Chapter 08- Inventories and Cost of Goods Sold

© The McGraw-Hill Companies, Inc., 2003McGraw-Hill/Irwin

INVENTORIES AND THE COST OF GOODS SOLD

Chapter

8


InventoryInventory

Goods ownedand held for sale

to customers

Goods ownedand held for sale

to customers

Current asset

Current asset

Inventory DefinedInventory Defined


INCOME STATEMENT

Revenue Cost of goods sold Gross profit Expenses Net income

Purchase cost (or manufacturing

costs)

as goods are sold

BALANCE SHEET

Current assets: Inventoryas

incurred

The Flow of Inventory CostsThe Flow of Inventory Costs


GENERAL JOURNAL

Date Account Titles and ExplanationPR Debit Credit

Entry on Purchase Date

Inventory $$$$

Accounts Payable $$$$

Entry on Sale Date

Cost of Goods Sold $$$$

Inventory $$$$

In a perpetual inventory system, inventory entries parallel the flow of costs.

The Flow of Inventory CostsThe Flow of Inventory Costs


When identical units of inventory have different unit costs, a question naturally

arises as to which of these costs should be used in recording a sale of inventory.

Which Unit Did We Sell? Which Unit Did We Sell?


A separate subsidiary account is maintained for each item in inventory.

A separate subsidiary account is maintained for each item in inventory.

How can we determine the unit cost for the Sept. 10 sale?

Item LL002 Primary supplier Electronic CityDescription Laser Light Secondary supplier Electric CompanyLocation Storeroom 2 Inventory level: Min: 25 Max: 200

Purchased Sold Balance

Date UnitsUnit Cost Total Units

Unit Cost

Cost of Goods Sold Units

Unit Cost Total

Sept. 5 100 30$ 3,000$ 100 30$ 3,000$ Sept. 9 75 50 3,750 100 30 3,000

75 50 3,750 Sept. 10 10 ? ? ? ? ?

? ? ?

Inventory Subsidiary LedgerInventory Subsidiary Ledger


Specific identification

LIFO

Average cost

FIFO

We use one of these inventory valuation methods to determine cost of inventory sold.

Inventory Cost FlowsInventory Cost Flows


The Bike Company (TBC)

Information for the Following Inventory Examples



Specific Identification Specific Identification

When a unit

is sold, the specific

cost of the unit sold is added to

cost of goods sold.


On August 14, TBC sold 20 bikes for $130 each.

Nine bikes originally cost $91 and 11 bikes originally cost $106.

On August 14, TBC sold 20 bikes for $130 each.

Nine bikes originally cost $91 and 11 bikes originally cost $106.

Continue

Specific Identification – Example Specific Identification – Example


ContinueLet’s look at the entries for

the Aug. 14 sale.


The Cost of Goods Sold for the August 14 sale is $1,985, leaving $515 and 5 units in inventory.



Continue

RetailRetail

CostCost

A similar entry ismade after each sale.




Additional purchases were made on August 17 and 28.

Costs associated with sales on August 31 were as follows: 1 @ $91, 3 @ $106, 15 @ $115, & 4 @ $119.

Additional purchases were made on August 17 and 28.

Costs associated with sales on August 31 were as follows: 1 @ $91, 3 @ $106, 15 @ $115, & 4 @ $119.

Continue


Cost of Goods Sold for

August 31 sale = $2,610

Cost of Goods Sold for

August 31 sale = $2,610


Balance Sheet

Inventory = $1,395

Income Statement

COGS = $4,595

1 @ 106$ = 106$ 5 @ 115$ = 575 6 @ 119$ = 714

End. Inv. 1,395$

1 @ 106$ = 106$ 5 @ 115$ = 575 6 @ 119$ = 714

End. Inv. 1,395$



Since specific identification is so

easy, can’t we use it all the time?

Not really. Specific identification is hard to use

when we sell a lot of inventory that has lots of

different costs.


Cost of Goods Available for

Sale

Units on hand on the date of

sale÷

Average-Cost MethodAverage-Cost Method

When a unit is sold,the average cost of each unit

in inventory is assigned to cost

of goods sold.

When a unit is sold,the average cost of each unit

in inventory is assigned to cost

of goods sold.


On August 14, TBC sold 20 bikes for $130 each. On August 14, TBC sold 20 bikes for $130 each.

Continue

The average cost per unit must be computed prior

to each sale.

The average cost per unit must be computed prior

to each sale.

Average-Cost Method – ExampleAverage-Cost Method – Example

$100 = $2,500 25$100 = $2,500 25


Continue

The average cost per unit is $100.


