Chapter 6: INVENTORY COSTING

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Presentation transcript:

Chapter 6: INVENTORY COSTING

Inventory Costing Determining inventory quantities Taking physical inventory Determining ownership of goods Inventory cost determination methods Specific identification Cost formulas: FIFO and average Financial Statement Effects Choice of cost determination method Inventory errors Presentation and analysis Valuing inventory at lower of cost and net realizable value Reporting and analyzing inventory

CHAPTER 6: Inventory Costing LEARNING OBJECTIVES Describe the steps in determining inventory quantities. Calculate cost of goods sold and ending inventory in a perpetual inventory system using the specific identification, FIFO, and weighted average methods of cost determination. Explain the financial statement effects of inventory cost determination methods. Determine the financial statement effects of inventory errors. Value inventory at the lower of cost or net realizable value. Demonstrate the presentation and analysis of inventory. Calculate ending inventory and cost of goods sold in a periodic inventory system using FIFO and weighted average inventory cost formulas (Appendix 6A). Estimate ending inventory using the gross profit and retail inventory methods (Appendix 6B). 4

Determining Inventory Quantities All companies count their inventory at least once a year Must determine amount and value of inventory to prepare accurate financial statements The determination of inventory quantities involves Taking a physical inventory of goods on hand Determining the ownership of the goods

Taking a Physical Inventory Involves counting, weighing, or measuring each kind of inventory on hand Strong internal controls needed for an accurate inventory count: Count done by employees not normally responsible for inventory Ensure items counted exist by observation Second count by another employee Ensure all items are counted only once and nothing is missed (use pre-numbered tags)

Determining Ownership Only include inventory owned by company Goods in Transit: On board a public carrier as at the count date Look at FOB point to determine if they should be included Consigned Goods: Goods being sold that are owned by others Excluded from inventory of consignee (who is selling on behalf of the owner, the consignor) Example: Artist display their paintings at art galleries for sale. Art Gallary is not the owner.

CHAPTER 6: Inventory Costing LEARNING OBJECTIVES Describe the steps in determining inventory quantities. Calculate cost of goods sold and ending inventory in a perpetual inventory system using the specific identification, FIFO, and weighted average methods of cost determination. Explain the financial statement effects of inventory cost determination methods. Determine the financial statement effects of inventory errors. Value inventory at the lower of cost or net realizable value. Demonstrate the presentation and analysis of inventory. Calculate ending inventory and cost of goods sold in a periodic inventory system using FIFO and weighted average inventory cost formulas (Appendix 6A). Estimate ending inventory using the gross profit and retail inventory methods (Appendix 6B). 8

Inventory Cost Determination Specific Identification Tracks the actual physical flow of goods Each inventory item is marked with its cost Used where goods are not ordinarily interchangeable Eg. Cars Cost Formulas Specific identification not always suitable A cost formula is used instead: First-in, first-out (FIFO) Weighted Average Last-in, First-out (LIFO) Flow of costs may not match physical flow

Inventory Costing in a Perpetual Inventory System FIFO: FIFO rule is applied at the time of each sale FIFO (First-in, first-out) Weighted Average: New average cost per unit is calculated after each purchase LIFO: Goods that are purchased the most recently are first ones to be sold

Perpetual Inventory System - First-in, First-out (FIFO) FIFO assumes oldest goods are sold first Costing: Costs of earliest goods purchased are first to be recognized as Cost of Goods Sold Costs of most recent goods purchased are recognized as ending inventory Often reflects the actual physical flow of merchandise Given the chart on the next slide, a physical inventory was counted at the end of the year determined 450 units remained on hand

Using FIFO

Perpetual System Inventory Costing – FIFO (Cont’d) Ending inventory and cost of goods sold under FIFO is the same for perpetual and periodic systems

Perpetual Inventory System - Weighted Average Assumes that it is not possible to measure specific physical flow of inventory So we use a weighted average unit cost Applied when goods are sold: to units sold to determine cost of goods sold to units on hand to determine ending inventory

