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Learning Objectives
1. Describe the importance of control over
inventory.
2. Describe three inventory cost flow assumptions
and how they impact the income statement and
balance sheet.
3. Determine the cost of inventory under the
perpetual inventory system, using the FIFO, LIFO,
and weighted average cost methods.
4. Determine the cost of inventory under the
periodic inventory system, using the FIFO, LIFO,
and weighted average cost methods.
Learning Objectives
5.
Compare and contrast the use of the three
inventory costing method.
6.
Describe and illustrate the reporting of
merchandise inventory in the financial
statements.
7.
Describe and illustrate the inventory turnover
and the number of days’ sales in inventory in
analyzing the efficiency and effectiveness of
inventory management.
c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.
Control of Inventory
o Two primary objectives of control over
inventory are:
 Safeguarding the inventory from damage or theft.
 Reporting inventory in the financial statements.
Safeguarding Inventory
o
The purchase order authorizes the purchase of
the inventory from an approved vendor.
Safeguarding Inventory
o The receiving report establishes an initial
record of the receipt of the inventory.
Safeguarding Inventory
o Recording inventory using a perpetual
inventory system is also an effective means of
control. The amount of inventory is always
available in the subsidiary inventory ledger.
Safeguarding Inventory
o Controls for safeguarding inventory should
include security measures to prevent damage
and customer or employee theft. Some
examples of security measures include the
following:
 Storing inventory in areas that are restricted to only
authorized employees.
 Locking high-priced inventory in cabinets.
 Using two-way mirrors, cameras, security tags, and
guards.
Reporting Inventory
o
A physical inventory or count of inventory
should be taken near year-end to make sure
that the quantity of inventory reported in the
financial statements is accurate.
c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.
INVENTORY COST
FLOW ASSUMPTIONS
Inventory Cost Flow Assumptions
Inventory Cost Flow Assumptions
o Assume that one unit is sold on May 30 for $20.
Depending upon which unit was sold, the gross
profit varies from $11 to $6 as shown below:
Inventory Cost Flow Assumptions
o Under the specific identification inventory cost
flow method, the unit sold is identified with a
specific purchase.
Inventory Cost Flow Assumptions
o
Under the first-in, first out (FIFO) inventory
cost flow method, the first units purchased are
assumed to be sold first and the ending
inventory is made up of the most recent
purchases.
Inventory Cost Flow Assumptions
o
Under the last-in, first out (LIFO) inventory
cost flow method, the last units purchased are
assumed to be sold first and the ending
inventory is made up of the first units
purchased.
Inventory Cost Flow Assumptions
o
Under the weighted average inventory cost
flow method, the cost of the units sold and in
ending inventory is a weighted average of the
purchase costs.
INVENTORY COST
FLOW ASSUMPTIONS
(continued)
INVENTORY COST
FLOW ASSUMPTIONS
(continued)
INVENTORY COST
FLOW ASSUMPTIONS
(concluded)
c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.
Inventory Costing Methods
o For purposes of illustration, the data for Item
127B are used, as shown below. We will
examine the perpetual inventory system first.
FIRST-IN, FIRSTOUT METHOD
(continued)
FIRST-IN, FIRSTOUT METHOD
(continued)
FIRST-IN, FIRSTOUT METHOD
(continued)
FIRST-IN, FIRSTOUT METHOD
(continued)
FIRST-IN, FIRSTOUT METHOD
(continued)
FIRST-IN, FIRSTOUT METHOD
(continued)
FIRST-IN, FIRSTOUT METHOD
(continued)
LAST-IN, FIRST-OUT
METHOD
(continued)
LAST-IN, FIRST-OUT
METHOD
(continued)
LAST-IN, FIRST-OUT
METHOD
(continued)
LAST-IN, FIRST-OUT
METHOD
(continued)
LAST-IN, FIRST-OUT
METHOD
(continued)
LAST-IN, FIRST-OUT
METHOD
LAST-IN, FIRST-OUT
METHOD
(continued)
Weighted Average Cost Method
o
When the weighted average cost method is
used in a perpetual system, an average unit
cost for each item is computed each time a
purchase is made.
o
This unit cost is then used to determine the
cost of each sale until another purchase is
made and a new average is computed. This
averaging technique is called a moving
average.
WEIGHTED
AVERAGE COST
METHOD
c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.
First-In, First-Out Method
o
Using FIFO, the earliest batch purchased is
considered the first batch of merchandise
sold. The physical flow does not have to match
the accounting method chosen. This time we
will be examining the periodic inventory
system.
First-In, First-Out Method
o Beginning inventory and purchases of Item
127B in January are as follows:
Cost of merchandise
available for sale
First-In, First-Out Method
o The physical count on January 31 shows that
800 units are on hand. (Conclusion: 1,300 units
were sold.) What is the cost of the ending
inventory?
First-In, First-Out Method
o Now we can calculate the cost of merchandise
sold as follows:
FIRST-IN, FIRSTOUT METHOD
Last-In, First-Out Method
o
Using LIFO, the most recent batch purchased
is considered the first batch of merchandise
sold. The actual flow of goods does not have to
be LIFO. For example, a store selling fresh fish
would want to sell the oldest fish first (which is
FIFO), even though LIFO is used for
accounting purposes.
