Cost of Goods
Sold and
Inventory:
Identification
and Valuation
2
Learning Objectives
 Define inventory for a merchandising
business, and identify the different types of
inventory for a manufacturing business.
 Explain the advantages and disadvantages
of both periodic and perpetual inventory
systems.
 Determine when ownership of goods in
transit changes hands and what
circumstances require shipped inventory to
be kept on the books.
3
Learning Objectives
 Compute total inventory acquisition cost.
 Use the four basic inventory valuation
methods: specific identification, average cost,
FIFO, and LIFO.
 Explain how LIFO inventory layers are
created, and describe the significance of the
LIFO reserve.
4
Learning Objectives
 Choose an inventory valuation method
based on the trade-offs among income tax
effects, bookkeeping costs, and the impact
on the financial statements.
 Analyze inventory using financing ratios,
and properly compare ratios of different
firms after adjusting for differences in
inventory valuation methods.
5
Learning Objectives
EXPANDED MATERIAL
 Use LIFO pools to simplify LIFO
calculations.
 Compute ending inventory and cost of
goods sold using dollar-value LIFO.
6
Unit Cost of Goods Sold
LIFO and FIFO in Times of Inflation
Beginning of
Year
LIFO assumes
the new units LIFO
are sold
FIFO
FIFO assumes
the old units are
sold
End of
Year
Time Line of Business Issues
Involved With Inventory
BUY
Raw
Materials
or Goods
for Resale
ADD
Value
SELL
Finished
Inventory
COMPUTE
Ending
Inventory and
Cost of Goods
Sold
7
8
What Is Inventory?
Inventory designates goods held for
sale in the normal course of business
and, in the case of a manufacturer,
goods in production or to be placed
in production.
How Much Inventory Do
Companies Have?
7
19
9
95
19
93
19
91
19
89
19
87
19
85
19
83
19
81
19
79
18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
19
Inventory as a Percentage of
Total Assets
Inventory Levels for the 50 Largest
Companies, 1979-1998
Source: Standard and Poor’s Compustat
9
10
Inventory Types
Sale
Income
Statement
Items
Cost of
Goods Sold
Finished
Goods
Cost of
Goods Sold
Balance Sheet Items
Retailer Merchandise
Manufacturer
Raw
Materials
Work in
Process
Direct Overhead
Labor
Sale
11
Periodic Inventory Systems
 Cost of Goods Sold is determined and
Inventory is adjusted to proper balance
at period end.
 All purchases of inventoriable
merchandise are recorded in the
Purchases account.
 Ending inventory is determined by
physical count of merchandise on
hand.
12
Perpetual Inventory Systems
 Cost of Goods Sold is determined and
Inventory is adjusted to proper balance
each time inventory is purchased or
sold.
 All purchases of inventoriable goods
are recorded in the Inventory account.
13
Example: Inventory Systems
Assume:
Beginning Inventory
Purchases
Sales
Ending inventory
(physical count)
50 units @ $10 $ 500
300 units @ $10 3,000
275 units @ $15 4,125
70 units @ $10
700
Make the journal entries to record the
purchases and sales for both the periodic and
perpetual inventory systems.
14
Example: Inventory Systems
Purchases of Inventory
Periodic Method
Purchases……………………..
Accounts Payable………….
3,000
3,000
Perpetual Method
Inventory……………………..
Accounts Payable………….
3,000
3,000
15
Example: Inventory Systems
Sales During the Period
Periodic Method
Accounts Receivable…………..
Sales………………………...
4,125
4,125
Perpetual Method
Accounts Receivable…………..
Sales………………………...
4,125
Cost of Goods Sold……………
Inventory……………………
2,750
4,125
2,750
16
Whose Inventory Is It?
• Goods in Inventory.
• Goods in Transit.
– FOB Shipping Point: buyer’s inventory
from time of shipment.
– FOB Destination: seller’s inventory
until receipt by buyer.
• Goods on Consignment: inventory of
the consignor, not the consignee.
17
Goods in Transit
FOB Shipping Point
Buyer
Seller
Quality
Produce
Goods being shipped are included in
inventory of buyer while in transit.
18
Goods in Transit
FOB Destination
Buyer
Seller
Quality
Produce
Goods being shipped are included in
inventory of seller until received by buyer.
19
Goods on Consignment
Title to goods sold on
consignment remains
with the shipper until
their sale or use by the
dealer or customer.
20
What Is Inventory Cost?
