Electronic Presentation by Douglas Cloud Pepperdine University Chapter 8 Inventories Electronic Presentation by Douglas Cloud Pepperdine University

After studying this chapter, you should be able to: Learning Goals 1. Identify the types of inventory used by merchandisers and manufacturers. 2. Summarize and provide examples of internal control procedures that apply to inventory. 3. Describe three inventory cost flow assumptions and how they impact the income statement and the balance sheet. After studying this chapter, you should be able to: Continued

Learning Goals 4. Determine the cost of inventory under the perpetual inventory system, using the first-in, first-out; last-in, first-out; and average cost methods. 5. Determine the cost of inventory under the periodic inventory system, using the first-in, first-out; last-in, first-out; and average cost methods. 6. Compare and contrast the use of the three inventory costing methods. Continued

Learning Goals 7. Determine the proper valuation of inventory at other than cost, using the lower-of-cost-or-market and net realizable value concepts. 8. Describe how inventories are being reduced through quick response. 9. Determine and interpret the inventory turnover ratio, the number of days’ sales in inventory, and lifo reserve adjustments.

Learning Goal 1 Identify the types of inventory used by merchandisers and manufacturers.

Materials inventory consists of the cost of raw materials used in manufacturing a product. Work in process inventory consists of the costs for partially completed products. Direct materials Direct labor costs Factory overhead

Finished goods inventory consists of the costs of direct materials, direct labor, and factory overhead for completed products. When the merchandise is sold, the costs are transferred to Cost of Goods Sold

Learning Goal 2 Summarize and provide examples of internal control procedures that apply to inventories.

Why is Inventory Control Important? Inventory is a significant asset and for many companies the largest asset. Inventory is central to the main activity of merchandising and manufacturing companies. Mistakes in determining inventory cost can cause critical errors in financial statements. Inventory must be protected from external risks ( such as fire and theft) and internal fraud by employees.

Using a perpetual inventory system, the amount of each type of merchandise is always readily available in a subsidiary inventory ledger.

To ensure the accuracy of the amount of inventory reported in the financial statements, a merchandising should take a physical count. This is true even though a firm uses a perpetual inventory system.

Learning Goal 3 Describe three inventory cost flow assumptions and how they impact the income statement and balance sheet.

Three identical units of Item X are purchased during May. One unit is sold on May 30 for $20, the unit that was purchased on May 18. Three identical units of Item X are purchased during May. Item X Units Cost May 10 Purchase 1 $ 9 18 Purchase 1 13 24 Purchase 1 14 Total 3 $36 Average cost per unit $12 Specific Identification

The gross profit from this sale would be $7, which is the selling price of $20 less the May 18th cost of $13.

Fifo Method Purchased goods FIFO Sold goods

Fifo Method Item X Units Cost May 10 Purchase 1 $ 9 18 Purchase 1 13 Total 3 $36 Average cost per unit $12

Effect of Inventory Costing Methods on Financial Statements Fifo Method Effect of Inventory Costing Methods on Financial Statements $14 13 Balance Sheet Merchandise inventory $27 Income Statement Sales $20 Cost of merchandise sold 9 Gross profit $11

Lifo Method Sold goods Purchased goods LIFO

Lifo Method Item X Units Cost May 10 Purchase 1 $ 9 18 Purchase 1 13 Total 3 $36 Average cost per unit $12

Effect of Inventory Costing Methods on Financial Statements Lifo Method Effect of Inventory Costing Methods on Financial Statements Income Statement Sales $20 Cost of merchandise sold 14 Gross profit $ 6 $13 9 Balance Sheet Merchandise inventory $22

Average Cost Method Purchased goods Sold goods Average Cost

Average Cost Method Item X Units Cost May 10 Purchase 1 $ 9 Total 3 $36 Average cost per unit $12

Effect of Inventory Costing Methods on Financial Statements Average Cost Method Effect of Inventory Costing Methods on Financial Statements $12 12 Income Statement Sales $20 Cost of merchandise sold 12 Gross profit $ 8 Balance Sheet Merchandise inventory $24

Inventory Costing Methods 600 500 400 300 200 100 Number of firms (> $1Billion Sales) FIFO LIFO Average cost

Learning Goal 4 Determine the cost of inventory under the perpetual inventory system, using the first-in, first-out; last-in, first-out; and average cost methods.

Perpetual Inventory System Inventory Cost Data Item 127B Units Cost Price Jan. 1 Inventory 10 $20 4 Sale 7 $30 10 Purchase 8 21 22 Sale 4 31 28 Sale 2 32 30 Purchase 10 22 Cost of Mdse. Sold Sale price assumptions are added to demonstrate journal entries and ease of calculating gross profit.

