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Inventories and Cost of SalesChapter

66

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Learning objectivesLearning objectives

1. Basics of Inventory 2. Inventory costing under a perpetual system

• Specific identification, FIFO, LIFO, weighted average

3. Inventory valuation and effect of inventory error • LCM principle

4. Decision analysis: • Inventory turnover

• Days sale in inventory

• Case: Walmart & Target

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1. Basics of Inventory - Determining Inventory Items

1. Basics of Inventory - Determining Inventory Items

Merchandise inventory includes all goods that a company owns and holds for sale, regardless of where the goods are located when inventory

is counted.

Items requiring special attention include:

Goods in Transit

Goods Damaged or

ObsoleteGoods on Consignment

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Public Carrier

Seller Buyer

1. Basics of Inventory - Goods in Transit1. Basics of Inventory - Goods in Transit

Public Carrier

Seller Buyer

FOB Shipping Point

Ownership passes to the buyer here.

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1. Basics of Inventory - Goods on Consignment

1. Basics of Inventory - Goods on Consignment

Merchandise is included in the inventory of the consignor, the owner of the inventory.

Consignor

Consignee

Thanks for selling my inventory in

your store.

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1. Basics of Inventory - Goods Damaged or Obsolete

1. Basics of Inventory - Goods Damaged or Obsolete

Damaged or obsolete goods are not counted in inventory.

Cost should be reduced to net realizable value.

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1. Basics of Inventory - Determining Inventory Costs

1. Basics of Inventory - Determining Inventory Costs

Invoice Cost

Include all expenditures necessary to bring an item to a salable condition and location.

Minus Discounts

Plus Import Duties

Plus Freight

Plus Storage

Plus Insurance

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1. Basics of Inventory - Internal Controls and Taking a Physical Count

1. Basics of Inventory - Internal Controls and Taking a Physical Count

Most companies take a physical count of inventory at least once each year.

When the physical count does not match the Merchandise Inventory account, an adjustment must be made.

Most companies take a physical count of inventory at least once each year.

When the physical count does not match the Merchandise Inventory account, an adjustment must be made.

InventoryCount Tag

Countedby _______

Quantity Counted ___

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2. Inventory Costing Under a Perpetual System

2. Inventory Costing Under a Perpetual System

Inventory Inventory affects . . . affects . . .

The matching The matching principle requires principle requires matching cost of matching cost of sales with sales.sales with sales.

Balance Balance SheetSheet

Balance Balance SheetSheet

Income Income StatementStatement

Income Income StatementStatement

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2. Inventory Costing Under a Perpetual System - Inventory decision2. Inventory Costing Under a Perpetual System - Inventory decision

Accounting for inventory

requires several decisions . . .

Costing Method. Specific Identification, FIFO, LIFO, or

Weighted Average Inventory System.

Perpetual or Periodic Items included in inventory and

their costs. Use of market values or other

estimates.

Costing Method. Specific Identification, FIFO, LIFO, or

Weighted Average Inventory System.

Perpetual or Periodic Items included in inventory and

their costs. Use of market values or other

estimates.

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2. Inventory Costing Under a Perpetual System - Frequency in Use of Inventory Methods2. Inventory Costing Under a Perpetual System - Frequency in Use of Inventory Methods

Exh. 6.1

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2. Inventory Costing Under a Perpetual System - Inventory Cost Flow Assumptions2. Inventory Costing Under a Perpetual System - Inventory Cost Flow Assumptions

First-In, First-Out(FIFO)

Assumes costs flow in the order incurred.

Last-In, First-Out(LIFO)

Assumes costs flow in the reverse order incurred.

Weighted Average

Assumes costs flow at an average of the costs available.

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Inventory Costing IllustrationInventory Costing Illustration

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Specific IdentificationSpecific Identification

When units are sold, the

specific cost of the unit

sold is added to cost of

goods sold.

When units are sold, the

specific cost of the unit

sold is added to cost of

goods sold.

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Specific IdentificationSpecific Identification

The above purchases were made by Trekking in August. On August 14, Trekking sold 8 bikes originally costing $91 and 12 bikes originally costing $106.

The above purchases were made by Trekking in August. On August 14, Trekking sold 8 bikes originally costing $91 and 12 bikes originally costing $106.

