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Cost of Cost of Goods Sold Goods Sold
and and Inventory: Inventory: IdentificatioIdentificatio
n and n and ValuationValuation
2
Define inventory for a merchandising business, and identify the different types of inventory for a manufacturing business.
Explain the advantages and disadvantages of both periodic and perpetual inventory systems.
Determine when ownership of goods in transit changes hands and what circumstances require shipped inventory to be kept on the books.
Learning Objectives
3
Compute total inventory acquisition cost. Use the four basic inventory valuation
methods: specific identification, average cost, FIFO, and LIFO.
Explain how LIFO inventory layers are created, and describe the significance of the LIFO reserve.
Learning Objectives
4
Learning Objectives
Choose an inventory valuation method based on the trade-offs among income tax effects, bookkeeping costs, and the impact on the financial statements.
Analyze inventory using financing ratios, and properly compare ratios of different firms after adjusting for differences in inventory valuation methods.
5
Learning Objectives
Use LIFO pools to simplify LIFO calculations.
Compute ending inventory and cost of goods sold using dollar-value LIFO.
EXPANDED MATERIAL
6
LIFO and FIFO in Times of Inflation
Uni
t Cos
t of
Goo
ds S
old
Beginning of Year
End of Year
FIFO assumes the old units are
soldFIFO
LIFO assumes the new units
are soldLIFO
7Time Line of Business Issues Involved With Inventory
BUY
Raw Materials or Goods for Resale
SELL
Finished Inventory
SELL COMPUTE
Ending Inventory and Cost of Goods
Sold
COMPUTEADD
Value
ADDADDADD
8
What Is Inventory?
Inventory designates goods held for sale in the normal course of business and, in the case of a
manufacturer, goods in production or to be placed in production.
Inventory designates goods held for sale in the normal course of business and, in the case of a
manufacturer, goods in production or to be placed in production.
9How Much Inventory Do Companies Have?
0%2%4%6%8%
10%12%14%16%18%
Inventory Levels for the 50 Largest Companies, 1979-1998
Inve
ntor
y as
a P
erce
ntag
e of
T
otal
Ass
ets
1998
Source: Standard and Poor’s Compustat
10
Inventory Types
MerchandiseMerchandiseMerchandiseMerchandise
Balance Sheet Items
IncomeStatement
Items
RetailerCost of Cost of
Goods SoldGoods SoldCost of Cost of
Goods SoldGoods SoldSale
Manufacturer
Raw Raw MaterialsMaterials
Raw Raw MaterialsMaterials
Cost of Cost of Goods SoldGoods Sold
Cost of Cost of Goods SoldGoods Sold
Sale
Finished Goods
Finished Goods
Work in Work in Process Process Work in Work in Process Process
OverheadDirectLabor
11
Periodic Inventory Systems
Cost of Goods Sold is determined and Inventory is adjusted to proper balance at period end.
All purchases of inventoriable merchandise are recorded in the Purchases account.
Ending inventory is determined by physical count of merchandise on hand.
12
Perpetual Inventory Systems
Cost of Goods Sold is determined and Inventory is adjusted to proper balance each time inventory is purchased or sold.
All purchases of inventoriable goods are recorded in the Inventory account.
13
Example: Inventory Systems
Assume:Beginning Inventory 50 units @ $10 $ 500Purchases 300 units @ $10 3,000Sales 275 units @ $15 4,125Ending inventory (physical count) 70 units @ $10 700
Make the journal entries to record the purchases and sales for both the periodic and
perpetual inventory systems.
14
Example: Inventory Systems
Purchases of Inventory
Periodic MethodPurchases…………………….. 3,000
Accounts Payable…………. 3,000
Perpetual MethodInventory…………………….. 3,000
Accounts Payable…………. 3,000
15
Example: Inventory Systems
Sales During the Period
Periodic MethodAccounts Receivable………….. 4,125
Sales………………………... 4,125
Perpetual MethodAccounts Receivable………….. 4,125
Sales………………………... 4,125
Cost of Goods Sold…………… 2,750Inventory…………………… 2,750
16
Whose Inventory Is It?
• Goods in Inventory.
• Goods in Transit.– FOB Shipping Point: buyer’s inventory
from time of shipment.
– FOB Destination: seller’s inventory until receipt by buyer.
• Goods on Consignment: inventory of the consignor, not the consignee.
17
Goods in Transit
Quality
Produce
Goods being shipped are included in inventory of buyer while in transit.
Goods being shipped are included in inventory of buyer while in transit.
FOB Shipping PointFOB Shipping PointFOB Shipping PointFOB Shipping Point
Seller Buyer
18
Goods in Transit
FOB DestinationFOB DestinationFOB DestinationFOB Destination
Quality
Produce
Goods being shipped are included in inventory of seller until received by buyer.
Goods being shipped are included in inventory of seller until received by buyer.
