chapter 9 Inventory and Cost of Goods Sold An electronic presentation by Douglas Cloud Pepperdine University

Learning Objectives 1. Define inventory for a merchandising business, and identify the different types of inventory for a manufacturing business. 2. Explain the advantages and disadvantages of both periodic and perpetual inventory systems. 3. Determine when ownership of goods in transit changes hands and what circumstances require shipped inventory to be kept on the books. Continued

Learning Objectives 4. Compute total inventory acquisition cost. 5. Use the four basic inventory valuation methods: specific identification, average cost, FIFO, and LIFO. 6. Explain how LIFO inventory layers are created, and describe the significance of the LIFO reserve. Continued

Learning Objectives 7. Choose an inventory valuation method based on the trade-offs among income tax effects, bookkeeping costs, and the impact on the financial statements. 8. Apply the lower-of-cost-or-market (LCM) rule to reflect declines in the market value of inventory. 9. Use the gross profit method to estimate ending inventory. Continued

Learning Objectives 10. Determine the financial statement impact of inventory recording errors. 11. Analyze inventory using financing ratios, and properly compare ratios of different firms after adjusting for differences in inventory valuation methods. 12. Account for the impact of changing prices on purchase commitments. 13. Record inventory purchase transactions denominated in foreign currencies. EXPANDED MATERIAL

LIFO and FIFO in Times of Inflation LIFO assumes the new units are sold LIFO Unit Cost of Goods Sold FIFO FIFO assumes the old units are sold Beginning of Year End of Year

Time Line of Business Issues Involved With Inventory BUY Raw Materials or Goods for Resale SELL Finished Inventory COMPUTE Value ADD Ending Inventory Cost of Goods Sold

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.

How Much Inventory Do Companies Have? Inventory Levels for the 50 Largest Companies, 1979-2000 1998 Inventory as a Percentage of Total Assets 2000 Source: Standard and Poor’s Compustat

Raw Materials are goods acquired for use in the production process. Materials that are necessary in the production process but are not directly incorporated into the product are referred to as indirect materials. Materials that are used directly in the production of goods are frequently referred to as direct materials.

Work in Process Work in process consists of materials partly processed and requiring further work before they can be sold. This inventory includes three cost elements. 1. Direct materials 2. Direct labor 3. Manufacturing overhead

Finished Goods Finished goods are the manufactured products awaiting sale. Balance Sheet Income Statement Direct Labor Raw Materials Cost of Goods Sold Work in Process Finished Goods Manufacturing Overhead

Summary Income Statement Items Balance Sheet Items Merchandise Cost of Goods Sold Sale Retailer Manufacturer Raw Materials Work in Process Finished Goods Cost of Goods Sold Sale Overhead Direct Labor 2

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. 3

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. 4

Inventory Systems Purchases of Inventory Periodic Method Accounts Payable 3,000 Perpetual Method Inventory 3,000 Accounts Payable 3,000

Inventory Systems Sales During the Period Periodic Method Accounts Receivable 4,125 Sales 4,125 Perpetual Method Accounts Receivable 4,125 Sales 4,125 Cost of Goods Sold 2,750 Inventory 2,750

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. 9

Goods in Transit FOB Shipping Point Seller Buyer Quality Produce Goods being shipped are included in inventory of buyer while in transit.

Goods in Transit FOB Destination Seller Buyer Quality Produce Goods being shipped are included in inventory of seller until received by buyer.

Goods on Consignment Title to goods sold on consignment remains with the shipper until their sale or use by the dealer or customer.

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. 10

Schedule of Cost of Goods Manufactured Bartlett Corporation Schedule of Cost of Goods Manufactured For the Year Ended December 31, 2005 The heading. Schedule of Cost of Goods Manufactured Bartlett Corporation For the Year Ended December 31, 2002

Schedule of Cost of Goods Manufactured Bartlett Corporation Schedule of Cost of Goods Manufactured For the Year Ended December 31, 2005 Direct materials: Raw materials $ 21,350 Purchases 107,500 Cost of raw materials available for use $128,850 Less raw materials inventory, Dec. 31 22,350 Raw materials used in production $106,500 Direct labor 96,850 Manufacturing overhead: Continued

Schedule of Cost of Goods Manufactured Manufacturing overhead: Indirect labor $ 40,000 Factory supervision 29,000 Depr.—factory building and equipment 20,000 Light, heat, and power 18,000 Factory supplies 15,000 Miscellaneous manufacturing overhead 12,055 134,055 Total manufacturing costs $337,405 Add work in process inventory, January 1 99,400 $366,805 Less work in process inventory, December 31 26,500 Cost of goods manufactured $340,305

