Inventories and Cost of Goods Sold Chapter 6 Inventories and Cost of Goods Sold Financial Accounting 4e by Porter and Norton

Inventory of Wholesalers and Retailers Purchased in finished form Resold without transformation Classified as “Merchandise Inventory” on balance sheet

CIRCUIT CITY Consolidated Balance Sheets [Partial] February 28, 2002 2001 ASSETS (in thousands) CURRENT ASSETS: Cash and cash equivalents $1,251,532 $ 446,131 Net accounts and notes receivable 726,541 585,761 Merchandise inventory 1,633,327 1,757,664 Prepaid expenses and other current assets 41,311 57,623 TOTAL CURRENT ASSETS 3,652,711 2,847,179 Property, plant and equipment, net 853,778 988,947 Other assets 32,897 35,207 TOTAL ASSETS $4,539,386 $3,871,333 More than 1/3 of total assets

Inventory of Manufacturers Costs Included in Inventory Direct Materials Direct Labor Manufacturing Overhead

Inventory of Manufacturers Balance Sheet Classifications Costs Included in Inventory Direct Materials Raw Materials Manufacture Products Direct Labor Work in Process Manufacturing Overhead Finished Goods

NIKE, INC. Consolidated Balance Sheets [Partial] May 31, 2001 2000 ASSETS (in millions) Current assets: Cash and cash equivalents $ 304.0 $ 254.3 Accounts receivable less allowance for doubtful accounts of $72.1 and $65.4 1,621.4 1,569.4 Inventories: Finished goods 1,399.4 1,416.6 Work in progress 15.1 17.3 Raw materials 9.6 12.1 1,424.1 1,446.0 Deferred income taxes 113.3 111.5 Prepaid expenses 162.5 215.2 Total current assets 3,625.3 3,596.4 Property, plant and equipment, net 1,618.8 1,583.4 Identifiable intangible assets and goodwill 397.3 410.9 Deferred income taxes and other assets 178.2 266.2 TOTAL ASSETS $ 5,819.6 $ 5,856.9

Inventory Valuation and Income Measurement Value Assigned to Inventory on Balance Sheet Value Expensed as Cost of Goods Sold on Income Statement When Sold =

Calculating Cost of Goods Sold Internal calculation Beginning inventory $ 500 + Purchases 1,200 = Cost of goods available for sale 1,700 - Ending inventory (600) = Cost of goods sold $ 1,100

Inventory costs include Any freight costs incurred by buyer Cost of insurance for inventory in transit Cost of storing inventory before selling Excise and sales taxes

Inventory Costing Methods Four costing methods available: Specific Identification Weighted Average First-in, First-out (FIFO) Last-in, First-out (LIFO)

Detailed Costing Method Example Calculate the cost of goods sold and ending inventory under each method using the data below: Beginning inventory, Jan. 1: 500 units (unit cost $10) Inventory purchases: Date Units Unit Cost 1/20 300 $ 11 4/8 400 12 9/5 200 13 12/12 100 14 Total purchases 1,000 Ending inventory, Dec. 31: 600 units 11

Specific Identification Method Step 1: Identify the specific units in inventory at the end of the year and their costs.

Specific Identification Method Units in ending inventory: Date purchased Units Cost Total cost 1/20 100 $11 $1,100 4/8 300 12 3,600 9/5 200 13 2,600 Ending inventory 600 $7,300 Units x Cost = Total cost

Specific Identification Method Step 2: Identify the units sold and calculate the cost of goods sold.

Specific Identification Method Date purchased Units Cost Total cost Beg. Inventory 500 $10 $5,000 1/20 200 11 2,200 4/8 100 12 1,200 12/12 100 14 1,400 Cost of goods sold 900 $9,800 Units x Cost = Total cost

Weighted Average Method Step 1: Calculate the cost of goods available for sale.

