Slide 8-1 Chapter 8 McGraw-Hill/Irwin INVENTORIES AND THE COST OF GOODS SOLD © The McGraw-Hill Companies, Inc., 2002 Slide 8-2 Inventory Defined Inventory Goods owned and held for sale to customers McGraw-Hill/Irwin Current asset © The McGraw-Hill Companies, Inc., 2002 Slide 8-3 The Flow of Inventory Costs BALANCE SHEET As purchase costs (or manufacturing costs) are incurred Current assets: Inventory $ $ INCOME STATEMENT Revenue Cost of goods sold Gross profit Expenses Net income McGraw-Hill/Irwin as goods are sold $ © The McGraw-Hill Companies, Inc., 2002 Slide 8-4 The Flow of Inventory Costs In a perpetual inventory system, inventory entries parallel the flow of costs. GENERAL JOURNAL Date Account Titles and Explanation Debit Credit Entry on Purchase Date Inventory $$$$ Accounts Payable $$$$ Entry on Sale Date Cost of Goods Sold Inventory McGraw-Hill/Irwin $$$$ $$$$ © The McGraw-Hill Companies, Inc., 2002 Slide 8-5 Which Unit Did We Sell? When identical units of inventory have different unit costs, a question naturally arises as to which of these costs should be used in recording a sale of inventory. GENERAL JOURNAL Date Account Titles and Explanation Debit Credit Entry on Sale Date Cost of Goods Sold Inventory McGraw-Hill/Irwin $$$$ $$$$ © The McGraw-Hill Companies, Inc., 2002 Slide 8-6 Inventory Subsidiary Ledger A separate subsidiary account is maintained for each item in inventory. Item LL002 Description Laser Light Location Storeroom 2 Purchased Date Sept. 5 Sept. 9 Units 100 75 Sept. 10 Unit Cost $ 30 50 Total $ 3,000 3,750 Sold Units Unit Cost 10 ? Primary supplier Electronic City Secondary supplier Electric Company Inventory level: Min: 25 Max: 200 Balance Cost of Goods Unit Sold Units Cost Total 100 $ 30 $ 3,000 100 30 3,000 75 50 3,750 ? ? ? ? ? ? ? How can we determine the unit cost for the Sept. 10 sale? McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002 Slide 8-7 Inventory Cost Flows We use one of these inventory valuation methods to determine cost of inventory sold. Specific identification Average cost FIFO LIFO McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002 Slide 8-8 Information for the Following Inventory Examples The Bike Company (TBC) Cost of Goods Available for Sale Aug. 1 Beg. Inventory 10 units @ Aug. 3 Purchased 15 units @ Aug. 17 Purchased 20 units @ Aug. 28 Purchased 10 units @ Retail Sales of Goods Aug. 14 Sales Aug. 31 Sales McGraw-Hill/Irwin $ $ $ $ 91 106 115 119 = = = = $ 910 $ 1,590 $ 2,300 $ 1,190 20 units @ $ 130 = 23 units @ $ 150 = $ 2,600 $ 3,450 © The McGraw-Hill Companies, Inc., 2002 Slide 8-9 Specific Identification When a unit is sold, the specific cost of the unit sold is added to cost of goods sold. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002 Slide 8-10 Specific Identification – Example Date Aug. 1 Aug. 3 Purchases Cost of Goods Sold 10 @ $ 91 = $ 910 15 @ $ 106 = $ 1,590 Inventory Balance $ 910 $ 2,500 On August 14, TBC sold 20 bikes for $130 each. Nine bikes originally cost $91 and 11 bikes originally cost $106. Continue McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002 Slide 8-11 Specific Identification – Example Date Purchases Aug. 1 10 @ $ 91 = $ 910 Aug. 3 15 @ $ 106 = $ 1,590 Aug. 14 Inventory Balance $ 910 $ 2,500 Cost of Goods Sold 9 @ $ 91 = $ 819 11 @ $ 106 = $ 1,166 $ 515 The Cost of Goods Sold for