Cash Discounts Records inventory net of any purchase (cash) discounts. Example: June 1—purchased merchandise for $10,000 Terms of payment: 2/10, n/30 Assuming a perpetual inventory method, record the purchase of the inventory and payment on June 8. 11

Supplier “Loan” Period Cash Discounts $9,800 Owed $10,000 Owed 10 Days 20 Days Supplier “Loan” Period Purchase Date End of Discount Period Final Payment Date

Cash Discounts—Net Method June 1 Inventory 9,800 Accounts Payable 9,800 June 8 Accounts Payable 9,800 Cash 9,800 13

Cash Discounts—Net Method Now, assume that the payment was not made until June 28.

Cash Discounts—Net Method June 28 Accounts Payable 9,800 Discounts Lost 200 Cash 10,000 14

Cash Discounts—Net Method If the invoice has not been paid at the end of the period (assume June 30) and the discount period has lapsed, the following adjusting entry is made: June 30 Discounts Lost 200 Accounts Payable 200

Cash Discounts—Gross Method Record inventory at gross cost; discounts are recorded only if taken. Example: June 1—purchased inventory for $10,000. Terms of payment: 2/10, n/30 Assuming a perpetual inventory method, record the purchase of the inventory and payment on June 8. 15

Cash Discounts—Gross Method June 1 Inventory 10,000 Accounts Payable 10,000 June 8 Accounts Payable 10,000 Inventory 200 Cash 9,800

Cash Discounts—Gross Method Again, assume that the payment was not made until June 28.

Cash Discounts—Gross Method June 28 Accounts Payable 10,000 Cash 10,000

Purchases Returns and Allowances Periodic Inventory System Accounts Payable 400 Purchase Returns and Allowances 400 Perpetual Inventory System Accounts Payable 400 Inventory 400

Inventory Valuation Methods Cost Allocation Methods FIFO Average Cost LIFO Specific Identification 19

Inventory Valuation Methods Assume: Purchases: January 1 200 @ $10 $ 2,000 March 23 300 @ $12 3,600 July 15 500 @ $11 5,500 November 6 100 @ $13 1,300 Total purchases 1,100 $12,400 Sales 700 @ $15 5

Frequency of Use of Inventory Valuation Methods U. S. Companies 1979 and 2000 Inventory 1979 2000 2000 Method All Companies All Companies Large Companies FIFO 75.6% 75.9% 68.6% LIFO 25.8% 15.7% 34.6% Average cost 20.8% 21.4% 32.9% Specific Identification 3.7% 4.5% 3.9% SOURCE: Standard and Poor’s COMPUSTAT

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. 20

Specific Identification Method Jan. 1 200 units @ $10 per unit Mar. 23 300 units @ $12 per unit July 15 500 units @ $11 per unit Nov. 6 100 units @ $13 per unit 1,100 units Sold 200 units from the January 1 and 500 from the July 15 purchase.

Specific Identification Method Jan. 1 200 units @ $10 per unit July 15 500 units @ $11 per unit Sold 700

Specific Identification Method Jan. 1 200 units @ $10 per unit = $2,000 = 5,500 July 15 500 units @ $11 per unit Total cost of goods sold $7,500

Specific Identification Method Goods Not Sold 300 units @ $12 per unit Mar. 23 = $3,600 = 1,300 100 units @ $13 per unit Nov. 6 Ending inventory $4,900

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. 22

Average Cost Method = $ 2,000 = 3,600 = 5,500 = 1,300 $12,400 Jan. 1 = $ 2,000 = 3,600 = 5,500 = 1,300 $12,400 Jan. 1 200 units @ $10 per unit Mar. 23 300 units @ $12 per unit July 15 500 units @ $11 per unit Nov. 6 100 units @ $13 per unit 1,100 units $12,400 1,100 units = $11.27 per unit (rounded) Cost of goods sold = $11.27 x 700 = $7,890 Ending inventory = $11.27 x 400 = $4,510

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. 21

First-in, First-out (FIFO) Method Jan. 1 200 units @ $10 per unit = $2,000 Sold 200 Mar. 23 300 units @ $12 per unit July 15 500 units @ $11 per unit Nov. 6 100 units @ $13 per unit

First-in, First-out (FIFO) Method Jan. 1 200 units @ $10 per unit = $2,000 = 3,600 Sold 300 Mar. 23 300 units @ $12 per unit July 15 500 units @ $11 per unit Nov. 6 100 units @ $13 per unit

