Albrecht Financial Accounting Pp t Chapter 07

8/13/2019 Albrecht Financial Accounting Pp t Chapter 07

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COPYRIGHT 2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western aretrademarks used herein under license. 1

Chapter 7

Inventory

Albrecht, Stice, Stice, Swain


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Types of Inventory

Raw materials Materials purchased for use in manufacturing

process.

Work in process Partially completed units in production.

Finished goods

Manufactured products ready for sale. Cost of goods sold

Costs incurred to purchase or manufacturethe merchandise sold during the period.


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Costs Included in Inventory

What costs are included in inventory?

Raw materials

Labor costs Manufacturing overhead

The indirect manufacturing costs associated withproducing inventory.

Freight in costs


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Who Owns the Inventory?

When goods are in transit?Q: Who owns inventory on a truck or railroad car?

A: The party who is paying the shipping costs.

When goods are on consignment?Q: Who owns inventory stocked in a warehouse?

A: The supplier until the inventory is sold. Thewarehouse owner stocks and sells the inventory andreceives a commission on sales as payment forservices rendered.


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Perpetual vs. Periodic Systems

Perpetual inventory system

Detailed records of the number of units andthe cost of each purchase and sale are

prepared THROUGHOUT the period.

Periodic inventory system

System of accounting where cost of goods

sold is determined and inventory is adjustedat the END of the accounting period, not whenmerchandise is purchased or sold.


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Perpetual vs. Periodic Method

Inventory is purchased:Inventory 500

Accounts Payable 500

Transportation costs:Inventory 10

Cash 10

Purchase returns:Accounts Payable 50

Inventory 50

Purchase discounts:Account Payable 450

Inventory 9Cash 441

Inventory is purchased:Purchases 500

Accounts Payable 500

Transportation costs:Freight In 10

Cash 10

Purchase returns:Accounts Payable 50

Purchase Returns 50

Purchase discounts:Accounts Payable 450

Purchase Discounts 9Cash 441


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Perpetual vs. Periodic Method

When inventory is sold:

Accounts Receivable 50Sales 50

Cost of Goods Sold 30

Inventory 30

Closing Entry:

None

When inventory is sold:

Accounts Receivable 50Sales 50

No inventory entry at time of

saleClosing Entries:

Inventory 451Purchase Returns 50

Purchase Discounts 9Freight In 10Purchases 500

Cost of Goods Sold 30

Inventory 30


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Inventory Counts

Inventory counts Necessary under both the periodic and the

perpetual method.

With a periodic system, a physical count isthe only way to get the informationnecessary to compute cost of goods sold.

Under perpetual method, physical counts

allow companies to determine inventoryshrinkage. Shrinkage equals the difference between what

ending inventory should be what the countreveals it is.


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Cost of Goods SoldComputations

Periodic Method

Beginning Inventory

+ Net Purchases

= Cost of GoodsAvailable for Sale

Ending Inventory

= Cost of Good Sold

Perpetual Method

Ending Inventory (frominventory system)

Ending Inventory (frominventory count)

= Inventory Shrinkage

+ Cost of Goods Sold (from

inventory system)= Total Cost of Goods Sold


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Inventory Cost FlowAssumptions

FIFO (first in, first out)

Oldest units sold first.

LIFO (last in, last out)

Newest units sold first.

Average Cost

Average cost per unit is calculated by taking theaverage cost of goods available for sale.

Specific Identification

Each item is specifically identified.

Usually used for large or expensive items (cars).


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Inventory Cost Flow

Rice King buys and sells rice and had thefollowing transactions for the year: June 10 Purchased 10 tons at $6 per ton.

July 28 Purchased 10 tons at $9 per ton.

October 10 Sold 10 tons at $11 per ton. How much did Rice King make during the year?

FIFO LIFO Avg. CostSold Sold Sold

Old Rice New Rice Mixed Rice

Sales ($11 x 10 tons) $110 $110 $110COGS (10 tons) 60 90 75Gross margin $ 50 $ 20 $ 35


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LIFO vs. FIFO

FIFO gives a bettermeasure of inventoryon the balance sheet.

