COPYRIGHT © 2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. 1 Chapter 7 Inventory Albrecht, Stice, Stice, Swain

2 Types of Inventory Raw materials –Materials purchased for use in manufacturing process. Work in process –Partially completed units in production. Finished goods –Manufactured products ready for sale. Cost of goods sold –Costs incurred to purchase or manufacture the merchandise sold during the period.

3 Costs Included in Inventory What costs are included in inventory? –Raw materials –Labor costs –Manufacturing overhead The indirect manufacturing costs associated with producing inventory. –Freight in costs

4 Perpetual vs. Periodic Systems Perpetual inventory system –Detailed records of the number of units and the cost of each purchase and sale are prepared THROUGHOUT the period. Periodic inventory system –System of accounting where cost of goods sold is determined and inventory is adjusted at the END of the accounting period, not when merchandise is purchased or sold.

5 Perpetual vs. Periodic Method Inventory is purchased: Inventory500 Accounts Payable 500 Transportation costs: Inventory 10 Cash 10 Purchase returns: Accounts Payable 50 Inventory 50 Purchase discounts: Account Payable450 Inventory 9 Cash 441 Inventory is purchased: Purchases500 Accounts Payable 500 Transportation costs: Freight In 10 Cash 10 Purchase returns: Accounts Payable 50 Purchase Returns 50 Purchase discounts: Accounts Payable450 Purchase Discounts 9 Cash 441

6 Perpetual vs. Periodic Method When inventory is sold: Accounts Receivable 50 Sales 50 Cost of Goods Sold 30 Inventory 30 Closing Entry: None When inventory is sold: Accounts Receivable 50 Sales 50 No inventory entry at time of sale Closing Entries: Inventory451 Purchase Returns 50 Purchase Discounts 9 Freight In 10 Purchases 500 Cost of Goods Sold 30 Inventory 30

7 Inventory Counts Inventory counts –Necessary under both the periodic and the perpetual method. –With a periodic system, a physical count is the only way to get the information necessary to compute cost of goods sold. –Under perpetual method, physical counts allow companies to determine inventory shrinkage. Shrinkage equals the difference between what ending inventory should be what the count reveals it is.

8 Cost of Goods Sold Computations Periodic Method Beginning Inventory + Net Purchases = Cost of Goods Available for Sale – Ending Inventory = Cost of Good Sold Perpetual Method Ending Inventory (from inventory system) – Ending Inventory (from inventory count) = Inventory Shrinkage + Cost of Goods Sold (from inventory system) = Total Cost of Goods Sold

9 Inventory Cost Flow Assumptions FIFO (first in, first out) –Oldest units sold first. LIFO (last in, first out) –Newest units sold first. Average Cost –Average cost per unit is calculated by taking the average cost of goods available for sale. Specific Identification –Each item is specifically identified. –Usually used for large or expensive items (cars).

Inventory Costing Methods

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7-2 - Example Exercise 7-1 The three identical units of Item QBM are purchased during February, as shown below. Feb. 8Purchase1$ 45 15Purchase148 26Purchase Item QBMUnits Cost Assume that one unit is sold on February 27 for $70. Determine the gross profit for February and ending inventory on February 28 using (a) first-in, first-out (FIFO); (b) last-in, first-out (LIFO); and (c) average cost methods. Total3$144 Average cost per unit$48 ($144 ÷ 3 units)

Follow My Example Gross ProfitEnding Inventory (a)First-in, first-out (FIFO):$25 ($70 – $45)$99 ($48 – $51) (b)Last-in, first-out (LIFO):$19 ($70 – $51)$93 ($45 + $48) (c)Average cost:$22 ($70 – $48)$96 ($48 x 2) $144/3 units

16 Inventory Cost Flow Rice King buys and sells rice and had the following transactions for the year: June 10 Purchased 10 tons at $6 per ton. July 28 Purchased 10 tons at $9 per ton. October 10 Sold 10 tons at $11 per ton. How much did Rice King make during the year? FIFO LIFOAvg. Cost SoldSoldSold Old RiceNew RiceMixed Rice Sales ($11 x 10 tons)$110$110$110 COGS (10 tons) Gross margin$ 50 $ 20 $ 35

17 LIFO vs. FIFO FIFO gives a better measure of inventory on the balance sheet. Therefore, FIFO is a better measure of inventory value. LIFO gives a better reflection of COGS on the income statement. Therefore, LIFO is a better measure of net income.

18 Managing Inventory It’s a balance! Avoid tying up resources in inventory. Vs. Maintaining sufficient inventory for smooth business operations.

19 Measuring the Management of Inventory Inventory Turnover –How many times during the year a company sells all of its inventory. Cost of Goods Sold Average Inventory

20 Measuring the Management of Inventory Number of Days’ Sales in Inventory –How many days worth of sales the company has in inventory. 365 Inventory Turnover Calculated as cost of goods sold divided by average inventory. (Shown in previous slide).

21 Managing the Operating Cycle Number of Days’ Purchases in Accounts Payable –How many days worth of inventory the company has in accounts payable. 365 Purchases / Average Account Payable Days’ Purchases in Accounts Payable External Financing Days’ Sales in Inventory Average Collection Period 30 Days80 Days 38 Days72 Days

22 Perpetual LIFO and Average Cost Complications arise because the “last in” and average cost change with every new purchase. –The cost of goods sold for each sale needs to be recomputed after a new purchase is made. –This means a lot more work. These complications do not occur with FIFO because the “first in” will always be the same.

23 Net Realizable Value –Selling price less selling costs. –Used to value inventory when it is damaged, used, or obsolete. When inventory needs to be written down: Loss on Write-down of Inventory Inventory To write down of inventory to its net realizable value.

24 Lower of Cost or Market Lower of cost or market –A basis for valuing inventory at the lower of original cost or current market value. Determining market value –Ceiling Maximum amount (net realizable value). –Replacement Cost What inventory could currently be purchased for. –Floor Minimum amount (net realizable value minus a normal profit). Market value is the middle of these three values.

25 Example: LCM Market Inventory ReplacementNRV Item Cost Floor Cost Ceiling A B C D Define market value as: Replacement cost, if it falls between the ceiling and the floor.,The floor, if the replacement cost is less than the floor.,The ceiling, if the replacement cost is higher than the ceiling. When replacement cost, ceiling, and floor are compared, market is always the middle value. Compare the defined market value with the original cost and choose the lower amount.

26 Using LCM LCM can be applied in three ways. –By computing cost and market figures for each item of inventory and using the lower of the two figures in EACH case. –By computing cost and market figures for the total inventory and then applying the LCM rule to that TOTAL. –By applying the LCM rule to categories of inventory.

27 Gross Margin Method –Used when a physical count of inventory is impossible or impractical. –Cost of goods sold and ending inventory are estimated using available information: Beginning inventory. Purchases. Historical gross margin percentage.

28 Gross Margin Method Example Orem Industries has net sales for January 1 to March 31 of $100,000 and net purchases of $65,000. Inventory on January 1 was $15,000 and the company has a historic gross profit percentage of 40%. Dollars % of sales Net sales revenue$100,000100% Cost of goods sold: Beginning inventory$15,000 Purchases 65,000 Total available for sale$80,000 Ending Inventory (3) 20,000 Cost of goods sold (2) 60,000 60% Gross margin (1)$ 40,000 40% (1)$100,000 X.40(2) $100,000 - $40,000 (3) $80,000 - $40,000