cost of sales

11

Cost of Sales and InventoryCost of Sales and Inventory

JOIN KHALID AZIZJOIN KHALID AZIZCOACHING CLASSESCOACHING CLASSES

ICMAP STAGE 1,2,3,4,5ICMAP STAGE 1,2,3,4,5ICAP MODULE A,B,C,DICAP MODULE A,B,C,D

PIPFAPIPFABBA & MBABBA & MBA

B.COM & M.COMB.COM & M.COMACCOUNTING OF O/A LEVELACCOUNTING OF O/A LEVEL

MA-ECONOMICSMA-ECONOMICS0322-33857520322-3385752

KARACHI, PAKISTANKARACHI, PAKISTAN .

22

Types of CompaniesTypes of Companies Merchandising companyMerchandising company

• Sells goods in same form as acquired.Sells goods in same form as acquired. Manufacturing companyManufacturing company

• Converts raw material into finished Converts raw material into finished goods.goods.

Service companyService company• Provides intangible services.Provides intangible services.

33

Inventory IssuesInventory Issues What is inventory?What is inventory? What costs are included in inventory?What costs are included in inventory? How do we separate COGS from End. How do we separate COGS from End.

Inv?Inv?

44

Inventories DefinitionInventories Definition Asset items held for sale in the Asset items held for sale in the

ordinary course of business or goods ordinary course of business or goods that will be used or consumed in the that will be used or consumed in the production of goods to be sold.production of goods to be sold.

55

Methods of Determining Methods of Determining Amounts In InventoryAmounts In Inventory

Periodic inventory method orPeriodic inventory method or Perpetual inventory method.Perpetual inventory method.

Measurement of inventories and cost Measurement of inventories and cost of sales are related.of sales are related.

66

Cost Flow AssumptionsCost Flow Assumptions Specific identification.Specific identification. Average cost.Average cost. First-in, first-out (FIFO).First-in, first-out (FIFO). Last-in, last-out (LIFO).Last-in, last-out (LIFO).

77

Types of Companies/InventoriesTypes of Companies/Inventories MerchandisingMerchandising

• Sells goods in same form in which they Sells goods in same form in which they are acquired.are acquired.

Inventory costs (and costs of goods sold) Inventory costs (and costs of goods sold) = acquisition costs.= acquisition costs.

88

Types of Companies/InventoriesTypes of Companies/Inventories(Continued)(Continued)

Manufacturing company converts Manufacturing company converts raw materials and purchased parts raw materials and purchased parts into finished goods.into finished goods. 3 types of inventories;3 types of inventories;

Materials.Materials. Work-in-process.Work-in-process. Finished goods.Finished goods.

99


Service organizations (hotels, beauty Service organizations (hotels, beauty parlors, plumbers)parlors, plumbers) May have materials inventories.May have materials inventories.

1010


Professional service firms Professional service firms (accounting firms, legal firms)(accounting firms, legal firms) Intangible inventory costs are costs Intangible inventory costs are costs

incurred for client but not yet billed incurred for client but not yet billed called jobs-in-progress or unbilled costs.called jobs-in-progress or unbilled costs.

1111

SuppliesSupplies Tangible items that will be consumed Tangible items that will be consumed

in the course of normal operations.in the course of normal operations. e.g., office and janitorial supplies, e.g., office and janitorial supplies,

lubricants, repair parts.lubricants, repair parts. Not sold and not accounted for as Not sold and not accounted for as

part of cost of goods sold.part of cost of goods sold.

1212

Merchandise CompaniesMerchandise Companies

Inventories accounted for at cost.Inventories accounted for at cost. Cost includes cost of Cost includes cost of

Acquiring merchandise (invoice cost of Acquiring merchandise (invoice cost of goods, freight-in)goods, freight-in)

Making goods ready for sale. ( unpacking Making goods ready for sale. ( unpacking and marking)and marking)

Adjust for:Adjust for: Returns and allowancesReturns and allowances Cash discounts from supplier.Cash discounts from supplier.

