1. chapter 9 Inventory and Cost of Goods Sold An electronic presentation
by Douglas Cloud
Pepperdine University

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

3. Learning Objectives 4. Compute total inventory acquisition cost.
5. Use the four basic inventory valuation methods: specific identification, average cost, FIFO, and LIFO.
6. Explain how LIFO inventory layers are created, and describe the significance of the LIFO reserve.
Continued

4. Learning Objectives
7. Choose an inventory valuation method based on the trade-offs among income tax effects, bookkeeping costs, and the impact on the financial statements.
8. Apply the lower-of-cost-or-market (LCM) rule to reflect declines in the market value of inventory.
9. Use the gross profit method to estimate ending inventory.
Continued

5. Learning Objectives
10. Determine the financial statement impact of inventory recording errors.
11. Analyze inventory using financing ratios, and properly compare ratios of different firms after adjusting for differences in inventory valuation methods.
12. Account for the impact of changing prices on purchase commitments.
13. Record inventory purchase transactions denominated in foreign currencies.
EXPANDED MATERIAL

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

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

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,
1998
Inventory as a Percentage of Total Assets
2000
Source: Standard and Poor’s Compustat

10. Raw Materials are goods acquired for use in the production process.
Materials that are necessary in the production process but are not directly incorporated into the product are referred to as indirect materials.
Materials that are used directly in the production of goods are frequently referred to as direct materials.

11. Work in Process
Work in process consists of materials partly processed and requiring further work before they can be sold. This inventory includes three cost elements.
1. Direct materials
2. Direct labor
3. Manufacturing overhead

12. Finished Goods
Finished goods are the manufactured products awaiting sale.
Balance Sheet
Income Statement
Direct Labor
Raw Materials
Cost of Goods Sold
Work in Process
Finished Goods
Manufacturing Overhead

13. Summary Income Statement Items Balance Sheet Items Merchandise
Cost of Goods Sold
Sale
Retailer
Manufacturer
Raw Materials
Work in Process
Finished Goods
Cost of Goods Sold
Sale
Overhead
Direct
Labor 2

14. 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. 3

15. 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. 4

16. Inventory Systems Purchases of Inventory Periodic Method
Accounts Payable 3,000
Perpetual Method
Inventory 3,000
Accounts Payable 3,000

17. 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

18. 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. 9

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

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

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

22. 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. 10

23. Schedule of Cost of Goods Manufactured
Bartlett Corporation
Schedule of Cost of Goods Manufactured
For the Year Ended December 31, 2005
The heading.
Schedule of Cost of Goods Manufactured
Bartlett Corporation
For the Year Ended December 31, 2002

24. Schedule of Cost of Goods Manufactured
Bartlett Corporation
Schedule of Cost of Goods Manufactured
For the Year Ended December 31, 2005
Direct materials:
Raw materials $ 21,350
Purchases 107,500
Cost of raw materials available for use $128,850
Less raw materials inventory, Dec ,350
Raw materials used in production $106,500
Direct labor 96,850
Manufacturing overhead:
Continued

25. Schedule of Cost of Goods Manufactured
Manufacturing overhead:
Indirect labor $ 40,000
Factory supervision 29,000
Depr.—factory building and equipment 20,000
Light, heat, and power 18,000
Factory supplies 15,000
Miscellaneous manufacturing overhead 12, ,055
Total manufacturing costs $337,405
Add work in process inventory, January ,400
$366,805
Less work in process inventory, December ,500
Cost of goods manufactured $340,305

26. Cash Discounts Records inventory net of any purchase (cash) discounts.
Example:
June 1—purchased merchandise for $10,000
Terms of payment: 2/10, n/30
Assuming a perpetual inventory method, record the purchase of the inventory and payment on June 8. 11

27. Supplier “Loan” Period
Cash Discounts
$9,800 Owed
$10,000 Owed
10 Days
20 Days
Supplier “Loan” Period
Purchase Date
End of Discount Period
Final Payment Date