Therefore, FIFO is abetter measure ofinventory value.

LIFO gives a betterreflection of COGS onthe income statement.

Therefore, LIFO is abetter measure of netincome.


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Managing Inventory

Its a balance!

Avoid tying up

resources in

inventory.

Vs.

Maintainingsufficient inventoryfor smooth businessoperations.


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Measuring the Management ofInventory

Inventory Turnover

How many times during the year a companysells all of its inventory.

Cost of Goods Sold

Average Inventory


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Measuring the Management ofInventory

Number of Days Sales in Inventory

How many days worth of sales the companyhas in inventory.

365

Inventory TurnoverCalculated as cost of goods

sold divided by averageinventory. (Shown in

previous slide).


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Managing the Operating Cycle

Number of Days Purchases in Accounts Payable

How many days worth of inventory the company hasin accounts payable.

365

Purchases / Average Account Payable

Days Purchases in

Accounts Payable

External Financing

Days Sales in

InventoryAverage Collection

Period

30 Days 80 Days

38 Days 72 Days


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Inventory Errors

Inventory errors

Beginning inventory

Purchases

Ending inventory

Affects

Cost of goods sold

Gross margin

Net income


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Inventory Errors

UnderstateEnding

Inventory

Sales OK

Beginning inventory OKNet purchases OKGoods available OKEnding inventory LOW

Cost of goods sold HIGH

Gross margin LOWExpenses OKNet income LOW

UnderstatePurchases

UnderstateBeginningInventory

UnderstateSales

OK

OKLOWLOWOK

LOW

HIGHOKHIGH

OK

LOWOKLOWOK

LOW

HIGHOKHIGH

LOW

OKOKOKOK

OK

LOWOKLOW


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Perpetual LIFO and AverageCost

Complications arise because the last inand average cost change with every newpurchase. The cost of goods sold for each sale needs to

be recomputed after a new purchase is made.

This means a lot more work.

These complications do not occur withFIFO because the first in will always bethe same.


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Net Realizable Value

Net Realizable Value

Selling price less selling costs.

Used to value inventory when it is damaged,

used, or obsolete.

When inventory needs to be wri t ten down :

Loss on Write-down of Inventory . . . . . . 200Inventory . . . . . . . . . . . . . . . . . . . . . . . 200

To w ri te down o f inventory to its net real izable value.


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Lower of Cost or Market

Lower of cost or market

A basis for valuing inventory at the lower of originalcost or current market value.

Determining market value Ceiling

Maximum amount (net realizable value).

Replacement Cost

What inventory could currently be purchased for.

Floor Minimum amount (net realizable value minus a normal profit).

Market value is the middle of these three values.


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Using LCM

LCM can be applied in three ways.

By computing cost and market figures foreach item of inventory and using the lower of

the two figures in EACH case. By computing cost and market figures for the

total inventory and then applying the LCM rule

to that TOTAL. By applying the LCM rule to categories ofinventory.


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Gross Margin Method

Gross Margin Method

Used when a physical count of inventory isimpossible or impractical.

Cost of goods sold and ending inventory areestimated using available information:

Beginning inventory.

Purchases. Historical gross margin percentage.


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Gross Margin Method Example

Orem Industries has net sales for January 1 to March31 of $100,000 and net purchases of $65,000.Inventory on January 1 was $15,000 and the companyhas a historic gross profit percentage of 40%.

Dollars % of salesNet sales revenue $100,000 100%Cost of goods sold:Beginning inventory $15,000Purchases 65,000

Total available for sale $80,000Ending Inventory (3) 20,000Cost of goods sold (2) 60,000 60%Gross margin (1) $ 40,000 40%

(1) $100 000 X 40 (2) $100 000 - $40 000 (3) $80 000 - $40 000

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Albrecht Financial Accounting Pp t Chapter 07