1313

Methods of Accounting for Methods of Accounting for Purchase (or cash) DiscountsPurchase (or cash) Discounts

Net of discountNet of discount Charge discounts not taken when paid.Charge discounts not taken when paid.

Record at invoice priceRecord at invoice price Record discount when taken.Record discount when taken.

1414

TerminologyTerminology Purchase = receipt of merchandise Purchase = receipt of merchandise

not to placing of a PO.not to placing of a PO. Usually title transfers when goods are Usually title transfers when goods are

shipped (FOB shipping point).shipped (FOB shipping point).

1515

Relationship of Inventory and Relationship of Inventory and Cost of Goods SoldCost of Goods Sold

Beginning inventory + net purchases = Beginning inventory + net purchases = goods available for salegoods available for sale

Goods available for sale = cost of goods Goods available for sale = cost of goods sold + ending inventory.sold + ending inventory.

Equivalently: Beg. inventory + net Equivalently: Beg. inventory + net purchases -ending inventory = cost of purchases -ending inventory = cost of goods sold.goods sold. Net purchases = gross purchases -purchase Net purchases = gross purchases -purchase

returns and allowances + freight-inreturns and allowances + freight-in

1616

Measurement IssueMeasurement Issue

Dividing goods available for sale Dividing goods available for sale between COGS and End. Inventory.between COGS and End. Inventory.

2 approaches:2 approaches:• Periodic inventory method.Periodic inventory method.• Perpetual inventory method.Perpetual inventory method.

1717

Periodic Inventory MethodPeriodic Inventory Method Determine amount of ending inventory Determine amount of ending inventory

and deduce costs of goods sold.and deduce costs of goods sold. Count inventory (i.e., a physical inventory Count inventory (i.e., a physical inventory

is taken) at the end of the period. is taken) at the end of the period. Multiply count times cost for each item to Multiply count times cost for each item to

determine total amount of inventory.determine total amount of inventory. Beginning inventory of current period = Beginning inventory of current period =

ending inventory of preceding period.ending inventory of preceding period. COGS = COGA - End. InventoryCOGS = COGA - End. Inventory

1818

Perpetual Inventory MethodPerpetual Inventory Method Measure amount actually delivered to Measure amount actually delivered to

customers; deduce ending inventory.customers; deduce ending inventory. Perpetual inventory record is kept for Perpetual inventory record is kept for

each item in the inventory.each item in the inventory. Advantages of perpetual inventory method:Advantages of perpetual inventory method:

Detailed record is useful.Detailed record is useful. Built in check.Built in check. Identifies shrinkage by item.Identifies shrinkage by item. Income statement can be prepared without Income statement can be prepared without

taking a physical inventory.taking a physical inventory.

1919

Retail MethodRetail Method Variation of perpetual method.Variation of perpetual method. Record purchases at cost and at retail. Record purchases at cost and at retail. Adjust retail prices for markdowns.Adjust retail prices for markdowns. Calculate gross margin percent and its Calculate gross margin percent and its

complement (the cost of goods sold as a complement (the cost of goods sold as a percent of retail).percent of retail). Cost of goods sold = Retail sales for the period * Cost of goods sold = Retail sales for the period *

cost of goods sold percent.cost of goods sold percent. Ending inventory = Beginning inventory + Ending inventory = Beginning inventory +

purchases -cost of goods sold.purchases -cost of goods sold.

2020

Gross Profit MethodGross Profit Method

Similar to retail method except uses Similar to retail method except uses an average or normal gross profit an average or normal gross profit percentage in the calculation.percentage in the calculation.

2121

Manufacturing CompaniesManufacturing Companies Product costs or cost of goods sold = Product costs or cost of goods sold =

materials and parts used + materials and parts used + conversion costsconversion costs Conversion costs = production labor + Conversion costs = production labor +

overhead (other costs incurred in overhead (other costs incurred in manufacturing).manufacturing).