First-in, First-out (FIFO) Method Jan. 1 200 units @ $10 per unit = $2,000 = 3,600 Mar. 23 300 units @ $12 per unit = 2,200 Sold 200 July 15 500 units @ $11 per unit Nov. 6 100 units @ $13 per unit Total cost of goods sold $7,800

First-in, First-out (FIFO) Method Goods Not Sold 300 units @ $12 per unit Mar. 23 = $3,600 = 1,300 100 units @ $13 per unit Nov. 6 Ending inventory $4,900

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. 23

Last-in, First-out (LIFO) Method Jan. 1 200 units @ $10 per unit Mar. 23 300 units @ $12 per unit July 15 500 units @ $11 per unit = $1,300 Sold 100 Nov. 6 100 units @ $13 per unit

Last-in, First-out (LIFO) Method Jan. 1 200 units @ $10 per unit Mar. 23 300 units @ $12 per unit July 15 500 units @ $11 per unit = $5,500 Sold 500 = $1,300 Nov. 6 100 units @ $13 per unit

Last-in, First-out (LIFO) Method Jan. 1 200 units @ $10 per unit = $1,200 Sold 100 Mar. 23 300 units @ $12 per unit July 15 500 units @ $11 per unit = $5,500 = $1,300 Nov. 6 100 units @ $13 per unit Total cost of goods sold $8,000

Last-in, First-out (LIFO) Method Goods Not Sold Jan. 1 200 units @ $10 per unit = $2,000 = 2,400 Mar. 23 200 units @ $12 per unit Ending inventory $4,400

Comparison of Inventory Methods (Periodic) Cost of Goods Sold Ending Inventory Specific identification $7,500 $4,900 Average cost $7,890 $4,510 FIFO $7,800 $4,600 LIFO $8,000 $4,400

Perpetual Inventory Assume: Beginning inventory 100 @ $10 $1,000 Purchases: April 10 80 @ $11 880 April 20 70 @ $12 840 Sales: April 18 90 @ $15 April 27 50 @ $16

FIFO Method—Perpetual FIFO periodic and FIFO perpetual provide identical results for cost of goods sold and inventory.

Average Cost Method—Perpetual Apr. 1 Beginning Inventory 100 units @ $10 $1,000 Apr. 10 Purchases 80 units @ $11 880 Apr. 10 Balance 180 units @ $10.44 $1,880 Apr. 18 Sales (90) units @ $10.44 (940) Apr. 18 Balance 90 units @ $10.44 $ 940 Apr. 20 Purchases 70 units @ $12 840 Apr. 20 Balance 160 units @ $11.125 $1,780 $1,880  180 Apr. 27 Sales (50) units @ $11.125 (556) Apr. 30 Balance 110 units @ $11.125 $1,224 $1,780  160 Ending inventory, $1,224

Cost of Goods Sold (140 units) $940 + $556 = $1,496 Average Cost Method—Perpetual Apr. 18 Sales (90) units @ $10.44 (940) Apr. 18 Balance 90 units @ $10.44 $ 940 Apr. 20 Purchases 70 units @ $12 840 Apr. 20 Balance 160 units @ $11.125 $1,780 Apr. 1 Beginning Inventory 100 units @ $10 $1,000 Apr. 10 Purchases 80 units @ $11 880 Apr. 10 Balance 180 units @ $10.44 $1,880 Apr. 27 Sales (50) units @ $11.125 (556) Apr. 30 Balance 110 units @ $11.125 $1,224 Cost of Goods Sold (140 units) $940 + $556 = $1,496

LIFO Method—Perpetual Perpetual Inventory System Beginning inventory Apr. 1 90 units @ $10 per unit 100 units @ $10 per unit Sold 10 Apr. 10 0 units @ $11 per unit 80 units @ $11 per unit 80 units @ $11 per unit Sold 80 Purchased 80 Apr. 20 70 units @ $12 per unit 20 units @ $12 per unit Sold 50 Purchased 70

LIFO Method—Perpetual Perpetual Inventory System = $ 900 = 0 = 240 $1,140 Apr. 1 Apr. 10 Apr. 20 100 units @ $10 per unit 90 units @ $10 per unit 80 units @ $11 per unit 70 units @ $12 per unit 20 units @ $12 per unit 0 units @ $11 per unit Ending inventory……………….. Beg. Inv. + Purchases – End. Inv. = Cost of Goods Sold $1,000 + $1,720 – $1,140 = $1,580

Size of LIFO Reserve for Selected U.S. Companies Reported LIFO LIFO Company Name Inventory Reserve General Motors $10,034 $1,814 Sears Roebuck 4,912 590 Ford 6,191 905 ExxonMobil 7,904 4,200 Deere & Co. 1,506 1,004 General Electric 8,565 676

