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. Merchandising Companies
Wholesalers resell inventory to retail companies or to professional users.
Retailers purchase inventory from manufacturers or wholesalers and then sell this inventory to end users.
Merchandising companies purchase inventories that are primarily in finished form for resale to customers
Merchandising companies purchase inventories that are primarily in finished form for resale to customers.
These companies may assemble, sort, repackage, redistribute, store, refrigerate, deliver, or install the inventory, but they don’t manufacture it. They simply serve as intermediaries in the process of moving inventory from the manufacturer, the company that actually makes the inventory, to the end user.
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6. Manufacturing Companies
These companies manufacture the inventories they sell, rather than buying them in finished form from suppliers.
Manufacturers classify inventory into three categories:
Raw materials inventory: Includes the cost of components that will become part of the finished product but have not yet been used in production.
Work-in-process inventory: Refers to the products that have started the production process but are not yet complete at the end of the period.
Finished goods inventory: It includes the cost of the units that have been completed by the end of the period but not yet sold.
Raw materials inventory includes the cost of components that will become part of the finished product but have not yet been used in production. (Raw materials sometimes are called direct materials. )
Work-in-process inventory refers to the products that have started the production process but are not yet complete at the end of the period.
Finished goods includes the cost of the units that have been completed by the end of the period but not yet sold.
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7. Types of Companies and Flow of Inventory Costs
In the slide we see the flow of inventory costs for the three types of companies.
Inventory’s journey begins when manufacturing companies purchase raw materials, hire workers, and incur manufacturing overhead during production. Once the products are finished, manufacturers normally pass inventories to merchandising companies, whether wholesalers or retailers. Merchandising companies then sell inventories to you, the end user. In some cases, manufacturers may sell directly to end users.
Some companies provide both services and inventories to customers.
In this chapter, we focus on merchandising companies, both wholesalers and retailers. Still, most of the accounting principles and procedures discussed here also apply to manufacturing companies. We don’t attempt to address all the unique problems of accumulating the direct costs of raw materials and labor and allocating manufacturing overhead. We leave those details for managerial and cost
accounting courses. Instead, we focus on the financial reporting implications of inventory cost flows.
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8. 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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9. Relationship between Inventory and Cost of Goods Sold
The costs of beginning inventory plus the additional purchases during the year make up the cost of inventory (cost of goods) available for sale.
Remember that inventory represents the cost of inventory not sold, while cost of goods sold represents the cost of inventory sold. Thus, we can see that the amount reported for inventory turns into the amount reported for cost of goods sold once the inventory is sold.
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10. Specific Identification Method
LO3 Determine the cost of goods sold and ending inventory using different inventory cost methods
Inventory cost method
Average
Cost
Specific
Identification
First in,
first out
(FIFO)
Last in,
first out
(LIFO)
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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11. Inventory Transactions for Mario’s Game Shop
It has 100 units of inventory at the beginning of the year and then makes two purchases during the year—one on April 25 and one on October 19.
There are 1,000 game cartridges available for sale.
During the year, it sells 800 video game cartridges for $15 each. This means that 200 cartridges remain in ending inventory at the end of the year.
Mario’s has 100 units of inventory at the beginning of the year and then makes two purchases during the year—one on April 25 and one on October 19. (Note the different unit costs at the time of each purchase.) There are 1,000 game cartridges available for sale. During the year, Mario’s sells 800 video game cartridges for $15 each. This means that 200 cartridges remain in ending inventory at the end of the year. But which 200? Do they include some of the $7 units from beginning inventory? Are they 200 of the $9 units from the April 25 purchase? Or, do they include some $11 units from the October 19 purchase? We consider these questions in next slides.
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12. First-In, First-Out (FIFO)
First units purchased are the first ones sold. Beginning inventory sells first, followed by the inventory from the first purchase during the year, followed by the inventory from the second purchase during the year, and so on.
Mario’s Game Shop, which 800 units were sold?
They were the first 800 units purchased, and that all other units remain in ending inventory.
We assume that all units from beginning inventory (100 units) and the April 25 purchase (300 units) were sold. For the final 400 units sold, we split the October 19 purchase of 600 units into two groups—400 units assumed sold and 200 units assumed not sold. We calculate cost of goods sold as the units of inventory assumed sold times their respective unit costs. [That is: (100 × $7) + (300 × $9) + (400 × $11) in our example.] Similarly, ending inventory equals the units assumed not sold times their respective unit costs (200 × $11 in our example).