Seller Buyer
19
Goods on Consignment
Title to goods sold on consignment remains with the shipper until
their sale or use by the dealer or customer.
Title to goods sold on consignment remains with the shipper until
their sale or use by the dealer or customer.
20
What Is Inventory Cost?
• Inventory Cost is all expenditures related to inventory acquisition, preparation, and placement for sale.
• Trade Discounts
– Convert the catalog price to the actual price.
– Record inventory at discounted price.
• Cash Discounts
– Granted for payment of invoices within a limited time period.
– Record inventory using the net method or gross method.
21
Cash Discounts--Net Method
• Records inventory net of any purchase (cash) discounts.
• Example:
June 1--purchased inventory for $100
Terms of payment: 2/10, n/30
Assuming a perpetual inventory method, record the purchase of the inventory and payment on June 8.
22
June 1Inventory.............................. 98
Accounts Payable.....…..... 98
Cash Discounts--Net Method
23
June 1Inventory.............................. 98
Accounts Payable.....…..... 98June 8Accounts Payable................ 98
Cash.........................…..... 98
Cash Discounts--Net Method
24
Cash Discounts--Net Method
Now, assume that the payment was not
made until June 28.
Now, assume that the payment was not
made until June 28.
25
June 28Accounts Payable..............…. 98Discounts Lost…………….. 2
Cash..............................…. 100
Cash Discounts--Net Method
26
Cash Discounts--Gross Method
• Record inventory at gross cost; discounts are recorded only if taken.
• Example:
June 1--purchased inventory for $100
Terms of payment: 2/10, n/30
Assuming a perpetual inventory method, record the purchase of the inventory and payment on June 8.
27
June 1Inventory.............................. 100
Accounts Payable.....…..... 100
Cash Discounts--Gross Method
28
June 1Inventory.............................. 100
Accounts Payable.....…..... 100June 8Accounts Payable................ 100
Inventory……………….. 2Cash.........................…..... 98
Cash Discounts--Gross Method
29
Again, assume that the payment was not made until June 28.
Again, assume that the payment was not made until June 28.
Cash Discounts--Gross Method
30
June 28Accounts Payable..............…. 100
Cash..............................….100
Cash Discounts--Gross Method
31
Cost of Goods Manufactured
The heading.The heading.
Bartlett CorporationSchedule of Cost of Goods ManufacturedFor the Year Ended December 31, 2002
Bartlett CorporationSchedule of Cost of Goods ManufacturedFor the Year Ended December 31, 2002
32
Cost of Goods Manufactured
Direct materials:Raw materials inventory, January 1, 2002 $ 21,350Purchases 107,500Cost of raw materials available for use $128,850Less: Raw materials inventory, December 31, 2002 22,350
Raw materials used in production $106,500Direct labor 96,850
ContinuedContinuedContinuedContinued
33
Cost of Goods Manufactured
Manufacturing overhead:Indirect labor $40,000Factor supervision 29,000Depreciation---factory buildings and equipment 20,000Light, heat, and power 18,000Factory supplies 15,000Miscellaneous mfg. overhead 12,055 134,055
Total manufacturing costs $337,405Add: Work in process, Jan. 1, 2002 29,400
$366,805Less: Work in process, Dec. 31, 2002 26,500Cost of goods manufactured $340,305
34
Impact of Cash Discounts
Purchase Date
End of Discount Period
$9,800 Owed
$10,000 Owed
Final Payment
Date
10 Days 20 Days
Supplier “Loan” Period
35
Inventory Cost Flow Methods
Cost Cost Allocation Allocation MethodsMethods
Specific Identification FIFO
Average Cost
LIFO
Actual Cost Cost Pools Dollar Value
36Frequency of Use of Inventory Valuation Methods
U. S. Companies1979 and 1998
U. S. Companies1979 and 1998
Inventory 1979 1998 1998 Method All Companies All Companies Large Companies
FIFO 75.6% 82.9% 72.6%LIFO 25.8% 12.5% 33.0%Average cost 20.8% 15.7% 30.0%Specific Identification 3.7% 3.2% 2.6%
37
Specific Identification Method
Assigns the actual cost of the asset to Inventory and Cost of Goods Sold.
Provides a highly objective method of matching costs because cost flow exactly matches physical goods flow.
Is almost impossible to implement cost effectively.
38
Specific IdentificationSpecific Identification
100 units @ $10 per unitApr. 1
Apr. 10
Apr. 20
80 units @ $11 per unit70 units @ $12 per unit
Sold 80 units from the beginning inventory, 40 units from the April 10 purchase, and 20
units from the April 20 purchase.
39
20 units @ $10 per unit
40 units @ $11 per unit50 units @ $12 per unit
Sold 80 units from the beginning inventory, 40 units from the April 10 purchase, and 20
units from the April 20 purchase.