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The Cost of Goods Sold for the August 14 sale is $2,000.

After this sale, there are 5 units in inventory at $500:

2 @ $91 3 @ $106

The Cost of Goods Sold for the August 14 sale is $2,000.

After this sale, there are 5 units in inventory at $500:

2 @ $91 3 @ $106

Specific IdentificationSpecific Identification

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Additional purchases were made on August 17 and 28.

The cost of items sold on August 31 were as follows: 2 @ $91

3 @ $10615 @ $115 3 @ $119

Additional purchases were made on August 17 and 28.

The cost of items sold on August 31 were as follows: 2 @ $91

3 @ $10615 @ $115 3 @ $119

Specific IdentificationSpecific Identification

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Specific IdentificationSpecific Identification

Cost of Goods Sold for August 31 = $2,582

Cost of Goods Sold for August 31 = $2,582

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Specific IdentificationSpecific Identification

After the August 31 sale, there are 12 units in inventory at $1,408:

5 @ $1157 @ $119

After the August 31 sale, there are 12 units in inventory at $1,408:

5 @ $1157 @ $119

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Specific IdentificationSpecific Identification

Balance Sheet Inventory = $1,408

Balance Sheet Inventory = $1,408

Income Statement COGS = $4,582

Income Statement COGS = $4,582

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Specific IdentificationSpecific Identification

Aug. 3 Merchandise inventory 1,590 Accounts payable 1,590

Aug. 14 Accounts receivable 2,600 Sales 2,600

Aug. 14 Cost of goods sold 2,000 Merchandise inventory 2,000

Aug. 17 Merchandise inventory 2,300 Accounts payable 2,300

Aug. 28 Merchandise inventory 1,190 Accounts payable 1,190

Aug. 31 Accounts receivable 3,450 Sales 3,450

Aug. 31 Cost of goods sold 2,582 Merchandise inventory 2,582

Here are the entries to record the purchases and sales entries for Trekking. The numbers in red are determined by

the cost flow assumption used.

All purchases and sales are

made on credit.

The selling price of

inventory was as follows:

8/14 $130 8/31 150

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

Cost of Goods Sold

Cost of Goods Sold

Ending InventoryEnding

Inventory

Oldest Costs

Oldest Costs

Recent Costs

Recent Costs

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

The above purchases were made by Trekking in August.

On August 14, Trekking sold 20 bikes.

The above purchases were made by Trekking in August.

On August 14, Trekking sold 20 bikes.

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

The Cost of Goods Sold for the August 14 sale is $1,970.

After this sale, there are 5 units in inventory at $530:

5 @ $106

The Cost of Goods Sold for the August 14 sale is $1,970.

After this sale, there are 5 units in inventory at $530:

5 @ $106

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

Additional purchases were made on August 17 and 28.

Twenty-three bikes were sold on August 31.

Additional purchases were made on August 17 and 28.

Twenty-three bikes were sold on August 31.

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

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

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

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

After the August 31 sale, there are 12 units in inventory at $1,420:

2 @ $11510 @ $119

After the August 31 sale, there are 12 units in inventory at $1,420:

2 @ $11510 @ $119

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

Balance Sheet Inventory = $1,420

Balance Sheet Inventory = $1,420

Income Statement COGS = $4,570

Income Statement COGS = $4,570

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

Aug. 3 Merchandise inventory 1,590 Accounts payable 1,590

Aug. 14 Accounts receivable 2,600 Sales 2,600

Aug. 14 Cost of goods sold 1,970 Merchandise inventory 1,970

Aug. 17 Merchandise inventory 2,300 Accounts payable 2,300

Aug. 28 Merchandise inventory 1,190 Accounts payable 1,190

Aug. 31 Accounts receivable 3,450 Sales 3,450

Aug. 31 Cost of goods sold 2,600 Merchandise inventory 2,600

Here are the entries to record the purchases and sales entries for Trekking. The numbers in red are determined by

the cost flow assumption used.

All purchases and sales are

made on credit.

The selling price of

inventory was as follows:

8/14 $130 8/31 150

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

Cost of Goods Sold

Cost of Goods Sold

Ending InventoryEnding

Inventory

Recent Costs

Recent Costs

Oldest Costs

Oldest Costs

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

The above purchases were made by Trekking in August.

On August 14, Trekking sold 20 bikes.

