Chapter 10
Cost of
Goods Sold
and
Inventory
Financial Statement Items
Covered in this Chapter
Balance Sheet
Current Assets
Income
Statement
Cost of Goods Sold
Inventory
Current Liabil
Accounts Payable
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Statement of
Cash Flows
Operating
Cash paid for
inventory
purchases
2
What is Inventory?
Inventory
• Represents goods that are either
manufactured or purchased for resale
in the normal course of business
• Classified as an asset on the balance
sheet
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4
Time Line of Business Issues
Involving Inventory
BUY
ADD
SELL
raw materials or
goods for resale
value
finished
inventory
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COMPUTE
ending
inventory
cost of
goods sold
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Inventory: Manufacturing Firm
• Three types:
– Raw materials
•Goods acquired in a raw state that will
eventually be finished products
– Work in process
•Partially finished products
– Finished goods
•Completed products waiting for sale
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Inventory Cost Flow:
Manufacturing Company
Balance Sheet
Raw
Materials
Work in
Process
Manufacturing
Overhead
Income Statement
Finished
Goods
Cost of
Goods Sold
Labor
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7
Inventory Ownership
• Legal title rule
– Entity holding legal title to the goods
– Report as an asset on the balance sheet
• Goods in transit
– Legal title depends upon the shipping
terms
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Goods in Transit
• Shipping terms:
– FOB (free-on-board) destination
•The seller is paying the shipping cost
•The seller owns the inventory until it is
delivered
– FOB shipping point
•The buyer is paying the shipping cost
•The buyer owns the inventory during
transit
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Ownership Transfer
for Goods in Transit
FOB Shipping Point
•Buyer owns goods in transit
•Ownership changes at shipping point
Seller
Buyer
FOB Destination
•Seller owns goods in transit
•Ownership changes at destination
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Goods on Consignment
• Dealer holds and sells merchandise
– Has possession but not asset
• Merchandise owned by supplier
– Has asset but not possession
• Dealer does not pay for the inventory
unless it is sold
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The Cost of Inventory
The Cost of Inventory
• The cost of inventory includes all costs
of acquisition and preparation for sale
– Purchase price
– Freight
– Receiving and storage costs
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The Cost of Inventory
• The cost of work in process and
finished goods inventory includes
– Raw materials
– Production labor
– Some allocation of factory overhead
•Activity-based cost (ABC) systems
allocate overhead based on some clearly
identified cost drivers
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Accounting for Inventory
and Cost of Goods Sold
Cost of Goods Sold
+
=
–
=
Beginning Inventory
Inventory Purchases
Goods Available for Sale
Ending Inventory
Cost of Goods Sold
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Overview of Perpetual
and Periodic Systems
• Perpetual system
– Inventory records are updated whenever a
purchase or a sale is made
– Advances in information technology have
made the cost of using this system
practical
• Periodic system
– Inventory records are not updated when a
sale is made
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17
Taking a Physical Count
of Inventory
• The actual quantity on hand is
determined by taking a physical count
• A cost is attached to the quantity
counted
• With a perpetual system, a physical
count can reveal inventory shrinkage
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Ending Inventory Errors
If ending
Cost of Goods Net Income
inventory is ... Sold is ...
is ...
Overstated
Understated
Overstated
Understated
Overstated
Understated
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Inventory Valuation
Methods
Inventory Valuation Methods
• Where specific identification is not possible,
an assumption must be made about which
cost is associated with the units remaining
• Four assumptions are accepted under U.S.
GAAP:
– Specific identification
– Average cost
– FIFO (first-in, first-out)
– LIFO (last-in, first-out)
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Example:
Inventory Valuation Methods
Assume the following data:
January 1
March 23
July 15
November 6
Units
200
300
500
100
1,100
Unit
Cost
$10
$12
$11
$13
Total
Cost
$2,000
3,600
5,500
1,300
$12,400
Sales: 700 units @ $15
Ending Inventory: 400 units
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Specific Identification
• Requires no assumption about the
flow of inventory units
• Inventory items are specifically
identified and valued
• The actual cost of goods sold can be
computed as inventory is sold
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Example:
Average Cost Method
Cost of Goods Available for Sale
= Average Cost Per Unit
Units Available for Sale
$12,400
= $11.27
1,100 units
Ending Inventory
400 Units × $11.27 $4,510
Cost of Goods Sold
700 Units × $11.27
7,890
Cost of Goods Available for Sale
$12,400
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Example:
FIFO
Purchases
Purchase Number of
Date
01-Jan
23-Mar
15-Jul
06-Nov
Units
Unit
Cost
FIFO Cost of Goods
Number of
Units
200 $ 10
300
12
500
11
100
13
1,100
Total Cost
200 $
300
200
0
700 $
2,000
3,600
2,200
7,800
Ending Inventory
Number of
Units
Total Cost
0 $
0
300
3,300
100
1,300
400 $ 3,300
Assumption: The units sold are the oldest units on hand.
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Example:
LIFO
Purchases
Purchase Number of Unit
Date
Units
Cost
06-Nov
100 $ 13
15-Jul
500
11
23-Mar
300
12
01-Jan
200
10
1,100
LIFO Cost of Goods
Number of
Units
Total Cost
100 $ 1,300
500
5,500
100
1,200
0
700 $ 8,000
Ending Inventory
Number of
Units
Total Cost
0 $
0
200
2,400
200
2,000
400 $ 2,400
Assumption: The units sold are the newest units on hand.