Let’s look at the entries for the Aug. 14 sale.


$100 = $2,500 25$100 = $2,500 25


Continue

RetailRetail

CostCost





Additional purchases were made on August 17 and August 28.

On August 31, an additional 23 units were sold.

Additional purchases were made on August 17 and August 28.


Continue



$114 = $3,990 35$114 = $3,990 35



$114 = $3,990 35$114 = $3,990 35The average cost per unit is $114.




Income Statement

COGS = $4,622

Balance Sheet

Inventory = $1,368

$114 × 12 = $1,368$114 × 12 = $1,368



Costs of Goods Sold

Costs of Goods Sold

Ending InventoryEnding

Inventory

Oldest Costs

Oldest Costs

Recent Costs

Recent Costs

First-In, First-Out Method (FIFO)First-In, First-Out Method (FIFO)



Continue



FIFO – Example FIFO – Example


RetailRetail

CostCost

ContinueA similar entry is

made after each sale.




Additional purchases were made on Aug. 17 and Aug. 28.




Continue


Cost of Goods Sold for August 31 = $2,600Cost of Goods Sold for August 31 = $2,600


Balance Sheet

Inventory = $1,420

Income Statement

COGS = $4,570

2 @ 115$ = 230$ 10 @ 119$ = 1,190

End. Inv. 1,420$

2 @ 115$ = 230$ 10 @ 119$ = 1,190

End. Inv. 1,420$



Costs of Goods Sold

Costs of Goods Sold


Inventory

Recent Costs

Recent Costs

Oldest Costs

Oldest Costs

Last-In, First-Out Method (LIFO)Last-In, First-Out Method (LIFO)



Continue

LIFO – Example LIFO – Example




Continue

RetailRetail

CostCost




© The McGraw-Hill Companies, Inc., 2003McGraw-Hill/IrwinContinue



On Aug. 31, an additional 23 units were sold.


On Aug. 31, an additional 23 units were sold.Cost of Goods Sold for August 31 = $2,685Cost of Goods Sold for August 31 = $2,685


Balance Sheet

Inventory = $1,260

Income Statement

COGS = $4,730


5 @ 91$ = 455$ 7 @ 115$ = 805

End. Inv. 1,260$

5 @ 91$ = 455$ 7 @ 115$ = 805

End. Inv. 1,260$


Inventory Valuation Methods: A SummaryCosts Allocated to:

Valuation Method

Cost of Goods Sold Inventory Comments

Specific Actual cost of Actual cost of units Parallels physical flow identification the units sold remaining Logical method when units

are uniqueMay be misleading for identical units

Average cost Number of units sold times the

Number of units on hand times the

Assigns all units the same average unit cost

average unit cost average unit cost Current costs are averaged in with older costs

First-in, First-out (FIFO)

Cost of earliest purchases on

Cost of most recently

Cost of goods sold is based on older costs

hand prior to the sale

purchased units Inventory valued at current costsMay overstate income during periods of rising prices; may increase income taxes due

Last-in, First-out (LIFO)

Cost of most recently

Cost of earliest purchases

Cost of goods sold shown at recent prices

purchased units (assumed still in inventory)

Inventory shown at old (and perhaps out of date) costsMost conservative method during periods of rising prices; often results in lower income taxes


Once a company has adopted a particular

accounting method, it should follow that

method consistently, rather than switch methods from one year to the next.

The Principle of ConsistencyThe Principle of Consistency


This inventory arrived just in time for us to use

in the manufacturing process.

Just-In-Time (JIT) Inventory Systems

Just-In-Time (JIT) Inventory Systems


The primary reason for taking a physical inventory is to adjust the perpetual inventory records for

unrecorded shrinkage losses, such as theft, spoilage, or breakage.

The primary reason for taking a physical inventory is to adjust the perpetual inventory records for

unrecorded shrinkage losses, such as theft, spoilage, or breakage.

Taking a Physical InventoryTaking a Physical Inventory


Reduces the value of the inventory.

Reduces the value of the inventory.

Adjust inventory value to the lower

of historical cost or current

replacement cost (market).

Adjust inventory value to the lower

of historical cost or current

replacement cost (market).

ObsolescenceObsolescence

Lower of Cost or Market

(LCM)

Lower of Cost or Market

(LCM)

LCM and Other Write-Downsof Inventory

LCM and Other Write-Downsof Inventory


Year End

A sale should be recorded when title to the merchandise passes to the

buyer.

