chapter 9
Inventory and
Cost of Goods
Sold
An electronic presentation
by Douglas Cloud
Pepperdine University
1
2
Learning Objectives
1. Define inventory for a merchandising
business, and identify the different types of
inventory for a manufacturing business.
2. Explain the advantages and disadvantages
of both periodic and perpetual inventory
systems.
3. Determine when ownership of goods in
transit changes hands and what
circumstances require shipped inventory to
be kept on the books.
Continued
3
Learning Objectives
4. Compute total inventory acquisition cost.
5. Use the four basic inventory valuation
methods: specific identification, average
cost, FIFO, and LIFO.
6. Explain how LIFO inventory layers are
created, and describe the significance of the
LIFO reserve.
Continued
4
Learning Objectives
7. Choose an inventory valuation method
based on the trade-offs among income tax
effects, bookkeeping costs, and the impact
on the financial statements.
8. Apply the lower-of-cost-or-market (LCM)
rule to reflect declines in the market value
of inventory.
9. Use the gross profit method to estimate
ending inventory.
Continued
5
Learning Objectives
10. Determine the financial statement impact
of inventory recording errors.
11. Analyze inventory using financing ratios,
and properly compare ratios of different
firms after adjusting for differences in
inventory valuation methods.
EXPANDED
MATERIAL
12.
Account for
the impact of changing prices
on purchase commitments.
13. Record inventory purchase transactions
denominated in foreign currencies.
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
SELL
COMPUTE
Value
Finished
Inventory
Cost
Ending
of
Goods
Inventory
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?
9
Source: Standard and Poor’s Compustat
99
19
97
19
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, 1979-2000
10
Raw Materials
Raw Materials are goods
acquired for use in theMaterials that are
necessary in the
production
process.
Materials that are used
production process but
directly in the production
are not directly
of goods are frequently
incorporated into the
referred to as direct
product are referred to as
materials.
indirect materials.
11
Work in Process
Work in process consists of materials
partly processed and requiring further
work before they can be sold. This
inventory includes three cost elements.
1. Direct materials
2. Direct labor
3. Manufacturing overhead
12
Finished Goods
Finished goods are the manufactured
products awaiting sale.
Balance Sheet
Income Statement
Direct Labor
Raw
Materials
Work in
Process
Manufacturing
Overhead
Finished
Goods
Cost of
Goods
Sold
13
Summary
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
14
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.
15
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.
16
Inventory Systems
Purchases of Inventory
Periodic Method
Purchases
Accounts Payable
3,000
3,000
Perpetual Method
Inventory
Accounts Payable
3,000
3,000
17
Inventory Systems
Sales During the Period
Periodic Method
Accounts Receivable
Sales
4,125
4,125
Perpetual Method
Accounts Receivable
Sales
Cost of Goods Sold
Inventory
4,125
4,125
2,750
2,750
18
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.
19
Goods in Transit
FOB Shipping Point
Buyer
Seller
Quality
Produce
Goods being shipped are included in
inventory of buyer while in transit.
20
Goods in Transit
FOB Destination
Buyer
Seller
Quality
Produce
Goods being shipped are included in
inventory of seller until received by buyer.
21
Goods on Consignment
Title to goods sold on
consignment remains
with the shipper until
their sale or use by the
dealer or customer.
22
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.
Schedule of Cost of Goods
Manufactured
Bartlett Corporation
Schedule of Cost of Goods Manufactured
For the Year Ended December 31, 2005
The heading.
Bartlett Corporation
Schedule of Cost of Goods Manufactured
For the Year Ended December 31, 2002
23
Schedule of Cost of Goods
Manufactured
Bartlett Corporation
Schedule of Cost of Goods Manufactured
For the Year Ended December 31, 2005
Direct materials:
Raw materials
Purchases
Cost of raw materials available for use
Less raw materials inventory, Dec. 31
Raw materials used in production
Direct labor
Manufacturing overhead:
Continued
$ 21,350
107,500
$128,850
22,350
$106,500
96,850
24
Schedule of Cost of Goods
Manufactured
Manufacturing overhead:
Indirect labor
$ 40,000
Factory supervision
29,000
Depr.—factory building and equipment
20,000
Light, heat, and power
18,000
Factory supplies
15,000
Miscellaneous manufacturing overhead
12,055 134,055
Total manufacturing costs
$337,405
Add work in process inventory, January 1
99,400
$366,805
Less work in process inventory, December 31
26,500
Cost of goods manufactured
$340,305
25
26
Cash Discounts
• Records inventory net of any purchase
(cash) discounts.
