Inventories 8. Managing Inventories OBJECTIVE 1: Explain the management decisions related to inventory accounting, evaluation of inventory level, and

Inventories8

Managing Inventories

OBJECTIVE 1: Explain the management decisions related to inventory accounting, evaluation of inventory level, and the effects of inventory misstatements on income measurement.

Key Ratios

• Inventory turnover

• Days’ inventory on hand

Figure 1: Management Choices in Accounting for Inventories

Figure 2: Inventory Turnover for Selected Industries

Figure 3: Days’ Inventory on Hand for Selected Industries


• Merchandise inventory is a current asset.– The matching principle is applied to inventory

valuation.– The higher the ending inventory, the lower the

cost of goods sold and the higher the gross profit and net income.


• Merchandise inventory is a current asset. (cont.)– Management chooses an inventory system

(periodic or perpetual), an inventory costing system (specific identification, average cost, FIFO, or LIFO), and a method of valuing inventory at market.


• In managing inventory levels, it is important to take into consideration both the costs of handling, storing, and financing inventories and the cost of lost sales.– Inventory turnover (cost of goods sold divided by

average inventory) is the number of times, on average, inventory is sold during the period.

– Days’ inventory on hand (365 divided by inventory turnover) is the number of days it takes to sell inventory.


• In managing inventory levels, it is important to take into consideration both the costs of handling, storing, and financing inventories and the cost of lost sales. (cont.)– Inventory levels are minimized by using

supply-chain management in a just-in-time operating environment.


• Beginning and ending inventory are an integral part of the calculation of cost of goods sold and, therefore, income before income taxes.– When ending inventory is under- or overstated,

income before income taxes will be under- or overstated, respectively.

– When beginning inventory is under- or overstated, income before income taxes will be over- or understated, respectively.


• Beginning and ending inventory are an integral part of the calculation of cost of goods sold and, therefore, income before income taxes. (cont.)– Inventory errors are counterbalancing because

their effects are reversed within two accounting periods.

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Inventory Cost and Valuation

OBJECTIVE 2: Define inventory cost, contrast goods flow and cost flow, and explain the lower-of-cost-or-market (LCM) rule.

Figure 4: Merchandise in Transit


• Inventory cost includes purchase price less discounts; freight-in and insurance in transit; and taxes and tariffs.


• Goods flows and cost flows– Goods flow is the actual physical flow of

goods into and out of the company.– Cost flow is an assumption made about costs

for accounting purposes.


• Goods flows and cost flows (cont.)– Merchandise inventory also includes the

following costs:• Incoming goods shipped FOB shipping point

• Outgoing goods shipped FOB destination

• Goods consigned to another company


• Goods flows and cost flows (cont.)– Merchandise inventory would not include the

following costs:• Incoming goods shipped FOB destination

• Outgoing goods shipped FOB shipping point

• Goods held on consignment from another company


• Inventory should be valued at the lower of cost or market.– First, cost is determined by historical, or

original, cost.– Market is defined as replacement cost.– Cost is compared with market.– Use of LCM can be an indicator that a

company is in trouble.


Inventory Cost Under the Periodic Inventory System

OBJECTIVE 3: Calculate inventory cost under the periodic inventory system using various costing methods.

Figure 5: The Impact of Costing Methods on the Income Statement and Balance Sheet Under the Periodic Inventory System


• Under the specific identification method, ending inventory can be identified as having come from specific purchases.– The specific identification method is used

primarily for high-priced items such as automobiles, furniture, and expensive jewelry.


• Under the average-cost method, an average cost per unit is calculated on goods available for sale to determine ending inventory and cost of goods sold.– An advantage of the average-cost method is that

cost increases and decreases are leveled out.

– A disadvantage of the average-cost method is that the most current costs are not used in income determination.


• Under FIFO, the first goods purchased are assumed to be the first sold.– In a period of rising prices, FIFO will produce

the highest net income of the four methods.– FIFO is criticized for magnifying the effects of

the business cycle on income.


• Under LIFO, the goods purchased most recently are assumed to be the first sold.– LIFO matches current costs with current

revenues, and the effects of the business cycle are smoothed out.

