Inventories & COGSCOGS

Inventory

• Definition: Inventory is defined as goods held for sale in the normal course of business or items used in the manufacture of products that will be sold in the normal course of business.

Inventory

• Inventory is recorded on the balance sheet at the lower of the cost or the market value of the inventory.

• The cost of inventory includes all costs necessary to bring the inventory to a saleable condition.

The “ins” of inventory The “outs” of inventory accounting accounting Acquisition costs Cost of goods sold

Cost of goods available for sale

Beginning inventory Ending inventory

B Inv+ Purchases = COGAS = COGS + E Inv

The “Ins” and “Outs” of Inventory Accounting

Keeping track of inventory quantities:

Perpetual vs. Periodic Inventory Systems

• Perpetual system: tracks units sold directlymore accurate, more timely,

potentially more costly

• Periodic system: infer quantities sold by using purchases/production, beginning and ending inventories.

Units sold = Beg. Units + Production –End. Unitsharder to detect inventory “shrinkage” (e.g., theft, spoilage) as well as management fraud

COSTING METHODS:• Once the unit cost of inventory is determined via the

preceding rules of logic, specific costing methods must be adopted. In other words, each unit of inventory will not have the exact same cost, and an assumption must be implemented to maintain a systematic approach to assigning costs to units on hand (and to units sold) At the end of the accounting period,

• The accounting question you must consider is: what is the cost of the ending inventory?

COSTING METHODS:• A company must adopt an inventory valuation

method (and that method must be applied consistently from year to year). The methods from which to choose are varied, generally consisting of one of the following:

First-in, first-out (FIFO) First-in, first-out (FIFO) Last-in, first-out (LIFO) Last-in, first-out (LIFO) Weighted-average Weighted-average

• Each of these methods entail certain cost-flow assumptions. Importantly, the assumptions bear no relation to the physical flow of goods; they are merely used to assign costs to inventory units.

FIRST-IN, FIRST-OUT

• CALCULATIONSCALCULATIONS: With first-in, first-out, the oldest cost (i.e., the first in) is matched against revenue and assigned to cost of goods sold. Conversely, the most recent purchases are assigned to units in ending inventory.

LAST-IN, FIRST-OUT

• CALCULATIONSCALCULATIONS: Last-in, first-out is just the reverse of FIFO; recent costs are assigned to goods sold while the oldest costs remain in inventory.

WEIGHTED AVERAGE

• CALCULATIONSCALCULATIONS: The weighted-average method relies on average unit cost to calculate cost of units sold and ending inventory. Average cost is determined by dividing total cost of goods available for sale by total units available for sale.

Example

• Beginning inventory balance that consisted of 4,000 units with a cost of $12 per unit. 5,000 units on hand at the end of the year.

FIFO• Ending inventory and cost of goods sold calculations are as

follows- Beginning inventory 4,000 X $12 = $48,000+Net purchases = (6,000 X $16) = $96,000

(8,000 X $17) = $136,000 Total = $232,000

Cost of goods available for sale total Cost of goods available for sale total $280,000. $280,000.Cost of goods sold 4,000 X $12 = $48,000

6,000 X $16 = $96,000 3,000 X $17 = $51,000

TotalTotal ==$195,000$195,000

Ending inventory 5,000 X $17 = $85,000= $85,000

LIFO• Ending inventory and cost of goods sold calculations are as

follows- Beginning inventory 4,000 X $12 = $48,000+Net purchases = (6,000 X $16) = $96,000

(8,000 X $17) = $136,000 Total = $232,000

Cost of goods available for sale total Cost of goods available for sale total $280,000. $280,000.Cost of goods sold 8,000 X $17 = $136,000

5,000 X $16 = $80,000 TotalTotal = = $216,000$216,000

Ending inventory 4,000 X $12 = $48,000 1,000 X $16 = $16,000 = $64,000= $64,000

Cost of goods available for sale $280,000Divided by units (4,000 + 6,000 + 8,000) 18,000

Average unit cost (note: do not round) $15.5555 per unit

Ending inventory (5,000 units @ $15.5555) $77,778

Cost of goods sold (13,000 units @ $15.5555) $202,222

WEIGHTED AVERAGEWEIGHTED AVERAGE

COMPARING INVENTORY METHODS

The following table reveals that the amount of grossprofit and ending inventory numbers appear quitedifferent, depending on the inventory methodselected:

Advantages Of FIFO Method

• Easy to apply• The assumed flow of costs often corresponds

with the normal physical flow of goods.• No manipulation of income is possible.• The balance sheet amount for inventory is

likely to approximate the current market value.

Disadvantages Of FIFO Method

• Recognizes “paper” profits.• Tax burden is heavier if used for tax purposes.

Advantages Of LIFO Method

• Reports both sales revenue and cost of goods sold in current dollars.

• Lower income taxes result if used for tax purposes when price is rising.

Disadvantages Of LIFO Method

• Matches the cost of not goods sold against revenues.

• Grossly understates inventory.• Permits income manipulation

Weighted Average Method

Advantages: Due to the averaging process, the effects of

year-end buying or not buying are lessened.

Disadvantages:Manipulation of income possible.

Net Realizable and Lower-of-cost-or-market method

• Net Realizable Value: Estimated selling price less the estimated costs preparing the item for sale.

• LCM- method that values inventory at the lower of its historical cost or its current market costs.

Beginning Inventory and Purchases

Units Unit Cost Sales Units

Beginning Inventory

6250 $3.00 February 03 5,250

March 15 5000 $3.12 May 04 4500May 10 8750 $3.30 September 16 8000August 12 6250 $3.48 October 09 7250November 20 3750 $3.72

Totals 30,000 Totals 25,000

Another Example:Another Example:

Compute Ending Inventory using FIFO, LIFO and Weighted Average Method.Compute Ending Inventory using FIFO, LIFO and Weighted Average Method.

Beginning Inventory and Purchases Units Unit Cost

Total Cost

Beginning Inventory 6250 $3.00 $18,750

March 15 5000 $3.12 $15,600May 10 8750 $3.30 $28,875August 12 6250 $3.48 $21,750November 20 3750 $3.72 $13,950$13,950

Totals 30,000 $98,925

Solution: Weighted Average MethodSolution: Weighted Average Method

Weighted Average Cost = $96,925/30,000 = $3.29756.Weighted Average Cost = $96,925/30,000 = $3.29756.Ending Inventory Cost = 5,000×$3.2975 = $16,488.Ending Inventory Cost = 5,000×$3.2975 = $16,488.

Beginning Inventory and Purchases

Units Unit Cost

Beginning Inventory

9 $3.00

Feb-23 12 $3.50Apr-20 30 $3.80May-04 40 $4.00November-30 9 $5.00Totals 100

Example-Please TryExample-Please Try

Calculate ending inventory costs under FIFO, LIFO and Weighted Calculate ending inventory costs under FIFO, LIFO and Weighted Average Method.Average Method.

Ending Inventory 20 units.Ending Inventory 20 units.