Class #3
Inventory Measurement
Inventory
Those assets that a company:
1. Intends to sell in the normal
course of business.
2. Has in production (work in process) for
future sale.
3. Uses currently in the production
of goods to be sold (raw materials).
Types of Inventories
Types of Inventory
Merchandise
Inventory
Manufacturing
Inventory
Goods acquired for
resale
•Raw Materials
•Work-in-Process
•Finished Goods
Raw
Materials
Inventory Cost Flows
Work in
Process
$XX (4)
(1) $XX
$XX
$XX (7)
Finished
Goods
$XX $XX (8)
Direct
Labor
(2) $XX
Cost of Good
Sold
$XX (5)
Manufacturing
Overhead
(3) $XX
$XX
$XX (6)
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
Raw materials purchased
Direct labor incurred
Manufacturing overhead incurred
Raw materials used
Direct labor applied
Manufacturing overhead applied
Work in process transferred to finished goods
Finished goods sold
Inventory Methods
Two accounting systems are used to record transactions
involving inventory:
Perpetual Inventory
System
Periodic Inventory
System
The inventory account
is continuously
updated as purchases
and sales are made.
The inventory account
is adjusted at the end
of a reporting cycle.
Perpetual Inventory System
Lothridge Wholesale Beverage Company (LWBC) begins
2013 with $120,000 in inventory. During the period it
purchases on account $600,000 of merchandise for resale
to customers.
2013
Inventory
Accounts payable
600,000
600,000
To record the purchase of merchandise inventory.
Returns of inventory are credited to the inventory
account.
Discounts on inventory purchases can be recorded
using the gross or net method.
Perpetual Inventory System
During 2013, LWBC sold, on account, inventory with a retail
price of $820,000 and a cost basis of $540,000, to customers.
2013
Inventory
Accounts payable
600,000
600,000
To record the purchase of merchandise inventory.
2013
Accounts receivable
Sales revenue
820,000
820,000
To record sales on account.
Cost of goods sold
Inventory
To record cost of goods sold.
540,000
540,000
Periodic Inventory System
The periodic inventory system is not designed to track
either the quantity or cost of merchandise inventory. Cost
of goods sold is calculated, using the schedule below, after
the physical inventory count at the end of the period.
Beginning Inventory
+ Net Purchases
Cost of Goods Available for Sale
- Ending Inventory
= Cost of Goods Sold
Periodic Inventory System
Lothridge Wholesale Beverage Company (LWBC) begins
2013 with $120,000 in inventory. During the period it
purchases on account $600,000 of merchandise for resale
to customers.
2013
Purchases
Accounts payable
To record the purchase of merchandise inventory.
600,000
600,000
Periodic Inventory System
During 2013, LWBC sold, on account, inventory with a retail
price of $820,000 to customers, and a cost basis of $540,000.
2013
Accounts receivable
Sales revenue
820,000
820,000
To record sales on account.
No entry is made to record cost of goods sold. A physical count
of ending inventory shows a balance of $180,000. Let’s
calculate cost of goods sold at the end of 2013.
Periodic Inventory System
Calculation of Cost of Goods Sold
Beginning inventory
Plus: Purchases
Cost of goods available for sale
Less: Ending inventory
Cost of goods sold
$
120,000
600,000
720,000
(180,000)
$ 540,000
We need the following adjusting entry to record cost of good sold.
December 31, 2013
Cost of goods sold
Inventory (ending)
Inventory (beginning)
Purchases
540,000
180,000
120,000
600,000
To adjust inventory, close the purchases account, and record cost of goods sold.
Comparison of Inventory Systems
Transaction or
Event
Periodic
Inventory
Perpetual
Inventory
Routine purchases of
various inventory items
Costs debited to
purchases account
Costs debited to
inventory account
Sale of inventory
No accounting
entries made
Debit Cost of goods
sold and credit
inventory
End-of-period
accounting entries and
related activities
Physical count of
inventory to
determine cost of
good sold
No separate
determination of cost
of goods sold
necessary
What is Included in Inventory?
General Rule
All goods owned by the company on the inventory date,
regardless of their location.
Goods in Transit
Depends on FOB
shipping terms.
