1 Chapter 6

2 Inventory cost –Includes everything that is paid in order to get the inventory ready to sell –Includes invoice price (less purchases discounts), freight, insurance in transit, taxes, tariffs, inspection costs and preparation costs.

3 Two methods of handling inventories: –the periodic inventory system, and –the perpetual inventory system

4 Periodic inventory system –COGS calculated at end of year: Beginning Inventory + Purchases Goods Available for Sale - Ending Inventory (From Physical Inventory) Cost of Goods Sold

5 Disadvantages of Periodic Method: –No information on theft or spoilage Everything not present is assumed to be sold –Unless physical inventory taken Don’t know COGS or Inventory Advantage –Cheap –Easy system to maintain

6 Perpetual Inventory System –Tracks COGS & Inventory continuously –Physical inventory at end of period Discrepancies attributable to theft and spoilage

7 Advantage of Perpetual System –Gives Information on theft –COGS & Inventory figures always available Disadvantage –May be expensive to maintain With computers & scanners – marginal cost may be minimal Have only seen Perpetual System in class so far

8 PeriodicPerpetual a. Purchase inventory on credit: D.PurchasesD.Merchandise Inventory Cr.Accounts PayableCr.Accounts Payable b. Transportation Costs on purchases: D.Freight InD.Freight In Cr.Accounts PayableCr.Accounts Payable c. Purchases Returns and Allowances: D.Accounts PayableD.Accounts Payable Cr.Purch. Ret & Allow.Cr.Merch. Inv.

9 PeriodicPerpetual d. Payments on Accounts Payable: D.Accounts PayableD.Accounts Payable Cr.CashCr.Cash e. Sale of Merchandise on Credit: D.Accounts ReceivableD.Accounts Receivable Cr.Sales Cr.Sales D.Cost of Goods Sold Cr.Merch. Inv. f. Payment of Delivery Costs D.Freight Out ExpenseD.Freight Out Expense Cr.CashCr.Cash

10 PeriodicPerpetual g. Return of Merchandise Sold: D.Sales Ret. & Allow.D.Sales Ret. & Allow. Cr.A/RCr.A/R D.Merchandise Inventory Cr.Cost of Goods Sold f. Receipts on Accounts Receivable: D.CashD.Cash Cr.A/RCr.A/R

11 Perpetual Inventory System –Have COGS always Periodic Inventory System –No COGS account –Calculate COGS – Net all inventory accounts Inventory Accounts closed to Income Summary Net figure ends up as debit balance in Income Summary –Just like closing COGS account to Income Summary in Perpetual System

12 Beginning Balance of Inventory (debit balance) +Purchases (debit balance) -Purchase Returns & Allowances (credit balance) -Purchase Discounts (credit balance) +Freight In (debit balance) Cost of Goods Available -Ending Balance of Inventory Cost of Goods Sold

13 INCOME SUMMARY (PARTIAL ENTRIES) Beg. Balance of InventoryPurch. Ret. & Allowances PurchasesPurchase Discounts Freight InEnding Balance of Inventory Cost of Goods Sold

14 D.Income Summary$50,000 Cr.Inventory$50,000 Close Inventory account –There were no additions to inventory during year Thus, Inventory is beginning inventory

15 D.Income Summary$300,000 Cr.Purchases$300,000 D.Income Summary$10,000 Cr.Freight-In$10,000 Close temporary inventory accounts:

16 D.Purchase Returns & Allowances$20,000 Cr.Income Summary$20,000 D.Purchase Discounts$30,000 Cr.Income Summary$30,000

17 D.Inventory$40,000 Cr.Income Summary$40,000 Physical Inventory – end of year –Add to Income Summary (credit) –Add to Inventory account (debit) You previously closed Inventory account This adds ending inventory figure Inventory now reflects end of year figure

18 INCOME SUMMARY (PARTIAL ENTRIES) Beg. Inventory $50,000 Purch. Ret & Allow $20,000 Purchases 300,000 Purch. Discounts 30,000 Freight In 10,000 End. Inventory 40,000 COGS $270,000

19 Beg. Inventory (debit balance)$50,000 +Purchases (debit balance)300,000 -Purch. Ret. & Allowances (credit balance)-20,000 -Purchase Discounts (credit balance)-30,000 +Freight In (debit balance)10, Cost of Goods Available$310,000 -Ending Balance of Inventory-40, Cost of Goods Sold$270,000

