Chapter 7 Inventory and the Cost of Sales

Chapter 7 Inventory and the Cost of Sales

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 2

Costs Included in Inventory Raw materials Labor costs Manufacturing overhead The indirect manufacturing costs associated with producing inventory Freight-in costs 3

Who Owns the Inventory When goods are in transit? Q: Who owns inventory on a truck or railroad car? A: The party who is paying the shipping costs. When goods are on consignment? Q: Who owns inventory stocked in a warehouse? A: The supplier until the inventory is sold. The warehouse owner stocks and sells the inventory and receives a commission on sales as payment for services rendered. 4

Perpetual vs. Periodic System 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 PERPETUAL METHOD Inventory is purchased: Inventory 500 Accounts Payable 500 Transportation costs: Inventory 10 Cash 10 Purchase returns: Accounts Payable 50 Inventory 50 Purchase discounts: Account Payable 450 Inventory 9 Cash 441 PERIODIC METHOD Inventory is purchased: Purchases 500 Accounts Payable 500 Transportation costs: Freight In 10 Cash 10 Purchase returns: Accounts Payable 50 Purchase Returns 50 Purchase discounts: Accounts Payable 450 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 None PERPETUAL METHOD Closing Entry PERIODIC METHOD When inventory is sold: Accounts Receivable 50 Sales 50 No inventory entry at time of sale Closing Entry Inventory 451 Purchase Returns 50 Purchase Discounts 9 Freight In 10 Purchases 500 Cost of Goods Sold 30 Inventory 30 7

Inventory Counts Necessary under both the periodic and the perpetual methods. 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 PERPETUAL METHOD Beginning Inventory + Net Purchases = Cost of Goods Available for Sale Ending Inventory = Cost of Good Sold PERIODIC 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, last 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) 10

Example: 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 LIFO Avg. Cost Sold Sold Sold Old Rice New Rice Mixed Rice Sales ($11 x 10 tons) $110 $110 $ 110 COGS (10 tons) 60 90 75 Gross margin $ 50 $ 20 $ 35 11

LIFO vs. FIFO LIFO gives a better reflection of COGS on the income statement. FIFO gives a better measure of inventory on the balance sheet. Therefore, LIFO is a better measure of net income. Therefore, FIFO is a better measure of inventory value. 12

Managing Inventory It s a balance! Avoid tying up resources in inventory Vs. Maintaining sufficient inventory for smooth business operations 13

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 14

Measuring the Management of Inventory Number of Days Sales in Inventory How many days worth of sales does the company have in inventory? 365 Inventory Turnover Cost of Goods Sold Average Inventory 15

Measuring the Operating Cycle Number of Days Purchases in Accounts Payable How many days worth of inventory does the company have in accounts payable? 365 Purchases / Average Accounts Payable 38 Days 72 Days Days Sales in Inventory Days Purchases in Accounts Payable Average Collection Period 30 Days 80 Days External Financing 16

Inventory Errors Beginning inventory Purchases Ending inventory These errors affect Cost of goods sold Gross margin Net income 17

Inventory Errors Understate Ending Inventory Understate Purchases Understate Beginning Inventory Understate Sales Sales LOW Beginning inventory Net purchases Goods available Ending inventory Cost of goods sold LOW HIGH LOW LOW LOW LOW LOW LOW Gross margin Expenses Net income LOW LOW HIGH HIGH HIGH HIGH LOW LOW 18

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. 19

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 200 Inventory 200 To write-down inventory to its net realizable value. 20

Lower-of-Cost-or-Market A basis for valuing inventory at the lower of original cost or current market value Determining market value Ceiling: Replacement Cost: purchased for. Maximum amount (net realizable value). What inventory could currently be Floor: Minimum amount (net realizable value normal profit). minus a Market value is the middle of these three values. 21

Example: Lower-of-Cost-or-Market (LCM) Inventory Market Replacement NRV Item Cost Floor Cost Ceiling A 34 20 32 30 B 42 32 36 46 C 52 44 42 62 D 38 50 32 68 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. 22

Using LCM LCM can be applied in three ways: 1. By computing cost and market figures for each item of inventory and using the lower of the two figures in EACH case 2. By computing cost and market figures for the total inventory and then applying the LCM rule to that TOTAL 3. By applying the LCM rule to categories of inventory 23

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 24

Example: Gross Margin Method 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 percent. Dollars % of sales Net sales revenue $100,000 100% 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 25

Chapter 7 Review Problem 26

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