Goods on Consignment
Expenditures Included in Inventory
Invoice Price
Purchase
Returns
+
Freight-in on
Purchases
Purchase
Discounts
Real World
• …the cost of warehousing and occupancy for our
Wal-Mart segment distribution facilities are
included in operating, selling and general and
administrative expenses. Because we do not
include the cost of our Wal-Mart segment
distribution facilities in cost of sales, our gross
profit and gross margin may not be comparable
to those of other retailers that may include all
costs related to their distribution facilities in costs
of sales and in the calculation of gross profit and
gross margin.
Purchase Returns
On November 8, 2013, LWBC returns merchandise that had a cost
to LWBC of $2,000.
Periodic Inventory Method
November 8, 2013
Accounts payable
Purchase returns
Perpetual Inventory Method
2,000
2,000
Accounts payable
Inventory
2,000
Returns of inventory are credited to the Purchase Returns
account when using the periodic inventory method.
The returns are credited to Inventory using the perpetual
inventory method.
2,000
Purchase Discounts
Gross Method
October 5, 2013
Purchases
Accounts payable
Net Method
20,000
20,000
October 14, 2013
Accounts payable
14,000
Purchase discounts
Cash
November 4, 2013
Accounts payable
Cash
Discount terms are
2/10, n/30.
$14,000
x 0.02
$ 280
280
13,720
6,000
6,000
Purchases
Accounts payable
19,600
Accounts payable
Cash
13,720
Accounts payable
Interest expense
Cash
5,880
120
Partial payment not
made within the
discount period
19,600
13,720
6,000
$20,000
x 0.02
$ 400
̵120
$ 280
Net Method Using Perpetual and Periodic
Perpetual Inventory Method
Description
Debit
Credit
Inventory
Accounts payable
Inventory
Cash
Accounts payable
Inventory
Accounts receivable
Sales revenue
5,880
5,880
160
160
200
200
8,300
8,300
Cost of goods sold
5,840
Inventory
Periodic Inventory Method
Purchases
5,880
Accounts payable
Freight-in
Cash
160
Accounts payable
Purchase returns
200
Accounts receivable
Sales revenue
8,300
5,840
5,880
160
200
8,300
Beginning inventory
Purchases
$ 5,880
Less: Returns
(200)
Plus: Freight-in
160
Net purchases
Cost of goods available for sale
Less: Ending inventory
Cost of goods sold
$
-
5,840
5,840
$ 5,840
Inventory Cost Flow Methods
•
Specific cost identification
•
Average cost
•
First-in, first-out (FIFO)
•
Last-in, first-out (LIFO)
Real World – Wal-Mart
The Company uses the retail last-in, first-out (LIFO)
method for general merchandise within the Wal-Mart
Stores segment, cost LIFO for the SAM’S CLUB
segment and grocery items within the Wal-Mart Stores
segment, and other cost methods, including the retail
first-in, first-out (FIFO) and average cost methods, for
the International segment. Inventories are not recorded
in excess of market value.
Specific Cost Identification
• Items are added to
inventory at cost when
they are purchased.

The specific cost of each
inventory item must be
known.
• COGS for each sale is
based on the specific cost
of the item sold.

Only for items with serial
#’s or other identity
means.