28. Cash Discounts—Net Method
June 1
Inventory 9,800
Accounts Payable 9,800
June 8
Accounts Payable 9,800
Cash 9,800 13

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

30. Cash Discounts—Net Method
June 28
Accounts Payable 9,800
Discounts Lost 200
Cash 10,000 14

31. Cash Discounts—Net Method
If the invoice has not been paid at the end of the period (assume June 30) and the discount period has lapsed, the following adjusting entry is made:
June 30
Discounts Lost 200
Accounts Payable 200

32. Cash Discounts—Gross Method
Record inventory at gross cost; discounts are recorded only if taken.
Example:
June 1—purchased inventory for $10,000.
Terms of payment: 2/10, n/30
Assuming a perpetual inventory method, record the purchase of the inventory and payment on June 8. 15

33. Cash Discounts—Gross Method
June 1
Inventory 10,000
Accounts Payable ,000
June 8
Accounts Payable 10,000
Inventory 200
Cash 9,800

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

35. Cash Discounts—Gross Method
June 28
Accounts Payable 10,000
Cash 10,000

36. Purchases Returns and Allowances
Periodic Inventory System
Accounts Payable 400
Purchase Returns and
Allowances 400
Perpetual Inventory System
Accounts Payable 400
Inventory 400

37. Inventory Valuation Methods
Cost Allocation Methods
FIFO
Average Cost
LIFO
Specific Identification 19

38. Inventory Valuation Methods
Assume:
Purchases:
January @ $10 $ 2,000
March @ $12 3,600
July @ $11 5,500
November @ $ ,300
Total purchases ,100 $12,400
Sales 700 @ $15 5

39. Frequency of Use of Inventory Valuation Methods
U. S. Companies
1979 and 2000
Inventory
Method All Companies All Companies Large Companies
FIFO 75.6% 75.9% 68.6%
LIFO 25.8% 15.7% 34.6%
Average cost 20.8% 21.4% 32.9%
Specific
Identification 3.7% 4.5% 3.9%
SOURCE: Standard and Poor’s COMPUSTAT

40. 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. 20

41. Specific Identification Method
Jan. 1
200 $10 per unit
Mar. 23
300 $12 per unit
July 15
500 $11 per unit
Nov. 6
100 $13 per unit
1,100 units
Sold 200 units from the January 1 and 500 from the July 15 purchase.

42. Specific Identification Method
Jan. 1
200 $10 per unit
July 15
500 $11 per unit
Sold 700

43. Specific Identification Method
Jan. 1
200 $10 per unit
= $2,000
= 5,500
July 15
500 $11 per unit
Total cost of goods sold $7,500

44. Specific Identification Method
Goods Not Sold
300 $12 per unit
Mar. 23
= $3,600
= 1,300
100 $13 per unit
Nov. 6
Ending inventory $4,900

45. 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. 22

46. Average Cost Method = $ 2,000 = 3,600 = 5,500 = 1,300 $12,400 Jan. 1
= $ 2,000
= 3,600
= 5,500
= 1,300
$12,400
Jan. 1
200 $10 per unit
Mar. 23
300 $12 per unit
July 15
500 $11 per unit
Nov. 6
100 $13 per unit
1,100 units
$12,400 1,100 units = $11.27 per unit (rounded)
Cost of goods sold = $11.27 x 700 = $7,890
Ending inventory = $11.27 x 400 = $4,510

47. 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. 21

48. First-in, First-out (FIFO) Method
Jan. 1
200 $10 per unit
= $2,000
Sold 200
Mar. 23
300 $12 per unit
July 15
500 $11 per unit
Nov. 6
100 $13 per unit

49. First-in, First-out (FIFO) Method
Jan. 1
200 $10 per unit
= $2,000
= 3,600
Sold 300
Mar. 23
300 $12 per unit
July 15
500 $11 per unit
Nov. 6
100 $13 per unit

50. First-in, First-out (FIFO) Method
Jan. 1
200 $10 per unit
= $2,000
= 3,600
Mar. 23
300 $12 per unit
= 2,200
Sold 200
July 15
500 $11 per unit
Nov. 6
100 $13 per unit
Total cost of goods sold $7,800

51. First-in, First-out (FIFO) Method
Goods Not Sold
300 $12 per unit
Mar. 23
= $3,600
= 1,300
100 $13 per unit
Nov. 6
Ending inventory $4,900