Apr. 1
Apr. 10
Apr. 20
Beg. Inv. + Purchases - End. Inv. = Cost of Goods Sold
Ending inventory…………….
= $ 200
= 440
= 600
$1,240
$1,000 + $1,720 - $1,240 = $1,480
Specific IdentificationSpecific Identification
40
Average Cost Method
• Assigns the same average cost to each unit sold and each item in inventory.
• For Periodic Inventory, the unit cost is the weighted average for the entire period.
• For Perpetual Inventory, the unit cost is computed as a moving average, which changes with each new purchase of goods.
41
= $1,000
= 880
= 840
$2,720
100 units @ $10 per unitApr. 1
Apr. 10
Apr. 20
80 units @ $11 per unit70 units @ $12 per unit
Sold 140 units during April.
250 units
Beg. Inv. + Purchases - End. Inv. = Cost of Goods Sold
$1,000 + $1,720 - $1,197 = $1,523
$2,720 250 units = $10.88$10.88 x 110 units = ending inventory of $1,197
Average Cost Method--Periodic
42
Apr. 18 Sales -90 units @ $10.44 -940Apr. 18 Balance 90 units @ $10.44 $ 940Apr. 20 Purchases 70 units @ $12 840Apr. 20 Balance 160 units @ $11.125 $1,780
Apr. 1 Beginning Inventory 100 units @ $10 $1,000Apr. 10 Purchases 80 units @ $11 880Apr. 10 Balance 180 units @ $10.44 $1,880
$1,880 180Apr. 27 Sales -50 units @ $11.125 -556Apr. 30 Balance 110 units @ $11.125 $1,224
$1,780 160Cost of Goods Sold (140 units) $940 + $556 $1,496Ending Inventory (110 units @ $11.125) $1,224
Average Cost Method--Perpetual
43
First-in, First-out (FIFO) Method
Assigns historical unit cost to Cost of Goods Sold in the order the costs are incurred.
Provides a close match between physical product flow and product cost flow.
Results in the same inventory valuation and Cost of Goods Sold regardless of whether perpetual or periodic inventory is used.
44
Last-in, First-out (LIFO) Method
Assigns the most recent historical costs to Cost of Goods Sold and the oldest costs to Inventory.
Is used primarily to minimize taxable income.
Results in differences between Cost of Goods Sold and Inventory for perpetual inventory versus periodic inventory.
45
100 units @ $10 per unitApr. 1
Apr. 10
Apr. 20
80 units @ $11 per unit
Sold 140 units during April.
10 units @ $11 per unit
Sold 0
Sold 70
Sold all70 units @ $12 per unit
Periodic Inventory SystemPeriodic Inventory System
0 units @ $12 per unit
Last-in, First-out (LIFO) Method
46
Beg. Inv. + Purchases - End. Inv. = Cost of Goods Sold
100 units @ $10 per unitApr. 1
Apr. 10
Apr. 20
80 units @ $11 per unit10 units @ $11 per unit70 units @ $12 per unit0 units @ $12 per unit
Ending inventory………………..
= $1,000
= 110
= 0
$1,110
$1,000 + $1,720 - $1,110 = $1,610
Periodic Inventory SystemPeriodic Inventory System
Last-in, First-out (LIFO) Method
47
100 units @ $10 per unit90 units @ $10 per unitApr. 1
Apr. 10
Apr. 20
80 units @ $11 per unit Purchased 8070 units @ $12 per unit
Perpetual Inventory SystemPerpetual Inventory System
20 units @ $12 per unitSold 8080 units @ $11 per unit0 units @ $11 per unit
Sold 10
Purchased 70Sold 50
Beginning inventory
Last-in, First-out (LIFO) Method
48
Apr. 1
Apr. 10
Apr. 20Ending inventory………………..
Beg. Inv. + Purchases - End. Inv. = Cost of Goods Sold
= $ 900
= 0
= 240
$1,140
$1,000 + $1,720 - $1,140 = $1,580
Perpetual Inventory SystemPerpetual Inventory System
Last-in, First-out (LIFO) Method
100 units @ $10 per unit90 units @ $10 per unit
80 units @ $11 per unit70 units @ $12 per unit20 units @ $12 per unit80 units @ $11 per unit0 units @ $11 per unit
49
Inventory Turnover
Appropriateness of inventory size and Appropriateness of inventory size and position can be measured by calculating position can be measured by calculating the the Inventory Turnover RatioInventory Turnover Ratio..
Appropriateness of inventory size and Appropriateness of inventory size and position can be measured by calculating position can be measured by calculating the the Inventory Turnover RatioInventory Turnover Ratio..
Inventory Turnover:
Cost of Goods Sold ÷ Average Inventory
50
Example: Inventory Turnover
Determine the inventory turnover.
