inventories and cost of goods sold

© The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin

INVENTORIES AND COST OF GOODS SOLD

Chapter

8


InventoryInventory

Goods ownedand held for sale

to customers

Goods ownedand held for sale

to customers

Current asset

Current asset

Inventory DefinedInventory Defined


INCOME STATEMENT

Revenue Cost of goods sold Gross profit Expenses Net income

Purchase costs (or manufacturing

costs)

as goods are sold

BALANCE SHEET

Asset Inventory

The Flow of Inventory CostsThe Flow of Inventory Costs


GENERAL JOURNAL

Date Account Titles and ExplanationPR Debit Credit

Entry on Purchase Date

Inventory $$$$

Accounts Payable $$$$

Entry on Sale Date

Cost of Goods Sold $$$$

Inventory $$$$

In a perpetual inventory system, inventory entries parallel the flow of costs.

The Flow of Inventory CostsThe Flow of Inventory Costs


When identical units of inventory have different unit costs, a question naturally

arises as to which of these costs should be used in recording a sale of inventory.

Which Unit Did We Sell? Which Unit Did We Sell?


A separate subsidiary account is maintained for each item in inventory.

A separate subsidiary account is maintained for each item in inventory.

How can we determine the unit cost for the Sept. 10 sale?

Item LL002 Primary supplier Electronic CityDescription Laser Light Secondary supplier Electric CompanyLocation Storeroom 2 Inventory level: Min: 25 Max: 200

Purchased Sold Balance

Date UnitsUnit Cost Total Units

Unit Cost

Cost of Goods Sold Units

Unit Cost Total

Sept. 5 100 30$ 3,000$ 100 30$ 3,000$ Sept. 9 75 50 3,750 100 30 3,000

75 50 3,750 Sept. 10 10 ? ? ? ? ?

? ? ?

Inventory Subsidiary LedgerInventory Subsidiary Ledger


Learning ObjectiveLearning Objective

LO1

In a perpetual inventory system, you are to determine the cost of

goods sold using (a) specific identification, (b) average cost, (c) FIFO, and (d) LIFO. You should

be able to discuss the advantages and shortcomings of each

method.


We use one of these inventory valuation methods to determine cost of inventory sold.

Inventory Cost FlowsInventory Cost Flows

SpecificIdentification

Average

Cost

LIFO

FIFOFIFO


The Bike Company (TBC)

Data for an IllustrationData for an Illustration


Specific Identification Specific Identification

When a unitis sold, its

specific cost is added to cost of

goods sold.

When a unitis sold, its

specific cost is added to cost of

goods sold.


On August 14, TBC sold 20 bikes for $130 each. On August 14, TBC sold 20 bikes for $130 each.

Of the bikes sold 9 originally cost $91 andOf the bikes sold 9 originally cost $91 and11 cost $106.11 cost $106.


Of the bikes sold 9 originally cost $91 andOf the bikes sold 9 originally cost $91 and11 cost $106.11 cost $106.



The Cost of Goods Sold for the August 14 sale is The Cost of Goods Sold for the August 14 sale is $1,985, leaving $515 and 5 units in inventory. $1,985, leaving $515 and 5 units in inventory.

The Cost of Goods Sold for the August 14 sale is The Cost of Goods Sold for the August 14 sale is $1,985, leaving $515 and 5 units in inventory. $1,985, leaving $515 and 5 units in inventory.

Let’s look at the entries for the Aug. 14 sale.Let’s look at the entries for the Aug. 14 sale.



Retail (20 × $103)Retail (20 × $103)

CostCost

A similar entry is made after each sale.A similar entry is made after each sale.



Additional purchases were made on August 17 and 28.

Costs associated with sales on August 31 were as follows: 1 @ $91, 3 @ $106, 15 @ $115, & 4 @ $119.

Additional purchases were made on August 17 and 28.

Costs associated with sales on August 31 were as follows: 1 @ $91, 3 @ $106, 15 @ $115, & 4 @ $119.


Cost of Goods Sold for

August 31 = $2,610

Cost of Goods Sold for

August 31 = $2,610


Balance Sheet

Inventory = $1,395

Income Statement

COGS = $4,595

1 @ 106$ = 106$ 5 @ 115$ = 575 6 @ 119$ = 714

End. Inv. 1,395$

1 @ 106$ = 106$ 5 @ 115$ = 575 6 @ 119$ = 714

End. Inv. 1,395$



Since specific identification is so

easy, can’t we use it all the time?Not really. Specific Not really. Specific

identification is hard to use identification is hard to use when we sell a lot of inventory when we sell a lot of inventory that has lots of different costs.that has lots of different costs.