20 Ownership of Goods –"FOB shipping point“ Title to goods transfers at seller’s place of business Buyer pays shipping costs Buyer includes goods being shipped in his/her Inventory –"FOB destination“ Title to goods transfers at the buyer’s place of business Seller pays shipping costs Seller includes goods being shipped in his/her inventory

21 Consigned Goods –Goods transferred physically to another company No transfer of title –Owner (Consignor) –Person in Possession (Consignee) –Consignor includes goods in his/her inventory

22 Inventory Costing Methods - Periodic Method –When computing COGS & Inventory make assumption on which goods are sold –Four Methods (Assumptions) specific identification average-cost first-in, first-out (FIFO) last-in, first-out (LIFO) –Calculations done at end of year

23 Units Purchased: units Assume the following purchases:

24 Units Sold: June1070units 30210units units Units in Ending Inventory:220units Assume the following sales:

25 Specific Identification Method –Keep track of which goods sold & still in inventory Might use Serial Numbers or Labels –Use actual flow of goods

26 50units from June 660 x$1.10=$55 50units from June 1350 x$1.20=$60 100units from June x$1.30=$130 80units from June 2580 x$1.40=$ Cost of Goods Sold :$357 You identify that these goods were sold:

27 50units from June 150 x$1.00=$50 100units from June x$1.20=$120 70units from June 2570 x$1.40=$ Cost of Remaining Inventory :$268 You identify that these goods are still on hand:

28 Specific Identification Method –Not common –Expensive when dealing with high volumes of goods –Permits companies to manipulate income by choosing to sell high-cost or low-cost items. –Used primarily for high-priced items E.g, computer processors, automobiles, expensive furniture & jewelry

29 Average Cost –Use average cost per unit For COGS For Inventory Total cost of goods on hand Number of units

Units Purchased:500units$625 Average Cost Per Unit$625/500=$1.25 Computer average:

31 Ending Cost of Goods Use average to calculate COGS & Ending Inventory:

32 Advantage of Average Cost Method –Levels out variations in cost

33 50units from June 160 x$1.00=$50 50units from June 650 x$1.10=$55 150units from June x$1.20=$180 30units from June 2080 x$1.30=$ Cost of Goods Sold :$324 First-In, First-Out Method (FIFO) Method –Assumes first goods sold are first good bought:

34 70units from June 2070 x$1.30=$91 150units from June x$1.40=$ Cost of Remaining Inventory :$301 Ending inventory consists of most recent purchases:

35 If Inflation –FIFO yields highest net income of the four methods

36 150units from June x$1.40=$ units from June x$1.30=$130 30units from June 1330 x$1.20=$ Cost of Goods Sold :$376 Last-In, First-Out (LIFO) Method –Assumes first goods sold are the last goods purchased:

37 50units from June 150 x$1.00=$50 50units from June 650 x$1.10=$55 120units from June x$1.20=$ Cost of Remaining Inventory :$249 Ending inventory assumed to consist of items from earliest purchases:

38 Inventory Using LIFO$249 LIFO Reserve Inventory Assuming FIFO$301 Company using LIFO reports LIFO Reserve –Difference between LIFO inventory & FIFO inventory –Disclosed in notes to financial statements

39 COGS Under FIFO$324 LIFO Reserve COGS Under LIFO$376 LIFO Reserve –Allows analysts to make allowances for use of LIFO –Indicates how much higher Retained Earnings would have been had company used FIFO.

40 Advantage of LIFO –With inflation LIFO best matches current costs with revenues –LIFO gives lowest net income of four methods. Lower income taxes –Have to use same method for tax & financial statement purposes

41 Disadvantage of LIFO –With inflation - Low income looks bad Analysts compensate for LIFO –Inventory valuation often unrealistic –If inventories shrink, cheap inventory costs results in high income taxes. Called a LIFO liquidation Retrains company from reducing inventory levels when it should for business reasons

42 Comparison of Inventory Methods –With Inflation FIFO produces a higher net income LIFO produces a lower net income Average cost method produces net income somewhere in between –With deflation Reverse is true. –LIFO best matches revenues & current costs –FIFO provides most realistic inventory value

