chapter 8

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Chapter 8 Inventories and

Cost of Goods Sold

Financial Accounting 4e by Porter and Norton

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Inventory of Wholesalers and Retailers

Purchased in finished form Resold without transformation Classified as “Merchandise Inventory”

on balance sheet

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CURRENT ASSETS:

Cash and cash equivalents $1,251,532 $ 446,131

Net accounts and notes receivable 726,541 585,761

Merchandise inventory 1,633,327 1,757,664

Prepaid expenses and other current assets 41,311 57,623

TOTAL CURRENT ASSETS 3,652,711 2,847,179

Property, plant and equipment, net 853,778 988,947

Other assets 32,897 35,207

TOTAL ASSETS $4,539,386 $3,871,333

CIRCUIT CITYConsolidated Balance Sheets [Partial]

February 28,2002 2001ASSETS (in thousands)

More than 1/3

of totalassets

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Inventory of Manufacturers

ManufacturingOverhead

Direct Materials

Direct Labor

Costs Included in Inventory

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Inventory of Manufacturers

ManufacturingOverhead

Direct Materials

Direct Labor Manufacture

Products

Work in Process

FinishedGoods

Raw Materials

Costs Includedin Inventory

Balance SheetClassifications

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Current assets:Cash and cash equivalents $ 304.0 $ 254.3Accounts receivable less allowance for

doubtful accounts of $72.1 and $65.4 1,621.4 1,569.4Inventories:

Finished goods 1,399.4 1,416.6Work in progress 15.1 17.3Raw materials 9.6 12.1

1,424.1 1,446.0Deferred income taxes 113.3 111.5Prepaid expenses 162.5 215.2

Total current assets 3,625.3 3,596.4

Property, plant and equipment, net 1,618.8 1,583.4Identifiable intangible assets and goodwill 397.3 410.9Deferred income taxes and other assets 178.2 266.2TOTAL ASSETS $ 5,819.6 $ 5,856.9

NIKE, INC.Consolidated Balance Sheets [Partial]

May 31,2001 2000ASSETS (in millions)

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Inventory Valuation and Income Measurement

Value Assigned toInventory

on BalanceSheet

ValueExpensedas Cost of Goods Soldon IncomeStatement

When Sold =

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Beginning inventory $ 500

+ Purchases 1,200

= Cost of goods available for sale 1,700

Calculating Cost of Goods Sold

Internal calculation

- Ending inventory (600)

= Cost of goods sold $ 1,100

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Inventory costs include

Any freight costs incurred by buyer Cost of insurance for inventory in transit Cost of storing inventory before selling Excise and sales taxes

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Inventory Costing MethodsFour costing methods available:

SpecificIdentification

WeightedAverage

First-in, First-out(FIFO)

Last-in, First-out(LIFO)

Beginning inventory, Jan. 1: 500 units (unit cost $10)

Inventory purchases:Date Units Unit Cost1/20 300 $ 114/8 400 129/5 200 1312/12 100 14Total purchases 1,000

Ending inventory, Dec. 31: 600 units

Detailed Costing Method Example

Calculate the cost of goods sold and ending inventory under each method using the data below:

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Specific Identification Method

Step 1: Identify the specific units in inventory at the end of the year and their costs.

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Units in ending inventory:

Date purchased Units Cost Total cost

1/20 100 $11 $1,100

4/8 300 12 3,600

9/5 200 13 2,600

Ending inventory 600 $7,300

Units x Cost = Total cost

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Step 2: Identify the units sold and calculate the cost of goods sold.

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Beg. Inventory 500 $10 $5,000

1/20 200 11 2,200

4/8 100 12 1,200

12/12 100 14 1,400

Cost of goods sold 900 $9,800

Units x Cost = Total cost

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Weighted Average Method

Step 1: Calculate the cost of goods available for sale.

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Beg. inventory 500 $10 $ 5,000

1/20 300 11 3,300

4/8 400 12 4,800

9/5 200 13 2,600

12/12 100 14 1,400

Cost of goods available for sale 1,500 $17,100

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Step 2: Divide the cost of goods availablefor sale by the total units todetermine the weighted averagecost per unit.

:

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Cost of Goods Available Units Available

$17,100 1,500

= $ 11.40/unit

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Step 3: Calculate ending inventory and COGS by multiplying the weighted average cost per unit by the # of units in ending inventory and the # of units sold.