Perpetual Average Cost
Picture This, LLC
Inventory of frame number 759
Cost per
Units
Unit
Beg. Inventory
2,000
$ 10.00
Purchase 9/3
1,000
10.75
Purchase 9/21
1,000
10.95
Units available for sale
4,000
Units sold in September
Sale 9/7
500
Sale 9/29
1,500
Units sold in September
2,000
Units in ending inventory
2,000
Total Cost
$ 20,000.00
10,750.00
10,950.00
$ 41,700.00
Perpetual Average Cost
Picture This, LLC
Inventory of frame number 759
Cost per
Units
Unit
Beg. Inventory
2,000
$ 10.00
Purchase 9/3
1,000
10.75
Purchase
9/21+ 10,750) ÷ (2,000 +1,000
10.95
($20,000
1.000) = $10.25
Units available for sale
4,000
Units sold in September
Sale 9/7
500
Sale 9/29
1,500
Units sold in September
2,000
Units in ending inventory
2,000
10.25
Total Cost
$ 20,000.00
10,750.00
10,950.00
$ 5,125.00
Perpetual Average Cost
Picture This, LLC
Inventory of frame number 759
Cost per
Units
Unit
Inventory at 9/21
2,500
$ 10.25
Purchase 9/21
1,000
10.95
Units available for sale
3,500
Total Cost
$ 25,625.00
10,950.00
($25,625 + 10,950) ÷ (2,500 + 1,000) = $10.45
Units sold in September
Sale 9/7
500
Sale 9/29
1,500
Units sold in September
2,000
Units in ending inventory
1,500
10.25
5,125
Perpetual Average Cost
Picture This, LLC
Inventory of frame number 759
Cost per
Units
Unit
September Inventory and Cost of Sales
Sale 9/7
500
10.25
Sale 9/29
1,500
10.45
Cost of goods sold
2,000
Ending inventory
2,000
10.45
Total Cost
$ 5,125.00
15,675.00
20,800.00
$ 20,900.00
$ 41,700.00
3,500 – 1,500 sold on 9/29 = 2,000 units in ending inventory at a cost of $10.45 per unit.
Weighted-Average Periodic System
Let’s use the same information to assign costs to
ending inventory and cost of goods sold using the
periodic system.
Ending Inventory
(2,000 units)
Beginning Inventory
(2,000 units)
Available
for Sale
(4,000 units)
Goods Sold
(2,000)
$41,700 ÷ 4,000 = $10.425 weighted-average
per unit cost
Weighted-Average Periodic System
Picture This, LLC
Inventory of frame number 759
Cost per
Units
Unit
Beginning inventory
2,000
$ 10.00
Purchase 9/3
1,000
10.75
Purchase 9/21
1,000
10.95
Units available for sale
4,000
Total Cost
$ 20,000.00
10,750.00
10,950.00
$ 41,700.00
Units sold in September
Sale 9/7
500
Sale 9/29
1,500
Units sold in September
2,000
Units in ending inventory
2,000
5,125.00
15,675.00
20,850.00
$ 20,850.00
10.25
10.45
$ 10.425
$ 10.425
First-In, First-Out (FIFO)
The FIFO
 The cost of the oldest
method
inventory items are
assumes that
charged to COGS when
items are sold
goods are sold.
in the
 The cost of the newest
chronological
inventory items remain
order of their
in ending inventory.
acquisition.
First-In, First-Out (FIFO)
Even though the periodic
and the perpetual
approaches differ in the
timing of adjustments to
inventory . . .
. . . COGS and Ending
Inventory Cost are the
same under both
approaches.
First-In, First-Out (FIFO)
Periodic Inventory System
Picture This, LLC
Inventory of frame number 759
Cost per
Units
Unit
Beginning inventory
2,000
$ 10.00
Purchase 9/3
1,000
10.75
Purchase 9/21
1,000
10.95
Units available for sale
4,000
Ending Inventory and Cost of Goods Sold
Cost of goods sold
2,000
Ending Inventory
2,000
Total Cost
$ 20,000.00
10,750.00
10,950.00
41,700.00
These 2,000 units
$ 10.425
20,850.00
come from
the
$ 10.425beginning
$ 20,850.00
inventory (first-in,
first-out).
First-In, First-Out (FIFO)
Periodic Inventory System
Picture This, LLC
Inventory of frame number 759
Cost per
Units
Unit
Beginning inventory
2,000
$ 10.00
Purchase 9/3
1,000
10.75
Purchase 9/21
1,000
10.95
Units available for sale
4,000
Total Cost
$ 20,000.00
10,750.00
10,950.00
41,700.00
Ending Inventory and Cost of Goods Sold
Cost of goods sold
2,000
Ending inventory
2,000
20,000.00
$ 20,850.00
$ 10.425
$ 10.425
First-In, First-Out (FIFO)
Periodic Inventory System
Picture This, LLC
Inventory of frame number 759
Cost per
Unit
Units
Beginning inventory
2,000
$ 10.00
Purchase 9/3
1,000
10.75
Purchase 9/21
1,000
10.95
Units available for sale
4,000
Total Cost
$ 20,000.00
10,750.00
10,950.00
41,700.00
Ending Inventory and Cost of Goods Sold
Cost of goods sold
2,000
$ 10.425
Ending inventory
2,000
$ 10.425
20,000.00
$ 21,700.00
Last-In, First-Out (LIFO)
The LIFO
 The cost of the newest
method
inventory items are
assumes that
charged to COGS when
the newest
goods are sold.
items are sold  The cost of the oldest
first, leaving the
inventory items remain
older units in
in inventory.
inventory.