FIFO Perpetual

FIFO Perpetual Inventory Account Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 10 20 200 The firm begins the year with 10 units of Item 127B on hand at a total cost of $200.

FIFO Perpetual Inventory Account Inventory Cost Data Item 127B Units Cost Price Jan. 1 Inventory 10 $20 4 Sale 7 $30 10 Purchase 8 21 22 Sale 4 31 28 Sale 2 32 30 Purchase 10 22 Cost of Mdse. Sold On January 4, 7 units of Item 127B are sold at $30 each.

The sale of 7 units leaves a balance of 3 units. FIFO Perpetual Inventory Account Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost 4 7 20 140 3 20 60 Jan. 1 10 20 200 The sale of 7 units leaves a balance of 3 units. On January 4, 7 units of Item 127B are sold at $30 each.

FIFO Perpetual Inventory Account Inventory Cost Data Item 127B Units Cost Price Jan. 1 Inventory 10 $20 4 Sale 7 $30 10 Purchase 8 21 22 Sale 4 31 28 Sale 2 32 30 Purchase 10 22 Cost of Mdse. Sold On January 10, the firm purchased eight units at $21 each.

FIFO Perpetual Inventory Account Item 127B On January 10, the firm purchased eight units at $21 each. Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 10 20 200 4 7 20 140 3 20 60 10 8 21 168 3 20 60 8 21 168 Because the purchase price of $21 is different than the cost of the previous three units on hand, the inventory balance of 11 units is accounted for at two prices.

FIFO Perpetual Inventory Account Inventory Cost Data Item 127B Units Cost Price Jan. 1 Inventory 10 $20 4 Sale 7 $30 10 Purchase 8 21 22 Sale 4 31 28 Sale 2 32 30 Purchase 10 22 Cost of Mdse. Sold On January 22, the firm sold four units for $31 each.

FIFO Perpetual Inventory Account Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 10 20 200 4 7 20 140 3 20 60 10 8 21 168 3 20 60 8 21 168 22 3 20 60 1 21 21 7 21 147 On January 22, the firm sold four units for $31 each. Of the four units sold, three are from the first units in (fifo) at a cost of $20.

FIFO Perpetual Inventory Account Inventory Cost Data Item 127B Units Cost Price Jan. 1 Inventory 10 $20 4 Sale 7 $30 10 Purchase 8 21 22 Sale 4 31 28 Sale 2 32 30 Purchase 10 22 Cost of Mdse. Sold On January 28, the firm sold two units at $32.

FIFO Perpetual Inventory Account Item 127B Purchases Cost of Mdse. Sold Inventory Balance On January 28, the firm sold two units at $32. Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 10 20 200 4 7 20 140 3 20 60 10 8 21 168 3 20 60 8 21 168 22 3 20 60 1 21 21 7 21 147 28 2 21 42 5 21 105

FIFO Perpetual Inventory Account Inventory Cost Data Item 127B Units Cost Price Jan. 1 Inventory 10 $20 4 Sale 7 $30 10 Purchase 8 21 22 Sale 4 31 28 Sale 2 32 30 Purchase 10 22 Cost of Mdse. Sold On January 30, purchased ten additional units of Item 127B at $22 each.

FIFO Perpetual Inventory Account Item 127B On January 30, purchased ten additional units of Item 127B at $22 each. Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 10 20 200 4 7 20 140 3 20 60 10 8 21 168 3 20 60 8 21 168 22 3 20 60 1 21 21 7 21 147 28 2 21 42 5 21 105 30 10 22 220 5 21 105 10 22 220

FIFO Perpetual Inventory Accounting Inventory Cost Data Item 127B Units Cost Price Jan. 1 Inventory 10 $20 4 Sale 7 $30 10 Purchase 8 21 22 Sale 4 31 28 Sale 2 32 30 Purchase 10 22 Cost of Mdse. Sold Let’s record this sale of Item 127B on January 4.

FIFO Perpetual Inventory Accounting Jan. 4 Accounts Receivable 210 Sales 210 4 Cost of Merchandise Sold 140 Merchandise Inventory 140

LIFO Perpetual

LIFO Perpetual Inventory Account Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 10 20 200 The firm begins the year with 10 units of Item 127B on hand at a total cost of $200.

LIFO Perpetual Inventory Account Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 10 20 200 4 7 20 140 3 20 60 On January 4, the firm sold 7 units at $30 each.

