1 CHAPTER 7 Cost of Goods Sold & Inventory

2 Key Terms Inventory (beginning, ending) Cost of goods sold (COGS) Inventory cost flow assumptions Lower of cost or market (LCM)

3 Inventory Tangible property that is held for resale or will be used in producing goods or services Reported on the Balance Sheet as a current asset Inventory is recorded at cost –Inventory cost includes invoice price, freight charges, inspection & preparation costs Periodic vs. perpetual inventory system –We assume periodic inventory system in all exercise

4 Example: purchase of inventory On March 17, Anthony Company received merchandise from its normal supplier. The invoice price was $3,600 with terms of 2/10, n/30 for 100 units of Part #345. The invoice was paid on March 17. Freight costs were $120 and the company paid $108 of interest on a loan to pay for the inventory. Prepare the journal entry to record the purchase of inventory.

5 Cost of goods sold equation: Beginning inventory Purchases of merchandise Goods available for sale Ending inventory Cost of goods sold + = =

6 Exercise: Compute cost of goods sold Magic Tunes Company sells iPods and iPod accessories in its retail store. Assume the following facts related to sales of one iPod model during 2008: Beginning ipod inventory = 300 units at a unit cost of $150 Ending ipod inventory = 200 units at a unit cost of $150 Purchases of ipods during the year = 450 units at a unit cost of $150 Using the cost of goods sold equation, compute the number of units and the cost of goods sold related to this model.

7 The Mustang Sweatshirt Company had 100 units of beginning inventory. During the period, two purchases of inventory were made. Ending inventory consists of 200 units. Thus, 400 units were sold. Beginning inventory 100 Purchases: #1 (250 units) 250 #2 (250 units) 250 Total purchases 500 Number of units available for sale 600 Ending inventory 200 Number of units sold 400 Beginning inventory 100 Purchases: #1 (250 units) 250 #2 (250 units) 250 Total purchases 500 Number of units available for sale 600 Ending inventory 200 Number of units sold 400 Illustration: Inventory Methods

8 Using these same facts about inventory, price per unit values have been added to the illustration. Beginning inventory (100 $10 per unit)$1,000 Purchases: #1 (250 $14 per unit)$3,500 #2 (250 $18 per unit)$4,500 Total purchases$8,000 Cost of goods available for sale (600 units)$9,000 Ending inventory (200 $? per unit) ? Cost of goods sold (400 $? per unit) ? Beginning inventory (100 $10 per unit)$1,000 Purchases: #1 (250 $14 per unit)$3,500 #2 (250 $18 per unit)$4,500 Total purchases$8,000 Cost of goods available for sale (600 units)$9,000 Ending inventory (200 $? per unit) ? Cost of goods sold (400 $? per unit) ?

9 Inventory Costing Methods First-in, first-out (FIFO) Last-in, first-out (LIFO) Weighted average cost Specific identification Also referred to as Inventory Cost Flow Assumptions The inventory costing methods are alternative ways of assigning inventory costs from goods available for sale to cost of goods sold (expense) and ending inventory (assets)

10 FIFO Costing Method Cost of goods available for sale (600 units)$9,000 Cost of goods sold (cost of the first 400 units): 100 $10 per unit (all of beginning inventory) 1, $14 per unit (all of purchase #1) 3, $18 per unit (from purchase #2) 900 Cost of goods sold ( ) $5,400 Ending inventory (cost of the last 200 units): 200 $18 per unit (from purchase #2) $3,600 FIFO Costing Method Cost of goods available for sale (600 units)$9,000 Cost of goods sold (cost of the first 400 units): 100 $10 per unit (all of beginning inventory) 1, $14 per unit (all of purchase #1) 3, $18 per unit (from purchase #2) 900 Cost of goods sold ( ) $5,400 Ending inventory (cost of the last 200 units): 200 $18 per unit (from purchase #2) $3,600 Beginning inventory (100 $10 per unit)1000 Purchases: 1) 250 $14 per unit3500 2) 250 $18 per unit4500 Total purchases8000 Cost of goods available for sale (600 units)9000 Ending inventory (200 $? per unit) ? Cost of goods sold (400 $? per unit) ? Beginning inventory (100 $10 per unit)1000 Purchases: 1) 250 $14 per unit3500 2) 250 $18 per unit4500 Total purchases8000 Cost of goods available for sale (600 units)9000 Ending inventory (200 $? per unit) ? Cost of goods sold (400 $? per unit) ?