52. 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. 23

53. Last-in, First-out (LIFO) Method
Jan. 1
200 $10 per unit
Mar. 23
300 $12 per unit
July 15
500 $11 per unit
= $1,300
Sold 100
Nov. 6
100 $13 per unit

54. Last-in, First-out (LIFO) Method
Jan. 1
200 $10 per unit
Mar. 23
300 $12 per unit
July 15
500 $11 per unit
= $5,500
Sold 500
= $1,300
Nov. 6
100 $13 per unit

55. Last-in, First-out (LIFO) Method
Jan. 1
200 $10 per unit
= $1,200
Sold 100
Mar. 23
300 $12 per unit
July 15
500 $11 per unit
= $5,500
= $1,300
Nov. 6
100 $13 per unit
Total cost of goods sold $8,000

56. Last-in, First-out (LIFO) Method
Goods Not Sold
Jan. 1
200 $10 per unit
= $2,000
= 2,400
Mar. 23
200 $12 per unit
Ending inventory $4,400

57. Comparison of Inventory Methods (Periodic)
Cost of Goods Sold
Ending Inventory
Specific identification $7,500 $4,900
Average cost $7,890 $4,510
FIFO $7,800 $4,600
LIFO $8,000 $4,400

58. Perpetual Inventory Assume: Beginning inventory 100 @ $10 $1,000
Purchases:
April @ $11 880
April 20 $12 840
Sales:
April @ $15
April 27 $16

59. FIFO Method—Perpetual
FIFO periodic and FIFO perpetual provide identical results for cost of goods sold and inventory.

60. Average Cost Method—Perpetual
Apr. 1 Beginning Inventory 100 $10 $1,000
Apr. 10 Purchases 80 $
Apr. 10 Balance 180 $10.44 $1,880
Apr. 18 Sales (90) $ (940)
Apr. 18 Balance 90 $10.44 $ 940
Apr. 20 Purchases 70 $
Apr. 20 Balance 160 $ $1,780
$1,880  180
Apr. 27 Sales (50) $ (556)
Apr. 30 Balance 110 $ $1,224
$1,780  160
Ending inventory, $1,224

61. Cost of Goods Sold (140 units) $940 + $556 = $1,496
Average Cost Method—Perpetual
Apr. 18 Sales (90) $ (940)
Apr. 18 Balance 90 $10.44 $ 940
Apr. 20 Purchases 70 $
Apr. 20 Balance 160 $ $1,780
Apr. 1 Beginning Inventory 100 $10 $1,000
Apr. 10 Purchases 80 $
Apr. 10 Balance 180 $10.44 $1,880
Apr. 27 Sales (50) $ (556)
Apr. 30 Balance 110 $ $1,224
Cost of Goods Sold (140 units) $940 + $556 = $1,496

62. LIFO Method—Perpetual
Perpetual Inventory System
Beginning inventory
Apr. 1
90 $10 per unit
100 $10 per unit
Sold 10
Apr. 10
0 $11 per unit
80 $11 per unit
80 $11 per unit
Sold 80
Purchased 80
Apr. 20
70 $12 per unit
20 $12 per unit
Sold 50
Purchased 70

63. LIFO Method—Perpetual
Perpetual Inventory System
= $ 900
= 0 =
$1,140
Apr. 1
Apr. 10
Apr. 20
100 $10 per unit
90 $10 per unit
80 $11 per unit
70 $12 per unit
20 $12 per unit
0 $11 per unit
Ending inventory………………..
Beg. Inv. + Purchases – End. Inv. = Cost of Goods Sold
$1, $1,720 – $1,140 = $1,580

64. Size of LIFO Reserve for Selected U.S. Companies
Reported
LIFO LIFO
Company Name Inventory Reserve
General Motors $10,034 $1,814
Sears Roebuck 4,
Ford 6,
ExxonMobil 7,904 4,200
Deere & Co. 1,506 1,004
General Electric 8,

65. FIFO Advantages Advantages:
Usually corresponds with physical flow of goods.
Ending inventory balance agrees closely with current replacement cost. 38

