Cost of Goods Sold and Inventory: Identification and Valuation

2  Define inventory for a merchandising business, and identify the different types of inventory for a manufacturing business.  Explain the advantages and disadvantages of both periodic and perpetual inventory systems.  Determine when ownership of goods in transit changes hands and what circumstances require shipped inventory to be kept on the books. Learning Objectives

3  Compute total inventory acquisition cost.  Use the four basic inventory valuation methods: specific identification, average cost, FIFO, and LIFO.  Explain how LIFO inventory layers are created, and describe the significance of the LIFO reserve. Learning Objectives

4  Choose an inventory valuation method based on the trade-offs among income tax effects, bookkeeping costs, and the impact on the financial statements.  Analyze inventory using financing ratios, and properly compare ratios of different firms after adjusting for differences in inventory valuation methods.

5 Learning Objectives  Use LIFO pools to simplify LIFO calculations.  Compute ending inventory and cost of goods sold using dollar-value LIFO. EXPANDED MATERIAL

6 LIFO and FIFO in Times of Inflation Unit Cost of Goods Sold Beginning of Year End of Year FIFO assumes the old units are sold FIFO LIFO assumes the new units are sold LIFO

7 Time Line of Business Issues Involved With Inventory BUY Raw Materials or Goods for Resale SELL Finished Inventory SELL COMPUTE Ending Inventory and Cost of Goods Sold COMPUTE ADD Value ADD

8 What Is Inventory? Inventory designates goods held for sale in the normal course of business and, in the case of a manufacturer, goods in production or to be placed in production.

9 How Much Inventory Do Companies Have? Inventory Levels for the 50 Largest Companies, Inventory as a Percentage of Total Assets 1998 Source: Standard and Poor’s Compustat

10 Inventory TypesMerchandiseMerchandise Balance Sheet Items Income Statement Items Retailer Cost of Goods Sold Sale Manufacturer Raw Materials Cost of Goods Sold Sale Finished Goods Work in Process Overhead Direct Labor

11 Periodic Inventory Systems Cost of Goods Sold is determined and Inventory is adjusted to proper balance at period end. All purchases of inventoriable merchandise are recorded in the Purchases account. Ending inventory is determined by physical count of merchandise on hand.

12 Perpetual Inventory Systems Cost of Goods Sold is determined and Inventory is adjusted to proper balance each time inventory is purchased or sold. All purchases of inventoriable goods are recorded in the Inventory account.

13 Example: Inventory Systems Assume: Beginning Inventory50 $10$ 500 Purchases 300 $103,000 Sales275 $154,125 Ending inventory (physical count)70 $10700 Make the journal entries to record the purchases and sales for both the periodic and perpetual inventory systems.

14 Example: Inventory Systems Purchases of Inventory Periodic Method Purchases……………………..3,000 Accounts Payable………….3,000 Perpetual Method Inventory……………………..3,000 Accounts Payable………….3,000

15 Example: Inventory Systems Sales During the Period Periodic Method Accounts Receivable…………..4,125 Sales………………………...4,125 Perpetual Method Accounts Receivable…………..4,125 Sales………………………...4,125 Cost of Goods Sold……………2,750 Inventory……………………2,750

16 Whose Inventory Is It? Goods in Inventory. Goods in Transit. –FOB Shipping Point: buyer’s inventory from time of shipment. –FOB Destination: seller’s inventory until receipt by buyer. Goods on Consignment: inventory of the consignor, not the consignee.

17 Goods in Transit Quality Produce Goods being shipped are included in inventory of buyer while in transit. FOB Shipping Point Seller Buyer

18 Goods in Transit FOB Destination Quality Produce Goods being shipped are included in inventory of seller until received by buyer. Seller Buyer

19 Goods on Consignment Title to goods sold on consignment remains with the shipper until their sale or use by the dealer or customer.

20 What Is Inventory Cost? Inventory Cost is all expenditures related to inventory acquisition, preparation, and placement for sale. Trade Discounts –Convert the catalog price to the actual price. –Record inventory at discounted price. Cash Discounts –Granted for payment of invoices within a limited time period. –Record inventory using the net method or gross method.

21 Cash Discounts--Net Method Records inventory net of any purchase (cash) discounts. Example: June 1--purchased inventory for $100 Terms of payment: 2/10, n/30 Assuming a perpetual inventory method, record the purchase of the inventory and payment on June 8.

22 June 1 Inventory Accounts Payable.....… Cash Discounts--Net Method

23 June 1 Inventory Accounts Payable.....… June 8 Accounts Payable Cash … Cash Discounts--Net Method

24 Cash Discounts--Net Method Now, assume that the payment was not made until June 28.

25 June 28 Accounts Payable ….98 Discounts Lost…………….. 2 Cash ….100 Cash Discounts--Net Method

26 Cash Discounts--Gross Method Record inventory at gross cost; discounts are recorded only if taken. Example: June 1--purchased inventory for $100 Terms of payment: 2/10, n/30 Assuming a perpetual inventory method, record the purchase of the inventory and payment on June 8.