11 LIFO Costing Method Cost of goods available for sale (600 units)$9,000 Cost of goods sold (cost of the last 400 units): 250 $18 per unit (all of purchase #2) 4, $14 per unit (from purchase #1) 2,100 Cost of goods sold ( )$6,600 Ending inventory (cost of the first 200 units): 100 $10 per unit (all of beginning inventory) 1, $14 per unit (from purchase #1) 1,400 Ending inventory ( )$2,400 LIFO Costing Method Cost of goods available for sale (600 units)$9,000 Cost of goods sold (cost of the last 400 units): 250 $18 per unit (all of purchase #2) 4, $14 per unit (from purchase #1) 2,100 Cost of goods sold ( )$6,600 Ending inventory (cost of the first 200 units): 100 $10 per unit (all of beginning inventory) 1, $14 per unit (from purchase #1) 1,400 Ending inventory ( )$2,400 Beginning inventory (100 $10 per unit)1000 Purchases: 1) 250 $14 per unit3500 2) 250 $18 per unit4500 Total purchases8000 Cost of goods available for sale (600 units)9000 Ending inventory (200 $? per unit) ? Cost of goods sold (400 $? per unit) ? Beginning inventory (100 $10 per unit)1000 Purchases: 1) 250 $14 per unit3500 2) 250 $18 per unit4500 Total purchases8000 Cost of goods available for sale (600 units)9000 Ending inventory (200 $? per unit) ? Cost of goods sold (400 $? per unit) ?

12 Weighted Average Costing Method Cost of goods available for sale (600 average cost of $15 per unit)$9,000 Cost of goods sold (400 $15 per unit)$6,000 Ending inventory (200 $15 per unit)$3,000 Weighted Average Costing Method Cost of goods available for sale (600 average cost of $15 per unit)$9,000 Cost of goods sold (400 $15 per unit)$6,000 Ending inventory (200 $15 per unit)$3,000 $9,000 cost of goods available for sale 600 units available for sale = $15 / unit cost of goods available for sale # of units available for sale Average cost =

13 Specific Identification Costing Method Cost of goods available for sale (600 units)$9,000 Cost of goods sold (200 units from purchase # 1 and 200 units from purchase #2): 200 $14 per unit (purchase #1)$2, $18 per unit (purchase #2)$3,600 Cost of goods sold ( )$6,400 Ending inventory (all items that were not sold): 100 $10 per unit (from beginning inventory)1, $14 per unit (from purchase #1) $18 per unit (from purchase #2) 900 Ending Inventory ( ) $2,600 Beginning inventory (100 $10 per unit)1000 Purchases: 1) 250 $14 per unit3500 2) 250 $18 per unit4500 Total purchases8000 Cost of goods available for sale (600 units)9000 Ending inventory (200 $? per unit) ? Cost of goods sold (400 $? per unit) ? Beginning inventory (100 $10 per unit)1000 Purchases: 1) 250 $14 per unit3500 2) 250 $18 per unit4500 Total purchases8000 Cost of goods available for sale (600 units)9000 Ending inventory (200 $? per unit) ? Cost of goods sold (400 $? per unit) ?

14 Exercise: Analyzing inventory costing methods At December 31, 2008, the accounting records for one item of inventory for Dallas Company showed the following: 2/20Purchase of 600 units at $32 each 4/1Sale of 700 units for $32,000 in cash 6/30Purchase of 500 units for $36 each 8/1Sale of 100 units for $4,600 on account Beginning inventory as of January 1,2008 consisted of 400 units at a unit cost of $30 each. Compute the dollar amount of ending inventory and cost of goods sold at December 31 under: a) FIFO b) LIFO c) Weighted average cost

15 Choice of inventory cost method When costs of inventory are declining, FIFO (LIFO) will produce highest (lowest) cost of goods sold and lowest (highest) valuation of ending inventory. When costs of inventory are rising, FIFO (LIFO) will produce lowest (highest) cost of goods sold and highest (lowest) valuation of ending inventory. Average cost method produces results in between FIFO and LIFO. Managers balance the trade off between net income effects and income tax effects when making a choice of inventory method. LIFO conformity rule

16 Lower of cost or market (LCM) Inventory is initially recorded at cost (historical cost principle). However, when the merchandises remaining in ending inventory can be replaced with identical merchandises at a lower cost (i.e., the market value / replacement cost is lower than the book value of inventory), the market value (i.e. the lower of two) should be used in inventory valuation. An adjusting entry is used to adjust the value of inventory to the lower value: decrease the ending inventory balance and increase the COGS for the current accounting period.

17 Exercise: Lower of cost or market Peterson Company has the following ending inventory information about four items stocked for regular sale: Item Quantity Unit cost (LIFO) Replacement cost (market) LCM unit cost Inventory (ending) A50 $15$13 $650 B ,000 C D What value should be recorded for inventory on the balance sheet under the lower of cost or market rule?

18 Ratio Analysis Inventory Cost of goods sold Turnover = Average inventory Average days 365 to sell inventory = Inventory Turnover