• Example:
June 1—purchased merchandise for
$10,000
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
$10,000
Owed
$9,800
Owed
10 Days
20 Days
Supplier “Loan” Period
Purchase
Date
End of
Discount
Period
Final
Payment
Date
28
Cash Discounts—Net Method
June 1
Inventory
Accounts Payable
9,800
June 8
Accounts Payable
Cash
9,800
9,800
9,800
29
Cash Discounts—Net Method
Now, assume that the
payment was not made
until June 28.
30
Cash Discounts—Net Method
June 28
Accounts Payable
Discounts Lost
Cash
9,800
200
10,000
31
Cash Discounts—Net Method
If the invoice has not been paid at the
end of the period (assume June 30) and
the discount period has lapsed, the
following adjusting entry is made:
June 30
Discounts Lost
Accounts Payable
200
200
32
Cash Discounts—Gross Method
• Record inventory at gross cost; discounts
are recorded only if taken.
• Example:
June 1—purchased inventory for $10,000.
Terms of payment: 2/10, n/30
Assuming a perpetual inventory method,
record the purchase of the inventory and
payment on June 8.
33
Cash Discounts—Gross Method
June 1
Inventory
Accounts Payable
June 8
Accounts Payable
Inventory
Cash
10,000
10,000
10,000
200
9,800
34
Cash Discounts—Gross Method
Again, assume that the
payment was not made
until June 28.
35
Cash Discounts—Gross Method
June 28
Accounts Payable
Cash
10,000
10,000
Purchases Returns and
Allowances
36
Periodic Inventory System
Accounts Payable
Purchase Returns and
Allowances
400
400
Perpetual Inventory System
Accounts Payable
Inventory
400
400
37
Inventory Valuation Methods
Cost
Allocation
Methods
Specific
Identification
FIFO
Average
Cost
LIFO
38
Inventory Valuation Methods
Assume:
Purchases:
January 1
March 23
July 15
November 6
Total purchases
Sales
200
300
500
100
1,100
700
@ $10
@ $12
@ $11
@ $13
$12,400
@ $15
$ 2,000
3,600
5,500
1,300
Frequency of Use of Inventory
Valuation Methods
U. S. Companies
1979 and 2000
Inventory
Method
1979
2000
2000
All Companies All Companies Large Companies
FIFO
75.6%
LIFO
25.8%
Average cost
20.8%
Specific
Identification 3.7%
75.9%
15.7%
21.4%
68.6%
34.6%
32.9%
4.5%
3.9%
SOURCE: Standard and Poor’s COMPUSTAT
39
40
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.
41
Specific Identification Method
Jan. 1
200 units @ $10 per unit
Mar. 23
July 15
Nov. 6
300 units @ $12 per unit
500 units @ $11 per unit
100 units @ $13 per unit
1,100 units
Sold 200 units from the January 1
and 500 from the July 15 purchase.
42
Specific Identification Method
Jan. 1
200 units @ $10 per unit
July 15
500 units @ $11 per unit
43
Specific Identification Method
Jan. 1
200 units @ $10 per unit
= $2,000
July 15
500 units @ $11 per unit
= 5,500
Total cost of goods sold
$7,500
44
Specific Identification Method
Goods Not Sold
Mar. 23
300 units @ $12 per unit
= $3,600
Nov. 6
100 units @ $13 per unit
= 1,300
Ending inventory
$4,900
45
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.
46
Average Cost Method
Jan. 1
200 units @ $10 per unit
Mar. 23
July 15
Nov. 6
300 units @ $12 per unit
500 units @ $11 per unit
100 units @ $13 per unit
1,100 units
= $ 2,000
=
3,600
=
5,500
=
1,300
$12,400
$12,400 1,100 units = $11.27 per unit (rounded)
Cost of goods sold = $11.27 x 700 = $7,890
Ending inventory = $11.27 x 400 = $4,510
47
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.