The amount of cost of goods sold Mario reports in the income statement will be $7,800 . The amount of ending inventory in the balance sheet will be $2,200.
You may have realized that we don’t actually need to directly calculate both cost of goods sold and inventory. Once we calculate one, the other is apparent. Because the two amounts always add up to the cost of goods available for sale ($10,000 in our example), knowing either amount allows us to subtract to find the other:
Realize, too, that the amounts reported for ending inventory and cost of goods sold do not represent the actual cost of inventory sold and not sold.
Companies are allowed to report inventory costs by assuming which units of inventory are sold and not sold, even if this does not match the actual flow.
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13. Last-In, First-Out (LIFO)
Last units purchased are the first ones sold.
If Mario sold 800 units, we assume all the 600 units purchased on October 19 (the last purchase) were sold, along with 200 units from the April 25 purchase. That leaves 100 of the units from the April 25 purchase and all 100 units from beginning inventory assumed to remain in ending inventory.
Using the last-in, first-out (LIFO) method , we assume that the last units purchased (the last in) are the first ones sold (the first out).
If Mario sold 800 units, we assume all the 600 units purchased on October 19 (the last purchase) were sold, along with 200 units from the April 25 purchase. That leaves 100 of the units from the April 25 purchase and all 100 units from beginning inventory assumed to remain in ending inventory (not sold).
Our calculations of cost of goods sold and ending inventory for the LIFO method are shown in the slide.
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14. Weighted-Average Cost
Both cost of goods sold and ending inventory consist of a random mixture of all the goods available for sale.
Each unit of inventory has a cost equal to the weighted-average cost of all inventory items.
Notice that the weighted-average cost of each game cartridge is $10, even though none of the game cartridges actually cost $10. However, on average, all the game cartridges cost $10, and this is the amount we use to calculate cost of goods sold and ending inventory under the weighted-average cost method.
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15. Comparison of Cost of Goods Sold Under the Three Inventory Cost Flow Assumptions
A company begins the year with one unit, purchases three units and sells two units.
FIFO: Inventory is sold in the order purchased.
LIFO: Inventory is sold in the opposite order that we purchased it.
Weighted-average cost: Inventory is sold using an average of all inventory purchased.
A company purchases three units of inventory and sells two.
Using FIFO, we assume inventory is sold in the order purchased; that is, the first purchase is sold first and the second purchase is sold second.
Using LIFO, we assume inventory is sold in the opposite order that we purchased it. The last unit purchased is sold first and the second-to-last unit purchased is sold second.
Using Weighted-average cost, we assume inventory is sold using an average of all inventory purchased.
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16. 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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17. Comparison of Inventory Cost Flow Assumptions When Prices Are Rising
A comparison of FIFO, LIFO, and average cost for Mario’s Game Shop is provided below.
When inventory costs are rising, Mario’s Game Shop will report both higher inventory in the balance sheet and higher gross profit in the income statement if it chooses FIFO. The reason is that FIFO assumes the lower costs of the earlier purchases become cost of goods sold first, leaving the higher costs of the later purchases in ending inventory. Under the same assumption (rising inventory costs), LIFO will produce the opposite effect: LIFO will report both the lowest inventory and the lowest gross profit. The weighted-average cost method typically produces amounts that fall between the FIFO and LIFO amounts for both cost of goods sold and ending inventory.
Accountants often call FIFO the balance-sheet approach: The amount it reports for ending inventory (which appears in the balance sheet ) better approximates the current cost of inventory,. The ending inventory amount reported under LIFO, in contrast, generally includes “old” inventory costs that do not realistically represent the cost of today’s inventory.
Accountants often call LIFO the income-statement approach: The amount it reports for cost of goods sold (which appears in the income statement ) more realistically matches the current costs of inventory needed to produce current revenues. Recall that LIFO assumes the last purchases are sold first, reporting the most recent inventory cost in cost of goods sold. However, also note that the most recent cost is not the same as the actual cost. FIFO better approximates actual cost of goods sold for most companies, since most companies’ actual physical flow follows FIFO.
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18. Reporting the LIFO Difference
Choice between FIFO and LIFO results in different amounts for ending inventory and cost of goods sold.
It complicates the investment decisions of stockholders.
Due to financial statement effects of different inventory methods, companies that choose LIFO must report what’s called their LIFO difference.