27 June 1 Inventory Accounts Payable.....… Cash Discounts--Gross Method

28 June 1 Inventory Accounts Payable.....… June 8 Accounts Payable Inventory………………..2 Cash … Cash Discounts--Gross Method

29 Again, assume that the payment was not made until June 28. Cash Discounts--Gross Method

30 June 28 Accounts Payable ….100 Cash ….100 Cash Discounts--Gross Method

31 Cost of Goods Manufactured The heading. Bartlett Corporation Schedule of Cost of Goods Manufactured For the Year Ended December 31, 2002

32 Cost of Goods Manufactured Direct materials: Raw materials inventory, January 1, 2002$ 21,350 Purchases107,500 Cost of raw materials available for use$128,850 Less: Raw materials inventory, December 31, ,350 Raw materials used in production$106,500 Direct labor96,850 ContinuedContinued

33 Cost of Goods Manufactured Manufacturing overhead: Indirect labor$40,000 Factor supervision29,000 Depreciation---factory buildings and equipment20,000 Light, heat, and power18,000 Factory supplies15,000 Miscellaneous mfg. overhead12,055134,055 Total manufacturing costs$337,405 Add: Work in process, Jan. 1, ,400 $366,805 Less: Work in process, Dec. 31, ,500 Cost of goods manufactured$340,305

34 Impact of Cash Discounts Purchase Date End of Discount Period $9,800 Owed $10,000 Owed Final Payment Date 10 Days20 Days Supplier “Loan” Period

35 Inventory Cost Flow Methods Cost Allocation Methods Specific Identification FIFO Average Cost LIFO Actual CostCost PoolsDollar Value

36 Frequency of Use of Inventory Valuation Methods U. S. Companies 1979 and 1998 U. S. Companies 1979 and 1998 Inventory Method All Companies All Companies Large Companies FIFO75.6%82.9%72.6% LIFO25.8%12.5%33.0% Average cost20.8%15.7%30.0% Specific Identification3.7%3.2%2.6%

37 Specific Identification Method  Assigns the actual cost of the asset to Inventory and Cost of Goods Sold.  Provides a highly objective method of matching costs because cost flow exactly matches physical goods flow.  Is almost impossible to implement cost effectively.

38 Specific Identification $10 per unit Apr. 1 Apr. 10 Apr. 20 $11 per unit $12 per unit Sold 80 units from the beginning inventory, 40 units from the April 10 purchase, and 20 units from the April 20 purchase.

39 $10 per unit $11 per unit $12 per unit Sold 80 units from the beginning inventory, 40 units from the April 10 purchase, and 20 units from the April 20 purchase. Apr. 1 Apr. 10 Apr. 20 Beg. Inv. + Purchases - End. Inv. = Cost of Goods Sold Ending inventory……………. = $ 200 =440 = 600 $1,240 $1,000 + $1,720 - $1,240 = $1,480 Specific Identification

40 Average Cost Method Assigns the same average cost to each unit sold and each item in inventory. For Periodic Inventory, the unit cost is the weighted average for the entire period. For Perpetual Inventory, the unit cost is computed as a moving average, which changes with each new purchase of goods.

41 = $1,000 =880 = 840 $2,720 $10 per unit Apr. 1 Apr. 10 Apr. 20 $11 per unit $12 per unit Sold 140 units during April. 250 units Beg. Inv. + Purchases - End. Inv. = Cost of Goods Sold $1,000 + $1,720 - $1,197 = $1,523 $2,720  250 units = $10.88 $10.88 x 110 units = ending inventory of $1,197 Average Cost Method--Periodic

42 Apr. $ Apr. $10.44$ 940 Apr. 20Purchases $ $11.125$1,780 Apr. 1Beginning $10$1,000 Apr.10Purchases $ $10.44$1,880 $1,880  180 Apr. $ Apr. $11.125$1,224 $1,780  160 Cost of Goods Sold (140 units) $940 + $556$1,496 Ending Inventory (110 $11.125)$1,224 Average Cost Method--Perpetual

43 First-in, First-out (FIFO) Method  Assigns historical unit cost to Cost of Goods Sold in the order the costs are incurred.  Provides a close match between physical product flow and product cost flow.  Results in the same inventory valuation and Cost of Goods Sold regardless of whether perpetual or periodic inventory is used.

44 Last-in, First-out (LIFO) Method  Assigns the most recent historical costs to Cost of Goods Sold and the oldest costs to Inventory.  Is used primarily to minimize taxable income.  Results in differences between Cost of Goods Sold and Inventory for perpetual inventory versus periodic inventory.

