Chapter McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Cost of Sales and Inventory 6

6-2 Inventory Issues What is inventory? What costs are included in inventory? How do we separate COGS from Ending Inventory?

6-3 Inventories Definition Asset items held for sale in the ordinary course of business or goods that will be used or consumed in the production of goods to be sold

6-4 Supplies Tangible items that will be consumed in the course of normal operations: e.g. office and janitorial supplies, lubricants, repair parts Not sold and not accounted for as part of cost of goods sold

6-5 Types of Companies Merchandising company: –Sells goods in same form as acquired Manufacturing company: –Converts raw material into finished goods Service company: –Provides intangible services

6-6 Merchandising Inventories Merchandising: Inventory costs (and COGS) = acquisition costs

6-7 Manufacturing Inventories Manufacturing company converts raw materials and purchased parts into finished goods: 3 types of inventories: Materials Work-in-process Finished goods

6-8 Service Inventories Service organizations (hotels, beauty parlors, plumbers): May have materials inventories

6-9 Professional Service Inventories Professional service firms (accounting firms, legal firms): Intangible inventory costs are costs incurred for client but not yet billed called jobs-in- progress or unbilled costs

6-10 Merchandise companies Inventories accounted for at cost: Cost includes cost of: Acquiring merchandise (invoice cost of goods, freight-in) Making goods ready for sale (unpacking and marking) Adjust for: Returns and allowances Cash discounts from supplier

6-11 Methods of accounting for purchase discounts Net of discount: Charge discounts not taken when paid Record at invoice price: Record discount when taken

6-12 Relationship of Inventory and COGS Beginning inventory + net purchases = goods available for sale Goods available for sale = cost of goods sold + ending inventory Equivalently: Beg. inventory + net purchases -ending inventory = cost of goods sold: Net purchases = gross purchases -purchase returns and allowances + freight-in

6-13 Measurement Issue Dividing goods available for sale between COGS and End. Inventory Measurement of inventories and cost of sales are related: –Periodic inventory method –Perpetual inventory method

6-14 Periodic inventory method Determine amount of ending inventory and deduce costs of goods sold: Count inventory (i.e., a physical inventory is taken) at the end of the period Multiply count times cost for each item to determine total amount of inventory: Beginning inventory of current period = ending inventory of preceding period

6-15 Perpetual Inventory Method Measure amount actually delivered to customers; deduce ending inventory Perpetual inventory record is kept for each item in inventory Advantages of perpetual inventory method: Detailed record is useful Built in check Identifies shrinkage by item Income statement can be prepared without taking a physical inventory

6-16 Manufacturing Companies Product costs or cost of goods sold = materials and parts used + conversion costs: Conversion costs = production labor + overhead (other costs incurred in manufacturing)

Types of Manufacturing Inventory Accounts Materials inventory or raw materials: Not yet used in production Adjusted for returns and freight-in Work-in-process: Goods started but not yet finished Materials + conversion costs Finished goods: Manufactured but not yet shipped. Materials + conversion costs

6-18 Professional service firms E.g. law and accounting firms: Labor, overhead, and incidental product costs but no materials cost Expensed in period billed (i.e., when revenues are recognized)

6-19 Inventory Costing Methods Specific identification Average cost FIFO LIFO

6-20 Specific identification Big ticket items Uniquely identified items: May offer opportunity to manipulate costs

6-21 Average Cost (Beginning inventory amount + purchases) / units available for sale = per unit inventory costs = per unit cost of goods sold: Periodic method: Computed for the entire period Perpetual method: A new unit cost can be calculated after each purchase

6-22 First-in, first-out (FIFO) Expenses costs of oldest purchases first Most recently purchased goods are in inventory: Likely but not necessary to follow actual flow of goods Ending inventory approximates current cost of goods

6-23 Last-in, last-out (LIFO) Assumes most recently purchased goods are sold first Inventory based on costs of oldest purchases: Cost of goods sold usually does not reflect physical flow Ending inventory may be costed at amounts of years ago: Inventory may be well below current costs

6-24 Arguments for FIFO Usually follows physical flow of goods If prices are based on oldest cost, results in best matching More accurate balance sheet valuation Non-theoretical/practical argument: Results in highest income during periods of rising prices

6-25 Arguments for LIFO If prices are based on current costs, results in best matching of revenues and costs and therefore most useful income statement Closest to reflecting current or replacement costs of goods sold: However, it is still historical costs and could differ from current costs

6-26 Arguments for LIFO (continued) During periods of price increases: Higher costs of goods sold Lower taxable income Lower income taxes Higher cash flows: If LIFO for tax purposes than also financial reporting

6-27 Lower of Cost or Market (LCM) Market price may be below cost due to: Physical deterioration Change in consumer tastes Technological obsolescence LCM is a reflection of conservatism concept Market is defined as replacement cost

6-28 Analysis of inventory Inventory turnover = Cost of goods sold / Inventory: Average for period or ending inventory Measures efficiency of asset usage Days inventory = Inventory / (Cost of goods sold 365) Gross margin as % of sales Ratios differ by industry

Chapter McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. End of Chapter 6 6