollar Value LIFO

1999 Ending Inventory Value

2000 Ending Inventory Value

$200,000 $299,000

If price index is 15%, the discount multiplier is: 1

1.15= 0.8696

$260,000

x 0.8696

InventoriesDollar Value LIFO

1999 Ending Inventory Value

2000 Ending Inventory Value

$200,000 $299,000

$260,000

x 0.8696

$60,000 of actual inventoryincrease (stated at year 1999 price levels)

InventoriesDollar Value LIFO

Year [a]Ending Value

[b]Disc.

Multiplier [1/Price Index]

[c] = [a] x [b]Ending Value(Base Year $)

[d]Real Increase in Inventory

(Base Year $)

[e]New

Layer at inflated

cost

1999(Base)

200,000 --- 200,000 --- 200,000

2000

2001

InventoriesDollar Value LIFO

Year [a]Ending Value

[b]Disc.

Multiplier [1/Price Index]

[c] = [a] x [b]Ending Value(Base Year $)

[d]Real Increase in Inventory

(Base Year $)

[e]New

Layer at inflated

cost

1999(Base)

200,000 --- 200,000 --- 200,000

2000 299,000

2001

InventoriesDollar Value LIFO

Year [a]Ending Value

[b]Disc.

Multiplier [1/Price Index]

[c] = [a] x [b]Ending Value(Base Year $)

[d]Real Increase in Inventory

(Base Year $)

[e]New

Layer at inflated

cost

1999(Base)

200,000 --- 200,000 --- 200,000

2000 299,000 1/1.15

2001

InventoriesDollar Value LIFO

Year [a]Ending Value

[b]Disc.

Multiplier [1/Price Index]

[c] = [a] x [b]Ending Value(Base Year $)

[d]Real Increase in Inventory

(Base Year $)

[e]New

Layer at inflated

cost

1999(Base)

200,000 --- 200,000 --- 200,000

2000 299,000 0.8696 260,000

2001

InventoriesDollar Value LIFO

Year [a]Ending Value

[b]Disc.

Multiplier [1/Price Index]

[c] = [a] x [b]Ending Value(Base Year $)

[d]Real Increase in Inventory

(Base Year $)

[e]New

Layer at inflated

cost

1999(Base)

200,000 --- 200,000 --- 200,000

2000 299,000 0.8696 260,000 60,000

2001

This is the real increase reinflated= 60,000 x 1.15 = 69,000

InventoriesDollar Value LIFO

Year [a]Ending Value

[b]Disc.

Multiplier [1/Price Index]

[c] = [a] x [b]Ending Value(Base Year $)

[d]Real Increase in Inventory

(Base Year $)

[e]New

Layer at inflated

cost

1999(Base)

200,000 --- 200,000 --- 200,000

2000 299,000 0.8696 260,000 60,000 69,000

2001

InventoriesDollar Value LIFO

Year [a]Ending Value

[b]Disc.

Multiplier [1/Price Index]

[c] = [a] x [b]Ending Value(Base Year $)

[d]Real Increase in Inventory

(Base Year $)

[e]New

Layer at inflated

cost

1999(Base)

200,000 --- 200,000 --- 200,000

2000 299,000 0.8696 260,000 60,000 69,000

2001 360,000 1/1.20

Assume a price index of 120 percent in this year.

InventoriesDollar Value LIFO

Year [a]Ending Value

[b]Disc.

Multiplier [1/Price Index]

[c] = [a] x [b]Ending Value(Base Year $)

[d]Real Increase in Inventory

(Base Year $)

[e]New

Layer at inflated

cost

1999(Base)

200,000 --- 200,000 --- 200,000

2000 299,000 0.8696 260,000 60,000 69,000

2001 360,000 0.8333 300,000

InventoriesDollar Value LIFO

Year [a]Ending Value

[b]Disc.

Multiplier [1/Price Index]

[c] = [a] x [b]Ending Value(Base Year $)

[d]Real Increase in Inventory

(Base Year $)

[e]New

Layer at inflated

cost

1999(Base)

200,000 --- 200,000 --- 200,000

2000 299,000 0.8696 260,000 60,000 69,000

2001 360,000 0.8333 300,000 40,000

InventoriesDollar Value LIFO

Year [a]Ending Value

[b]Disc.

Multiplier [1/Price Index]

[c] = [a] x [b]Ending Value(Base Year $)

[d]Real Increase in Inventory

(Base Year $)

[e]New

Layer at inflated

cost

1999(Base)

200,000 --- 200,000 --- 200,000

2000 299,000 0.8696 260,000 60,000 69,000

2001 360,000 0.8333 300,000 40,000 48,000

This is the real increase reinflated= 40,000 x 1.20 = 48,000

InventoriesDollar Value LIFO

Year [e]New Layer at inflated cost

1999(Base)

200,000

2000 69,000

2001 48,000

This is how the inventory would be layered on the books.