the August 14 sale is $1,985, leaving $515 and 5 units in inventory. Continue McGraw-Hill/Irwin Let’s look at the entries for the Aug. 14 sale. © The McGraw-Hill Companies, Inc., 2002 Slide 8-12 Specific Identification – Example GENERAL JOURNAL Date Account Titles and Explanation Aug. 14 Cash Retail Debit 2,600 Sales 14 Cost of Goods Sold 2,600 Cost 1,985 Inventory A similar entry is made after each sale. McGraw-Hill/Irwin Credit 1,985 Continue © The McGraw-Hill Companies, Inc., 2002 Slide 8-13 Specific Identification – Example Date Purchases Aug. 1 10 @ $ 91 = $ 910 Aug. 3 15 @ $ 106 = $ 1,590 Aug. 14 Cost of Goods Sold for August 31 = 20 @ $ 115 = $ 2,300 $2,610 10 @ $ 119 = $ 1,190 Inventory Balance $ 910 $ 2,500 Cost of Goods Sold 9 @ $ 91 = $ 819 11 @ $ 106 = $ 1,166 $ 515 $ 2,815 $ 4,005 Aug. 17 Aug. 28 Aug. 31 Additional purchases were made 1 @on$August 91 = 17$and9128. 3 @ $ 106 = $ 318 Costs associated with sales on August 31 were as follows: 1 @ $91, 15 @ $ 115 = $ 1,725 3 @ $106, 15 @ $115, & 4 @ $119. 4 @ $ 119 = $ 476 $ 1,395 McGraw-Hill/Irwin Continue © The McGraw-Hill Companies, Inc., 2002 Slide 8-14 Specific Identification – Example Date Purchases Aug. 1 10 @ $ 91 = $ 910 Aug. 3 15 @ $ 106 = $ 1,590 Income Statement Aug. 14 COGS = $4,595 Aug. 17 Aug. 28 Aug. 31 20 @ $ 115 = $ 2,300 10 @ $ 119 = $ 1,190 Balance Sheet Inventory = $1,395 McGraw-Hill/Irwin Inventory Balance $ 910 $ 2,500 Cost of Goods Sold 9 @ $ 91 = $ 819 11 @ $ 106 = $ 1,166 1 @ $ 91 = $ 91 3 @ $ 106 = $ 318 15 @ $ 115 = $ 1,725 4 @ $ 119 = $ 476 $ $ $ 515 2,815 4,005 $ 1,395 1 @ $ 106 = $ 106 5 @ $ 115 = 575 6 @ $ 119 = 714 End. Inv. © The$McGraw-Hill 1,395 Companies, Inc., 2002 Slide 8-15 Since specific identification is so easy, can’t we use it all the time? McGraw-Hill/Irwin Not really. Specific identification is hard to use when we sell a lot of inventory that has lots of different costs. © The McGraw-Hill Companies, Inc., 2002 Slide 8-16 Average-Cost Method When a unit is sold, the average cost of each unit in inventory is assigned to cost of goods sold. Cost of Goods Units on hand Available for ÷ on the date of Sale sale McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002 Slide 8-17 Average-Cost Method – Example Date Aug. 1 Aug. 3 Purchases Cost of Goods Sold 10 @ $ 91 = $ 910 15 @ $ 106 = $ 1,590 The average cost per unit must be computed prior to each sale. Inventory Balance $ 910 $ 2,500 $100 = $2,500 25 On August 14, TBC sold 20 bikes for $130 each. Continue McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002 Slide 8-18 Average-Cost Method – Example Date Purchases Aug. 1 10 @ $ 91 = $ 910 Aug. 3 15 @ $ 106 = $ 1,590 Aug. 14 The average cost per unit is $100. Continue McGraw-Hill/Irwin Inventory Balance Cost of Goods Sold $ 910 $ 2,500 20 @ $ 100 = $ 2,000 $ 500 $100 = $2,500 25 Let’s look at the entries for the Aug. 14 sale. © The McGraw-Hill Companies, Inc., 2002 Slide 8-19 Average-Cost Method – Example GENERAL JOURNAL Date Account Titles and Explanation Aug. 14 Cash Retail Debit 2,600 Sales 14 Cost of Goods Sold 2,600 Cost 2,000 Inventory A similar entry is made after each sale. McGraw-Hill/Irwin Credit 2,000 Continue © The McGraw-Hill Companies, Inc., 2002 Slide 8-20 Average-Cost Method – Example Date Aug. 1 Aug. 3 Aug. 14 Aug. 17 Aug. 28 Purchases 10 @ $ 91 = $ 910 15 @ $ 106 = $ 1,590 