Last-In, First-Out (LIFO)
Unlike FIFO, using the
LIFO method may
result in COGS and
Ending Inventory Cost
that differ under the
periodic and perpetual
approaches.
Last-In, First-Out
Perpetual Inventory System
Picture This, LLC
Inventory of frame number 759
Cost per
Units
Unit
Beginning inventory
2,000
$ 10.00
Purchase 9/3
1,000
10.75
Purchase 9/21
1,000
10.95
Units available for sale
4,000
Units sold in September
Sale 9/7
500
Sale 9/29
1,500
Units sold in September
2,000
Units in ending inventory
2,000
Total Cost
$ 20,000.00
10,750.00
10,950.00
$ 41,700.00
These are the
oldest units
in
10.25
5,125.00
inventory
and are
10.45
15,675.00
most likely
to
$ 10.425
20,850.00
remain$in
inventory
$ 10.425
20,850.00
when using LIFO.
Last-In, First-Out
Perpetual Inventory System
Picture This, LLC
Inventory of frame number 759
Cost per
Units
Unit
Beginning inventory
2,000
$ 10.00
Purchase 9/3
1,000
10.75
Purchase 9/21
1,000
10.95
Units available for sale
4,000
Total Cost
$ 20,000.00
10,750.00
10,950.00
$ 41,700.00
Units sold in September
Sale 9/7
500
10.75
5,375.00
SaleCost
9/29 of Goods Sold for
1,500
10.45
The
the September
715,675.00
sale come
Units sold
September of September
2,000
$ 3,
10.425
20,850.00
from
theinpurchase
so we record
the
Units in
inventory
2,000(500$ 10.425
$ 20,850.00
cost
ofending
goods
sold at $5,375
units times
$10.75).
Last-In, First-Out
Perpetual Inventory System
Picture This, LLC
Inventory of frame number 759
Cost per
Units
Unit
Total Cost
Beginning inventory
2,000
$ 10.00
$ 20,000.00
Purchase 9/3
1,000
10.75
10,750.00
Purchase 9/21
1,000
10.95
10,950.00
Units
available
for sale
$ 41,700.00
The
Cost
of Goods
Sold for the4,000
September 29 sale come
from the
purchase of September 3 (500 remaining units) plus 1,000 units from
the purchase
ofSeptember
September 21, for a total of 1,500 units,
Units sold in
Sale 9/7
500
10.75
5,375.00
Sale 9/29
1,500
10.45
15,675.00
Units sold in September
2,000
$ 10.425
20,850.00
Units in ending inventory
2,000
$ 10.425
$ 20,850.00
Last-In, First-Out
Perpetual Inventory System
Picture This, LLC
Inventory of frame number 759
Cost per
Units
Unit
Total Cost
Beginning inventory
2,000
$ 10.00
$ 20,000.00
Purchase 9/3
1,000
10.75
10,750.00
Purchase 9/21
1,000
10.95
10,950.00
9/21 purchase
1,000 $ 10.95 $ 10,950.00
Units available
for sale
4,000
$ 41,700.00
9/3 purchase
500
10.75
5,375.00
Units
in September
Cost sold
of goods
sold
1,500
$ 16,325.00
Sale 9/7
500
10.75
5,375.00
Sale 9/29
1,500
10.45
16,325.00
Cost of goods sold
2,000
$ 10.425
21,700.00
Ending inventory
2,000
$ 10.00
$ 20,000.00
Last-In, First-Out
Periodic Inventory System
Picture This, LLC
Inventory of frame number 759
Beginning inventory
Purchase 9/3
Purchase 9/21
Units available for sale
Units
2,000
1,000
1,000
4,000
Units sold in September
Sale 9/7
500
Sale 9/29
1,500
Units sold in September
2,000
Units in ending inventory
2,000
Cost per
Unit
$ 10.00
10.75
10.95
10.25
10.45
$ 10.425
$ 10.425
Total Cost
$ 20,000.00
10,750.00
10,950.00
$ 41,700.00
5,125.00
15,675.00
20,850.00
$ 20,850.00
Last-In, First-Out
Periodic Inventory System
Picture This, LLC
Inventory of frame number 759
Beginning inventory
Purchase 9/3
Purchase 9/21
Units available for sale
Units
2,000
1,000
1,000
4,000
Units sold in September
Cost of goods sold
2,000
Ending inventory
2,000
Cost per
Unit
$ 10.00
10.75
10.95
$ 10.425
$ 10.425
Total Cost
$ 20,000.00
10,750.00
10,950.00
$ 41,700.00
21,700.00
$ 20,000.00
When Prices Are Rising . . .