Last-In, First-Out Method
o Assume again that the physical count on
January 31 is 800 units (and that 1,300 units
were sold). What is the cost of the
merchandise sold?
LAST-IN, FIRST-OUT
METHOD
Weighted Average Cost Method
o
The weighted average cost method uses the
weighted average unit cost for determining
cost of merchandise sold and the ending
merchandise inventory.
Weighted Average Cost Method
Average cost
per unit
Ending
Inventory
Weighted Average Cost Method
c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.
Comparing Inventory Cost Methods
o Using the perpetual inventory system
illustration with sales of $39,000 (1,300 units x
$30), the differences in ending inventory, cost
of merchandise sold, and gross profit are
illustrated in the next three slides.
PARTIAL INCOME
STATEMENTS
(FIFO)
PARTIAL INCOME
STATEMENTS
(WEIGHTED AVERAGE COST)
PARTIAL INCOME
STATEMENTS
(LIFO)
COMPARING
INVENTORY COST
METHODS
Comparing Inventory Cost Methods
o When the FIFO method is used during a
period of inflation or rising prices, FIFO will
show a larger profit than the other two
inventory costing methods.
Comparing Inventory Cost Methods
o When the LIFO method is used during a period
of inflation or rising prices, LIFO will show a
lower profit than the other two inventory
costing methods.
o During a period of rising prices, using LIFO
offers an income tax savings compared to the
other two inventory costing methods.
Comparing Inventory Cost Methods
o The weighted average cost method of
inventory costing is a compromise between
FIFO and LIFO. Net income for the weighted
average cost method is somewhere between
the net incomes of LIFO and FIFO.
c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.
Reporting Merchandise Inventory
o Cost is the primary basis for valuing and
reporting inventories in the financial
statements. However, inventory may be valued
at other than cost in the following cases:
 The cost of replacing items in inventory is below the
recorded cost.
 The inventory cannot be sold at normal prices due
to imperfections, style changes, or other causes.
Valuation at Lower of Cost or Market
o Market, as used in lower-of-cost-or-market
method, is the cost to replace the merchandise
on the inventory date.
Valuation at Lower of Cost or Market
o Cost and replacement cost can be determined
for the following:
 Each item in the inventory.
 Each major class or category of inventory.
 Total inventory as a whole.
VALUATION AT
LOWER OF COST OR
MARKET
Valuation at Net Realizable Value
o
Merchandise that is out of date, spoiled, or
damaged should be written down to its net
realizable value. This is the estimated selling
price less any direct costs of disposal, such as
sales commissions or special advertising.
Valuation at Net Realizable Value
o Assume the following data about an item of
damaged merchandise:
Original cost
Estimated selling price
Selling expenses
$1,000
800
150
o The merchandise should be valued at its net
realizable value of $650 ($800 – $150).
Merchandise Inventory on the Balance Sheet
o
Merchandise inventory is usually presented in
the Current Assets section of the balance
sheet, following receivables.
Merchandise Inventory on the Balance Sheet
o The method of determining the cost of the
inventory (FIFO, LIFO, or weighted average)
and the method of valuing the inventory (cost
or the lower of cost or market) should be
shown.
MERCHANDISE
INVENTORY ON THE
BALANCE SHEET
Inventory Errors
o Some reasons that inventory errors may occur
include the following:
 Physical inventory on hand was miscounted.
 Costs were incorrectly assigned to inventory.
 Inventory in transit was incorrectly included or
excluded from inventory.
 Consigned inventory was incorrectly included or
excluded from inventory.
Inventory Errors
o
Inventory errors often arise from consigned
inventory. Manufacturers sometimes ship
merchandise to retailers who act as the
manufacturer’s agent.
Inventory Errors
o The manufacturer, called the consignor, retains
title until the goods are sold. Such merchandise
is said to be shipped on consignment to the
retailer, called the consignee.
INVENTORY
ERRORS
LO 6
BALANCE SHEET
EFFECTS
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Inventory Turnover
o
Inventory turnover measures the relationship
between cost of merchandise sold and the
amount of inventory carried during the
period. It is calculated as follows:
Cost of Merchandise Sold
Inventory Turnover =
Average Inventory
Inventory Turnover
o Inventory turnover for Best Buy is shown below
(in millions).
Inventory Turnover
o The number of days’ sales in inventory
measures the length of time it takes to acquire,
sell, and replace the inventory. It is computed
as follows:
Number of Days’ =
Sales in Inventory
Average Inventory
Average Daily Cost of
Merchandise Sold
Inventory Turnover
o The number of days’ sales in inventory for Best
Buy is computed below (in millions).
c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.
Retail Method of Inventory Costing
o
The retail inventory method of estimating
inventory cost requires costs and retail prices
to be maintained for the merchandise
available for sale.
o
A ratio of cost to retail price is then used to
convert ending inventory at retail to estimate
the ending inventory cost.
RETAIL METHOD
OF INVENTORY
COSTING
Gross Profit Method of Inventory Costing
o The gross profit method uses the estimated
gross profit for the period to estimate the
inventory at the end of the period.
GROSS PROFIT
METHOD OF
INVENTORY COSTING
c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.