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Examples of Costs Included in Inventory Purchase price Taxes paid Costs for shipping the product Insurance during transit Labor required to assemble the product Returns to and allowances from the vendor Purchase discounts from the vendor 2

Types of Inventory Systems Perpetual– Cost of goods Sold updated with each sale Periodic- Cost of Goods Sold and recorded only at the end of a period.

Inventory Costing Methods To determine the cost of inventory sold, companies can use one of the following methods: Moving average LIFO FIFO Specific Identification

Relationships Summarized

LIFO Reserve LIFO reserve is the difference between the inventory reported on a LIFO basis and what inventory would be if reported on a FIFO basis. The reserve is cumulative and can be calculated by multiplying the reserve by the company’s tax rate. EXAMPLE (from Safeway’s 2010 financial footnotes): Inventories valued at FIFO: $1,720M Inventories valued at LIFO: $1,685M Difference: ($1,720 - $1,685 = $35M). Assuming a tax rate of 30%, the taxes that Safeway has deferred as of the end of 2010 are $10.5 M ($35 X 30%). 6

If inventory is understated If inventory is overstated Inventory Errors If inventory is understated If inventory is overstated Current Period Next Period Inventory Understated Correct Overstated Cost of goods sold Net income Total assets

Major Groups of Inventories Application of Lower-of-Cost-or-Market Inventories in total Major Groups of Inventories Individual Inventory Items

LCM Example Dryden has four types of inventory (A,B,C,&D) in 2 groups. Cost and market values are computed for each inventory type, each inventory group, and total inventory. The three right columns show the value that should be reported for inventory when applying LCM to total inventories, to the two groups of inventory, and to each individual inventory item. 9

LCM Example No journal adjustment needed if Dryden uses the total inventories cost approach or the inventory group approach because LCM = Cost 10

LCM Example However, if Dryden applies LCM to individual inventory items, it will need to adjust its inventory by $120. 11

Assessing Inventory Using Horizontal & Vertical Analysis

Inventory Turnover Ratio This ratio compares the cost of goods sold during a period to the average inventory balance during that period and measures the ability to sell inventory. Target’s 2010 Inventory Turnover Ratio: 13

Days-in-Inventory Ratio This ratio converts the inventory turnover ratio into a measure of days by dividing the turnover ratio into 365 days. Target’s 2010 Days-In-Inventory Ratio: 14

Periodic Inventory System Appendix: Periodic Inventory System A periodic inventory system does not update the inventory and cost of goods sold accounts during the period. Instead, when purchases are made, they are recorded in a temporary account called Purchases and when sales are made, the resulting revenue is recorded, but not the cost of goods sold.

Three Steps using Inventory Costing Methods Under a Periodic System Count the inventory on hand at the end of the period. 1 Use an inventory costing method to assign a cost to the ending inventory. 2 Calculate cost of goods sold using the cost of goods sold model. 3

End of Chapter 7