2222

3 Types of Manufacturing 3 Types of Manufacturing Inventory AccountsInventory Accounts

Materials inventory or raw materials.Materials inventory or raw materials. Not yet used in production.Not yet used in production. Adjusted for returns and freight-in. Adjusted for returns and freight-in.

Work-in-process.Work-in-process. Goods started but not yet finished. Goods started but not yet finished. Costed at total costs incurred.Costed at total costs incurred.

Finished goodsFinished goods Manufactured but not yet shipped. Manufactured but not yet shipped. Costed at total costs incurred.Costed at total costs incurred.

2323

Flow Through AccountsFlow Through Accounts

Pattern:Pattern:• Tfrd Out = beg inv + tfrd in - end invTfrd Out = beg inv + tfrd in - end inv

2424

Raw Materials InventoryRaw Materials Inventory

Tfrd Out = beg inv + tfrd in - end Tfrd Out = beg inv + tfrd in - end invinv

Materials used = beg inv + Materials used = beg inv + purchases -end invpurchases -end inv

2525

Work in ProcessWork in Process


Cost of goods manufactured = beg Cost of goods manufactured = beg inv + (inv + (materials usedmaterials used + labor + + labor + overhead) - end invoverhead) - end inv

2626

Finished GoodsFinished Goods


Cost of goods sold = beg inv + Cost of goods sold = beg inv + Cost Cost of goods manufacturedof goods manufactured - end inv - end inv

2727

Product Costing SystemsProduct Costing Systems

Perpetual inventory system for Perpetual inventory system for manufacturing companies. manufacturing companies.

(Chapters 17-19)(Chapters 17-19)

2828

Product CostsProduct Costs = inventory costs = inventoriable costs.= inventory costs = inventoriable costs. Expensed (COGS) in period when FG Expensed (COGS) in period when FG

sold.sold. GAAP requires full production costing.GAAP requires full production costing.

Materials cost.Materials cost. Labor costs incurred directly in producing Labor costs incurred directly in producing

the product.the product. Other production or indirect or indirect Other production or indirect or indirect

production or production overhead costs. production or production overhead costs.

2929

Period CostsPeriod Costs Costs that are expensed in the period Costs that are expensed in the period

incurred. incurred. Much of SG&A (Selling, General & Much of SG&A (Selling, General &

Administrative) Expenses on IS.Administrative) Expenses on IS.

3030

Professional Service FirmsProfessional Service Firms E.g., law and accounting firms.E.g., law and accounting firms.

Labor , overhead, and incidental product Labor , overhead, and incidental product costs but no materials cost.costs but no materials cost.

Expensed in period billed (i.e., when Expensed in period billed (i.e., when revenues are recognized).revenues are recognized).

3131

Inventory Costing MethodsInventory Costing Methods(Cost Flow Assumptions)(Cost Flow Assumptions)

Specific identification.Specific identification. Average cost.Average cost. FIFOFIFO LIFOLIFO

3232

Specific IdentificationSpecific Identification

Big ticket items.Big ticket items. Uniquely identified items.Uniquely identified items.

May offer opportunity to manipulate May offer opportunity to manipulate costs.costs.

3333

Average CostAverage Cost (Beginning inventory amount + (Beginning inventory amount +

purchases) / units available for sale purchases) / units available for sale = per unit inventory costs = per unit = per unit inventory costs = per unit cost of goods soldcost of goods sold Periodic method.Periodic method.

Computed for the entire period.Computed for the entire period. Perpetual method.Perpetual method.

A new unit cost can be calculated after each A new unit cost can be calculated after each purchase.purchase.

3434

First-in, First-out (FIFO).First-in, First-out (FIFO).

Expenses costs of oldest purchases Expenses costs of oldest purchases first.first.

Most recently purchased goods are in Most recently purchased goods are in inventory.inventory. Likely but not necessary to follow actual Likely but not necessary to follow actual

flow of goods.flow of goods. Ending inventory approximates current Ending inventory approximates current

cost of goods.cost of goods.

3535

Last-in, Last-out (LIFO).Last-in, Last-out (LIFO).