The above purchases were made by Trekking in August.

On August 14, Trekking sold 20 bikes.

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

The Cost of Goods Sold for the August 14 sale is $2,045.

After this sale, there are 5 units in inventory at $455:

5 @ $91

The Cost of Goods Sold for the August 14 sale is $2,045.

After this sale, there are 5 units in inventory at $455:

5 @ $91

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

Additional purchases were made on August 17 and 28.

Twenty-three bikes were sold on August 31.

Additional purchases were made on August 17 and 28.

Twenty-three bikes were sold on August 31.

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

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

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

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

After the August 31 sale, there are 12 units in inventory at $1,260:

5 @ $91 7 @ $115

After the August 31 sale, there are 12 units in inventory at $1,260:

5 @ $91 7 @ $115

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

Balance Sheet Inventory = $1,260

Balance Sheet Inventory = $1,260

Income Statement COGS = $4,730

Income Statement COGS = $4,730

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

Aug. 3 Merchandise inventory 1,590 Accounts payable 1,590

Aug. 14 Accounts receivable 2,600 Sales 2,600

Aug. 14 Cost of goods sold 2,045 Merchandise inventory 2,045

Aug. 17 Merchandise inventory 2,300 Accounts payable 2,300

Aug. 28 Merchandise inventory 1,190 Accounts payable 1,190

Aug. 31 Accounts receivable 3,450 Sales 3,450

Aug. 31 Cost of goods sold 2,685 Merchandise inventory 2,685

Here are the entries to record the purchases and sales entries for Trekking. The numbers in red are determined by

the cost flow assumption used.

All purchases and sales are

made on credit.

The selling price of

inventory was as follows:

8/14 $130 8/31 150

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Weighted AverageWeighted Average

When a unit is sold, the average cost of each unit in inventory is assigned to

cost of goods sold.

When a unit is sold, the average cost of each unit in inventory is assigned to

cost of goods sold.

Cost of Goods Available for

Sale

Units on hand on the date of

sale÷

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Weighted AverageWeighted Average

The above purchases were made by Trekking in August.

On August 14, Trekking sold 20 bikes.

The above purchases were made by Trekking in August.

On August 14, Trekking sold 20 bikes.

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Cost of goods available for sale 2,500$ Total units in inventory 25 Weighted average cost per unit 100$

Cost of goods available for sale 2,500$ Total units in inventory 25 Weighted average cost per unit 100$

÷

Weighted AverageWeighted Average

First, we need to compute the weighted average cost per unit of items in inventory.

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Weighted AverageWeighted Average

The Cost of Goods Sold for the August 14 sale is $2,000.

After this sale, there are 5 units in inventory at $500:

5 @ $100

The Cost of Goods Sold for the August 14 sale is $2,000.

After this sale, there are 5 units in inventory at $500:

5 @ $100

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Weighted AverageWeighted Average

Additional purchases were made on August 17 and 28.

Twenty-three bikes were sold on August 31.

Additional purchases were made on August 17 and 28.

Twenty-three bikes were sold on August 31.

What is the weighted average cost per unit of items in inventory?

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Weighted AverageWeighted Average

Cost of goods available for sale 3,990$ Total units in inventory 35 Weighted average cost per unit 114$

Cost of goods available for sale 3,990$ Total units in inventory 35 Weighted average cost per unit 114$

÷

UnitsInventory 8/14 5 Purchase 8/17 20 Purchase 8/28 10 Units available for sale 35

UnitsInventory 8/14 5 Purchase 8/17 20 Purchase 8/28 10 Units available for sale 35

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Weighted AverageWeighted Average

Cost of Goods Sold for August 31 = $2,622

Cost of Goods Sold for August 31 = $2,622

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Weighted AverageWeighted Average

After the August 31 sale, there are 12 units in inventory at $1,368:

12 @ $114

After the August 31 sale, there are 12 units in inventory at $1,368:

12 @ $114

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Weighted AverageWeighted Average

Balance Sheet Inventory = $1,368

Balance Sheet Inventory = $1,368

Income Statement COGS = $4,622

Income Statement COGS = $4,622

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Weighted AverageWeighted Average

Aug. 3 Merchandise inventory 1,590 Accounts payable 1,590

Aug. 14 Accounts receivable 2,600 Sales 2,600

Aug. 14 Cost of goods sold 2,000 Merchandise inventory 2,000

Aug. 17 Merchandise inventory 2,300 Accounts payable 2,300

Aug. 28 Merchandise inventory 1,190 Accounts payable 1,190

Aug. 31 Accounts receivable 3,450 Sales 3,450

Aug. 31 Cost of goods sold 2,622 Merchandise inventory 2,622

Here are the entries to record the purchases and sales entries for Trekking. The numbers in red are determined by

the cost flow assumption used.

