Inventories & COGS

Inventory Definition: Inventory is defined as goods held for sale in the normal course of business or items used in the manufacture of products that will be sold in the normal course of business.

Inventory Inventory is recorded on the balance sheet at the lower of the cost or the market value of the inventory. The cost of inventory includes all costs necessary to bring the inventory to a saleable condition.

The “ins” of inventory The “outs” of inventory accounting accounting Acquisition costs Cost of goods sold Cost of goods available for sale Beginning inventory Ending inventory B Inv+ Purchases = COGAS = COGS + E Inv The “Ins” and “Outs” of Inventory Accounting

Keeping track of inventory quantities: Perpetual vs. Periodic Inventory Systems Perpetual system: tracks units sold directly more accurate, more timely, potentially more costly Periodic system: infer quantities sold by using purchases/production, beginning and ending inventories. Units sold = Beg. Units + Production –End. Units harder to detect inventory “shrinkage” (e.g., theft, spoilage) as well as management fraud

COSTING METHODS: Once the unit cost of inventory is determined via the preceding rules of logic, specific costing methods must be adopted. In other words, each unit of inventory will not have the exact same cost, and an assumption must be implemented to maintain a systematic approach to assigning costs to units on hand (and to units sold) At the end of the accounting period, The accounting question you must consider is: what is the cost of the ending inventory?

COSTING METHODS: A company must adopt an inventory valuation method (and that method must be applied consistently from year to year). The methods from which to choose are varied, generally consisting of one of the following: First-in, first-out (FIFO) Last-in, first-out (LIFO) Weighted-average Each of these methods entail certain cost-flow assumptions. Importantly, the assumptions bear no relation to the physical flow of goods; they are merely used to assign costs to inventory units.

FIRST-IN, FIRST-OUT CALCULATIONS CALCULATIONS: With first-in, first-out, the oldest cost (i.e., the first in) is matched against revenue and assigned to cost of goods sold. Conversely, the most recent purchases are assigned to units in ending inventory.

LAST-IN, FIRST-OUT CALCULATIONS CALCULATIONS: Last-in, first-out is just the reverse of FIFO; recent costs are assigned to goods sold while the oldest costs remain in inventory.

WEIGHTED AVERAGE CALCULATIONS CALCULATIONS: The weighted-average method relies on average unit cost to calculate cost of units sold and ending inventory. Average cost is determined by dividing total cost of goods available for sale by total units available for sale.

Example Beginning inventory balance that consisted of 4,000 units with a cost of $12 per unit. 5,000 units on hand at the end of the year.

FIFO Ending inventory and cost of goods sold calculations are as follows- Beginning inventory 4,000 X $12 = $48,000 +Net purchases = (6,000 X $16) = $96,000 (8,000 X $17) = $136,000 Total = $232,000 Cost of goods available for sale total $280,000. Cost of goods sold 4,000 X $12 = $48,000 6,000 X $16 = $96,000 Total =$195,000 3,000 X $17 = $51,000 Total =$195,000 Ending inventory = $85,000 5,000 X $17 = $85,000

LIFO Ending inventory and cost of goods sold calculations are as follows- Beginning inventory 4,000 X $12 = $48,000 +Net purchases = (6,000 X $16) = $96,000 (8,000 X $17) = $136,000 Total = $232,000 Cost of goods available for sale total $280,000. Cost of goods sold 8,000 X $17 = $136,000 5,000 X $16 = $80,000 Total = $216,000 Ending inventory 4,000 X $12 = $48,000 = $64,000 1,000 X $16 = $16,000= $64,000

Cost of goods available for sale$280,000 Divided by units (4, , ,000)18,000 Average unit cost (note: do not round) $ per unit Ending inventory (5,000 $ ) $77,778 Cost of goods sold (13,000 $ ) $202,222 WEIGHTED AVERAGE

COMPARING INVENTORY METHODS The following table reveals that the amount of gross profit and ending inventory numbers appear quite different, depending on the inventory method selected:

Advantages Of FIFO Method Easy to apply The assumed flow of costs often corresponds with the normal physical flow of goods. No manipulation of income is possible. The balance sheet amount for inventory is likely to approximate the current market value.

Disadvantages Of FIFO Method Recognizes “paper” profits. Tax burden is heavier if used for tax purposes.

Advantages Of LIFO Method Reports both sales revenue and cost of goods sold in current dollars. Lower income taxes result if used for tax purposes when price is rising.

Disadvantages Of LIFO Method Matches the cost of not goods sold against revenues. Grossly understates inventory. Permits income manipulation

Weighted Average Method Advantages: Due to the averaging process, the effects of year-end buying or not buying are lessened. Disadvantages: Manipulation of income possible.

Net Realizable and Lower-of-cost-or- market method Net Realizable Value: Estimated selling price less the estimated costs preparing the item for sale. LCM- method that values inventory at the lower of its historical cost or its current market costs.

Beginning Inventory and Purchases UnitsUnit CostSalesUnits Beginning Inventory 6250$3.00February 035,250 March $3.12May May $3.30September August $3.48October November $3.72 Totals30,000Totals25,000 Another Example: Compute Ending Inventory using FIFO, LIFO and Weighted Average Method. Compute Ending Inventory using FIFO, LIFO and Weighted Average Method.

Beginning Inventory and PurchasesUnitsUnit Cost Total Cost Beginning Inventory6250$3.00$18,750 March $3.12$15,600 May $3.30$28,875 August $3.48$21,750 November $3.72$13,950 Totals30,000$98,925 Solution: Weighted Average Method Weighted Average Cost = $96,925/30,000 = $ Ending Inventory Cost = 5,000×$ = $16,488.

Beginning Inventory and Purchases UnitsUnit Cost Beginning Inventory 9$3.00 Feb-2312$3.50 Apr-2030$3.80 May-0440$4.00 November-309$5.00 Totals100 Example-Please Try Calculate ending inventory costs under FIFO, LIFO and Weighted Average Method. Ending Inventory 20 units.