– Disadvantages of LIFO include reporting the lowest net income of the four methods in inflationary times, often an unrealistic inventory valuation, and lack of acceptance in most other countries.


Impact of Inventory Decisions

OBJECTIVE 4: Explain the effects of inventory costing methods on income determination and income taxes.

Table 1: Effects of Inventory Costing Methods on Gross Margin

Figure 6: Inventory Costing Methods Used by 600 Large Companies


• During periods of rising prices, FIFO provides a higher gross margin than LIFO. The average-cost method produces gross margin that is between those of FIFO and LIFO. No generalization can be made about the specific identification method.– During periods of falling prices, LIFO

produces a higher gross margin than FIFO.


• Effects on the financial statements– In general, LIFO best follows the matching rule.– In general, FIFO provides a more up-to-date

ending inventory figure for balance sheet purposes.

– The inventory method chosen must be applied consistently. When LIFO is used for tax purposes, it must also be used for financial reporting.


• A LIFO liquidation occurs when the quantity of ending inventory is less than the quantity of beginning inventory. This generally produces higher income before taxes.– When ending inventory is understated, income

before income taxes for the period will be understated.

– When ending inventory is overstated, income before income taxes for the period will be overstated.


• A LIFO liquidation occurs when the quantity of ending inventory is less than the quantity of beginning inventory. This generally produces higher income before taxes. (cont.)– When beginning inventory is understated,

income before income taxes for the period will be overstated.

– When beginning inventory is overstated, income before income taxes for the period will be understated.


• A company’s choice of inventory method will affect not only its profitability, but also its liquidity and cash flows.


Inventory Cost Under the Perpetual Inventory System

SUPPLEMENTAL OBJECTIVE 5: Calculate inventory cost under the perpetual inventory system using various costing methods.

Figure 7: The Impact of Costing Methods on the Income Statement and Balance Sheet Under the Perpetual Inventory System


• The specific identification method is applied the same way in the perpetual system as in the periodic system and produces the same results.

• Using the average-cost method in a perpetual system, a moving average is computed after each purchase.


• Using FIFO and LIFO in a perpetual system, list each inventory layer separately.

• FIFO will yield the same ending inventory figure under the perpetual system as under the periodic system.


• LIFO will usually produce different figures for ending inventory and cost of goods sold in a perpetual system than in a periodic system.


Valuing Inventory by Estimation

SUPPLEMENTAL OBJECTIVE 6: Use the retail method and gross profit method to estimate the cost of ending inventory.

Table 2: Retail Method of Inventory Estimation

Table 3: Gross Profit Method of Inventory Estimation


• The retail method can be used when the relationship between cost and selling price is relatively constant. Applying this method is complicated by retail prices that change during the year, different markups that exist on different types of merchandise, and sales volumes of different types of merchandise that vary.– With the retail method, records must be kept at cost

and at retail.


• The retail method can be used when the relationship between cost and selling price is relatively constant. Applying this method is complicated by retail prices that change during the year, different markups that exist on different types of merchandise, and sales volumes of different types of merchandise that vary. (cont.)


– Applying the retail method involves four steps.• Compute goods available for sale at cost and at

retail.

• Compute a cost-to-retail ratio.

• Subtract sales from goods available for sale at retail to obtain ending inventory at retail.

• Multiply ending inventory at retail by the cost-to-retail ratio to determine ending inventory at cost.


• The gross profit method can be used when the gross profit ratio remains relatively constant.– The gross profit method is used in place of the

retail method when records of retail prices of beginning inventory and purchases are not kept.

– The gross profit method is generally used when inventory is destroyed or stolen.


• The gross profit method can be used when the gross profit ratio remains relatively constant.– Applying the gross profit method involves three

steps.• Compute goods available for sale (at cost) by adding

purchases to beginning inventory.• Compute estimated cost of goods sold by deducting the

estimated gross margin from sales.• Subtract estimated cost of goods sold from cost of

goods available for sale to obtain estimated ending inventory.


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Inventories 8. Managing Inventories OBJECTIVE 1: Explain the management decisions related to inventory accounting, evaluation of inventory level, and