All purchases and sales are

made on credit.

The selling price of

inventory was as follows:

8/14 $130 8/31 150

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2. Inventory Costing Under a Perpetual System - Financial Statement Effects of Costing Methods2. Inventory Costing Under a Perpetual System - Financial Statement Effects of Costing Methods

Because prices change, inventory methods nearly always assign different cost amounts.

Because prices change, inventory methods nearly always assign different cost amounts.

Exh. 6.8

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Financial Statement Effects of Costing Methods

Financial Statement Effects of Costing Methods

Advantages of MethodsAdvantages of MethodsAdvantages of MethodsAdvantages of Methods

Smooths out Smooths out price changes.price changes.Smooths out Smooths out

price changes.price changes.

Better matches Better matches current costs in cost current costs in cost of goods sold with of goods sold with

revenues.revenues.

Better matches Better matches current costs in cost current costs in cost of goods sold with of goods sold with

revenues.revenues.

Ending inventory Ending inventory approximates approximates

current current replacement cost.replacement cost.

Ending inventory Ending inventory approximates approximates

current current replacement cost.replacement cost.

First-In, First-In, First-OutFirst-OutFirst-In, First-In, First-OutFirst-Out

Weighted Weighted AverageAverage

Weighted Weighted AverageAverage

Last-In, Last-In, First-OutFirst-OutLast-In, Last-In,

First-OutFirst-Out

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2. Inventory Costing Under a Perpetual System - Tax Effects of Costing Methods2. Inventory Costing Under a Perpetual System - Tax Effects of Costing Methods

The Internal Revenue Service (IRS) The Internal Revenue Service (IRS) identifies several acceptable methods for identifies several acceptable methods for

inventory costing for reporting taxable inventory costing for reporting taxable income.income.

The Internal Revenue Service (IRS) The Internal Revenue Service (IRS) identifies several acceptable methods for identifies several acceptable methods for

inventory costing for reporting taxable inventory costing for reporting taxable income.income.

If LIFO is used for If LIFO is used for tax tax purposespurposes, the IRS requires , the IRS requires

it be used in financial it be used in financial statements.statements.

If LIFO is used for If LIFO is used for tax tax purposespurposes, the IRS requires , the IRS requires

it be used in financial it be used in financial statements.statements.

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2. Inventory Costing Under a Perpetual System - Consistency in Using Costing Methods2. Inventory Costing Under a Perpetual System - Consistency in Using Costing Methods

The The consistency principleconsistency principle requires a company to requires a company to use the same accounting methods period after use the same accounting methods period after

period so that financial statements are period so that financial statements are comparable across periods.comparable across periods.

The The consistency principleconsistency principle requires a company to requires a company to use the same accounting methods period after use the same accounting methods period after

period so that financial statements are period so that financial statements are comparable across periods.comparable across periods.

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3. Inventory valuation and effect of inventory error - Lower of Cost or Market3. Inventory valuation and effect of inventory error - Lower of Cost or Market

Inventory must be reported at market value Inventory must be reported at market value when when marketmarket is is lowerlower than cost.than cost.

Inventory must be reported at market value Inventory must be reported at market value when when marketmarket is is lowerlower than cost.than cost.

Can be applied three ways:Can be applied three ways:(1)(1) separately to each separately to each

individual item.individual item.(2)(2) to major categories of to major categories of

assets.assets.(3)(3) to the whole inventory.to the whole inventory.

Can be applied three ways:Can be applied three ways:(1)(1) separately to each separately to each

individual item.individual item.(2)(2) to major categories of to major categories of

assets.assets.(3)(3) to the whole inventory.to the whole inventory.

Defined as current Defined as current replacement costreplacement cost (not sales price).(not sales price).Consistent withConsistent with

the conservatismthe conservatismprinciple.principle.