• Inventory Cost is all expenditures related to
inventory acquisition, preparation, and placement
for sale.
• Trade Discounts
– Convert the catalog price to the actual price.
– Record inventory at discounted price.
• Cash Discounts
– Granted for payment of invoices within a
limited time period.
– Record inventory using the net method or gross
method.
21
Cash Discounts--Net Method
• Records inventory net of any purchase
(cash) discounts.
• Example:
June 1--purchased inventory for $100
Terms of payment: 2/10, n/30
Assuming a perpetual inventory method,
record the purchase of the inventory and
payment on June 8.
22
Cash Discounts--Net Method
June 1
Inventory.............................. 98
Accounts Payable.....….....
98
23
Cash Discounts--Net Method
June 1
Inventory.............................. 98
Accounts Payable.....….....
June 8
Accounts Payable................ 98
Cash.........................….....
98
98
24
Cash Discounts--Net Method
Now, assume that the
payment was not made
until June 28.
25
Cash Discounts--Net Method
June 28
Accounts Payable..............….
Discounts Lost……………..
Cash..............................….
98
2
100
26
Cash Discounts--Gross Method
• Record inventory at gross cost; discounts
are recorded only if taken.
• Example:
June 1--purchased inventory for $100
Terms of payment: 2/10, n/30
Assuming a perpetual inventory method,
record the purchase of the inventory and
payment on June 8.
27
Cash Discounts--Gross Method
June 1
Inventory.............................. 100
Accounts Payable.....….....
100
28
Cash Discounts--Gross Method
June 1
Inventory.............................. 100
Accounts Payable.....….....
100
June 8
Accounts Payable................ 100
Inventory………………..
2
Cash.........................….....
98
29
Cash Discounts--Gross Method
Again, assume that the
payment was not made
until June 28.
30
Cash Discounts--Gross Method
June 28
Accounts Payable..............…. 100
Cash..............................….
100
31
Cost of Goods Manufactured
Bartlett Corporation
Schedule of Cost of Goods Manufactured
For the Year Ended December 31, 2002
The heading.
Bartlett Corporation
Schedule of Cost of Goods Manufactured
For the Year Ended December 31, 2002
32
Cost of Goods Manufactured
Direct materials:
Raw materials inventory,
January 1, 2002
$ 21,350
Purchases
107,500
Cost of raw materials available
for use
$128,850
Less: Raw materials inventory,
December 31, 2002
22,350
Raw materials used in production
Direct labor
Continued
$106,500
96,850
33
Cost of Goods Manufactured
Manufacturing overhead:
Indirect labor
Factor supervision
Depreciation---factory buildings
and equipment
Light, heat, and power
Factory supplies
Miscellaneous mfg. overhead
Total manufacturing costs
Add: Work in process, Jan. 1, 2002
$40,000
29,000
20,000
18,000
15,000
12,055
Less: Work in process, Dec. 31, 2002
Cost of goods manufactured
134,055
$337,405
29,400
$366,805
26,500
$340,305
34
Impact of Cash Discounts
$10,000
Owed
$9,800
Owed
10 Days
20 Days
Supplier “Loan” Period
Purchase
Date
End of
Discount
Period
Final
Payment
Date
35
Inventory Cost Flow Methods
Cost
Allocation
Methods
Specific
Identification
Actual Cost
FIFO
Average
Cost
Cost Pools
LIFO
Dollar Value
Frequency of Use of Inventory
Valuation Methods
U. S. Companies
1979 and 1998
Inventory
Method
1979
1998
1998
All Companies All Companies Large Companies
FIFO
75.6%
LIFO
25.8%
Average cost
20.8%
Specific
Identification 3.7%
82.9%
12.5%
15.7%
72.6%
33.0%
30.0%
3.2%
2.6%
36
37
Specific Identification Method
 Assigns the actual cost of the asset to
Inventory and Cost of Goods Sold.
 Provides a highly objective method of
matching costs because cost flow
exactly matches physical goods flow.
 Is almost impossible to implement
cost effectively.
38
Specific Identification
Apr. 1
Apr. 10
Apr. 20
100 units @ $10 per unit
80 units @ $11 per unit
70 units @ $12 per unit
Sold 80 units from the beginning inventory,
40 units from the April 10 purchase, and 20
units from the April 20 purchase.