43 Inventory Costing Methods - Perpetual System –Which inventory sold determined at time of sale Not end of year –Specific identification method - same results under both systems Actual goods sold determine COGS - same at end of year & at time of sale –FIFO method - same results First units bought determine COGS – same at end of year & at time of sale

Units Purchased:100units$105 Average Cost Per Unit$105/100=$1.05 Average Cost Method –You compute average cost after each purchase –COGS for 70 units sold on June 10 is $73.50 ($1.05/unit) –Unsold units – use $1.05 cost

45 Calculation Units Purchased:430units$ Average Cost Per Unit$551.50/430=$1.28

46 For June 30 sale of 210 units –Average cost - $1.28 / unit used –COGS – 210 units x $1.28 = $ –Ending Inventory – 220 units x $1.28 = $ Total COGS is $ ($ )

47 June 10 Sale 50units from June 650 x$1.10=$55 20units from June 120 x$1.00=$ Cost of Goods Sold :$75 LIFO –Use last units bought before sale:

48 June 10 Remaining Units 30units from June 130 x$1.00=$ Cost of Remaining Inventory :$30 Unsold units on June 10 are:

49 150units from June x$1.40=$210 60units from June x$1.30=$ Cost of Goods Sold :$288 COGS for June 30 sale: Total COGS is $363 ($75 + $288)

50 30units from June 130 x$1.00=$30 150units from June x$1.20=$180 40units from June 2940 x$1.30=$ Cost of Remaining Inventory :$262 Ending Inventory on June 30:

51 Inventory on Balance Sheet - Lower of cost or market. –Example of conservatism Market value of inventory –Current replacement cost or –Net realizable value Liquidation sales price less selling expenses

52 Comparison of cost to market done on –specific item level –major category level, or –total inventory level Compare –Cost FIFO, LIFO, Specific ID, or Average –Market Replacement Value or Net Realizable Value

53 Tax rules don’t permit all of methods described above –Examples Total inventory comparison not allowed Can’t use LIFO with lower of cost or market

54 What Happens When Your Physical Inventory is Wrong? –Remember this year’s ending inventory is next year’s beginning inventory Mistake affects two years –What if Physical Inventory is too Low? You forgot to count inventory in one warehouse

55 This YearNext Year Beg. Bal.$ XXX + Purch.+XXX Available$XXX -End. Inv.-Too Low  Beg. Bal.$ Too Low COGSToo High+ Purch.+ XXX =======Available$ Too Low ↓-End. Inv.XXX Net IncomeToo LowCOGS$ Too Low ======== ↓ Net IncomeToo High

56 Two effects in first year –Income Statement - Net Income is too low –Balance Sheet - Inventory is too low Second year –Income Statement – Net Income is too high –Effects on net income over two years offset each other out Retained Earnings is correct at end of second year

57 What if Physical Inventory is too High? You counted inventory in transit when you shouldn’t have You counted some inventory twice

58 This YearNext Year Beg. Bal.$ XXX + Purch.+XXX Available$XXX -End. Inv.-Too High  Beg. Bal.$ Too High COGSToo Low+ Purch.+ XXX =======Available$ Too High ↓-End. Inv.XXX Net IncomeToo HighCOGS$ Too High ======== ↓ Net IncomeToo Low

59 Two effects in first year –Income Statement - Net Income is too high –Balance Sheet - Inventory is too high Second year –Income Statement – Net Income is too low –Effects on net income over two years offset each other out Retained Earnings is correct at end of second year

60 Inventory very important –Company needs enough inventory to meet customer demands –Doesn’t want too much inventory Ties up resources, and Inventory can become obsolete Just-In-Time system used by many companies –Want inventory to arrive when needed. Dell has competitive advantage –Keeps relatively low inventory levels –Meets customer demands quickly

61 Financial Analysts use two ratios to look at inventory: –Inventory Turnover Ratio –Days in Inventory

62 Inventory Turnover Ratio –Indicates number of times, on average, inventory is sold during the period How many times Inventory Turnsover Cost of Goods Sold Average Inventory

63 Days In Inventory –Indicates average number of days between purchase and sale of inventory –How long does it take you to sell your inventory Inventory Turnover Ratio

64 My way to remember calculation: –Calculate how much inventory you sell in a day: Cost of Goods Sold –Divide one day’s sales into your average inventory level for the year: Average Inventory Inventory Sold in One Day –Mathematically the same as other approach