1. Inventory and Cost of Goods Sold
Chapter 06
Inventory and Cost of Goods Sold
This chapter is divided into 3 parts
Part A: Understanding Inventory and Cost of Goods Sold
Part B: Recording Inventory Transactions
Part C: Other Inventory Reporting Issues
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 1

2. Inventory
Includes items a company intends for sale to customers. For example, clothes at The Limited, shoes at Payless ShoeSource, building supplies at Home Depot, and so on.
Also includes items that are not yet finished products. For instance, lumber at a cabinet manufacturer, and rubber at a tire manufacturer are part of inventory because the firm will use them to make a finished product for sale to customers
We report inventory as a current asset in the balance sheet—an asset because it represents a valuable resource the company owns, and current because the company expects to convert it to cash in the near term. At the end of the period, the amount the company reports for inventory is the cost of inventory not yet sold.
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3. Understanding Inventory and Cost of Goods Sold
Part A
Understanding Inventory and Cost of Goods Sold
In preceding chapters, we dealt mostly with companies that provide a service. Many companies, though, earn revenues by selling inventory rather than a service. Cost of the inventory that was sold during the period is known as Cost of goods sold.
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4. Manufacturing company
LO1 Trace the flow of inventory costs from manufacturing companies to merchandising companies
Inventory
Merchandise company
Manufacturing company
Wholesaler
Retailer
Raw
material
Work in
progress
Finished
goods
Many companies, earn revenues by selling inventory rather than a service. These companies are either manufacturing or merchandising companies.
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5. LO2 Calculate cost of goods sold
Inventory represents the cost of inventory not sold, while cost of goods sold represents the cost of inventory sold.
Also referred to as cost of sales, cost of merchandise sold, or cost of products sold.
The costs of beginning inventory plus additional purchases make up the cost of goods (or inventory) available for sale.
Let’s think a little more about the relationship between ending inventory in the balance sheet and cost of goods sold in the income statement.
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6. Specific Identification Method
LO3 Determine the cost of goods sold and ending inventory using different inventory cost methods
Inventory cost method
Specific
Identification
First in,
first out
(FIFO)
Last in,
first out
(LIFO)
Average
Cost
Specific Identification Method
To this point, we’ve discussed the cost of inventory without considering how we determine that cost. We do that now by considering four methods for inventory costing:
Specific Identification
First-In, first-Out (FIFO)
Last-In, first-Out (LIFO)
Weighted-average cost.
The specific identification method is the method you might think of as the most logical. It matches or identifies each unit of inventory with its actual cost. As you might imagine, though, the specific identification method is practicable only for companies selling unique, expensive products. For example, an automobile has a unique serial number that we can match to an invoice identifying the actual purchase price. Fine jewelry and pieces of art are other possibilities. Specific identification works well in such cases. However, the specific identification method is practicable only for companies selling unique, expensive products.
Specific identification would be very difficult for such merchandisers. Although bar codes and RFID tags now make it possible to identify and track each unit of inventory, the costs of doing so outweigh the benefits for multiple, small inventory items. For that reason, the specific identification method is used primarily by companies with unique, expensive products with low sales volume.
For practical reasons, most companies use one of the other three inventory cost flow assumptions—FIFO, LIFO, or average cost—to determine cost of goods sold and inventory. Note the use of the word assumptions: Each of these three inventory cost methods assumes a particular pattern of inventory cost flows. However, the actual flow of inventory does not need to match the assumed cost flow in order for the company to use a particular method.
This method you might think of as the most logical.
It matches or identifies each unit of inventory with its actual cost.
Practicable only for companies selling unique, expensive products.
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7. Effects of Managers’ Choice of Inventory
LO4 Explain the financial statement effects and tax effects of inventory cost flow assumptions
Effects of Managers’ Choice of Inventory
Reporting Methods
Why Choose FIFO?
Matches physical flow
for most companies.
Results in higher assets
and net income when
inventory costs are rising.
Has a balance sheet
focus.
Why Choose LIFO?
Results in tax savings
when inventory costs are
rising.
Has an income statement
focus.
Companies are free to choose FIFO, LIFO, or average cost to report inventory and cost of goods sold. However, because inventory costs generally change over time, this means that the reported amounts for ending inventory and cost of goods sold will not be the same across inventory reporting methods. These differences could cause investors and creditors to make bad decisions if they are not aware of differences in inventory assumptions.
Most companies’ actual physical flow follows FIFO.
FIFO matches physical flow for most companies.
FIFO generally results in higher assets and net income when inventory costs are rising.
FIFO has a balance sheet focus.
If FIFO results in higher total assets and higher net income and produces amounts that most closely follow the actual flow of inventory, why would any company choose LIFO?
The primary benefit of choosing LIFO is tax savings.
LIFO has an income statement focus.
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8. Recording Inventory Transactions
Part B
Recording Inventory Transactions
To this point in the chapter, we have talked about purchases and sales of inventories and how to track their costs. But we haven’t discussed how to record inventory transactions. Companies record inventory transactions with either a perpetual inventory system or a periodic inventory system
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9. LO5 Record inventory transactions using a perpetual inventory system.
To see how to record inventory transactions using a perpetual inventory system, we will look again at the inventory transactions for Mario’s Game Shop.