Weighted Average Method Date purchased Units Cost Total cost Beg. inventory 500 $10 $ 5,000 1/20 300 11 3,300 4/8 400 12 4,800 9/5 200 13 2,600 12/12 100 14 1,400 Cost of goods available for sale 1,500 $17,100

: Weighted Average Method Step 2: Divide the cost of goods available for sale by the total units to determine the weighted average cost per unit. :

Weighted Average Method Cost of Goods Available Units Available $17,100 1,500 = $ 11.40/unit

X Avg. Cost # Units Weighted Average Method Step 3: Calculate ending inventory and COGS by multiplying the weighted average cost per unit by the # of units in ending inventory and the # of units sold. X Avg. Cost # Units

Weighted Average Method ALLOCATE TO Ending Cost of Inventory Goods Sold Units on hand 600 Units sold 900 Weighted average cost X $11.40 $ 11.40 Total cost of goods available of $17,100 allocated: $6,840 $10,260

First-in, First-out (FIFO) Method Step 1: Assign the cost of the beginning inventory to cost of goods sold. 1st in

First-in, First-out (FIFO) Method ALLOCATE TO Ending Cost of Units Cost Inventory Goods Sold 1/1 500 $10 $5,000 1/20 300 $11 4/8 400 $12 9/5 200 $13 12/12 100 $14

First-in, First-out (FIFO) Method Step 2: Continue to work forward until you assign the total # of units sold during the period to cost of goods sold. Allocate the remaining units to ending inventory. etc. 3rd 2nd

First-in, First-out (FIFO) Method ALLOCATE TO Ending Cost of Units Cost Inventory Goods Sold 1/1 500 $10 $5,000 1/20 300 $11 3,300 4/8 300 / 100 $12 $3,600 1,200 9/5 200 $13 2,600 12/12 100 $14 1,400 TOTALS $7,600 $9,500

Last-in, First-out (LIFO) Method Step 1: Assign the cost of the last units purchased to cost of goods sold. 1st in

Last-in, First-out (LIFO) Method ALLOCATE TO Ending Cost of Units Cost Inventory Goods Sold 1/1 500 $10 1/20 300 $11 4/8 400 $12 9/5 200 $13 12/12 100 $14 $1,400

Last-in, First-out (LIFO) Method Step 2: Work backward until you assign the total # of units sold during the period to cost of goods sold (allocate the remaining units to ending inventory). 1st in

Last-in, First-out (LIFO) Method ALLOCATE TO Ending Cost of Units Cost Inventory Goods Sold 1/1 500 $10 $5,000 1/20 100 / 200 $11 1,100 $2,200 4/8 400 $12 4,800 9/5 200 $13 2,600 12/12 100 $14 1,400 TOTALS $6,100 $11,000

Comparison of Costing Methods Cost of Goods Sold Goods Available for Sale Ending Inventory Specific Identification $7,300 9,800 $17,100 Weighted Average 6,840 10,260 17,100 FIFO 7,600 9,500 17,000 LIFO 6,100 11,000 17,100

Comparison of Costing Methods Weighted Avg. FIFO LIFO In periods of rising prices: highest COGS? lowest COGS? highest gross margin? lowest net income? lowest income taxes? X

LIFO Issues LIFO Liquidation LIFO Conformity Rule LIFO Reserve liquidation can result in high gross margin (and large tax bill) LIFO Conformity Rule if used for tax, LIFO must also be used for books LIFO Reserve difference between inventory value stated at FIFO and value stated at LIFO

Reasons for Inventory Errors Mathematical mistakes Physical inventory counting errors Cut-off problems - in-transit Goods on consignment

Effect of Inventory Errors on the Income Statement Reported Corrected Effect Sales $1,000,000 $1,000,000 Beginning inventory $ 200,000 200,000 Add: Purchases 700,000 700,000 Goods available for sale $ 900,000 $ 900,000 Less: Ending inventory 300,000 250,000 $50 OS Cost of goods sold $ 600,000 $ 650,000 50 US Gross margin $ 400,000 $ 350,000 50 OS Operating expenses 150,000 150,000 Net income 250,000 200,000 50 OS OS = overstatement US = understatement

Effect of Inventory Errors on the Income Statement Reported Corrected Effect Sales $1,500,000 $1,500,000 Beginning inventory $ 300,000 250,000 $50 OS Add: Purchases 1,100,000 1,100,000 Goods available for sale $1,400,000 $1,350,000 50 OS Less: Ending inventory 350,000 350,000 Cost of goods sold $1,050,000 $1,000,000 50 OS Gross margin $ 450,000 $ 500,000 50 US Operating expenses 120,000 120,000 Net income 330,000 380,000 50 US OS = overstatement US = understatement