Defined as current Defined as current replacement costreplacement cost (not sales price).(not sales price).Consistent withConsistent with

the conservatismthe conservatismprinciple.principle.

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Lower of Cost or MarketLower of Cost or Market

A motorsports retailer has the following items in inventory:A motorsports retailer has the following items in inventory:A motorsports retailer has the following items in inventory:A motorsports retailer has the following items in inventory:

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Lower of Cost or MarketLower of Cost or Market

Here is how to compute lower of cost or market Here is how to compute lower of cost or market for for individual inventory itemsindividual inventory items..

Here is how to compute lower of cost or market Here is how to compute lower of cost or market for for individual inventory itemsindividual inventory items..

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Lower of Cost or MarketLower of Cost or Market

Here is how to compute lower of cost or market Here is how to compute lower of cost or market for for the two groups of inventory itemsthe two groups of inventory items..

Here is how to compute lower of cost or market Here is how to compute lower of cost or market for for the two groups of inventory itemsthe two groups of inventory items..

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Lower of Cost or MarketLower of Cost or Market

Here is how to compute lower of cost or market Here is how to compute lower of cost or market for for the entire inventorythe entire inventory..

Here is how to compute lower of cost or market Here is how to compute lower of cost or market for for the entire inventorythe entire inventory..

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3. Inventory valuation and effect of inventory error - Financial Statement Effects of Inventory Errors3. Inventory valuation and effect of inventory error - Financial Statement Effects of Inventory Errors

Income Statement EffectsIncome Statement Effects

Exh. 6.10

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Financial Statement Effects of Inventory ErrorsFinancial Statement Effects of Inventory Errors

Balance Sheet EffectsBalance Sheet Effects

Exh. 6.12

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4. Decision Analysis - Inventory Turnover4. Decision Analysis - Inventory Turnover

Shows how many times a company turns over its Shows how many times a company turns over its inventory during a period. Indicator of how well inventory during a period. Indicator of how well

management is controlling the amount of inventory management is controlling the amount of inventory available.available.

Shows how many times a company turns over its Shows how many times a company turns over its inventory during a period. Indicator of how well inventory during a period. Indicator of how well

management is controlling the amount of inventory management is controlling the amount of inventory available.available.

Inventory Inventory TurnoverTurnover ==

Cost of goods sold Cost of goods sold

Avg. inventoryAvg. inventory

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4. Decision Analysis - Days’ Sales in Inventory4. Decision Analysis - Days’ Sales in Inventory

Reveals how much inventory is available in Reveals how much inventory is available in terms of the number of days’ sales.terms of the number of days’ sales.

Reveals how much inventory is available in Reveals how much inventory is available in terms of the number of days’ sales.terms of the number of days’ sales.

Days' Sales in Days' Sales in InventoryInventory ==

Ending Inventory Ending Inventory

Cost of goods soldCost of goods sold ×× 365365

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4. Decision Analysis - Supermarket4. Decision Analysis - Supermarket

1. Industry Characteristics High volume, relative cheaper price Chain of stores

2. Key success factors Inventory control Store location decision

3. Companies for analysis Walmart Target

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6. Walmat & Target - Inventory Turnover6. Walmat & Target - Inventory Turnover

  2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995

WMT 7.76 7.80 7.79 7.68 7.39 6.99 6.83 6.33 5.59 5.05 4.50

Target 6.22 5.86 5.62 6.35 6.24 6.27 6.33 6.48 6.25    

Inventory Turnover

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

1994 1996 1998 2000 2002 2004 2006

Year

Inv

en

tory

Tu

rno

ve

r

WMT Target

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6. Walmat & Target - Days’ Sales in Inventory6. Walmat & Target - Days’ Sales in Inventory

Days' Sales in Inventory

22.00

32.00

42.00

52.00

62.00

72.00

82.00

92.00

1994 1996 1998 2000 2002 2004 2006

Year

Da

ys

'Sa

les

in In

ve

nto

ry

WMT Target

  2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995

WMT 48.88 49.42 48.87 49.95 50.59 54.44 57.81 58.27 66.26 71.97 81.13

Target 61.01 62.50 68.70 59.38 59.83 61.49 60.20 60.16 58.40    

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End of Chapter 6End of Chapter 6