Assumes most recently purchased Assumes most recently purchased goods are sold firstgoods are sold first

Inventory based on costs of oldest Inventory based on costs of oldest purchases.purchases. Cost of goods sold usually does not Cost of goods sold usually does not

reflect physical flow.reflect physical flow. Ending inventory may be costed at Ending inventory may be costed at

amounts of years ago. amounts of years ago. Inventory may be well below current costs.Inventory may be well below current costs.

3636

LIFO ReserveLIFO Reserve FIFO for management.FIFO for management. LIFO financial reporting.LIFO financial reporting.

LIFO reserve = FIFO inventory amount - LIFO reserve = FIFO inventory amount - LIFO inventory amount.LIFO inventory amount.

3737

Arguments for FIFOArguments for FIFO

Usually follows physical flow of goods.Usually follows physical flow of goods. If prices are based on oldest cost, If prices are based on oldest cost,

results in best matching.results in best matching. More accurate balance sheet More accurate balance sheet

valuation.valuation. Non-theoretical/practical argument:Non-theoretical/practical argument:

Results in highest income during periods Results in highest income during periods of rising prices.of rising prices.

3838

Arguments for LIFOArguments for LIFO

If prices are based on current costs, If prices are based on current costs, results in best matching of revenues results in best matching of revenues and costs and therefore most useful and costs and therefore most useful income statement.income statement.

Closest to reflecting current or Closest to reflecting current or replacement costs of goods sold.replacement costs of goods sold. However, it is still historical costs and However, it is still historical costs and

does differ from current costs.does differ from current costs.

3939

Arguments for LIFOArguments for LIFO(continued)(continued)

During periods of price increases:During periods of price increases: Higher costs of goods sold.Higher costs of goods sold. Lower taxable income.Lower taxable income. Lower income taxes.Lower income taxes. Higher cash flows.Higher cash flows.

If LIFO for tax purposes than also financial If LIFO for tax purposes than also financial reporting.reporting.

4040

Why Not More LIFO?Why Not More LIFO?

Most countries do not permit. Most countries do not permit. Would require a double set of books.Would require a double set of books.

Prices of some items are not Prices of some items are not increasing.increasing.

Because of IRS conformity Because of IRS conformity requirement, lower earnings reported requirement, lower earnings reported to shareholders.to shareholders.

4141

Lower of Cost or Market (LCM)Lower of Cost or Market (LCM)

Market price may be below cost due Market price may be below cost due to:to: Physical deterioration.Physical deterioration. Change in consumer tastes.Change in consumer tastes. Technological obsolescence.Technological obsolescence.

LCM is a reflection of conservatism LCM is a reflection of conservatism concept.concept.

Market is defined as replacement cost.Market is defined as replacement cost.

4242

Upper and Lower BoundsUpper and Lower Bounds

Ceiling or upper bound:Ceiling or upper bound: Net realizable value (NRV). Net realizable value (NRV).

NRV = estimated selling price - estimated NRV = estimated selling price - estimated costs of selling.costs of selling.

So inventory not above cash that will be So inventory not above cash that will be received.received.

Floor or lower bound:Floor or lower bound: NRV - normal profit margin.NRV - normal profit margin.

So inventory not written down artificially low.So inventory not written down artificially low.

4343

Steps in Applying LCMSteps in Applying LCM Compute market, floor and ceiling Compute market, floor and ceiling

amounts.amounts. Select the middle amount as market.Select the middle amount as market. Select lower of cost or market.Select lower of cost or market.

4444

Analysis of InventoryAnalysis of Inventory

Inventory turnover = Cost of goods Inventory turnover = Cost of goods sold / Inventorysold / Inventory Can use average or ending inventory.Can use average or ending inventory. Measures efficiency of asset usage.Measures efficiency of asset usage.

Differs by industry. Differs by industry. Days’ inventory = Inventory / (Cost Days’ inventory = Inventory / (Cost

of goods sold of goods sold 365) 365)

cost of sales

Business