Counterbalancing Errors Assume ending inventory is overstated (+) by $50,000 in 2004: 2004 Beginning inventory $xxx,xxx Add: Purchases xxx,xxx = Goods available for sale xxx,xxx Less: Ending inventory + 50,000 = Cost of goods sold - 50,000

Counterbalancing Errors 2004 ending inventory becomes 2005 beginning inventory: 2004 2005 Beginning inventory $ xxx,xxx + 50,000 Add: Purchases xxx,xxx = Goods available for sale xxx,xxx Less: Ending inventory +50,000 = Cost of goods sold - 50,000

Counterbalancing Errors The 2004 error reverses in 2005 (but 2004 inventory and both 2004 and 2005 profits are misstated by $50,000): 2004 2005 Beginning inventory $xxx,xxx $+50,000 Add: Purchases xxx,xxx xxx,xxx = Goods available for sale xxx,xxx + 50,000 Less: Ending inventory + 50,000 xxx,xxx = Cost of goods sold - 50,000 + 50,000

Report loss in year market falls below cost… Lower of Cost or Market Before After Price Price Change Change Cost 150 120 Report loss in year market falls below cost… 39

Lower of Cost or Market Price Price Change Change Before After Price Price Change Change Selling price $200 $160 Cost 150 120 Gross margin $ 50 $ 40 …to maintain normal G.M.% when sold Gross margin % 25% 25% 40

Lower of Cost or Market Market = replacement cost (not retail value) Cost determined under one of four methods Justified on basis of conservatism Can be applied to: entire inventory individual items groups of items

Estimating Inventory Values Sometimes impossible or impractical to measure inventory at cost Estimation is necessary Two methods used to estimate ending inventory values: gross profit method retail inventory method

Use income statement model but Gross Profit Method 1 Beginning inventory 2 + Purchases 3 = Cost of goods available for sale 4 - Ending inventory 5 = Cost of goods sold Use income statement model but reverse steps 4 and 5

* Cost of goods sold is estimated as a percentage of sales Gross Profit Method Beginning inventory $ 100,000 + Purchases 30,000 = Cost of goods available for sale 130,000 - Cost of goods sold (estimated) * 90,000 = Ending inventory (estimated) $ 40,000 * Cost of goods sold is estimated as a percentage of sales

Inventory Turnover Ratio Cost of Goods Sold Average Inventory The number of times per period inventory is turned over (i.e., sold)

Inventory Turnover Ratios Example: Circuit City 5.9 times per year Safeway 9.3 times per year Can you compare the two ratios?

Days’ Sales in Inventory # of Days in Period Inventory Turnover Ratio The average # of days inventory is on hand before its sold. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 28 29 30 31 27

Days’ Sales in Inventory Circuit City 365 = 61 days 5.9 Safeway 365 = 39 days 9.3 Do these averages seem reasonable?

Statement of Cash Flows Cash Flows from Operating Activities: Net income $ xxx Increase in inventory – Decrease in inventory + Increase in accts. payable + Decrease in accts. payable – - OR - Cash paid for inventory purchases – Indirect Method Direct Method

Inventory Costing Methods with the Use of a Perpetual Inventory System Appendix Accounting Tools: Inventory Costing Methods with the Use of a Perpetual Inventory System

Comparison of Periodic and Perpetual Inventory Systems Purchased on account 500 units at $8 each. Periodic: Purchases 4,000 Accounts Payable 4,000 Perpetual: Inventory 4,000 Accounts Payable 4,000

Comparison of Periodic and Perpetual Inventory Systems Returned for credit 100 units damaged in transit. Periodic: Accounts Payable 800 Purchase Returns & Allowances 800 Perpetual: Accounts Payable 800 Inventory 800

Comparison of Periodic and Perpetual Inventory Systems Sold on account 200 units at $10 each. Periodic: Accounts Receivable 2,000 Sales Revenue 2,000 Perpetual: Accounts Receivable 2,000 Sales Revenue 2,000 Cost of Goods Sold 1,600 Inventory 1,600

FIFO Costing With a Perpetual System FIFO applied at time of sale Same FIFO inventory total under periodic and perpetual systems

LIFO Costing With a Perpetual System LIFO applied at time of sale Different LIFO inventory total under periodic and perpetual systems because of pricing gap

Moving Average With a Perpetual System New weighted average cost is computed for each purchase Different inventory total under weighted average (periodic) and moving average (perpetual)

End of Chapter 6