• Cost of Goods Sold $1,000• Beginning Inventory $ 90• Ending Inventory $ 110
• Cost of Goods Sold $1,000• Beginning Inventory $ 90• Ending Inventory $ 110
51
• Cost of Goods Sold $1,000• Beginning Inventory $ 90• Ending Inventory $ 110
• Cost of Goods Sold $1,000• Beginning Inventory $ 90• Ending Inventory $ 110
$1,000
($90 + $110)/2= 10
Example: Inventory Turnover
52Number of Days’ Sales in Inventory
$1,000
($90 + $110)/2= 10
36510
Number of days’ sales in inventory is 36.5
53
Example--Dollar-Value LIFO
1. Compute ending inventory at ending prices.
2. Compute beginning inventory at ending prices.
3. Compute the difference. An increase represents a new LIFO layer.
4. LIFO ending inventory is beginning inventory at base-year prices plus the new LIFO layer.
54
Assuming 1999 is the first year Harry’s Hardware, Inc. uses dollar-value LIFO, the following slides illustrate the calculations for 2000, 2001, and 2002 ending inventory.
Example--Dollar-Value LIFO
55
Assume the following inventory data for Harry’s:
Inventory
Year (nominal) Price Index
1999 $ 76 1.0
2000 $ 108 1.2
2001 $ 90 1.5
2002 $ 255 1.7
Example--Dollar-Value LIFO
56
Inv @ Dollar-Inv @ Base Base Value
EoY EoY Year Year Layer LIFOYear Cost Index Cost Layers Index Cost
1999 $ 76 ÷1.0 = $ 76 $ 76 x 1.0 = $ 76.0
Example--Dollar-Value LIFO
Ending Ending inventoryinventoryDVLifoDVLifo
19991999
Ending Ending inventoryinventoryDVLifoDVLifo
19991999
57
Inv @ Dollar-Inv @ Base Base Value
EoY EoY Year Year Layer LIFOYear Cost Index Cost Layers Index Cost
2000 $108
1999 $ 76 ÷1.0 = $ 76 $ 76 x 1.0 = $ 76.0
Example--Dollar-Value LIFO
58
Inv @ Dollar-Inv @ Base Base Value
EoY EoY Year Year Layer LIFOYear Cost Index Cost Layers Index Cost
2000 $108 ÷1.2 = $ 901999 $ 76 ÷1.0 = $ 76 $ 76 x 1.0 = $ 76.0
Example--Dollar-Value LIFO
59
Inv @ Dollar-Inv @ Base Base Value
EoY EoY Year Year Layer LIFOYear Cost Index Cost Layers Index Cost
2000 $108 ÷1.2 = $ 901999 $ 76 ÷1.0 = $ 76 $ 76 x 1.0 = $ 76.0
$ 76 x 1.0 = $ 76.0 14 x 1.2 = 16.8
Example--Dollar-Value LIFO
Ending inventory (DV Lifo, 2000) $ 92.8
60
Inv @ Dollar-Inv @ Base Base Value
EoY EoY Year Year Layer LIFOYear Cost Index Cost Layers Index Cost
2001 $ 90 ÷1.5 = $ 60 $ 60 x 1.0 = $ 60.0
Example--Dollar-Value LIFO
2000 $108 ÷1.2 = $ 901999 $ 76 ÷1.0 = $ 76 $ 76 x 1.0 = $ 76.0
$ 76 x 1.0 = $ 76.0 14 x 1.2 = 16.8
Ending inventory (DV Lifo, 2000) $ 92.8
ContinuedContinuedContinuedContinued
61
2002 $255 ÷1.7 = $150 $ 60 x 1.0 = $ 60.090 x 1.7 = 153.0
Inv @ Dollar-Inv @ Base Base Value
EoY EoY Year Year Layer LIFOYear Cost Index Cost Layers Index Cost
2001 $ 90 ÷1.5 = $ 60 $ 60 x 1.0 = $ 60.0
Example--Dollar-Value LIFO
Ending inventory (DV Lifo, 2002) $213.0Ending Ending inventoryinventoryDVLifoDVLifo
20012001
Ending Ending inventoryinventoryDVLifoDVLifo
20012001
62
LIFO Advantages
Advantages:
• Matches current costs with current revenues.
• Excludes inventory holding gains from gross profit.
• Income tax deferral.
63
Disadvantages:• Does not correspond with the physical flow
of goods.• Potential LIFO liquidation can draw old
costs into cost of goods sold.• Ending inventory balance can be much
lower than current replacement cost.
LIFO Disadvantages
64
FIFO Advantages
Advantages:
• Corresponds with physical flow of goods.
• Ending inventory balance is close to current replacement cost.
65
Disadvantages:
• Matches older costs with current revenues.
• Inventory holding gains and losses are part of gross profit.
• No income tax deferral.
FIFO Disadvantages
66
The EndThe End