39
Specific Identification
Apr. 1
Apr. 10
Apr. 20
20 units @ $10 per unit
= $ 200
=
440
40 units @ $11 per unit
50 units @ $12 per unit
=
600
Ending inventory……………. $1,240
Sold 80 units from the beginning inventory,
40 units from the April 10 purchase, and 20
units from the April 20 purchase.
Beg. Inv. + Purchases - End. Inv. = Cost of Goods Sold
$1,000 + $1,720 - $1,240 =
$1,480
40
Average Cost Method
• Assigns the same average cost to each
unit sold and each item in inventory.
• For Periodic Inventory, the unit cost is
the weighted average for the entire
period.
• For Perpetual Inventory, the unit cost is
computed as a moving average, which
changes with each new purchase of
goods.
41
Average Cost Method--Periodic
Apr. 1
Apr. 10
Apr. 20
100 units @ $10 per unit
=
=
=
$1,000
880
840
$2,720
80 units @ $11 per unit
70 units @ $12 per unit
250 units
$2,720  250 units = $10.88
$10.88 x 110 units = ending inventory of $1,197
Sold 140-units
Beg. Inv. + Purchases
End.during
Inv. = April.
Cost of Goods Sold
$1,000 + $1,720 - $1,197 =
$1,523
42
Average Cost Method--Perpetual
Apr.
Apr.
Apr.
Apr.
Apr.
Apr.
Apr.
Apr.
Apr.
1
10
10
18
18
20
20
27
30
Beginning Inventory
Purchases
Balance
Sales
Balance
Purchases
Balance
Sales
Balance
100
80
180
-90
90
70
160
-50
110
units @ $10
$1,000
units @ $11
880
units @ $10.44 $1,880
units @ $10.44
-940
units @ $10.44 $ 940
units @ $12
840
$1,880
 180
units @
$11.125
$1,780
units @ $11.125 -556
units @ $11.125 $1,224
Cost of Goods Sold (140 units) $940 + $556
$1,496
Ending Inventory (110 units @ $11.125) $1,780  160
$1,224
43
First-in, First-out (FIFO) Method
 Assigns historical unit cost to Cost of
Goods Sold in the order the costs are
incurred.
 Provides a close match between physical
product flow and product cost flow.
 Results in the same inventory valuation
and Cost of Goods Sold regardless of
whether perpetual or periodic inventory
is used.
44
Last-in, First-out (LIFO) Method
 Assigns the most recent historical
costs to Cost of Goods Sold and the
oldest costs to Inventory.
 Is used primarily to minimize taxable
income.
 Results in differences between Cost of
Goods Sold and Inventory for
perpetual inventory versus periodic
inventory.
45
Last-in, First-out (LIFO) Method
Periodic Inventory System
Apr. 1
Apr. 10
Apr. 20
100 units @ $10 per unit
Sold 0
10 units @ $11 per unit
80
700 units @ $12 per unit
Sold 70
Sold 140 units during April.
Sold all
46
Last-in, First-out (LIFO) Method
Periodic Inventory System
Apr. 1
Apr. 10
Apr. 20
$1,000
110
80 units @ $11 per unit
10
0
700 units @ $12 per unit
Ending inventory……………….. $1,110
100 units @ $10 per unit
=
=
=
Beg. Inv. + Purchases - End. Inv. = Cost of Goods Sold
$1,000 + $1,720 - $1,110 =
$1,610
47
Last-in, First-out (LIFO) Method
Perpetual Inventory System
Apr. 1
Apr. 10
Apr. 20
90
100
800
20
70
units @ $10 per unit
units @ $11 per unit
units @ $12 per unit
Beginning
Sold 10
inventory
Purchased
Sold
80 80
Purchased
Sold 50 70
48
Last-in, First-out (LIFO) Method
Perpetual Inventory System
Apr. 1
Apr. 10
Apr. 20
= $ 900
90 units @ $10 per unit
100
=
0
800 units @ $11 per unit
=
240
20
70 units @ $12 per unit
Ending inventory……………….. $1,140
Beg. Inv. + Purchases - End. Inv. = Cost of Goods Sold
$1,000 + $1,720 - $1,140 =
$1,580
49
Inventory Turnover
Appropriateness of inventory size and
position can be measured by calculating
the Inventory Turnover Ratio.
Inventory Turnover:
Cost of Goods Sold ÷ Average Inventory
50
Example: Inventory Turnover
• Cost of Goods Sold
• Beginning Inventory
• Ending Inventory
$1,000
$ 90
$ 110
Determine the inventory
turnover.