XAvg.Cost

# Units

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ALLOCATE TO Ending Cost of Inventory Goods

SoldUnits on hand 600 Units sold 900Weighted average cost X $11.40 $ 11.40

Total cost of goods available of $17,100 allocated: $6,840 $10,260

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First-in, First-out (FIFO) Method

Step 1: Assign the cost of the beginning inventory to cost of goods sold.

1stin

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ALLOCATE TOEnding Cost ofUnits Cost Inventory Goods Sold

1/1 500 $10 $5,000

1/20 300 $11

4/8 400 $12

9/5 200 $13

12/12 100 $14

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Step 2: Continue to work forward until you assign the total # of units sold during the period to cost of goods sold. Allocate the remaining units to ending inventory.

2nd3rd etc.

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1/1 500 $10 $5,000

1/20 300 $11 3,300

4/8 300 / 100 $12 $3,600 1,200

9/5 200 $13 2,600

12/12 100 $14 1,400

TOTALS $7,600 $9,500

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Last-in, First-out (LIFO) Method

Step 1: Assign the cost of the last units purchased to cost of goods sold.

1stin

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1/1 500 $10

1/20 300 $11

4/8 400 $12

9/5 200 $13

12/12 100 $14 $1,400

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1stin

Step 2: Work backward until you assign the total # of units sold during the period to cost of goods sold (allocate the remaining units to ending inventory).


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1/1 500 $10 $5,000

1/20 100 / 200 $11 1,100 $2,200

4/8 400 $12 4,800

9/5 200 $13 2,600

12/12 100 $14 1,400

TOTALS $6,100 $11,000

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Comparison of Costing Methods

Cost of GoodsSold

Ending Inventory

11,000

6,840

7,600

10,260

9,500

17,100

17,000

17,100

WeightedAverage

FIFO

LIFO

Goods Available for Sale

6,100

Specific Identification $7,300 9,800 $17,100

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Comparison of Costing Methods

X XX

XX

Weighted Avg. FIFO LIFO

In periods of rising prices:

highest COGS? lowest COGS?highest gross margin?lowest net income?lowest income taxes?

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LIFO Issues

LIFO Liquidation liquidation can result in high gross margin

(and large tax bill) LIFO Conformity Rule

if used for tax, LIFO must also be used for books

LIFO Reserve difference between inventory value stated at

FIFO and value stated at LIFO

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Reasons for Inventory Errors

Mathematical mistakes Physical inventory counting errors Cut-off problems - in-transit Goods on consignment

Lower of Cost or Market

Before After

Price PriceChange Change

Cost 150 120

Report loss in year

market falls below cost…

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Before After

Price PriceChange Change

Selling price $200 $160

Cost 150 120

Gross margin $ 50 $ 40


Gross margin % 25% 25%

…to maintain

normal G.M.%

when sold

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Market = replacement cost (not retail value) Cost determined under one of four methods Justified on basis of conservatism Can be applied to:

entire inventory individual items groups of items


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Estimating Inventory Values

Sometimes impossible or impractical to measure inventory at cost– Estimation is necessary

Two methods used to estimate ending inventory values:– gross profit method– retail inventory method

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Gross Profit Method

1 Beginning inventory

2 + Purchases

3 = Cost of goods available for sale

4 - Ending inventory

5 = Cost of goods sold

Use income statement model butreverse steps 4 and 5

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Gross Profit Method

Beginning inventory $ 100,000

+ Purchases 30,000

= Cost of goods available for sale 130,000

- Cost of goods sold (estimated) * 90,000

= Ending inventory (estimated) $ 40,000

* Cost of goods sold is estimated as a percentage of sales

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Cost of Goods SoldAverage Inventory

Inventory Turnover Ratio

The number of times per period inventory is turned over (i.e., sold)

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Circuit City 5.9 times per yearSafeway 9.3 times per year

Inventory Turnover Ratios

Example:

Can you compare the two ratios?

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Days’ Sales in Inventory

The average # of days inventory is on handbefore its sold.

# of Days in PeriodInventory Turnover

Ratio

1 2 3

4 5 6 7 8 9 10

11 12 13 14 15 16 17

18 19 20 21 22 23 24

25 26 28 29 30 3127

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Days’ Sales in Inventory

Circuit City 365 = 61 days5.9

Safeway 365 = 39 days9.3

Do these averages seem reasonable?

chapter 8

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