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Comparison of Methods
Goods
Available
for Sale
=
Ending
Inventory
+ Goods Sold
1,100 units =
400 units
+
700 units
FIFO
$12,400
=
$4,600
+
$7,800
LIFO
$12,400
=
$4,400
+
$8,000
Average
Cost
$12,400
=
$4,510
+
$7,890
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Comparison of Methods
• In period of rising prices, highest Net
Income with FIFO
• LIFO favored for tax purposes
– Must also use for financial reporting
• Choice:
– High profits and high taxes with FIFO
– Low profits and low taxes with LIFO
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More About LIFO
LIFO Layers
• Any year in which the number of
units purchased exceeds the number
of units sold, a new LIFO layer is
created in ending inventory
• The creation of LIFO layers results in
ending inventory at very old prices
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LIFO Layers Example
Purchases
Year of Number of Unit
Purchase
Units
Cost
2004
120
$5
2005
2006
150
160
Sales
Number of
Units
100
$10
$15
120
120
Ending Inventory
Number of
Units
Unit Cost Total Cost
20
$5
$100
20
30
$5
$10
$400
20
30
40
$5
$10
$15
$1,000
20 units from 2004 + 30 units from 2005
20 units from 2004 + 30 units from 2005 + 40 units from 2006
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LIFO Reserve
• The difference between the LIFO
ending inventory amount and the
amount obtained using another method
(e.g., FIFO or average cost)
• Disclosed to aid in comparing
companies that use different inventory
cost flow assumptions
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LIFO Liquidation
• Occurs when the number of units
purchased does not exceed the number
of units sold
• The old LIFO layer costs to flow
through cost of goods sold, reducing
cost of goods sold and increasing net
income
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Inventory Estimation
and Valuation
Gross Profit Method
• Used to estimate inventory without
actually taking a physical count
• The gross profit percentage is
applied to estimate cost of goods
sold, and ultimately gross profit
 Sales - CGS  = Gross Profit %
Sales
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Example:
Gross Profit Method
Assume the following data:
Beginning inventory, January 1
$25,000
Purchases, January 1 through January 31
40,000
Sales, January 1 through January 31
50,000
Historical gross profit percentage
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40%
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Gross Profit Method
Sales (actual)
$50,000
100%
20,000
40%
$30,000
60%
Gross profit (estimate)
Cost of goods sold (estimate)
Beginning inventory (actual)
+ Purchases (actual)
= Cost of goods avail for sale (actual)
$25,000
40,000
65,000
- Cost of goods sold (estimate)
30,000
= Ending inventory (estimate)
35,000
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Lower of Cost or Market
• Recognizes inventory price declines,
but not price increases until the
inventory is sold
• Market value is defined as
– Replacement cost or
– Net realizable value
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Lower of Cost or Market
•
•
•
Replacement cost is the cost to buy
equivalent new inventory items
Net realizable value is the amount
expected to be received when the
inventory is sold
Rule of thumb: Inventory is valued on the
balance sheet at the lowest of
1. historical cost,
2. replacement cost, or
3. net realizable value
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Lower of Cost or Market
• An inventory write-down when
market value is lower than cost
recognizes the economic loss when it
happens rather than when the
inventory is sold
• This is another example of the
principle of conservatism
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Evaluating Inventory Levels
and Budgeting Cash
Disbursements
Evaluating the Level of Inventory
• Inventory turnover
– Measures how many times a company
turns over its inventory during the year
• Number of days’ sales in inventory
– Measures the number of days’ sales
represented in the inventory value
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Evaluating the Level of Inventory
Cost of Goods Sold
Inventory turnover =
Average Inventory
365
Number of Days' Sales in Inventory =
Inventory Turnover
These ratios are compared with those of other
firms in the same industry and with
comparable ratios for the same firm in
previous years.
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Number of Days’ Purchases in
Accounts Payable
365
Number of Days' Purchases =
in Accounts Payable
Inventory Turnover
Indicates how long it takes for a
company to pay its suppliers
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Managing Cash Flow
Number of Days’ Sales in
Inventory
Average Collection
Period
Operating Cycle
Detailed cash payment forecasting is used to
plan the specific timing of loan receipts and
repayments
Number of
Days’
Purchases
in Accounts
Payable
External financing needed
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Budgeting Cash Outflows
• A cash budget is an important tool in
helping management plan its cash
needs
• Estimating cash and credit sales, as
well as estimating the pattern of
collection of accounts receivable, are
key to the cash receipts budgeting
process
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Cash Budgeting Example
Sales
November
December
January
February
March
$100,000
200,000
100,000
50,000
150,000
Cost of Goods Sold =
80% of sales
Merchandise Payment Pattern
Month after purchase
50%
Second month following
50%
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January Sales
Cost of Goods Sold Percentage
Inventory required
for estimated sales
Adjustment for desired
inventory levels
Required Purchases
100,000
80%
80,000
0
80,000
Pay in February
$40,000
Pay in March
$40,000
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Third Quarter
Cash Disbursements for Inventory
Total Sales
November December January February
March
$ 100,000 $ 200,000 $ 100,000 $ 50,000 $ 150,000
Cost of Goods Sold (80%)
$ 80,000 $ 160,000 $ 80,000 $ 40,000 $ 120,000
Inventory Purchases
$ 80,000 $ 160,000 $ 80,000 $ 40,000 $ 120,000
Cash Disburse for Inven:
November Purchases
December Purchases
January Purchases
February Purchases
March Purchases
40,000
$
40,000
80,000
80,000
40,000
40,000
20,000
-
- $ 40,000 $ 120,000 $ 120,000 $ 60,000
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In Summary ...
• Retailer inventory: purchased for resale
• Manufacturer inventory: raw materials purchased for
further processing; work in process, and finished goods
held for resale
• Inventory cost: all costs necessary to bring to a point of
readiness
• Cost flow assumptions: LIFO, FIFO, and average cost
• LIFO creates layers; inventory is carried at oldest (lowest)
costs which results in higher cost of sales, lower profit,
and lower taxes
• Gross profit method is an estimation tool for inventory
value
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