48
First-in, First-out (FIFO) Method
Jan. 1
200 units @ $10 per unit
Mar. 23
July 15
Nov. 6
300 units @ $12 per unit
500 units @ $11 per unit
100 units @ $13 per unit
= $2,000
Sold 200
49
First-in, First-out (FIFO) Method
Jan. 1
200 units @ $10 per unit
Mar. 23
July 15
Nov. 6
300 units @ $12 per unit
500 units @ $11 per unit
100 units @ $13 per unit
= $2,000
= 3,600
Sold 300
50
First-in, First-out (FIFO) Method
Jan. 1
200 units @ $10 per unit
Mar. 23
July 15
Nov. 6
300 units @ $12 per unit
500 units @ $11 per unit
100 units @ $13 per unit
Total cost of goods sold
= $2,000
= 3,600
= 2,200
Sold 200
$7,800
51
First-in, First-out (FIFO) Method
Goods Not Sold
Mar. 23
300 units @ $12 per unit
= $3,600
Nov. 6
100 units @ $13 per unit
= 1,300
Ending inventory
$4,900
52
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.
53
Last-in, First-out (LIFO) Method
Jan. 1
200 units @ $10 per unit
Mar. 23
July 15
Nov. 6
300 units @ $12 per unit
500 units @ $11 per unit
100 units @ $13 per unit
= $1,300
Sold 100
54
Last-in, First-out (LIFO) Method
Jan. 1
200 units @ $10 per unit
Mar. 23
July 15
Nov. 6
300 units @ $12 per unit
500 units @ $11 per unit
100 units @ $13 per unit
= $5,500
Sold 500
= $1,300
55
Last-in, First-out (LIFO) Method
Jan. 1
200 units @ $10 per unit
Mar. 23
July 15
Nov. 6
300 units @ $12 per unit
500 units @ $11 per unit
100 units @ $13 per unit
Total cost of goods sold
= $1,200
Sold 100
= $5,500
= $1,300
$8,000
56
Last-in, First-out (LIFO) Method
Goods Not Sold
Jan. 1
200 units @ $10 per unit
Mar. 23
200 units @ $12 per unit
Ending inventory
= $2,000
= 2,400
$4,400
Comparison of Inventory
Methods (Periodic)
Cost of
Goods Sold
$7,500
Ending
Inventory
$4,900
Average cost
$7,890
$4,510
FIFO
$7,800
$4,600
LIFO
$8,000
$4,400
Specific identification
57
58
Perpetual Inventory
Assume:
Beginning inventory
Purchases:
April 10
April 20
Sales:
April 18
April 27
100
@ $10
$1,000
80
70
@ $11
@ $12
880
840
90
50
@ $15
@ $16
59
FIFO Method—Perpetual
FIFO periodic and FIFO
perpetual provide identical
results for cost of goods sold
and inventory.
60
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 units @ $10
$1,000
80 units @ $11
880
180 units @ $10.44 $1,880
(90) units @ $10.44
(940)
90 units @ $10.44 $ 940
70 units @ $12
840
 180
160 units $1,880
@ $11.125
$1,780
(50) units @ $11.125 (556)
110 units @ $11.125 $1,224
$1,780  160
Ending inventory, $1,224
61
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 units @ $10
$1,000
80 units @ $11
880
180 units @ $10.44 $1,880
(90) units @ $10.44
(940)
90 units @ $10.44 $ 940
70 units @ $12
840
160 units @ $11.125 $1,780
(50) units @ $11.125 (556)
110 units @ $11.125 $1,224
Cost of Goods Sold (140 units) $940 + $556 = $1,496
62
LIFO Method—Perpetual
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
63
LIFO Method—Perpetual
Perpetual Inventory System
= $ 900
90 units @ $10 per unit
100
=
0
Apr. 10
800 units @ $11 per unit
=
240
20
Apr. 20
70 units @ $12 per unit
Ending inventory……………….. $1,140
Apr. 1
Beg. Inv. + Purchases – End. Inv. = Cost of Goods Sold
$1,000 + $1,720 – $1,140 =
$1,580
Size of LIFO Reserve for
Selected U.S. Companies
Reported
LIFO
Inventory
$10,034
LIFO
Reserve
$1,814
Sears Roebuck
4,912
590
Ford
6,191
905
ExxonMobil
7,904
4,200
Deere & Co.
1,506
1,004
General Electric
8,565
676
Company Name
General Motors
64
65
FIFO Advantages
Advantages:
• Usually corresponds with physical
flow of goods.