66. FIFO Disadvantages Disadvantages:
Can cause older costs to be matched with current revenues.
Inventory holding gains and losses are included as part of gross profit.
Yields higher taxable income in times of inflation if inventory levels are stable or increasing. 39

67. LIFO Advantages Advantages:
Matches current costs with current revenues.
Excludes inventory holding gains from gross profit.
Yields lower taxable income in times of inflation if inventory levels are stable or increasing. 38

68. LIFO Disadvantages Disadvantages:
Usually does not correspond with the physical flow of goods.
Potential LIFO liquidation means old cost in LIFO layers can be drawn in to cost of goods sold.
Ending inventory balance can be much lower than current replacement cost.
LIFO liquidation can result in greatly increased tax payments when inventory levels decline. 39

69. The term “market” in lower of cost or market means replacement cost.

70. Lower of Cost or Market
Ceiling: Estimated selling price – normal selling costs
Ceiling: Also known as the net realizable value
Replacement Cost
Market
compare
Floor: Net realizable value – a normal profit margin
Historical Cost

71. Lower of Cost or Market Case A Ceiling: $0.80 $0.70 $0.70 $0.65
Floor: $0.55
Historical Cost
$0.65
LCM = $0.65

72. Lower of Cost or Market Case B Ceiling: $0.80 $0.60 $0.60 $0.65
Floor: $0.55
Historical Cost
$0.65
LCM = $0.60

73. Click on the button to skip LCM examples
Lower of Cost or Market
Ceiling: $0.80
Case C
$0.50
$0.55
Market
Floor: $0.55
Historical Cost
$0.65
Click on the button to skip LCM examples
LCM = $0.55

74. Lower of Cost or Market Case D Ceiling: $0.80 $0.45 $0.55 $0.50
Floor: $0.55
Historical Cost
$0.50
LCM = $0.50

75. Lower of Cost or Market Case E Ceiling: $0.80 $0.85 $0.80 $0.75
Floor: $0.55
Historical Cost
$0.75
LCM = $0.75

76. Lower of Cost or Market Case F Ceiling: $0.80 $1.00 $0.80 $0.90
Floor: $0.55
Historical Cost
$0.90
LCM = $0.80

77. Last year’s 40% is considered a good estimate.
Gross Profit Method
Beginning inventory, January 1 $25,000
Sales, January 1–January 31 50,000
Purchases, January 1–January 31 40,000
Historical gross profit percentage
Last year 40 %
Two years ago 37
Three years ago 42
Last year’s 40% is considered a good estimate.

78. Gross Profit Method Sales (actual) $50,000 100 %
Cost of goods sold (estimate) 30, %
Gross profit (estimate) $20, %
Beginning inventory (actual) $25,000
+ Purchases (actual) 40,000
– Cost of goods available for sale (actual) $65,000
– Ending inventory (estimate) 35,000
= Cost of goods sold (estimate) $30,000

79. Gross Profit Method Sales (actual) $50,000 100 %
Cost of goods sold (estimate) 31, %
Gross profit (estimate) $18, %
Beginning inventory (actual) $25,000
+ Purchases (actual) 40,000
– Cost of goods available for sale (actual) $65,000
– Ending inventory (estimate) 33,500
= Cost of goods sold (estimate) $31,500

80. Gross Profit Method Sales (actual) $50,000 100 %
Cost of goods sold (estimate) 29, %
Gross profit (estimate) $21, %
Beginning inventory (actual) $25,000
+ Purchases (actual) 40,000
– Cost of goods available for sale (actual) $65,000
– Ending inventory (estimate) 36,000
= Cost of goods sold (estimate) $29,000

81. 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 24

82. Determine the inventory turnover.
Cost of Goods Sold $1,000
Beginning Inventory $
Ending Inventory $ 110
Determine the inventory turnover. 25

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

84. Number of Days’ Sales in Inventory
$1,000
($90 + $110)/2
= 10
365 10
Number of days’ sales in inventory is 36.5

85. Number of Days’ Sales in Inventory
Company Sales in Inventory
IBM 31.4 days
Dell 5.7 days
General Motors 28.2 days
Ford 19.4 days
Nike 90.5 days
Reebok days
Wal-Mart 46.9 days
Kmart 74.6 days

86. chapter 9
The End