LIFO Perpetual Inventory Account Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 10 20 200 4 7 20 140 3 20 60 10 8 21 168 3 20 60 8 21 168 Note that a new layer is formed. On January 10, the firm purchased eight units at $21 each.

LIFO Perpetual Inventory Account Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 10 20 200 4 7 20 140 3 20 60 10 8 21 168 3 20 60 8 21 168 22 4 21 84 3 20 60 4 21 84 Of the four units sold, all come from the most recent purchase at a cost of $21 each. On January 22, the firm sells four units at $31 each.

LIFO Perpetual Inventory Account Item 127B Purchases Cost of Mdse. Sold Inventory Balance Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 10 20 200 4 7 20 140 3 20 60 10 8 21 168 3 20 60 8 21 168 22 4 21 84 3 20 60 4 21 84 28 2 21 42 3 20 60 2 21 42 On January 28, sold two units at $32 each.

LIFO Perpetual Inventory Account Item 127B Purchases Cost of Mdse. Sold Inventory Balance On January 30, purchase 10 units at $22 each. Unit Total Unit Total Unit Total Date Qty. Cost Cost Qty. Cost Cost Qty. Cost Cost Jan. 1 10 20 200 4 7 20 140 3 20 60 10 8 21 168 3 20 60 8 21 168 22 4 21 84 3 20 60 4 21 84 28 2 21 42 3 20 60 2 21 42 30 10 22 220 3 20 60 2 21 42 10 22 220

Learning Goal 5 Determine the cost of inventory under the periodic inventory system, using the first-in, first-out; last-in, first-out; and average cost methods.

Note: These amounts are not from the textbook. Fifo Periodic 200 units @ $9 Jan. 1 Beginning Inventory 300 units @ $10 Mar. 10 Purchase 400 units @ $11 Sept. 21 Purchase 100 units @ $12 Nov. 18 Purchase Note: These amounts are not from the textbook. 1,000 units available for sale during year

Cost of merchandise available for sale Fifo Periodic 200 units @ $9 = $1,800 Jan. 1 = 3,000 Mar. 10 = 4,400 Sept. 21 = 1,200 Nov. 18 300 units @ $10 400 units @ $11 100 units @ $12 1,000 units available for sale during year $10,400 Cost of merchandise available for sale

Fifo Periodic A physical count on December 31 reveals that 700 of the 1,000 units have been sold.

Fifo Periodic Using fifo, the first units purchased are theoretically the first units sold. Let’s count starting with January 1.

Fifo Periodic 200 units @ $9 Sold these 200 = $1,800 Jan. 1 = 0 Mar. 10 = 3,000 Mar. 10 Sold 200 of these 200 units @ $11 400 units @ $11 = 2,200 Sept. 21 = 4,400 Sept. 21 100 units @ $12 = 1,200 Nov. 18 1,000 units available for sale during year $10,400 $ 3,400 Ending inventory

Fifo Periodic Cost of merchandise available for sale $10,400 Less ending inventory 3,400 Cost of merchandise sold $ 7,000

Summary of Fifo Periodic Cost of Merchandise Sold Merchandise Available for Sale Purchases $1,800 200 units at $9 Jan. 1 200 units at $9 $1,800 $3,000 300 units at $10 Mar. 10 300 units at $10 $3,000 $2,200 200 units at $11 Sep. 21 400 units at $11 $7,000 700 units $4,400 Merchandise Inventory Nov. 18 100 units at $12 $1,200 $2,200 200 units at $11 1,000 units $10,400 $1,200 100 units at $12 $3,400 300 units

Lifo Periodic Jan. 1 Beginning Inventory 200 units @ $9 Mar. 10 Purchase 400 units @ $11 Sept. 21 Purchase 100 units @ $12 Nov. 18 Purchase 1,000 units available for sale during year Using lifo, the most recent batch purchased is considered the first batch of merchandise sold.

Assume again that 700 units were sold during the year. Lifo Periodic Assume again that 700 units were sold during the year. 200 units @ $9 Jan. 1 Beginning Inventory 300 units @ $10 Mar. 10 Purchase 400 units @ $11 Sept. 21 Purchase 100 units @ $12 Nov. 18 Purchase 1,000 units available for sale during year

Lifo Periodic 200 units @ $9 = $1,800 Jan. 1 = 3,000 Mar. 10 = 4,400 Sept. 21 = 1,200 Nov. 18 100 units @ $10 Sold 200 of these 300 units @ $10 1,000 400 units @ $11 Sold these 400 Sold these 100 100 units @ $12 1,000 units available for sale during year $2,800

