CHAPTER
6
INVENTORY COSTING
TAKING PHYSICAL
INVENTORY
• Needs to happen at least once a year
• This is done to verify or correct what you
have on paper for your inventory value
• Actually count, weigh, or measure what you
have in inventory
• Easiest to do when business is closed or
sales are very low, so there isn’t a lot of
activity to cause confusion
TO COUNT OR NOT TO COUNT

There are a couple of situations where people get
confused about what to include in inventory
1. Goods in Transit
2. Consigned Goods
GOODS IN TRANSIT





Who do goods belong to when they are in
the process of being shipped from the seller
to the buyer?
The answer is it depends on the terms of
the transaction
Whoever is paying for the shipping is the
owner of the good during shipment
FOB shipping point  buyer is owner and
should count as inventory
FOB destination  seller is owner and
should count as inventory
CONSIGNED GOODS
When a company agrees to sell another
company’s goods for a fee without taking
ownership of the item
 The holder of the goods (consignee) does
not count these items in their inventory
 The shipper of the goods (consignor) does
count them, as they still own the item(s) in
question

SPECIFIC IDENTIFICATION
This is the best method for determining cost
 Each item is tagged with it`s cost, that
follows the item as long as it is in the
company
 With this method you could look at the
remaining inventory and know the value
 This method is expensive and usually
automated

INVENTORY COSTING
Once the inventory is counted a value needs
to be attached to it
 When all inventory for 1 specific item was
purchased for the same price this is easy
 When inventory costs vary attaching a
value becomes more difficult

BE 2, PAGE 317
Mary Ann’s Hat Shop counted the entire inventory in the store on
August 31 and arrived at a total inventory cost of $65 000.
The count included $5000 of inventory held on consignment for a
local designer;
$500 of inventory that was being held for customers who were
deciding if they actually wanted to purchase the merchandise;
and $750 of inventory that had been sold to customers but was
being held for alterations.
There were two shipments of inventory received on September 1.
The first shipment cost $6000. It had been shipped on August 29,
terms FOB destination, and the freight charges were $240.
The second shipment cost$3750. It had been shipped on August
28, terms FOB shipping point, and the freight charges were $150.
Neither of these shipments were included in the August 31 count.
Calculate the correct cost of the inventory on August 31.
ANSWER
BRIEF EXERCISE 6-2
The correct cost of inventory is:
Total cost per inventory count
Less:
Inventory on consignment
Inventory held for alterations
$65,000
(5,000)
(750)
Add:
Goods shipped FOB shipping point prior to Aug. 31 3,750
Freight on inventory purchases
150
Correct inventory cost at August 31
$63,150
PRACTICE
 BE6-3,
BE6-4, E6-1, E6-2,
E6-3 (a,b,c), E6-4
USING ACTUAL PHYSICAL
FLOW COSTING



The specific identification method tracks the
actual physical flow of the goods.
Each item of inventory is marked, tagged, or
coded with its specific unit cost.
It is most frequently used when the company
sells a limited variety of high unit-cost items.
USING ASSUMED COST
FLOW METHODS



Other cost flow methods are allowed since
specific identification is often impractical.
These methods assume flows of costs that
may be unrelated to the physical flow of
goods.
Cost flow assumptions:
1. First-in, first-out (FIFO).
2. Average cost.
3. Last-in, first-out (LIFO).
Fraser Valley Electronics

Assume that Fraser Valley Electronics has the following information for one of its
products, a Z202 Astro Condenser:
The company had a total of 1,000 units available for sale during the year. The
total cost of the 1,000 units available for sale was $12,000. A physical inventory
count at the end of the year determined that 450 units remained on hand.
Consequently, it can be calculated that 550 (1,000 − 450) units were sold
during the year.
FIFO



The FIFO method assumes that the earliest
goods purchased are the first to be sold.
Often reflects the actual physical flow of
merchandise.
Under FIFO, the costs of the earliest goods
purchased are the first to be recognized as
cost of goods sold. The costs of the most
recent goods purchased are recognized as
the ending inventory.
FIFO method assumes earliest goods purchased are the first to be sold
AVERAGE COST