A sale should be recorded when title to the merchandise passes to the

buyer.

F.O.B. shipping

point title passes to

buyer at the point of

shipment.

F.O.B. shipping

point title passes to


shipment.

F.O.B. destination point title passes to


destination.

F.O.B. destination point title passes to


destination.

Goods In TransitGoods In Transit


In a periodic inventory system, inventory entries are as follows.

Note that an entry is not made to inventory.

Note that an entry is not made to inventory.

Periodic Inventory SystemsPeriodic Inventory Systems


In a periodic inventory system, inventory entries are as follows.



The inventory on hand and the cost of goods

sold for the year are not

determined until year-end.



Specific identification

LIFO

Average cost

FIFO

We use one of these inventory valuation methods in a periodic inventory system.



Computers, Inc.Mouse Pad Inventory

Date Units $/Unit TotalBeginning Inventory 1,000 5.25$ 5,250.00$ Purchases:Jan. 3 300 5.30 1,590.00 June 20 150 5.60 840.00 Sept. 15 200 5.80 1,160.00 Nov. 29 150 5.90 885.00 Goods Available for Sale 1,800 9,725.00$

Ending Inventory 1,200 ?

Cost of Goods Sold 600 ?




By reviewing actual purchase invoices,

Computers, Inc. determines that the 1,200 mouse pads on hand at year-end have

an actual total cost of $6,400.

Determine the cost of goods sold for the year.

Specific Identification – ExampleSpecific Identification – Example




Ending Inventory 1,200 6,400.00$

Cost of Goods Sold 600 3,325.00$

Cost of Goods Sold$9,725 - $6,400 = $3,325

Cost of Goods Sold$9,725 - $6,400 = $3,325

Specific Identification – ExampleSpecific Identification – Example


Total Cost of Goods

Available for Sale

Total Number of Units

Available for Sale

÷

The average cost is calculated at year-

end as follows:

The average cost is calculated at year-

end as follows:

Average-Cost MethodAverage-Cost Method






Avg. Cost $9,725 1,800 = $5.40278

Avg. Cost $9,725 1,800 = $5.40278

Average-Cost Method – ExampleAverage-Cost Method – ExampleComputers, Inc.

Mouse Pad InventoryDate Units $/Unit Total

Beginning Inventory 1,000 5.25$ 5,250.00$ Purchases:Jan. 3 300 5.30 1,590.00 June 20 150 5.60 840.00 Sept. 15 200 5.80 1,160.00 Nov. 29 150 5.90 885.00 Goods Available for Sale 1,800 9,725.00$



Ending InventoryAvg. Cost $5.40278 1,200

= $6,483

Ending InventoryAvg. Cost $5.40278 1,200

= $6,483

Cost of Goods SoldAvg. Cost $5.40278 600 =

$3,242

Cost of Goods SoldAvg. Cost $5.40278 600 =

$3,242


Costs of Goods Sold

Costs of Goods Sold


Inventory

Oldest Costs

Oldest Costs

Recent Costs

Recent Costs

First-In, First-Out Method (FIFO)First-In, First-Out Method (FIFO)


Remember: Start with the 11/29

purchase and then add other purchases until you reach the number of units in ending inventory.

FIFO – ExampleFIFO – ExampleComputers, Inc.






Date Beg. Inv. Purchases End. Inv.Cost of

Goods Sold

Nov. 29 150@$5.90 150@$5.90Units 150

Now, let’s complete the table.

Now, let’s complete the table.

FIFO – ExampleFIFO – Example


Goods Sold1,000@$5.25 600@$5.25

400@$5.25Jan. 3 300@$5.30 300@$5.30June 20 150@$5.60 150@$5.60Sept. 15 200@$5.80 200@$5.80Nov. 29 150@$5.90 150@$5.90Units 1,200 600

Now, we have allocated the cost to all 1,200 units

in ending inventory.


Goods Sold1,000@$5.25 600@$5.25

400@$5.25Jan. 3 300@$5.30 300@$5.30June 20 150@$5.60 150@$5.60Sept. 15 200@$5.80 200@$5.80Nov. 29 150@$5.90 150@$5.90Units 1,200 600

Costs $6,575 $3,150

Cost of Goods Available for Sale $9,725


Completing the table summarizes the

computations just made.

FIFO – ExampleFIFO – ExampleComputers, Inc.






Costs of Goods Sold

Costs of Goods Sold


Inventory

Recent Costs

Recent Costs

Oldest Costs

Oldest Costs

Last-In, First-Out Method (LIFO)Last-In, First-Out Method (LIFO)


Remember: Start with beginning inventory and then add other purchases until you reach the number of

units in ending inventory.