LIFO difference is the additional amount of inventory a company would report if it used FIFO instead of LIFO.
Companies that have been using LIFO for a long time or that have seen dramatic increases in inventory costs, the LIFO difference can be substantial.
LIFO difference reported by Rite Aid Corporation which uses LIFO to account for most of its inventory follows.
If Rite Aid had used FIFO instead of LIFO, reported inventory amounts would have been $746 million greater and $563 million greater in 2009 and 2008, respectively. The magnitude of these effects can have a significant influence on investors’ decisions.
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19. 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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20. Perpetual inventory system and Periodic inventory system
It maintains a continual—that is,
perpetual—tracking of inventory.
A continual tracking helps
a company to better
manage its inventory
levels.
Periodic Inventory
It does not continually
modify inventory amounts,
but instead periodically
adjusts for purchases and
sales of inventory at the
end of the reporting period
based on a physical count
of inventory on hand.
As a practical matter, most companies with the help of scanners and bar codes keep track of their inventory units using a perpetual system but report inventory in the balance sheet and cost of goods sold in the income statement using a periodic system.
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21. 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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22. Inventory Purchases
To record the purchase of new inventory, we debit inventory (an asset) to show that the company’s balance of this asset account has increased. At the same time, if the purchase was paid in cash, we credit cash. Or more likely, if the company made the purchase on account, we credit accounts payable, increasing total liabilities. Thus, Mario records the first purchase of 300 units for $2,700 on April 25 as:
To record the purchase of new inventory, we debit inventory (an asset) to show that the company’s balance of this asset account has increased. At the same time, if the purchase was paid in cash, we credit cash. Or more likely, if the company made the purchase on account, we credit accounts payable, increasing total liabilities.
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23. Inventory Sales
On July 17, Mario sold 300 units of inventory on account for $15 each, resulting in total sales of $4,500. We make two entries to record the sale:
The first entry shows an increase to the asset account (in this case, Accounts Receivable) and an increase in sales revenue.
The second entry adjusts the Inventory and Cost of Goods Sold accounts.
We make two entries to record the sale:
The first entry shows an increase to the asset account (in this case, Accounts Receivable) and an increase in sales revenue.
The second entry adjusts the Inventory and Cost of Goods Sold accounts.
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24. Other inventory transactions
On October 19, Mario purchased 600 additional units of inventory for $6,600 on account.
On December 15, Mario sold another 500 units for $15 each, on account. Again, we make two entries to record the sale:
The first increases Accounts Receivable and Sales Revenue ($7,500 = 500 units x $15 ). The second adjusts the Cost of Goods Sold and Inventory accounts ($5,300 = [100 units x $9] + [400 units x $11] ).
After recording all purchases and sales of inventory for the year, we can determine the ending balance of inventory by examining the postings to the ledger account. Thus, Mario’s ending inventory is $2,200, as shown in the inventory ledger account.
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25. Simple Adjustment from FIFO to LIFO.
Mario’s ending balance of inventory using FIFO is $2,200. Under LIFO, it is only $1,600. As a result, if Mario wants to adjust its FIFO inventory records to LIFO for preparing financial statements, it needs to adjust inventory downward by $600 (decreasing the balance in ending inventory from $2,200 to $1,600).
In practice, virtually all companies maintain their own inventory records using the FIFO assumption, because that’s how they typically sell their actual inventory. However, as discussed earlier, for preparing financial statements, many companies choose to report their inventory using the LIFO assumption. So, how does a company adjust its own inventory records maintained on a FIFO basis to LIFO basis for preparing financial statements? The adjustment is referred to as the LIFO adjustment , and you’ll see that this involves a very simple adjustment.
In rare situations where the LIFO ending inventory balance is greater than the FIFO inventory balance (such as when inventory costs are declining), the entry for the LIFO adjustment would be reverse
The inventory ledger account for Mario’s Game Shop after the LIFO adjustment. Notice that the balance of inventory has decreased to reflect the amount reported under the LIFO method.
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26. Additional Inventory Transactions – Freight Charges
Mario pays $300 for freight charges associated with the purchase of inventory on April 25
Freight Charges: A significant cost associated with inventory for most merchandising companies includes freight (also called shipping) charges. This includes the cost of shipments of inventory from suppliers, as well as the cost of shipments to customers.