Lifo Periodic Cost of merchandise available for sale $10,400 Less ending inventory 2,800 Cost of merchandise sold $ 7,600

Summary of Lifo Periodic Merchandise Inventory Merchandise Available for Sale Purchases $1,800 200 units at $9 Jan. 1 200 units at $9 $1,000 100 units at $10 $1,800 $2,800 300 units Mar. 10 300 units at $10 $3,000 Cost of Merchandise Sold Sep. 21 400 units at $11 $4,400 $2,000 200 units at $10 Nov. 18 100 units at $12 $1,200 $4,400 400 units at $11 1,000 units $10,400 $1,200 100 units at $12 $7,600 700 units

Average Cost Periodic 200 units @ $9 Jan. 1 Beginning Inventory The average cost periodic method is based on the average cost of identical units. 300 units @ $10 Mar. 10 Purchase 400 units @ $11 Sept. 21 Purchase 100 units @ $12 Nov. 18 Purchase 1,000 units available for sale during year

Average Cost Periodic 200 units @ $9 = $ 1,800 1,000 units available for sale during year $10,400 Cost of merchandise available for sale

Average Cost Periodic Cost of Merchandise Available for Sale = Average Unit Cost Units Available for Sale During Year $10,400 1,000 Units = $10.40 per Unit

…or, 700 units sold times $10.40 equals $7,280. Average Cost Periodic Cost of merchandise available for sale $10,400 Less ending inventory ($10.40 x 300) 3,120 Cost of merchandise sold $ 7,280 …or, 700 units sold times $10.40 equals $7,280.

Learning Goal 6 Compare and contrast the use of the three inventory costing methods.

First-In, First-Out Net sales $15,000 Cost of merchandise sold: Beginning inventory $ 1,800 Purchases 8,600 Merchandise available for sale $10,400 Less ending inventory 3,400 Cost of merchandise sold 7,000 Gross profit $ 8,000

Average Cost Net sales $15,000 Cost of merchandise sold: Beginning inventory $ 1,800 Purchases 8,600 Merchandise available for sale $10,400 Less ending inventory 3,120 Cost of merchandise sold 7,280 Gross profit $ 7,720

Last-In, First-Out Net sales $15,000 Cost of merchandise sold: Beginning inventory $ 1,800 Purchases 8,600 Merchandise available for sale $10,400 Less ending inventory 2,800 Cost of merchandise sold 7,600 Gross profit $ 7,400

Learning Goal 7 Determine the proper valuation of inventory at other than cost, using the lower-of-cost-or-market and net realizable value concepts.

In the lower-of-cost-or-market method, market is the cost to replace the merchandise on the inventory date.

Valuation of Inventory at Lower-of-Cost-or-Market Unit Unit Inventory Cost Market Total Total Lower Item Quantity Price Price Cost Market C or M $ 3,800 2,700 4,650 3,920 Total $15,520 $15,472 $15,070 A 400 $10.25 $ 9.50 $ 4,100 $ 3,800 B 120 22.50 24.10 2,700 2,892 C 600 8.00 7.75 4,800 4,650 D 280 14.00 14.75 3,920 4,130 The market decline is either: 1. Based on total inventory ($15,520 – $15,472) = $48 2. Based on individual items ($15,520 – $15,070) = $450

Learning Goal 8 Describe how inventories are being reduced through quick response.

To satisfy customer demand with the least amount of inventory and inefficiency, merchandisers and manufacturers are embracing quick response. Quick response is used to optimize inventory levels by electronically sharing common forecast, inventory, sales, and payment information between manufacturers and merchandisers, using the Internet or other electronic means.

Learning Goal 9 Determine and interpret the inventory turnover ratio, the number of days’ sales in inventory, and lifo reserve adjustments.

Inventory Turnover Ratios Safeway Inc. Zale Cost of merchandise sold $22,482,400,000 $920,003,000 Inventories: Beginning of year $2,444,900,000 $571,669,000 End of year $2,508,000,000 $630,450,000 Average $2,476,450,000 $601,059,500 Inventory turnover 9.1 times 1.5 times Cost of merchandise sold Average inventory Use: To assess the efficiency in the management of inventory

Number of Days’ Sales in Inventory Safeway Inc. Zale Average daily cost of merchandise sold: $22,482,400,000/365 $61,595,616 $920,003,000/365 $2,520,556 Ending inventory $2,508,000,000 $630,450,000 Average selling period 41 days 250 days Inventory, end of year Average daily cost of merchandise sold Generally, the lower number of days’ sales in inventory, the better.

Chapter 8 The End