20 @ $ 115 = $ 2,300 10 @ $ 119 = $ 1,190 Inventory Balance Cost of Goods Sold $ 910 $ 2,500 20 @ $ 100 = $ 2,000 $ 500 $ 2,800 $ 3,990 Additional purchases were made on August 17 and August 28. On August 31, an additional 23 units were sold. Continue McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002 Slide 8-21 Date Aug. 1 Aug. 3 Aug. 14 Aug. 17 Aug. 28 Average-Cost Method – Example Purchases 10 @ $ 91 = $ 15 @ $ 106 = $ 1,590 20 @ $ 115 = $ 2,300 10 @ $ 119 = $ 1,190 Total Purchases Less: Sales to Date Units on Hand McGraw-Hill/Irwin 55 -20 35 910 Inventory Balance Cost of Goods Sold $ 910 $ 2,500 20 @ $ 100 = $ 2,000 $ 500 $ 2,800 $ 3,990 $114 = $3,990 35 © The McGraw-Hill Companies, Inc., 2002 Slide 8-22 Date Aug. 1 Aug. 3 Aug. 14 Aug. 17 Aug. 28 Aug. 31 Average-Cost Method – Example Purchases 10 @ $ 91 = $ 910 15 @ $ 106 = $ 1,590 20 @ $ 115 = $ 2,300 10 @ $ 119 = $ 1,190 The average cost per unit is $114. McGraw-Hill/Irwin Inventory Balance Cost of Goods Sold $ 910 $ 2,500 20 @ $ 100 = $ 2,000 $ 500 $ 2,800 $ 3,990 23 @ $ 114 = $ 2,622 $ 1,368 $114 = $3,990 35 © The McGraw-Hill Companies, Inc., 2002 Slide 8-23 Average-Cost Method – Example Date Purchases Aug. 1 10 @ $ 91 = $ 910 Income Statement Aug. 3 15 @ $ 106 = $ 1,590 = $4,622 Aug. COGS 14 Aug. 17 20 @ $ 115 = $ 2,300 Aug. 28 10 @ $ 119 = $ 1,190 Aug. 31 Inventory Balance Cost of Goods Sold $ 910 $ 2,500 20 @ $ 100 = $ 2,000 $ 500 $ 2,800 $ 3,990 23 @ $ 114 = $ 2,622 $ 1,368 Balance Sheet Inventory = $1,368 $114 × 12 = $1,368 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002 Slide 8-24 First-In, First-Out Method (FIFO) Oldest Costs Costs of Goods Sold Recent Costs Ending Inventory McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002 Slide 8-25 FIFO – Example Date Purchases Aug. 1 10 @ $ 91 = $ 910 Aug. 3 15 @ $ 106 = $ 1,590 Aug. 14 Inventory Balance $ 910 $ 2,500 Cost of Goods Sold 10 @ $ 91 = $ 910 10 @ $ 106 = $ 1,060 $ 530 The Cost of Goods Sold for the August 14 sale is $1,970, leaving $530 and 5 units in inventory. On August 14, TBC sold 20 bikes for $130 each. Continue McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002 Slide 8-26 FIFO – Example GENERAL JOURNAL Date Account Titles and Explanation Aug. 14 Cash Retail Debit 2,600 Sales 14 Cost of Goods Sold 2,600 Cost 1,970 Inventory A similar entry is made after each sale. McGraw-Hill/Irwin Credit 1,970 Continue © The McGraw-Hill Companies, Inc., 2002 Slide 8-27 FIFO – Example Purchases Date Aug. 1 10 @ $ 91 = $ 910 Aug. 3 15 @ $ 106 = $ 1,590 Aug. 14 Aug. 17 20 @ Aug. 28 10 @ Aug. 31 $ 115 = $ 2,300 $ 119 = $ 1,190 Inventory Balance $ 910 $ 2,500 Cost of Goods Sold 10 @ $ 91 = $ 910 10 @ $ 106 = $ 1,060 5 @ $ 106 = $ 18 @ $ 115 = $ 2,070 $ 530 $ 2,830 $ 4,020 530 $ 1,420 Additional purchases were made on Aug. 17 and Aug. 28. CostOn ofAugust Goods Sold for August 31 = $2,600 31, an additional 23 units were sold. McGraw-Hill/Irwin Continue © The McGraw-Hill Companies, Inc., 2002 Slide 8-28 FIFO – Example Date Purchases Aug. 1 10 @ $ 91 = $ 910 Aug. 3 15 @ $ 106 = $ 1,590 Income Statement Aug. 14 COGS = $4,570 Aug. 17 Aug. 28 Aug. 31 20 @ $ 115 = $ 2,300 10 @ $ 119 = $ 1,190 Balance Sheet Inventory = $1,420 McGraw-Hill/Irwin Inventory Balance $ 910 $ 2,500 Cost of Goods Sold 10 @ $ 91 = $ 910 10 @ $ 106 = $ 1,060 5 @ $ 106 = $ 18 @ $ 115 = $ 2,070 $ 530 $ 2,830 $ 4,020 530 $ 1,420 2 @ $ 115 = $ 230 10 @ $ 119 = 1,190 End. Inv. $ 1,420 © The McGraw-Hill Companies, Inc., 2002 Slide 8-29 Last-In, First-Out Method (LIFO) Recent Costs Costs of Goods Sold Oldest Costs Ending Inventory McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002 Slide 8-30 LIFO – Example Date Purchases Aug. 1 10 @ $ 91 = $ 910 Aug. 3 15 @ $ 106 = $ 1,590 Aug. 14 Inventory Balance $ 910 $ 2,500 Cost of Goods Sold 15 @ $ 106 = $ 1,590 5 @ $ 91 = $ 455 $ 455 The Cost of Goods Sold for the August 14 sale is $2,045, leaving $455 and 5 units in inventory. On August 14, TBC sold 20 bikes for $130 each. Continue McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002 Slide 8-31 LIFO – Example GENERAL JOURNAL Date Account Titles and Explanation Aug. 14 Cash Retail Debit 2,600 Sales 14 Cost of Goods Sold 2,600 Cost 2,045 Inventory A similar entry is made after each sale. McGraw-Hill/Irwin Credit 2,045 Continue © The McGraw-Hill Companies, Inc., 2002 Slide 8-32 LIFO – Example Purchases Date Aug. 1 10 @ $ 91 = $ 910 Aug. 3 15 @ $ 106 = $ 1,590 Aug. 14 Aug. 17 20 @ Aug. 28 10 @ Aug. 31 $ 115 = $ 2,300 $ 119 = $ 1,190 Inventory Balance $ 910 $ 2,500 Cost of Goods Sold 15 @ $ 106 = $ 1,590 5 @ $ 91 = $ 10 @ $ 119 = $ 1,190 13 @ $ 115 = $ 1,495 455 $ 455 $ 2,755 $ 3,945 $ 1,260 Additional purchases were made on Aug. 17 and Aug. 28. Cost of Goods Sold for August 31 = $2,685 On Aug. 31, an additional 23 units were sold. McGraw-Hill/Irwin Continue © The McGraw-Hill Companies, Inc., 2002 Slide 8-33 LIFO – Example Date Purchases Aug. 1 10 @ $ 91 = $ 910 Aug. 3 15 @ $ 106 = $ 1,590 Income Statement Aug. 14 COGS = $4,730 Aug. 17 Aug. 28 Aug. 31 20 @ $ 115 = $ 2,300 10 @ $ 119 = $ 1,190 Balance Sheet Inventory = $1,260 McGraw-Hill/Irwin Inventory Balance $ 910 $ 2,500 Cost of Goods Sold 15 @ $ 106 = $ 1,590 5 @ $ 91 = $ 10 @ $ 119 = $ 1,190 13 @ $ 115 = $ 1,495 455 $ 455 $ 2,755 $ 3,945 $ 1,260 5 @ $ 91 = $ 455 7 @ $ 115 = 805 End. Inv. $ 1,260 © The McGraw-Hill Companies, Inc., 2002 Inventory Valuation Methods: A Summary Costs Allocated to: Valuation Cost of Goods Method Sold Inventory Comments Specific Actual cost of Actual cost of units Parallels physical flow identification the units sold remaining Logical method when units are unique May be misleading for identical units Average cost Number of units Number of units on Assigns all units the same sold times the hand times the average unit cost average unit cost average unit cost Current costs are averaged in with older costs First-in, First-out Cost of earliest Cost of most Cost of goods sold is based (FIFO) purchases on recently on older costs hand prior to the purchased units Inventory valued at current sale costs May overstate income during periods of rising prices; may increase income taxes due Last-in, First-out Cost of most Cost of earliest Cost of goods sold shown at (LIFO) recently purchases recent prices purchased units (assumed still in Inventory shown at old (and inventory) perhaps out of date) costs Most conservative method during periods of rising prices; often results in lower © The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin income taxes Slide 8-34 Slide 8-35 The Principle of Consistency Once a company has adopted a particular accounting method, it should follow that method consistently, rather than switch methods from one year to the next. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002 Slide 8-36 Just-In-Time (JIT) Inventory Systems This inventory arrived just in time for us to use in the manufacturing process. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002 Slide 8-37 Taking a Physical Inventory The primary reason for taking a physical inventory is to adjust the perpetual inventory records for unrecorded shrinkage losses, such as theft, spoilage, or breakage. GENERAL JOURNAL Date Account Titles and Explanation Dec. 31 Cost of Goods Sold Inventory McGraw-Hill/Irwin Debit Credit $$$$ $$$$ © The McGraw-Hill Companies, Inc., 2002 Slide 8-38 LCM and Other Write-Downs of Inventory Obsolescence Lower of Cost or Market (LCM) McGraw-Hill/Irwin Reduces the value of the inventory. Adjust inventory value to the lower of historical cost or current replacement cost (market). © The McGraw-Hill Companies, Inc., 2002 Slide 8-39 Goods In Transit A sale should be recorded when title to the merchandise passes to the buyer. F.O.B. shipping point ⎯ title passes to buyer at the point of shipment. McGraw-Hill/Irwin Year End F.O.B. destination point ⎯ title passes to buyer at the point of destination. © The McGraw-Hill Companies, Inc., 2002 Slide 8-40 Periodic Inventory Systems In a periodic inventory system, inventory entries are as follows. GENERAL JOURNAL Date Account Titles and Explanation Debit Credit Entry on Purchase Date Purchases Accounts Payable $$$$ $$$$ Note that an entry is not made to inventory. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002 Slide 8-41 Periodic Inventory Systems In a periodic inventory system, inventory entries are as follows. GENERAL JOURNAL Account Titles and Explanation Date Debit Credit Entry on Sale Date No entry to inventory. Accounts Receivable Sales McGraw-Hill/Irwin $$$$ $$$$ © The McGraw-Hill Companies, Inc., 2002 Slide 8-42 Periodic Inventory Systems The inventory on hand and the cost of goods sold for the year are not determined until year-end. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002 Slide 8-43 Periodic Inventory Systems We use one of these inventory valuation methods in a periodic inventory system. Specific identification Average cost FIFO LIFO McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002 Slide 8-44 Information for the Following Inventory Examples Computers, Inc. Mouse Pad Inventory Units $/Unit Date Beginning Inventory Purchases: Jan. 3 June 20 Sept. 15 Nov. 29 Goods Available for Sale Ending Inventory Cost of Goods Sold McGraw-Hill/Irwin 1,000 $ 300 150 200 150 Total 5.25 $ 5,250.00 5.30 5.60 5.80 5.90 1,590.00 840.00 1,160.00 885.00 1,800 $ 9,725.00 1,200 ? 600 ? © The McGraw-Hill Companies, Inc., 2002 Slide 8-45 Specific Identification – Example By reviewing actual purchase invoices, Computers, Inc. determines that the 1,200 mouse pads on hand at year-end have an actual total cost of $6,400. Determine the cost of goods sold for the year. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002 Slide 8-46 Specific Identification – Example Computers, Inc. Mouse Pad Inventory Units $/Unit Date Beginning Inventory 1,000 $ Purchases: Jan. 3 300 June 20 150 Sept. 200 Cost15 of Goods Sold Nov. 29 150 $9,725 Goods $6,400 = $3,325 Available for Sale 1,800 - Ending Inventory Cost of Goods Sold McGraw-Hill/Irwin Total 5.25 $ 5,250.00 5.30 5.60 5.80 5.90 1,590.00 840.00 1,160.00 885.00 $ 9,725.00 1,200 $ 6,400.00 600 $ 3,325.00 © The McGraw-Hill Companies, Inc., 2002 Slide 8-47 Average-Cost Method The average cost is calculated at yearend as follows: Total Cost of Goods Available for Sale McGraw-Hill/Irwin ÷ Total Number of Units Available for Sale © The McGraw-Hill Companies, Inc., 2002 Slide 8-48 Average-Cost Method – Example Avg. Cost $9,725 1,800 = $5.40278 Ending Inventory Avg. Cost $5.40278 1,200 = $6,483 Cost of Goods Sold Avg. Cost $5.40278 600 = $3,242 Date Beginning Inventory Purchases: Jan. 3 June 20 Sept. 15 Nov. 29 Goods Available for Sale Ending Inventory Cost of Goods Sold McGraw-Hill/Irwin Computers, Inc. Mouse Pad Inventory Units $/Unit Total 1,000 $ 5.25 $ 5,250.00 300 150 200 150 5.30 5.60 5.80 5.90 1,590.00 840.00 1,160.00 885.00 1,800 $ 9,725.00 1,200 1,200 $ 6,483.00 ? 600 $ 3,242.00 ? © The McGraw-Hill Companies, Inc., 2002 Slide 8-49 First-In, First-Out Method (FIFO) Oldest Costs Costs of Goods Sold Recent Costs Ending Inventory McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002 Slide 8-50 FIFO – Example Remember: Start with the 11/29 purchase and then add other purchases until you reach the number of units in ending inventory. Date Beginning Inventory Purchases: Jan. 3 June 20 Sept. 15 Nov. 29 Goods Available for Sale Ending Inventory Cost of Goods Sold McGraw-Hill/Irwin Computers, Inc. Mouse Pad Inventory Units $/Unit Total 1,000 $ 5.25 $ 5,250.00 300 150 200 150 5.30 5.60 5.80 5.90 1,590.00 840.00 1,160.00 885.00 1,800 $ 9,725.00 1,200 ? 600 ? © The McGraw-Hill Companies, Inc., 2002 Slide 8-51 FIFO – Example Date Jan. 3 June 20 Sept. 15 Nov. 29 Units Beg. Inv. Purchases 1,000@$5.25 300@$5.30 150@$5.60 200@$5.80 150@$5.90 Now, we have allocated Costs End. Inv. Cost of Goods Sold 600@$5.25 400@$5.25 300@$5.30 150@$5.60 200@$5.80 150@$5.90 1,200 150 600 $6,575 $3,150 the cost to allNow, 1,200 let’s unitscomplete the table. endingAvailable inventory. Cost in of Goods for Sale $9,725 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002 Slide 8-52 FIFO – Example Completing the table summarizes the computations just made. Date Beginning Inventory Purchases: Jan. 3 June 20 Sept. 15 Nov. 29 Goods Available for Sale Ending Inventory Cost of Goods Sold McGraw-Hill/Irwin Computers, Inc. Mouse Pad Inventory Units $/Unit Total 1,000 $ 5.25 $ 5,250.00 300 150 200 150 5.30 5.60 5.80 5.90 1,590.00 840.00 1,160.00 885.00 1,800 $ 9,725.00 1,200 $ 6,575.00 600 $ 3,150.00 © The McGraw-Hill Companies, Inc., 2002 Slide 8-53 Last-In, First-Out Method (LIFO) Recent Costs Costs of Goods Sold Oldest Costs Ending Inventory McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002 Slide 8-54 LIFO – Example Remember: Start with beginning inventory and then add other purchases until you reach the number of units in ending inventory. Date Beginning Inventory Purchases: Jan. 3 June 20 Sept. 15 Nov. 29 Goods Available for Sale Ending Inventory Cost of Goods Sold McGraw-Hill/Irwin Computers, Inc. Mouse Pad Inventory Units $/Unit Total 1,000 $ 5.25 $ 5,250.00 300 150 200 150 5.30 5.60 5.80 5.90 1,590.00 840.00 1,160.00 885.00 1,800 $ 9,725.00 1,200 ? 