The average cost method assumes that the
goods available for sale are homogeneous.
The allocation of the cost of goods
available for sale is made on the basis of
the weighted average unit cost incurred.
The weighted average unit cost is then
applied to the units sold to determine the
cost of goods sold and to the units on hand
to determine the ending inventory.
Average Cost Method
Average Cost Method
Average cost method assumes that goods available for sale are
homogeneous
LIFO




The LIFO method assumes that the latest
goods purchased are the first to be sold
and that the earliest goods purchased
remain in ending inventory.
Seldom coincides with the actual physical
flow of inventory.
Under the periodic method, all goods
purchased during the year are assumed to
be available for the first sale, regardless of
date of purchase.
Rarely used in Canada.
LIFO method assumes latest goods purchased are the first to be sold
PRACTICE
 BE6-5,
BE6-6, BE6-7, BE6-8,
E6-7, E6-8
INCOME STATEMENT EFFECTS



In periods of rising prices, FIFO reports the
highest net income, LIFO the lowest and
average cost falls in the middle.
The reverse is true when prices are
falling.
When prices are constant, all cost flow
methods will yield the same results.
BALANCE SHEET EFFECTS
FIFO produces the best balance sheet
valuation since the inventory costs are closer
to their current, or replacement, costs.
USING INVENTORY COST FLOW
METHODS CONSISTENTLY



A company needs to use its chosen cost
flow method consistently from one
accounting period to another.
Such consistent application enhances the
comparability of financial statements over
successive time periods.
When a company adopts a different cost
flow method, the change and its effects on
net income should be disclosed in the
financial statements.
INVENTORY ERRORS - INCOME
STATEMENT EFFECTS



Both beginning and ending inventories appear
on the income statement.
The ending inventory of one period
automatically becomes the beginning
inventory of the next period.
Inventory errors affect the
determination of cost of goods
sold and net income.
FORMULA FOR
COST OF GOODS SOLD
Beginning
Inventory
+
Cost of _ Ending
Goods
Inventory
Purchased
=
Cost of
Goods
Sold
The effects on cost of goods sold can be
determined by entering the incorrect data
in the above formula and then substituting
the correct data.
EFFECTS OF INVENTORY
ERRORS ON CURRENT YEAR’S
INCOME STATEMENT
Inventory Error
Cost of
Goods Sold
Understate beginning inventory Understated
Overstate beginning inventory
Overstated
Understate ending inventory
Overstated
Overstate ending inventory
Understated
Net Income
Overstated
Understated
Understated
Overstated
An error in ending inventory of the current period
will have a reverse effect on net income of the next
accounting period.
ENDING INVENTORY ERROR –
BALANCE SHEET EFFECTS
The effect of ending inventory errors on the
balance sheet can be determined by using the
basic accounting equation:
Assets = Liabilities + Owner’s Equity
Ending Inventory
Error
Overstated
Understated
Assets
Overstated
Understated
Liabilities
None
None
Owner’s Equity
Overstated
Understated
VALUING INVENTORY AT THE
LOWER OF COST AND MARKET



When the value of inventory is lower than
the cost, the inventory is written down to
its market value.
This is known as the lower of cost and
market (LCM) method.
Market is defined as replacement cost or
net realizable value.
ILLUSTRATION 6-20
ALTERNATIVE LOWER OF COST
AND MARKET (LCM) RESULTS
Cost
Television sets
Consoles
$
Portables
Total
Video equipment
Recorders
Movies
Total
Total inventory
$
Market
60,000
45,000
105,000
$
48,000
15,000
63,000
168,000
45,000
14,000
59,000
$ 166,000
LCM
55,000
52,000
107,000
$ 166,000
The common practice is to use total inventory
rather than individual items or major
categories in determining the LCM valuation.
INVENTORY TURNOVER
Shows how many time inventory is sold, or
turns over in a period
 The higher the turns the less money is tied
up in inventory
 The higher the inventory turns the better

COGS
Average
Inventory
Inventory
Turnover
DAYS SALES IN INVENTORY
Takes inventory turnover and puts into
terms of how long inventory is on hand
before it sells
 Holding inventory costs money
 The lower the better

Days in
Year
Inventory
Turnover
Days Sales
In Inventory
PRACTICE
 BE6-9,
BE6-10, BE6-11,
BE6-15, BE6-16, E6-9, E6-10,
E6-11(a)
REVIEW
 P6-7A,
P6-8A