Recall that from January 1 through December 31, Mario sold 800 games. Now let’s modify the example by giving exact dates for the sale of the 800 games—300 on July 17 and 500 on December 15. The exhibit shows the order of inventory transactions for Mario’s Game Shop, including the total cost of the inventory and the total revenue from the sale of the 800 games.
Using this information, let’s see how Mario would record purchases and sales of inventory
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10. LO6 Prepare a multiple-step income statement
For merchandising companies, Sales and purchases of inventory are most important set of transactions , companies report revenues and expenses from these separately from other revenues and expenses.
It makes easier for investors and other financial statement users to determine the profitability of a company’s inventory transactions.
Use the information for Incredible to calculate gross profit on the sale and purchase of inventory.
Mario sold 800 units during the year for $15 each (or $12,000 total). This amount is reported as net sales. From net sales, we subtract the cost of the 800 ($8,046) units sold. The difference between net sales of inventory and the cost of that inventory is the company’s gross profit. Mario’s gross profit is $3,954.
After gross profit, we see that the next item reported is selling, general, and administrative expenses, often referred to as operating expenses. We discussed several types of operating expenses in earlier chapters—wages, utilities, advertising, supplies, rent, insurance, and bad debts. These costs are normal for operating most companies. Gross profit reduced by these operating expenses is referred to as operating income (or sometimes referred to as income from operations ).
After operating income, a company reports nonoperating revenues and expenses . Nonoperating revenues and expenses arise from activities that are not part of the company’s primary operations. Interest revenue and interest expense are examples. (In Chapter 7 we will discuss another common nonoperating item—gains and losses on the sale of long-term assets.) Investors focus less on nonoperating items than on income from operations, as these nonoperating activities often do not have long-term implications on the company’s profitability.
Combining operating income with nonoperating revenues and expenses yields income before income taxes . For Mario’s Game Shop the amount of nonoperating expenses exceeds the amount of nonoperating revenues, so income before income taxes is lower than operating income.
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11. LOWER-OF-COST-OR-MARKET METHOD
Part C
LOWER-OF-COST-OR-MARKET METHOD
What happens if the value of inventory falls below its original cost before a company can sell it? For example, think about the store where you usually buy your clothes. You’ve probably noticed the store selling leftover inventory at deeply discounted prices after the end of each selling season to make room for the next season’s clothing line. The value of the company’s old clothing inventory has likely fallen below its original cost. Is it appropriate to report the reduced-value inventory at its original cost?
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12. LO7 Apply the lower-of-cost-or-market method for inventories
When the value of inventory falls below its cost, companies are required to report inventory at the lower market value. And it is considered to be the replacement cost.
Once it has determined both the cost and market value of inventory, the company reports ending inventory in the balance sheet at the lower of the two amounts.
In other words, what is the cost to replace the inventory item in its identical form? The cost of inventory is the amount initially recorded in the accounting records based on methods we discussed in the previous section (specific identification, FIFO, LIFO, or weighted-average cost). Once it has determined both the cost and market value of inventory, the company reports ending inventory in the balance sheet at the lower of the two amounts. This is known as the lower-of-cost-or-market (LCM) method to valuing inventory.
To see how we apply the lower-of-cost-or-market method to inventory amounts, assume Mario’s Game Shop sells FunStation 2 and FunStation 3.
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13. Inventory turnover ratio
LO8 Analyze management of inventory using the inventory turnover ratio and gross profit ratio
If managers purchase too much inventory, the company runs the risk of the inventory becoming obsolete and market value falling below cost.
Analysts as well as managers often use the inventory turnover ratio to evaluate a company’s effectiveness in managing its investment in inventory.
Investors often rely on the gross profit ratio to determine the core profitability of a company’s operations.
Inventory turnover ratio shows the number of times the firm sells its average inventory balance during a reporting period.
Inventory turnover ratio shows the number of times the firm sells its average inventory balance during a reporting period. The more frequently a business is able to sell or “turn over” its average inventory balance, the less the company needs to invest in inventory for a given level of sales. Other things equal, a higher ratio indicates greater effectiveness of a company in managing its investment in inventory.
Inventory turnover ratio =
Cost of goods sold
Average inventory
Average days in inventory indicates the approximate number of days the average inventory is held.
Average days in inventory =
365
Inventory turnover ratio
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14. LO9 Record inventory transactions using a periodic inventory system.
Recall that under a perpetual inventory system we maintain a continual—or perpetual —record of inventory purchased and sold. In contrast, using a periodic inventory system we do not continually modify inventory amounts. Instead, we periodically adjust for purchases and sales of inventory at the end of the reporting period, based on a physical count of inventory on hand.
To demonstrate the differences in these two systems, record inventory transactions under the periodic system using the same information that we used to demonstrate the perpetual inventory system.
To make the distinction between the perpetual system and periodic system easier, look at the side-by-side comparisons provided in the text.
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15. LO10 Determine the financial statement effects of inventory errors
Errors can unknowingly occur in inventory amounts if there are mistakes in a physical count of inventory or in the pricing of inventory quantities.
The formula for cost of goods sold, follows
Notice that an error in calculating ending inventory (an asset in the balance sheet) causes an error in calculating cost of goods sold (an expense in the income statement). If cost of goods sold is misstated, gross profit will be misstated as well, but in the opposite direction. This is true because gross profit equals sales minus cost of goods sold.
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16. End of chapter 06
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