• Ending inventory balance agrees
closely with current replacement cost.
66
FIFO Disadvantages
Disadvantages:
• Can cause older costs to be matched
with current revenues.
• Inventory holding gains and losses are
included as part of gross profit.
• Yields higher taxable income in times
of inflation if inventory levels are
stable or increasing.
67
LIFO Advantages
Advantages:
• Matches current costs with current
revenues.
• Excludes inventory holding gains from
gross profit.
• Yields lower taxable income in times
of inflation if inventory levels are
stable or increasing.
68
LIFO Disadvantages
Disadvantages:
• Usually does not correspond with the
physical flow of goods.
• Potential LIFO liquidation means old cost
in LIFO layers can be drawn in to cost of
goods sold.
• Ending inventory balance can be much
lower than current replacement cost.
• LIFO liquidation can result in greatly
increased tax payments when inventory
levels decline.
69
Lower of Cost or Market
The term “market” in lower
of cost or market means
replacement cost.
70
Lower of Cost or Market
Ceiling:
Ceiling:
Also
Estimated
known as
selling
the net
price –realizable
normal selling
value costs
Replacement
Cost
Market
compare
Historical Cost
Floor: Net realizable value –
a normal profit margin
71
Lower of Cost or Market
Ceiling: $0.80
$0.70
$0.70 Market
Historical
$0.65 Cost
Floor: $0.55
LCM = $0.65
72
Lower of Cost or Market
Ceiling: $0.80
$0.60
$0.60 Market
Historical
$0.65 Cost
Floor: $0.55
LCM = $0.60
73
Lower of Cost or Market
Ceiling: $0.80
$0.50
$0.55 Market
Historical
$0.65 Cost
Click on the
button to skip
LCM
examples
Floor: $0.55
LCM = $0.55
74
Lower of Cost or Market
Ceiling: $0.80
$0.45
$0.55 Market
Historical
$0.50 Cost
Floor: $0.55
LCM = $0.50
75
Lower of Cost or Market
Ceiling: $0.80
$0.85
$0.80 Market
Historical
$0.75 Cost
Floor: $0.55
LCM = $0.75
76
Lower of Cost or Market
Ceiling: $0.80
$1.00
$0.80 Market
Historical
$0.90 Cost
Floor: $0.55
LCM = $0.80
77
Gross Profit Method
Beginning inventory, January 1
$25,000
Sales, January 1–January 31
50,000
Purchases, January 1–January 31 40,000
Historical gross profit percentage
Last year
40 %
Two years ago
37
Three years ago
42
Last year’s 40% is considered a good estimate.
78
Gross Profit Method
Sales (actual)
$50,000 100 %
Cost of goods sold (estimate) 30,000
60 %
Gross profit (estimate)
$20,000
40 %
Beginning inventory (actual)
$25,000
+ Purchases (actual)
40,000
– Cost of goods available for
sale (actual)
$65,000
– Ending inventory (estimate)
35,000
= Cost of goods sold (estimate)
$30,000
79
Gross Profit Method
Sales (actual)
$50,000 100 %
Cost of goods sold (estimate) 31,500
63 %
Gross profit (estimate)
$18,500
37 %
Beginning inventory (actual)
$25,000
+ Purchases (actual)
40,000
– Cost of goods available for
sale (actual)
$65,000
– Ending inventory (estimate)
33,500
= Cost of goods sold (estimate)
$31,500
80
Gross Profit Method
Sales (actual)
$50,000 100 %
Cost of goods sold (estimate) 29,000
58 %
Gross profit (estimate)
$21,000
42 %
Beginning inventory (actual)
$25,000
+ Purchases (actual)
40,000
– Cost of goods available for
sale (actual)
$65,000
– Ending inventory (estimate)
36,000
= Cost of goods sold (estimate)
$29,000
81
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
82
Inventory Turnover
• Cost of Goods Sold
• Beginning Inventory
• Ending Inventory
$1,000
$ 90
$ 110
Determine the inventory
turnover.
83
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
84
Number of Days’ Sales
in Inventory
Company
IBM
Dell
General Motors
Ford
Nike
Reebok.
Wal-Mart
Kmart
Number of Days’
Sales in Inventory
31.4 days
5.7 days
28.2 days
19.4 days
90.5 days
82.9 days
46.9 days
74.6 days
85
chapter 9
The End
86
87