Specific IdentificationSpecific Identification


Cost of Goods Available for

Sale

Units on hand on the date of

sale÷

Average-Cost MethodAverage-Cost Method

When a unit is sold,the average cost of each unitaverage cost of each unit

in inventory is assigned to costof goods sold.

When a unit is sold,the average cost of each unitaverage cost of each unit

in inventory is assigned to costof goods sold.


On August 14, TBC sold 20 bikes for $130 each. On August 14, TBC sold 20 bikes for $130 each. On August 14, TBC sold 20 bikes for $130 each. On August 14, TBC sold 20 bikes for $130 each.

The average cost per unit must be computed prior

to each sale.

The average cost per unit must be computed prior

to each sale.


$2,500 25 = $100$2,500 25 = $100


The average cost per The average cost per unit is $100.unit is $100.

The average cost per The average cost per unit is $100.unit is $100.

Let’s look at the entries for the Aug. 14 sale.


$100 = $2,500 25$100 = $2,500 25


RetailRetail

CostCost

A similar entry is made after each sale.A similar entry is made after each sale.A similar entry is made after each sale.A similar entry is made after each sale.



Additional purchases were made on August 17 Additional purchases were made on August 17 and August 28.and August 28.

On August 31, an additional 23 units were sold.On August 31, an additional 23 units were sold.

Additional purchases were made on August 17 Additional purchases were made on August 17 and August 28.and August 28.

On August 31, an additional 23 units were sold.On August 31, an additional 23 units were sold.



$114 = $3,990 35$114 = $3,990 35



$114 = $3,990 35$114 = $3,990 35The average cost per unit is $114.

The average cost per unit is $114.



Income Statement

COGS = $4,622

Balance Sheet

Inventory = $1,368

$114 × 12 = $1,368$114 × 12 = $1,368



Costs of Goods Sold

Costs of Goods Sold

Ending InventoryEnding

Inventory

Oldest Costs

Oldest Costs

Recent Costs

Recent Costs

First-In, First-Out Method (FIFO)First-In, First-Out Method (FIFO)


On August 14, TBC sold 20 bikes for $130 each. On August 14, TBC sold 20 bikes for $130 each. On August 14, TBC sold 20 bikes for $130 each. On August 14, TBC sold 20 bikes for $130 each.

The Cost of Goods Sold for the August 14 sale is $1,970, The Cost of Goods Sold for the August 14 sale is $1,970, leaving $530 and 5 units in inventory. leaving $530 and 5 units in inventory.

The Cost of Goods Sold for the August 14 sale is $1,970, The Cost of Goods Sold for the August 14 sale is $1,970, leaving $530 and 5 units in inventory. leaving $530 and 5 units in inventory.



RetailRetail

CostCost




Additional purchases were made on Aug. 17 and Aug. 28.

On August 31, an additional 23 units were sold.

Additional purchases were made on Aug. 17 and Aug. 28.

On August 31, an additional 23 units were sold.


Cost of Goods Sold for August 31 = $2,600Cost of Goods Sold for August 31 = $2,600Cost of Goods Sold for August 31 = $2,600Cost of Goods Sold for August 31 = $2,600


Balance Sheet

Inventory = $1,420

Income Statement

COGS = $4,570

2 @ 115$ = 230$ 10 @ 119$ = 1,190

End. Inv. 1,420$

2 @ 115$ = 230$ 10 @ 119$ = 1,190

End. Inv. 1,420$



Costs of Goods Sold

Costs of Goods Sold


Inventory

Recent Costs

Recent Costs

Oldest Costs

Oldest Costs

Last-In, First-Out Method (LIFO)Last-In, First-Out Method (LIFO)




The Cost of Goods Sold for the August 14 sale is $2,045, leaving $455 and 5 units in inventory.

The Cost of Goods Sold for the August 14 sale is $2,045, leaving $455 and 5 units in inventory.


RetailRetail

CostCost





Additional purchases were made on Aug. 17 and Aug. 28.Additional purchases were made on Aug. 17 and Aug. 28.

On Aug. 31, an additional 23 units were sold.On Aug. 31, an additional 23 units were sold.

Additional purchases were made on Aug. 17 and Aug. 28.Additional purchases were made on Aug. 17 and Aug. 28.

On Aug. 31, an additional 23 units were sold.On Aug. 31, an additional 23 units were sold.