Average Cost = +

Perpetual System Inventory Costing – Weighted Average (Cont’d) Under a perpetual inventory system, a new weighted average is calculated after each purchase. This average is then applied to: Units sold, to determine cost of goods sold Remaining units on hand, to determine ending inventory

LIFO Latest goods purchased assumed to be first sold Seldom coincides with actual physical flow of inventory Costing: Costs of earliest goods purchased remain in ending inventory Costs of most recent goods purchased are first to be recognized as Cost of Goods Sold Recent changes prohibit its use in Canada

Using LIFO

Perpetual System Inventory Costing – Weighted Average (Cont’d)

CHAPTER 6: Inventory Costing LEARNING OBJECTIVES Describe the steps in determining inventory quantities. Calculate cost of goods sold and ending inventory in a perpetual inventory system using the specific identification, FIFO, and weighted average methods of cost determination. Explain the financial statement effects of inventory cost determination methods. Determine the financial statement effects of inventory errors. Value inventory at the lower of cost or net realizable value. Demonstrate the presentation and analysis of inventory. Calculate ending inventory and cost of goods sold in a periodic inventory system using FIFO and weighted average inventory cost formulas (Appendix 6A). Estimate ending inventory using the gross profit and retail inventory methods (Appendix 6B). 20

Financial Statement Effects Income statement effect: When prices rising, FIFO produces higher profit When prices falling, opposite is true Balance sheet effect: FIFO provides the most current valuation of inventory More closely approximates replacement cost Cost formula should be used consistently Enhances comparability of statements over time Choose the method that best corresponds with actual physical flow

CHAPTER 6: Inventory Costing LEARNING OBJECTIVES Describe the steps in determining inventory quantities. Calculate cost of goods sold and ending inventory in a perpetual inventory system using the specific identification, FIFO, and weighted average methods of cost determination. Explain the financial statement effects of inventory cost determination methods. Determine the financial statement effects of inventory errors. Value inventory at the lower of cost or net realizable value. Demonstrate the presentation and analysis of inventory. Calculate ending inventory and cost of goods sold in a periodic inventory system using FIFO and weighted average inventory cost formulas (Appendix 6A). Estimate ending inventory using the gross profit and retail inventory methods (Appendix 6B). 22

Errors in inventory affect both income statement and balance sheet Inventory Errors Errors in inventory affect both income statement and balance sheet Through the calculation of cost of goods sold Ending inventory of one period becomes beginning inventory of the next period Errors in ending inventory carry over to the following period

Income Statement Effects Effect of inventory errors on the current year’s income statement: An error in ending inventory of one period will have the reverse effect on profit of the next period

Assets = Liabilities + Owner’s Equity Balance Sheet Errors Effect can be determined by using the basic accounting equation: Assets = Liabilities + Owner’s Equity An error in ending inventory in one period will cause an error in beginning inventory in the next period

CHAPTER 6: Inventory Costing LEARNING OBJECTIVES Describe the steps in determining inventory quantities. Calculate cost of goods sold and ending inventory in a perpetual inventory system using the specific identification, FIFO, and weighted average methods of cost determination. Explain the financial statement effects of inventory cost determination methods. Determine the financial statement effects of inventory errors. Value inventory at the lower of cost or net realizable value. Demonstrate the presentation and analysis of inventory. Calculate ending inventory and cost of goods sold in a periodic inventory system using FIFO and weighted average inventory cost formulas (Appendix 6A). Estimate ending inventory using the gross profit and retail inventory methods (Appendix 6B). 26

Inventory Valuation Sometimes, before reporting inventory we must first ensure that it’s properly valued Lower of cost and net realizable value (LCM) when realizable value of inventory is lower than cost, it is written down to that lower value Net realizable value: selling price less any costs to make the goods ready for sale Assessed on an item-by-item basis Reversed if net realizable value increases before goods are sold