600 ? © The McGraw-Hill Companies, Inc., 2002 Slide 8-55 LIFO – Example Date Jan. 3 June 20 Sept. 15 Nov. 29 Units Beg. Inv. Purchases End. Inv. 1,000@$5.25 1,000@$5.25 300@$5.30 200@$5.30 150@$5.60 200@$5.80 150@$5.90 Now, we have allocated Costs the cost to all 1,200 units inventory. Cost in of ending Goods Available for Sale McGraw-Hill/Irwin 1,000 1,200 Cost of Goods Sold 100@$5.30 150@$5.60 200@$5.80 150@$5.90 100 600 $6,310 $3,415 Next, let’s complete the $9,725 table. © The McGraw-Hill Companies, Inc., 2002 Slide 8-56 LIFO – Example Completing the table summarizes the computations just made. Date Beginning Inventory Purchases: Jan. 3 June 20 Sept. 15 Nov. 29 Goods Available for Sale Ending Inventory Cost of Goods Sold McGraw-Hill/Irwin Computers, Inc. Mouse Pad Inventory Units $/Unit Total 1,000 $ 5.25 $ 5,250.00 300 150 200 150 5.30 5.60 5.80 5.90 1,590.00 840.00 1,160.00 885.00 1,800 $ 9,725.00 1,200 $ 6,310.00 600 $ 3,415.00 © The McGraw-Hill Companies, Inc., 2002 Slide 8-57 Importance of an Accurate Valuation of Inventory Errors in Measuring Inventory Beginning Inventory Ending Inventory Effect on Income Statement Overstated Understated Overstated Understated + + - + + Ending Inventory 0 0 Retained Earnings - + Goods Available for Sale Cost of Goods Sold Gross Profit Net Income 0 0 + + + - + + - Effect on Balance Sheet An error in ending inventory in a year will result in the same error in the beginning inventory of the next year. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002 Slide 8-58 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002 Slide 8-59 The Gross Profit Method Determine cost of goods available for sale. Estimate cost of goods sold by multiplying the net sales by the cost ratio. Deduct cost of goods sold from cost of goods available for sale to determine ending inventory. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002 Slide 8-60 Gross Profit Method – Example In March of 2003, Chemico’s inventory was destroyed by fire. Chemico’s normal gross profit ratio is 30% of net sales. At the time of the fire, Chemico showed the following balances: Sales $ 31,500 Sales returns 1,500 Beginning Inventory 12,000 Net cost of goods purchased 20,500 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002 Slide 8-61 Gross Profit Method – Example Computing Inventory using the Gross Profit Method Goods Available for Sale: $ Beginning Inventory Net cost of goods purchased Goods available for sale $ Less estimated cost of goods sold: $ 31,500 Sales (1,500) Less sales returns $ 30,000 Net sales Estimated cost of goods sold Estimated March inventory loss $ McGraw-Hill/Irwin 12,000 20,500 32,500 × 70% (21,000) 11,500 © The McGraw-Hill Companies, Inc., 2002 Slide 8-62 Inventory Turnover Rate Measures how quickly a company sells its merchandise inventory. Merchandise Turnover = Cost of goods sold Average inventory Average Inventory = (Beg. Inv. + End. Inv.) ÷ 2 A ratio that is low compared to competitors suggests inefficient use of assets. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002 Slide 8-63 Accounting Methods Can Affect Analytical Ratios Remember that identical companies that use different inventory methods (e.g., FIFO and LIFO) will have different inventory turnover ratios. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002 Slide 8-64 End of Chapter 8 Careful! If you drop the inventory we will have another write down. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
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