Cost of Goods Sold for August 31 = $2,685Cost of Goods Sold for August 31 = $2,685


Balance Sheet

Inventory = $1,260

Income Statement

COGS = $4,730


5 @ 91$ = 455$ 7 @ 115$ = 805

End. Inv. 1,260$

5 @ 91$ = 455$ 7 @ 115$ = 805

End. Inv. 1,260$


Inventory Valuation Methods: A SummaryCosts Allocated to:

Valuation Method

Cost of Goods Sold Inventory Comments

Specific Actual cost of Actual cost of units Parallels physical flow identification the units sold remaining Logical method when units

are uniqueMay be misleading for identical units

Average cost Number of units sold times the

Number of units on hand times the

Assigns all units the same average unit cost

average unit cost average unit cost Current costs are averaged in with older costs

First-in, First-out (FIFO)

Cost of earliest purchases on

Cost of most recently

Cost of goods sold is based on older costs

hand prior to the sale

purchased units Inventory valued at current costsMay overstate income during periods of rising prices; may increase income taxes due

Last-in, First-out (LIFO)

Cost of most recently

Cost of earliest purchases

Cost of goods sold shown at recent prices

purchased units (assumed still in inventory)

Inventory shown at old (and perhaps out of date) costsMost conservative method during periods of rising prices; often results in lower income taxes


Once a company has adopted a particular

accounting method, it should follow that

method consistentlyrather than switch

methods from one year to the next.

The Principle of ConsistencyThe Principle of Consistency



LO2

To explain the need for taking a physical

inventory.


This inventory arrived just in time for us to use it in the manufacturing

process.

Just-In-Time (JIT) Inventory Systems

Just-In-Time (JIT) Inventory Systems


The primary reason for taking a physical inventory is to adjust the perpetual inventory records for

unrecorded shrinkage losses, such as theft, spoilage, or breakage.

The primary reason for taking a physical inventory is to adjust the perpetual inventory records for

unrecorded shrinkage losses, such as theft, spoilage, or breakage.

Taking a Physical InventoryTaking a Physical Inventory



LO3

To record shrinkage losses and other year-

end adjustments to inventory.


Reduces the value of the inventory.

Reduces the value of the inventory.ObsolescenceObsolescence

Adjust inventory value to the lower

of historical cost or current

replacement cost (market).

Adjust inventory value to the lower

of historical cost or current

replacement cost (market).

Lower of Cost or Market

(LCM)

Lower of Cost or Market

(LCM)

LCM and Other Write-Downsof Inventory





Cost Market Individual

Items Inventory Category

Total Inventory

Bicycles: Boy's bicycles 4,200$ 4,600$ 4,200 Girls bicycles 3,800 3,100 3,100 Junior bicycle 5,700 5,000 5,000 Total 13,700$ 12,700$ 12,700 Bicycle accessories: Training wheels 485$ 525$ 485 Headlamps 312 400 312 Protective helmets 700 600 600 Gloves 245 212 212 Kneepads 195 145 145 Total 1,937$ 1,882$ 1,882 Total inventory 15,637$ 14,582$ 14,054$ 14,582$ 14,582$

LCM Applied on the Basis of . . .


Year End

A sale should be recorded when title to the merchandise passes to the buyer.

A sale should be recorded when title to the merchandise passes to the buyer.

F.O.B. F.O.B. shipping shipping

pointpoint title passes to

buyer at the point of

shipment.

F.O.B. F.O.B. shipping shipping

pointpoint title passes to


shipment.

F.O.B. F.O.B. destination destination pointpoint title passes to


destination.

F.O.B. F.O.B. destination destination pointpoint title passes to


destination.

Goods In TransitGoods In Transit



LO4

In a periodic inventory system, you are to determine the cost of goods sold using (a) specific identification, (b) average cost, (c) FIFO, and

(d) LIFO.


In a periodic inventory system, inventory entries are as follows.

Note that an entry is not made to inventory.

Note that an entry is not made to inventory.

Periodic Inventory SystemsPeriodic Inventory Systems


In a periodic inventory system, inventory entries are as follows.



The inventory on hand and the cost of goods sold for the year are not determined until

year-end.



Specific identification

LIFO

Average cost

FIFO

We use one of these inventory valuation methods in a periodic inventory system.



Computers, Inc.Mouse Pad Inventory

Date Units $/Unit TotalBeginning Inventory 1,000 5.25$ 5,250.00$ Purchases:Jan. 3 300 5.30 1,590.00 June 20 150 5.60 840.00 Sept. 15 200 5.80 1,160.00 Nov. 29 150 5.90 885.00 Goods Available for Sale 1,800 9,725.00$

Ending Inventory 1,200 ?