51
Example: Inventory Turnover
• Cost of Goods Sold
• Beginning Inventory
• Ending Inventory
$1,000
($90 + $110)/2
$1,000
$ 90
$ 110
= 10
Number of Days’ Sales
in Inventory
$1,000
($90 + $110)/2
365
10
Number of days’ sales in
inventory is 36.5
= 10
52
53
Example--Dollar-Value LIFO
1. Compute ending inventory at ending
prices.
2. Compute beginning inventory at ending
prices.
3. Compute the difference. An increase
represents a new LIFO layer.
4. LIFO ending inventory is beginning
inventory at base-year prices plus the
new LIFO layer.
54
Example--Dollar-Value LIFO
Assuming 1999 is the first year Harry’s
Hardware, Inc. uses dollar-value LIFO,
the following slides illustrate the
calculations for 2000, 2001, and 2002
ending inventory.
55
Example--Dollar-Value LIFO
Assume the following inventory data for
Harry’s:
Inventory
Year
(nominal)
Price Index
1999
$ 76
1.0
2000
$ 108
1.2
2001
$ 90
1.5
2002
$ 255
1.7
56
Example--Dollar-Value LIFO
Inv @
DollarInv @ Base Base
Value
EoY EoY Year Year Layer LIFO
Year Cost Index Cost Layers Index Cost
1999 $ 76 ÷1.0 = $ 76 $ 76 x 1.0 = $ 76.0
Ending
inventory
DVLifo
1999
57
Example--Dollar-Value LIFO
Inv @
DollarInv @ Base Base
Value
EoY EoY Year Year Layer LIFO
Year Cost Index Cost Layers Index Cost
1999 $ 76 ÷1.0 = $ 76 $ 76 x 1.0 = $ 76.0
2000 $108
58
Example--Dollar-Value LIFO
Inv @
DollarInv @ Base Base
Value
EoY EoY Year Year Layer LIFO
Year Cost Index Cost Layers Index Cost
1999 $ 76 ÷1.0 = $ 76 $ 76 x 1.0 = $ 76.0
2000 $108 ÷1.2 = $ 90
59
Example--Dollar-Value LIFO
Inv @
DollarInv @ Base Base
Value
EoY EoY Year Year Layer LIFO
Year Cost Index Cost Layers Index Cost
1999 $ 76 ÷1.0 = $ 76 $ 76 x 1.0 = $ 76.0
2000 $108 ÷1.2 = $ 90 $ 76 x 1.0 = $ 76.0
14 x 1.2 = 16.8
Ending inventory (DV Lifo, 2000)
$ 92.8
60
Example--Dollar-Value LIFO
Inv @
DollarInv @ Base Base
Value
EoY EoY Year Year Layer LIFO
Year Cost Index Cost Layers Index Cost
1999 $ 76 ÷1.0 = $ 76 $ 76 x 1.0 = $ 76.0
2000 $108 ÷1.2 = $ 90 $ 76 x 1.0 = $ 76.0
14 x 1.2 = 16.8
Ending inventory (DV Lifo, 2000)
$ 92.8
2001 $ 90 ÷1.5 = $ 60 $ 60 x 1.0 = $ 60.0
Continued
61
Example--Dollar-Value LIFO
Inv @
DollarInv @ Base Base
Value
EoY EoY Year Year Layer LIFO
Year Cost Index Cost Layers Index Cost
2001 $ 90 ÷1.5 = $ 60 $ 60 x 1.0 = $ 60.0
2002 $255 ÷1.7 = $150 $ 60 x 1.0 = $ 60.0
90 x 1.7 = 153.0
Ending
Ending inventory (DV Lifo, 2002)
$213.0
inventory
DVLifo
2001
62
LIFO Advantages
Advantages:
• Matches current costs with current
revenues.
• Excludes inventory holding gains from
gross profit.
• Income tax deferral.
63
LIFO Disadvantages
Disadvantages:
• Does not correspond with the physical
flow of goods.
• Potential LIFO liquidation can draw
old costs into cost of goods sold.
• Ending inventory balance can be much
lower than current replacement cost.
64
FIFO Advantages
Advantages:
• Corresponds with physical flow of
goods.
• Ending inventory balance is close to
current replacement cost.
65
FIFO Disadvantages
Disadvantages:
• Matches older costs with current
revenues.
• Inventory holding gains and losses are
part of gross profit.
• No income tax deferral.
66
The End