When goods are shipped, they are shipped with terms FOB shipping point or FOB destination. FOB stands for “free on board” and indicates when title (ownership) passes from the seller to the buyer.
FOB shipping point means title passes when the seller ships the inventory , not when the buyer receives it. The fact that a buyer does not have actual physical possession of the inventory does not prevent
transfer of title to the buyer’s inventory. In contrast, if the seller ships the inventory
FOB destination, then title does not transfer to the buyer when the inventory is shipped. The buyer would not record the purchase transaction until the shipped inventory reached its destination, the buyer’s location.
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27. Additional Inventory Transactions – Purchase Discounts.
Mario on April 30, pays for the units purchased on April 25, less a 2% purchase discount.
Purchase Discounts: Discounts received for prompt payment of within a certain period is known as Purchase discounts.
Purchase discounts allow buyers to trim a portion of the cost of the purchase in exchange for payment within a certain period of time.
Buyers are not required to take purchase discounts, but many find it advantageous to do so.
Purchase discounts allow buyers to trim a portion of the cost of the purchase in exchange for payment within a certain period of time. Buyers are not required to take purchase discounts, but many find it advantageous to do so.
Just as freight charges add to the cost of inventory and therefore increase the cost of goods sold once those items are sold, purchase discounts subtract from the cost of inventory and therefore reduce cost of goods sold once those items are sold.
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28. Additional Inventory Transactions – Purchase Returns.
Mario decides on October 22 to return 50 defective units from the 600 units purchased on October 19 for $11 each
Purchase Returns. Occasionally, a company will find inventory items to be unacceptable for some reason—perhaps they are damaged or are different from what was ordered. In those cases, the company returns the items to the supplier and records the purchase return as a reduction in both Inventory and Accounts Payable.
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29. 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 Mario's Game Shop 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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30. 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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31. 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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32. Calculating the Lower of Cost or Market
The write-down of inventory has the effect not only of reducing total assets, but also of reducing net income and retained earnings.
FunStation 3 inventory, on the other hand, remains on the books at its original cost of $8,000 (= $400 x 20), since cost is less than market value. Mario’s doesn’t need to make any adjustment for these inventory items.
After adjusting inventory to the lower-of-cost-or-market, the store calculates its ending inventory balance.
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33. 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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34. Analyze the inventory of Best Buy and Radio Shack Corporation
We can analyze the inventory of Best Buy and Radio Shack Corporation by calculating these ratios for both companies.
Best Buy sells a large volume of commonly purchased products.
Radio Shack sells a variety of high-end specialty products, including electronics, toys and other home and personal care products that typically are not carried by most other retailers.
Below are relevant amounts for each company.
Best Buy sells a large volume of commonly purchased products. In contrast, Radio Shack sells more distinct electronic items.
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35. Computation of the Inventory Turnover Ratio
The turnover ratio is more than twice as high for Best Buy. On average, it takes Radio Shack an additional 56 days to sell its inventory. If the two companies had the same business strategies, this would be strong evidence that Best Buy has superior management of inventory. In this case, though, the difference in inventory turnover more likely is related to the type of products the two stores sell. Specialty items are not expected to sell as quickly. As we see in the next section, Radio Shack offsets its relatively low inventory turnover with a relatively high profit margin.
The turnover ratio is more than twice as high for Best Buy. On average, it takes Radio Shack an additional 56 days to sell its inventory.
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36. Computation of Gross Profit Ratio
Gross profit ratio: Important indicator of the company’s successful management of inventory.
Gross profit ratio =
Gross profit
Net sales
Measures the amount by which the sale price of inventory exceeds its cost per dollar of sales.
Higher the ratio, higher is the “markup” a company is able to achieve on its inventories.
The gross profit ratio measures the amount by which the sale price of inventory exceeds its cost per dollar of sales. The higher the ratio, the higher is the “markup” a company is able to achieve on its inventories. Best Buy and Radio Shack report the following information.
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37. Calculation of Gross Profit Ratio for Best buy and Radio Shack
For Best Buy, this means that for every $1 of sales revenue, the company spends $0.76 on inventory, resulting in a gross profit of $ In contrast, the gross profit ratio for Radio Shack is 46%.
We saw earlier that Radio Shack’s inventory turnover is about half that of Best Buy. But, we see now that Radio Shack makes up for that lower turnover with a gross profit margin about twice that of Best Buy. The products Best Buy sells are familiar goods, and competition from companies like Dell, Sony, Target, and Wal-mart for these high-volume items keeps sale prices low compared to costs. Because Radio Shack specializes in unique lower-volume products, there is less competition, allowing greater price markups. As products become more highly specialized, gross profit ratios typically increase even further.
