6_Cost of Sales and Inventories

Chapter 6: Chapter 6: Cost Cost of Sales & Inventoriesof Sales & Inventories

PresentorPresentor: Group 1 : Group 1 -- BM 220BM 220JeniceJenice Joy Joy SumawaySumaway

Mike Mike AgenciaAgenciaReference: Accounting Text & Cases 11Reference: Accounting Text & Cases 11thth Ed Ed

by: Robert Anthony ET ALby: Robert Anthony ET AL

Discussion OutlineDiscussion Outline

• Overview & Accounting details for 3 types of companies– Merchandising – Manufacturing– Service

• Inventory Costing Methods• Lower of Cost or Market• Analysis of Inventory• Case: Browning Manufacturing Company

Cost of Sales & Inventories

Type of CompaniesType of Companies

• Merchandising

– Sells good in substantially the same physical form as that in which it acquires them.

• Manufacturing

– Converts raw materials & purchased parts into finished goods.

• Service organizations

– Finish intangible services rather than tangible goods.


Merchandising CompaniesMerchandising Companies

• The Basic Measurement Problem

• 2 Types of Inventory Method

– Periodic Inventory Method

– Perpetual Inventory Method

• Retail Method


Merchandise Inventory & FlowsMerchandise Inventory & Flows

Ending Inventory

Beginning Inventory

Purchases$ 7,400

Cost of Goods Sold$ ???

(BI+Purchases-

EI$4,000

Available for Sale $11,400

Cost of Inventory

$ ?? (BI+Purch

ased –COGS)

Illustration 6-1Cost of Sales & Inventories

Inventory MethodsInventory Methods

1. Periodic Inventoryo A physical count is made of merchandise in the

ending inventory & the cost of inventory is determined

o When goods are purchased, a separate set of accounts is used to accumulate information on the net cost of the purchases.

o No entries are made to the inventory account as the merchandise is bought & sold. Only at the end of period, when the inventory is counted, will entries be made to the inventory account to establish proper balance.


Periodic Inventory MethodPeriodic Inventory Method

Assume that physical inventory shows the cost of merchandise remaining at the end of the period is $2,000

Beginning Inventory $4,000

Plus: Purchases $7,400

Equals: Goods available for sales $11,400

Less: Ending Inventory $ 2,000

Cost of Goods Sold $ 9,400


Periodic Inventory MethodPeriodic Inventory Method

Calculation with additional details:

Beginning Inventory $4,000Plus: Purchases $7,400 Freight-in $ 600

$ 7,600Less: Purchase Returns $ 200Net Purchases: $7,400Goods available for sale $11,400Less: Ending Inventory $ 2,000



Periodic Inventory MethodPeriodic Inventory MethodBeginning Balance Entry


Merchandising Inventory $4,000

Temporary Purchases, Purchase Returns & Freight-in accounts are closed to COGS by entries


Purchase Returns $ 200

Purchases $7,000

Freight-in $ 600

Merchandise inventory entry

Merchandise Inventory $ 2,000

Cost of Goods Sold $2,000

Finally, COGS closed

Income Summary $ 9,400

Cost of Goods Sold $9,400Cost of Sales & Inventories


2. Perpetual Inventory Method

o A record is maintained of each item carried in the inventory.

o Inventory account is continuously updated

o Ending inventory should reconcile with the actual physical count


Perpetual Inventory MethodPerpetual Inventory Method

• Illustration 6.2 Perpetual Inventory Card

• Ledger Account


Perp Invty Card.xlsx


2. Perpetual Inventory Method

o A record is maintained of each item carried in the inventory.

o Inventory account is continuously updated

o Ending inventory should reconcile with the actual physical count


Manufacturing AccountsManufacturing Accounts

• 3 types of Inventory Accounts

• Materials used

• COGS Manufactured

• COGS Sold

• Product Costing System

• Product Costs & Period CostsCost of Sales & Inventories

Manufacturing Company:Manufacturing Company:3 Types of Inventory Accounts3 Types of Inventory Accounts

1. Materials Inventory

o acquisition cost

2. Work in Process Inventory

o Materials thus far issued for them

o Conversion costs incurred on these items up to the end of accounting period

3. Finished Goods Inventory

o Total cost incurred in manufacturing


Manufacturing Inventories & FlowManufacturing Inventories & Flow

Ending Inventory

Beginning Inventory

Purchases

Ending Inventory

Beginning Inventory

Ending Inventory

Beginning Inventory

Materials used

Materials Inventory

Conversion Cost

Work in Process Inventory

Completed Goods

Finished Goods

Inventory

Cost of Goods Sold


Manufacturing Inventories & FlowManufacturing Inventories & Flow

• Illustration 6.4

– Flow of Costs Through Inventories


Flow of cost through inventories.xlsx

Costs of Goods SoldCosts of Goods Sold

COGS = Finished Goods Invty + Cost of Goods manufactured – Finished Goods inventory

Example:


Product Costing SystemsProduct Costing Systems

• A system that the cost of each product is accumulated as it flows through production process


Production Costs & Period CostsProduction Costs & Period Costs

• Product Costs & Inventory Costs

– Items of cost included in the cost of producing goods

• GAAP principles, cost of each product includes:

1. Material cost

2. Cost incurred directly in bringing the product to its existing condition or location (direct labor cost)

3. Indirect production cost


Service CompaniesService Companies

• Personal services organization– May identify the labor cost of the people directly

providing the service and supplies costs as elements of cost of sales, to distinguish them from “office overhead” costs.