LIFO – ExampleLIFO – ExampleComputers, Inc.







Goods Sold1,000@$5.25 1,000@$5.25

Units 1,000

LIFO – ExampleLIFO – Example


Goods Sold1,000@$5.25 1,000@$5.25

Jan. 3 300@$5.30 200@$5.30100@$5.30

Units 1,200 100

Now, we have allocated the cost to all 1,200 units

in ending inventory.

Next, let’s complete the

table.

Next, let’s complete the

table.


Goods Sold1,000@$5.25 1,000@$5.25

Jan. 3 300@$5.30 200@$5.30100@$5.30

June 20 150@$5.60 150@$5.60Sept. 15 200@$5.80 200@$5.80Nov. 29 150@$5.90 150@$5.90Units 1,200 600

Costs $6,310 $3,415

Cost of Goods Available for Sale $9,725


Completing the table summarizes the

computations just made.

LIFO – ExampleLIFO – ExampleComputers, Inc.






Errors in Measuring InventoryBeginning Inventory Ending Inventory

Effect on Income Statement Overstated Understated Overstated Understated

Goods Available for Sale + - 0 0

Cost of Goods Sold + - - +Gross Profit - + + -Net Income - + + -Effect on Balance Sheet

Ending Inventory 0 0 + -Retained Earnings - + + -

An error in ending inventory in a year will result in the same error in the beginning inventory of the next year.

An error in ending inventory in a year will result in the same error in the beginning inventory of the next year.

Importance of an Accurate Valuation of Inventory

Importance of an Accurate Valuation of Inventory


For interim financial statements, we may need to estimate ending inventory and cost of goods sold.


Determine cost of goods available for sale.

Estimate cost of goods sold by multiplying the net sales by the cost ratio.

Deduct cost of goods sold from cost of goods available for sale to determine ending inventory.

Determine cost of goods available for sale.

Estimate cost of goods sold by multiplying the net sales by the cost ratio.

Deduct cost of goods sold from cost of goods available for sale to determine ending inventory.

The Gross Profit MethodThe Gross Profit Method


In March of 2003, Chemico’s inventory was destroyed by fire. Chemico’s normal gross profit ratio is 30% of net sales. At the time of the fire,

Chemico showed the following balances:

In March of 2003, Chemico’s inventory was destroyed by fire. Chemico’s normal gross profit ratio is 30% of net sales. At the time of the fire,

Chemico showed the following balances:

Sales 31,500$ Sales returns 1,500 Beginning Inventory 12,000 Net cost of goods purchased 20,500

Sales 31,500$ Sales returns 1,500 Beginning Inventory 12,000 Net cost of goods purchased 20,500

Gross Profit Method – ExampleGross Profit Method – Example


Gross Profit Method – ExampleGross Profit Method – Example

× 70%


Retail Inventory MethodRetail Inventory Method

EndingInventoryat Cost

EndingInventoryat Cost

EndingInventoryat Retail

EndingInventoryat Retail

Uses both the retail value and cost of items for sale to calculate a cost

to retail ratio.

Must know . . .Sales for the period.Beginning inventory at retail and

cost.Net purchases at retail and cost.



Webb, Inc. uses the retail method to estimate inventory at the end of each

month. For the month of May the controller gathers the following

information:

Let’s estimate inventory at May 31.

Webb, Inc. uses the retail method to estimate inventory at the end of each

month. For the month of May the controller gathers the following

information:

Let’s estimate inventory at May 31.

Cost RetailBeg. Inventory 27,000$ 45,000$ Net Purchases 180,000 300,000 Net Sales n/a 310,000










Measures how quickly a companysells its merchandise inventory.

Measures how quickly a companysells its merchandise inventory.

A ratio that is low compared to competitors suggests inefficient use of assets.

A ratio that is low compared to competitors suggests inefficient use of assets.

Average Inventory = (Beg. Inv. + End. Inv.) ÷ 2Average Inventory = (Beg. Inv. + End. Inv.) ÷ 2

Inventory Turnover RateInventory Turnover Rate


Remember that identical companies that use different

inventory methods (e.g., FIFO and LIFO) will have

different inventory turnover ratios.

Accounting Methods Can Affect Analytical Ratios

Accounting Methods Can Affect Analytical Ratios


End of Chapter 8End of Chapter 8

Education

Chapter 08- Inventories and Cost of Goods Sold