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38. 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, let’s 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, let’s look at side-by-side comparisons. The perpetual entries are repeated from those in the chapter.
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39. Comparing Perpetual and Periodic inventory system – Inventory Purchase and Sales
Transaction on April 25 involves the purchase of $2,700 of inventory on account. Under the periodic system, instead of debiting the inventory account, we debit a purchases account.
Remember, we’re not continually adjusting the inventory account under the periodic method. We use the purchases account to temporarily track increases in inventory.
Transaction on July 17 involves the sale on account of 300 units of inventory for $4,500.
Notice that under the periodic system, we record the revenue earned, but we don’t record the reduction in inventory or the increase in cost of goods sold at the time of the sale. Instead, we will record these at the end of the period.
Final two transactions are:
The purchase of 600 additional units of inventory for $6,600 on account on October 19 and
The sale of 500 units for $7,500 on account on December 15.
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40. Comparing Perpetual and Periodic inventory system – Freight charges, Purchase discounts and returns
On April 25, Mario pays freight charges of $300 for inventory purchased on April 25.
On April 30, Mario pays for the units purchased on April 25, less a 2% purchase discount.
On October 22, Mario returns 50 defective units from the October 19 purchase.
Freight Charges: Under the perpetual system discussed in the chapter, we saw that freight charges are included as an additional cost of inventory. Here we’ll see that under the periodic system, we record these charges in a separate account called Freight-in.
Purchase discounts and returns: Under the perpetual system, purchase discounts and purchase returns are recorded as a reduction in inventory cost. Under the periodic system, these transactions are recorded in separate accounts— Purchase Discounts and Purchase Returns.
In the perpetual system, we credit purchase returns and purchase discounts to Inventory. The purchase returns and purchase discounts accounts used in the periodic system are referred to as contra purchases accounts.
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41. Comparing Perpetual and Periodic inventory system – Period-End Adjustment
A period-end adjustment is needed only under the periodic system.
Adjusts the balance of inventory to its proper ending balance.
Records the cost of goods sold for the period, to match inventory costs with the related revenues.
Closes (or zeros out) the temporary purchases accounts (Purchases, Freight-in, Purchase Discounts, and Purchase Returns).
Notice that (1) the balance of inventory is updated for its ending amount of $1,650, while its beginning balance of $700 is eliminated, (2) cost of goods sold is recorded for $8,046, and (3) temporary accounts related to purchases are closed to zero.
If you look carefully, you may notice that the amount of cost of goods sold above calculated under the periodic system is the same as that calculated under the perpetual system.
The periodic system and perpetual system will always produce the same amounts for cost of goods sold and inventory when the FIFO inventory method is used.
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42. 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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43. Determine the financial statement effects of inventory errors
Summary of Effects of Inventory Error in the Current Year.
Relationship between Cost of Goods Sold in the Current Year and the Following Year
The amount of ending inventory this year is the amount of beginning inventory next year. An error in ending inventory this year will create an error in beginning inventory next year.
Notice that ending inventory is subtracted in calculating cost of goods sold in year 1 (the year of the inventory error). That same amount becomes beginning inventory in the following year and is added in calculating cost of goods sold. Because of this, an error in calculating ending inventory in the current year will automatically affect cost of goods sold in the following year in the opposite direction .
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44. Inventory Amounts
Now, assume the company mistakenly reports ending inventory in 2012 as $400, instead of $500. The effect of the mistake is shown in the slide.
Notice three things: First, the amount reported for inventory is correct by the end of the second year, $800. This is true even if the company never discovered its inventory mistake in 2012.
Second, the total amount reported for cost of goods sold over the two-year period from 2012 to 2013 is the same ($6,800) whether the error occurs or not. That’s because the overstatement to cost of goods sold of $100 in 2012 is offset by an understatement of $100 in This also means that the inventory error affects gross profit in each of the two years, but the combined two-year gross profit amount
is unaffected.
Third, if the combined two-year gross profit is correct, then retained earnings will also be correct by the end of Thus, the inventory error in 2012 has no effect on the accounting equation at the end of Assets (inventory) and stockholders’ equity (retained earnings) are correctly stated.
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45. End of chapter 06
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