• Building trade firms & repair business

• Professional service firms– Have labor costs but no material costs

• Acctg entries --- Accts receivable, Billings (Revenues), Project expenses, Jobs in progress


INVENTORY COSTING METHODSINVENTORY COSTING METHODS

- The measurement of inventory and cost of goods sold when the per – unit cost of one or more items in inventory changes during the accounting period

INVENTORY:

- Assets that are intended for sale, are in process of being produced for sale or are to be used in producing goods.


Four Types of Inventory ValuationFour Types of Inventory Valuation

1. Specific Identification

2. Average Cost

3. First-in, first-out (FIFO)

4. Last-in, first-out (LIFO)


EXAMPLE DATA:EXAMPLE DATA:

Units Unit Cost Total Cost

Inventory 01/01 100 $8 $800

Purchased 06/01 60 9 540

Purchased 10/ 01 80 10 800

Goods available

for sale 240 8.917 2,140

Goods sold 150 - -

Ending Inventory 90


Inventory Valuation Inventory Valuation

1. SPECIFIC IDENTIFICATION:

- Common practice w/ certain big-ticket items such as automobiles & unique items (e.g. paintings, expensive jewelry & etc.)

- each item that is sold and each item remaining in inventory is separately identified in respect to it's purchase cost.


Example: (specific identification)Example: (specific identification)


Units Sold 100 $8 $800

Units Sold 50 9 450

Cost of Goods Sold 150 - 1,250


2. AVERAGE COST METHOD

- This method is quite straightforward; it takesthe weighted average of all units available forsale during the accounting period and then usesthat average cost to determine the valueof COGS and ending inventory


http://www.investopedia.com/terms/w/weightedaverage.asp



Example (average cost):Example (average cost):


Inventory 01/01 100 $8 $800

Purchased 06/01 60 9 540

Purchased 10/ 01 80 10 800

Goods available

for sale 240 8.917 2,140/

240 units

Average Cost $8.917


3. FIFO (First-in, first-out) Method

- This method assumes that the first unit making its way into inventory is the first sold.

- Cost of goods sold - approximate the physical flow of the goods

- Ending Inventory – approximates the current cost of the goods


Example (FIFO):Example (FIFO):


Cost of Goods Sold:

From Beginning Inventory 100 $8 $800

From purchases of Jan. 1 50 9 450

COGS 150 $1, 250

Ending Inventory:

From Purchases of June 1 10 $9 $90

From purchase of October 1 80 10 800

Ending Inventory: 90 $890


4. LIFO (Last-in, first-out) Method

- Opposite of FIFO

- This method assumes that the last unit makingits way into inventory is sold first. The olderinventory, therefore, is left over at the end ofthe accounting period

- COGS – based on cost of recent purchases

- Ending Inventory – costed at cost of the oldestunits available


Example(LIFO):Example(LIFO):Units Unit Cost Total Cost

Cost of Goods Sold:From purchases of October 1 80 $10 $800From purchases of June 1 60 9 540From Inventory Jan. 1 10 8 80

COGS 150 $1, 420

Ending Inventory:From beginning inventory 90 8 $720


LIFO Dollar Value Method- method of valuation used on inventory of physically unlike items.

Inventory Pool – a pool wherein unlike items are grouped. (example: all hardware products)

LIFO reserve – mathematical difference between two inventory amounts; one based on LIFO & the other one based on other valuation method.


Summary of illustrative case:Summary of illustrative case:

COGS Inventory TOTAL

FIFO $1,250 $890 $2,130

Average Cost 1,338 802 2,130

LIFO 1,420 720 2,130

FIFO – lowest COGS, highest inventory

Average Cost – Somewhere in between

LIFO – highest COGS, lowest inventory


Arguments for FIFO

1. Cost of goods that are physically sold arematched with the revenues generated of thatsold goods.(physical flow of inventory iscorrupted if LIFO is used)

2. It should reflect the true value of inventory w/c is the current cost


Arguments for LIFO

1. Gross margin should reflect the differencebetween sales revenue w/c are currentamounts & the current COGS.

- (Current COGS/ replacement cost inventoryaccounting/ NIFO)cost of acquiring identicalitems to those sold to replenish the inventory

2. Argument of FIFO regarding current cost ofinventory can be mitigated through disclosureof LIFO reserves in the notes to FS.


Income Tax ConsiderationIncome Tax Consideration

- FIFO yields the highest income – tax is higher

- LIFO yields the lowest income – tax is lower

Why not more LIFO if tax is lower?

- in industries where deflation is the trend, LIFOwould yield the highest income resulting to ahigher tax (e.g. technology).

- Cashflow income reported to stockholders willbe low resulting to a smaller earnings/ share.


Lower of Cost or MarketLower of Cost or Market

- general inventory valuation principle deriving from conservatism concept where inventory is reported at balance sheet at lower of cost or market.

Rules in using this valuation:

1. Should not be higher with the NRV.

2. Should not be lower than NRV less normal profit margin


Inventory AnalysisInventory Analysis

Inventory Turnover = COGS/ *Inventory

*valued at ending invty. or average (beg. + end/ 2)

- A ratio showing how many times acompany's inventory is sold and replaced over aperiod

Days Inventory = (Inventory/COGS)(365 days)

= 365/ Inventory turnover

- Period how long inventory is disposed in terms of days


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6_Cost of Sales and Inventories