Cost of Goods Sold 600 ?

Information for the Following Inventory Examples

Information for the Following Inventory Examples


By reviewing actual purchase invoices,

Computers, Inc. determines that the 1,200 mouse pads on hand at year-end have

an actual total cost of $6,400.

Determine the cost of goods sold for the year.





Ending Inventory 1,200 6,400.00$

Cost of Goods Sold 600 3,325.00$

Cost of Goods Sold$9,725 - $6,400 = $3,325

Cost of Goods Sold$9,725 - $6,400 = $3,325



Total Cost of Total Cost of Goods Goods

Available for Available for SaleSale

Total Number Total Number of Units of Units

Available for Available for SaleSale

÷

The average cost is calculated at year-

end as follows:

The average cost is calculated at year-

end as follows:







Avg. Cost $9,725 1,800 = $5.40278

Avg. Cost $9,725 1,800 = $5.40278






Ending InventoryAvg. Cost $5.40278 1,200

= $6,483

Ending InventoryAvg. Cost $5.40278 1,200

= $6,483

Cost of Goods SoldAvg. Cost $5.40278 600 =

$3,242

Cost of Goods SoldAvg. Cost $5.40278 600 =

$3,242


Costs of Goods Sold

Costs of Goods Sold


Inventory

Oldest Costs

Oldest Costs

Recent Costs

Recent Costs



Remember: Start with the

11/29 purchase and then add

other purchases until you reach the number of units in ending

inventory.

Remember: Start with the

11/29 purchase and then add

other purchases until you reach the number of units in ending

inventory.







Date Beg. Inv. Purchases End. Inv.Cost of

Goods Sold

Nov. 29 150@$5.90 150@$5.90Units 150

Now, let’s complete the table.

Now, let’s complete the table.



Goods Sold1,000@$5.25 600@$5.25

400@$5.25Jan. 3 300@$5.30 300@$5.30June 20 150@$5.60 150@$5.60Sept. 15 200@$5.80 200@$5.80Nov. 29 150@$5.90 150@$5.90Units 1,200 600

Now, we have allocated the cost to all 1,200 units

in ending inventory.


Goods Sold1,000@$5.25 600@$5.25

400@$5.25Jan. 3 300@$5.30 300@$5.30June 20 150@$5.60 150@$5.60Sept. 15 200@$5.80 200@$5.80Nov. 29 150@$5.90 150@$5.90Units 1,200 600

Costs $6,575 $3,150

Cost of Goods Available for Sale $9,725


Completing the table

summarizes the

computations just made.


summarizes the

computations just made.







Costs of Goods Sold

Costs of Goods Sold


Inventory

Recent Costs

Recent Costs

Oldest Costs

Oldest Costs



Remember: Start with beginning inventory and then add other purchases until you reach the

number of units in ending inventory.

Remember: Start with beginning inventory and then add other purchases until you reach the

number of units in ending inventory.








Goods Sold1,000@$5.25 1,000@$5.25

Units 1,000



Goods Sold1,000@$5.25 1,000@$5.25

Jan. 3 300@$5.30 200@$5.30100@$5.30

Units 1,200 100

Now, we have allocated the cost to all 1,200 units

in ending inventory.

Next, let’s complete the

table.

Next, let’s complete the

table.


Goods Sold1,000@$5.25 1,000@$5.25

Jan. 3 300@$5.30 200@$5.30100@$5.30

June 20 150@$5.60 150@$5.60Sept. 15 200@$5.80 200@$5.80Nov. 29 150@$5.90 150@$5.90Units 1,200 600

Costs $6,310 $3,415

Cost of Goods Available for Sale $9,725



summarizes the computations

just made.


summarizes the computations

just made.








LO5

To explain the effects on the income statement of

errors in inventory valuation.


Errors in Measuring InventoryBeginning Inventory Ending Inventory

Effect on Income Statement Overstated Understated Overstated Understated

Goods Available for Sale + - NE NE

Cost of Goods Sold + - - +Gross Profit - + + -Net Income - + + -Effect on Balance Sheet

Ending Inventory NE NE + -Retained Earnings - + + -

An error in ending inventory in a year will result in the same error in the beginning inventory of the next year.

An error in ending inventory in a year will result in the same error in the beginning inventory of the next year.

Importance of an Accurate Valuation of Inventory

Importance of an Accurate Valuation of Inventory



LO6

To estimate the cost of goods sold and ending inventory by the gross

profit method and by the retail method.