45 $10 per unit Apr. 1 Apr. 10 Apr. 20 $11 per unit Sold 140 units during April. $11 per unit Sold 0 Sold 70 Sold all $12 per unit Periodic Inventory System $12 per unit Last-in, First-out (LIFO) Method

46 Beg. Inv. + Purchases - End. Inv. = Cost of Goods Sold $10 per unit Apr. 1 Apr. 10 Apr. 20 $11 per $11 per unit $12 per unit $12 per unit Ending inventory……………….. = $1,000 =110 = 0 $1,110 $1,000 + $1,720 - $1,110 = $1,610 Periodic Inventory System Last-in, First-out (LIFO) Method

47 $10 per unit $10 per unit Apr. 1 Apr. 10 Apr. 20 $11 per unit Purchased 80 $12 per unit Perpetual Inventory System $12 per unit Sold 80 $11 per $11 per unit Sold 10Purchased 70Sold 50 Beginning inventory Last-in, First-out (LIFO) Method

48 Apr. 1 Apr. 10 Apr. 20 Ending inventory……………….. Beg. Inv. + Purchases - End. Inv. = Cost of Goods Sold = $ 900 =0 = 240 $1,140 $1,000 + $1,720 - $1,140 = $1,580 Perpetual Inventory System Last-in, First-out (LIFO) Method $10 per unit $10 per unit $11 per unit $12 per unit $12 per unit $11 per $11 per unit

49 Inventory Turnover Appropriateness of inventory size and position can be measured by calculating the Inventory Turnover Ratio. Inventory Turnover: Cost of Goods Sold ÷ Average Inventory

50 Example: Inventory Turnover Determine the inventory turnover. Cost of Goods Sold$1,000 Beginning Inventory$ 90 Ending Inventory$ 110 Cost of Goods Sold$1,000 Beginning Inventory$ 90 Ending Inventory$ 110

51 Cost of Goods Sold$1,000 Beginning Inventory$ 90 Ending Inventory$ 110 Cost of Goods Sold$1,000 Beginning Inventory$ 90 Ending Inventory$ 110 $1,000 ($90 + $110)/2 = 10 Example: Inventory Turnover

52 Number of Days’ Sales in Inventory $1,000 ($90 + $110)/2 = Number of days’ sales in inventory is 36.5

53 Example--Dollar-Value LIFO 1.Compute ending inventory at ending prices. 2.Compute beginning inventory at ending prices. 3.Compute the difference. An increase represents a new LIFO layer. 4.LIFO ending inventory is beginning inventory at base-year prices plus the new LIFO layer.

54 Assuming 1999 is the first year Harry’s Hardware, Inc. uses dollar-value LIFO, the following slides illustrate the calculations for 2000, 2001, and 2002 ending inventory. Example--Dollar-Value LIFO

55 Assume the following inventory data for Harry’s: Inventory Year(nominal)Price Index 1999 $ $ $ $ Example--Dollar-Value LIFO

56 EoYEoYYearYearLayer LIFOYearCostIndexCostLayers IndexCost 1999 $ 76 ÷1.0 = $ 76 $ 76 x 1.0 = $ 76.0 Example--Dollar-Value LIFOEndinginventoryDVLifo1999EndinginventoryDVLifo1999

57 EoYEoYYearYearLayer LIFOYearCostIndexCostLayers IndexCost 2000 $ $ 76 ÷1.0 = $ 76 $ 76 x 1.0 = $ 76.0 Example--Dollar-Value LIFO

58 EoYEoYYearYearLayer LIFOYearCostIndexCostLayers IndexCost 2000 $108 ÷1.2 = $ $ 76 ÷1.0 = $ 76 $ 76 x 1.0 = $ 76.0 Example--Dollar-Value LIFO

59 EoYEoYYearYearLayer LIFOYearCostIndexCostLayers IndexCost 2000 $108 ÷1.2 = $ $ 76 ÷1.0 = $ 76 $ 76 x 1.0 = $ 76.0 $ 76 x 1.0 = $ x 1.2 = 16.8 Example--Dollar-Value LIFO Ending inventory (DV Lifo, 2000)$ 92.8

60 EoYEoYYearYearLayer LIFOYearCostIndexCostLayers IndexCost 2001 $ 90 ÷1.5 = $ 60 $ 60 x 1.0 = $ 60.0 Example--Dollar-Value LIFO 2000 $108 ÷1.2 = $ $ 76 ÷1.0 = $ 76 $ 76 x 1.0 = $ 76.0 $ 76 x 1.0 = $ x 1.2 = 16.8 Ending inventory (DV Lifo, 2000)$ 92.8 ContinuedContinued

$255 ÷1.7 = $150 $ 60 x 1.0 = $ x 1.7= EoYEoYYearYearLayer LIFOYearCostIndexCostLayers IndexCost 2001 $ 90 ÷1.5 = $ 60 $ 60 x 1.0 = $ 60.0 Example--Dollar-Value LIFO Ending inventory (DV Lifo, 2002)$213.0EndinginventoryDVLifo2001EndinginventoryDVLifo2001

62 LIFO Advantages Advantages: Matches current costs with current revenues. Excludes inventory holding gains from gross profit. Income tax deferral.

63 Disadvantages: Does not correspond with the physical flow of goods. Potential LIFO liquidation can draw old costs into cost of goods sold. Ending inventory balance can be much lower than current replacement cost. LIFO Disadvantages

64 FIFO Advantages Advantages: Corresponds with physical flow of goods. Ending inventory balance is close to current replacement cost.

65 Disadvantages: Matches older costs with current revenues. Inventory holding gains and losses are part of gross profit. No income tax deferral. FIFO Disadvantages

66 The End