FIFO Advantages Advantages: Usually corresponds with physical flow of goods. Ending inventory balance agrees closely with current replacement cost. 38

FIFO Disadvantages Disadvantages: Can cause older costs to be matched with current revenues. Inventory holding gains and losses are included as part of gross profit. Yields higher taxable income in times of inflation if inventory levels are stable or increasing. 39

LIFO Advantages Advantages: Matches current costs with current revenues. Excludes inventory holding gains from gross profit. Yields lower taxable income in times of inflation if inventory levels are stable or increasing. 38

LIFO Disadvantages Disadvantages: Usually does not correspond with the physical flow of goods. Potential LIFO liquidation means old cost in LIFO layers can be drawn in to cost of goods sold. Ending inventory balance can be much lower than current replacement cost. LIFO liquidation can result in greatly increased tax payments when inventory levels decline. 39

The term “market” in lower of cost or market means replacement cost.

Lower of Cost or Market Ceiling: Estimated selling price – normal selling costs Ceiling: Also known as the net realizable value Replacement Cost Market compare Floor: Net realizable value – a normal profit margin Historical Cost

Lower of Cost or Market Case A Ceiling: $0.80 $0.70 $0.70 $0.65 Floor: $0.55 Historical Cost $0.65 LCM = $0.65

Lower of Cost or Market Case B Ceiling: $0.80 $0.60 $0.60 $0.65 Floor: $0.55 Historical Cost $0.65 LCM = $0.60

Click on the button to skip LCM examples Lower of Cost or Market Ceiling: $0.80 Case C $0.50 $0.55 Market Floor: $0.55 Historical Cost $0.65 Click on the button to skip LCM examples LCM = $0.55

Lower of Cost or Market Case D Ceiling: $0.80 $0.45 $0.55 $0.50 Floor: $0.55 Historical Cost $0.50 LCM = $0.50

Lower of Cost or Market Case E Ceiling: $0.80 $0.85 $0.80 $0.75 Floor: $0.55 Historical Cost $0.75 LCM = $0.75

Lower of Cost or Market Case F Ceiling: $0.80 $1.00 $0.80 $0.90 Floor: $0.55 Historical Cost $0.90 LCM = $0.80

Last year’s 40% is considered a good estimate. Gross Profit Method Beginning inventory, January 1 $25,000 Sales, January 1–January 31 50,000 Purchases, January 1–January 31 40,000 Historical gross profit percentage Last year 40 % Two years ago 37 Three years ago 42 Last year’s 40% is considered a good estimate.

Gross Profit Method Sales (actual) $50,000 100 % Cost of goods sold (estimate) 30,000 60 % Gross profit (estimate) $20,000 40 % Beginning inventory (actual) $25,000 + Purchases (actual) 40,000 – Cost of goods available for sale (actual) $65,000 – Ending inventory (estimate) 35,000 = Cost of goods sold (estimate) $30,000

Gross Profit Method Sales (actual) $50,000 100 % Cost of goods sold (estimate) 31,500 63 % Gross profit (estimate) $18,500 37 % Beginning inventory (actual) $25,000 + Purchases (actual) 40,000 – Cost of goods available for sale (actual) $65,000 – Ending inventory (estimate) 33,500 = Cost of goods sold (estimate) $31,500

Gross Profit Method Sales (actual) $50,000 100 % Cost of goods sold (estimate) 29,000 58 % Gross profit (estimate) $21,000 42 % Beginning inventory (actual) $25,000 + Purchases (actual) 40,000 – Cost of goods available for sale (actual) $65,000 – Ending inventory (estimate) 36,000 = Cost of goods sold (estimate) $29,000

Inventory Turnover Appropriateness of inventory size and position can be measured by calculating the Inventory Turnover Ratio. Inventory Turnover: Cost of Goods Sold ÷ Average Inventory 24

Determine the inventory turnover. Cost of Goods Sold $1,000 Beginning Inventory $ 90 Ending Inventory $ 110 Determine the inventory turnover. 25

Inventory Turnover Cost of Goods Sold $1,000 Beginning Inventory $ 90 Ending Inventory $ 110 $1,000 ($90 + $110)/2 = 10

Number of Days’ Sales in Inventory $1,000 ($90 + $110)/2 = 10 365 10 Number of days’ sales in inventory is 36.5

Number of Days’ Sales in Inventory Company Sales in Inventory IBM 31.4 days Dell 5.7 days General Motors 28.2 days Ford 19.4 days Nike 90.5 days Reebok. 82.9 days Wal-Mart 46.9 days Kmart 74.6 days

chapter 9 The End