For interim financial statements, we may

need to estimate ending inventory and cost of

goods sold.


Determine cost of goods Determine cost of goods available for sale.available for sale.

Estimate cost of goods sold by Estimate cost of goods sold by multiplying the net sales by the multiplying the net sales by the cost ratio.cost ratio.

Deduct cost of goods sold Deduct cost of goods sold from cost of goods available from cost of goods available for sale to determine ending for sale to determine ending inventory.inventory.

Determine cost of goods Determine cost of goods available for sale.available for sale.

Estimate cost of goods sold by Estimate cost of goods sold by multiplying the net sales by the multiplying the net sales by the cost ratio.cost ratio.

Deduct cost of goods sold Deduct cost of goods sold from cost of goods available from cost of goods available for sale to determine ending for sale to determine ending inventory.inventory.

The Gross Profit MethodThe Gross Profit Method


In March of 2007, Matrix Company’s inventory was destroyed by fire. Matrix normal gross profit ratio is 30% of net sales. At the time of the fire, Matrix

showed the following balances:

In March of 2007, Matrix Company’s inventory was destroyed by fire. Matrix normal gross profit ratio is 30% of net sales. At the time of the fire, Matrix

showed the following balances:

Sales 31,500$ Sales returns 1,500 Beginning Inventory 12,000 Net cost of goods purchased 20,500

Sales 31,500$ Sales returns 1,500 Beginning Inventory 12,000 Net cost of goods purchased 20,500



Goods Available for Sale: Beginning Inventory 12,000$ Net cost of goods purchased 20,500 Goods available for sale 32,500$ Less estimated cost of goods sold: Sales 31,500$ Less sales returns (1,500) Net sales 30,000$

Estimated cost of goods sold (21,000) Estimated March inventory loss 11,500$

Estimating Inventory The Gross Profit Method








× 70%× 70%

Step 1

Step 2

Step 3


The Retail MethodThe Retail Method

The The retail methodretail method of estimating inventory requires of estimating inventory requires that management determine the value of ending that management determine the value of ending

inventory at retail prices.inventory at retail prices.

The The retail methodretail method of estimating inventory requires of estimating inventory requires that management determine the value of ending that management determine the value of ending

inventory at retail prices.inventory at retail prices.

Goods available for sale at cost 32,500$ Goods available for sale at retail 50,000 Physical count of ending inventory priced at retail 22,000

Information for Matrix CompanyThe Retail Method

In March of 2007, Matrix Company’s inventory was In March of 2007, Matrix Company’s inventory was destroyed by fire. At the time of the fire, Matrix’s destroyed by fire. At the time of the fire, Matrix’s management collected the following information:management collected the following information:

In March of 2007, Matrix Company’s inventory was In March of 2007, Matrix Company’s inventory was destroyed by fire. At the time of the fire, Matrix’s destroyed by fire. At the time of the fire, Matrix’s management collected the following information:management collected the following information:


The Retail MethodThe Retail Method

a Goods available for sale at cost 32,500$ b Goods available for sale at retail 50,000 c Cost ratio [a b] 65%d Physical count of ending inventory priced at retail 22,000 e Estimated ending inventory at cost [ c d] 14,300$

Estimating Inventory The Retail Method

Matrix would follow the steps below to estimate Matrix would follow the steps below to estimate their ending inventory using the retail method.their ending inventory using the retail method.

Matrix would follow the steps below to estimate Matrix would follow the steps below to estimate their ending inventory using the retail method.their ending inventory using the retail method.



LO7

To compute the inventory turnover rate and explain its uses.


Measures how quickly a companysells its merchandise inventory.

Measures how quickly a companysells its merchandise inventory.

A ratio that is low compared to competitors suggests inefficient use of assets.

A ratio that is low compared to competitors suggests inefficient use of assets.

Average Inventory = (Beginning Inventory + Ending Inventory) ÷ 2Average Inventory = (Beginning Inventory + Ending Inventory) ÷ 2

Financial AnalysisFinancial Analysis


Measures how many days on average it takes to sell its

inventory.

Measures how many days on average it takes to sell its

inventory.

Financial AnalysisFinancial Analysis


Remember that identical companies that use different

inventory methods (e.g., FIFO and LIFO) will have different

inventory turnover ratios.

Accounting Methods Can Affect Financial Ratios

Accounting Methods Can Affect Financial Ratios


End of Chapter 8End of Chapter 8

inventories and cost of goods sold

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