LCM

LCM If Nemesis TV company applied the LCM rule, it would report its inventory at $159 000 on its balance sheet What is the accounting entry to reflect the Net Realizable Value? Dr COGS 9000 Cr Merchandising Inventory 9000 To record decline inventory value from original cost of $168 000 to market value of $159 000

LCM Cont’d What happens to our Net Income and Owner’s Equity in this example? Reduces both by 9000

CHAPTER 6: Inventory Costing LEARNING OBJECTIVES Describe the steps in determining inventory quantities. Calculate cost of goods sold and ending inventory in a perpetual inventory system using the specific identification, FIFO, and weighted average methods of cost determination. Explain the financial statement effects of inventory cost determination methods. Determine the financial statement effects of inventory errors. Value inventory at the lower of cost or net realizable value. Demonstrate the presentation and analysis of inventory. Calculate ending inventory and cost of goods sold in a periodic inventory system using FIFO and weighted average inventory cost formulas (Appendix 6A). Estimate ending inventory using the gross profit and retail inventory methods (Appendix 6B). 31

Classifying and Reporting Inventory Depends on whether company is a merchandiser or manufacturer Merchandiser buys its inventory – only one classification used Manufacturer produces its inventory – classified into raw materials, work in process and finished goods Typically recorded as a current asset, but can be non-current if not sold in one year

Must balance competing objectives: Analysis of Inventory Must balance competing objectives: Excessive levels of inventory leads to high carrying costs Too little inventory may result in lost sales Ratios help determine whether a company has too much or too little inventory: Inventory turnover ratio Days sales in inventory

Inventory Turnover Ratio = Cost of Goods Sold ÷ Average Inventory The number of times inventory is sold (“turns over”) during a given period The more times inventory turns over, the more efficiently sales are being made Average inventory is usually average of beginning and ending inventories

Days Sales in Inventory = Days in Year ÷ Inventory Turnover The number of days on average that the inventory is on hand before being sold Compare over years and with industry averages

CHAPTER 6: Inventory Costing LEARNING OBJECTIVES Describe the steps in determining inventory quantities. Calculate cost of goods sold and ending inventory in a perpetual inventory system using the specific identification, FIFO, and weighted average methods of cost determination. Explain the financial statement effects of inventory cost determination methods. Determine the financial statement effects of inventory errors. Value inventory at the lower of cost or net realizable value. Demonstrate the presentation and analysis of inventory. Calculate ending inventory and cost of goods sold in a periodic inventory system using FIFO and weighted average inventory cost formulas (Appendix 6A). Estimate ending inventory using the gross profit and retail inventory methods (Appendix 6B). 36

Appendix 6A: Inventory Cost Formulas in Periodic Systems: FIFO

Inventory Cost Formulas in Periodic Systems: Weighted Average

CHAPTER 6: Inventory Costing LEARNING OBJECTIVES Describe the steps in determining inventory quantities. Calculate cost of goods sold and ending inventory in a perpetual inventory system using the specific identification, FIFO, and weighted average methods of cost determination. Explain the financial statement effects of inventory cost determination methods. Determine the financial statement effects of inventory errors. Value inventory at the lower of cost or net realizable value. Demonstrate the presentation and analysis of inventory. Calculate ending inventory and cost of goods sold in a periodic inventory system using FIFO and weighted average inventory cost formulas (Appendix 6A). Estimate ending inventory using the gross profit and retail inventory methods (Appendix 6B). 39

Appendix 6B: Estimating Inventories Not always possible or practical to count inventory – must be estimated Two estimating methods are available Gross profit method Estimated gross profit = net sales × gross profit margin Estimated cost of goods sold = net sales − estimated gross profit Estimated ending inventory = goods available for sale − cost estimated cost of goods sold

Appendix 6B: Estimating Inventories 2 Retail inventory method uses the cost-to-retail ratio applied to ending inventory at retail to determine the estimated cost of the inventory Calculation: Ending inventory at retail = goods available for sale at retail − net sales Cost-to-retail ratio = goods available for sale at cost ÷ goods available for sale at retail Estimated cost of ending inventory = ending inventory at retail × cost-to-retail ratio