FIFO
• Matches low (older)
costs with current
(higher) sales.
• Inventory is valued
at approximate
replacement cost.
• Results in higher
pre-tax income.
LIFO
 Matches high (newer)
costs with current
(higher) sales.
 Inventory is valued
based on low (older)
cost basis.
 Results in lower pretax income.
U. S. GAAP vs. IFRS
LIFO is an important issue for U.S. multinational
companies. Unless the U.S. Congress repeals the LIFO
conformity rule, an inability to use LIFO under IFRS will
impose a serious impediment to convergence.
• LIFO is permitted and used by
U.S. Companies.
• If used for income tax reporting,
the company must use LIFO for
financial reporting.
• Conformity with IAS No. 2 would
cause many U.S. companies to
lose a valuable tax shelter.
 IAS No. 2, Inventories, does not
permit the use of LIFO.
 Because of this restriction, many
U.S. multinational companies use
LIFO only for domestic
inventories.
Decision Makers’ Perspective
Factors Influencing Method Choice
How closely do
reported
costs reflect actual
flow of inventory?
How are income
taxes affected by
inventory method
choice?
How well are costs
matched against
related revenues?
Supplemental LIFO Disclosures
Many companies use LIFO for external reporting and
income tax purposes but maintain internal records using
FIFO or average cost.
The conversion from FIFO or average cost
to LIFO takes place at the end of the
period. The conversion may look like this:
Total inventories at FIFO
Less: LIFO allowance
Inventories, at LIFO cost
2014
2013
$ 15,429
(1,508)
$ 13,921
$ 15,387
(1,525)
$ 13,862
LIFO Liquidation
When prices rise . . .
LIFO inventory costs in the balance
sheet are “out of date” because they
reflect old purchase transactions.
If inventory declines,
these “out of date” costs
may be charged to
current earnings.
This LIFO
liquidation
results in
“paper profits.”
Inventory Management
Gross profit ratio =
The higher the ratio, the higher the
markup a company is able to
achieve on its products.
Gross profit
Net sales
Inventory turnover ratio =
Designed to evaluate a company’s
effectiveness in managing its
investment in inventory
Cost of goods sold
Average inventory
(Beginning inventory + Ending inventory
2
Quality of Earnings
Changes in the ratios we discussed above often provide information
about the quality of a company’s current period earnings. For example,
a slowing turnover ratio combined with higher than normal inventory
levels may indicate the potential for decreased production, obsolete
inventory, or a need to decrease prices to sell inventory (which will then
decrease gross profit ratios and net income).
Many believe that manipulating income reduces earnings quality
because it can mask permanent earnings. Inventory write-downs and
changes in inventory method are two additional inventory-related
techniques a company could use to manipulate earnings.
Methods of Simplifying LIFO
LIFO Inventory Pools
The objectives of using LIFO inventory pools are to simplify
recordkeeping by grouping inventory units into pools based
on physical similarities of the individual units and to reduce
the risk of LIFO layer liquidation. For example, a glass
company might group its various grades of window glass into
a single window pool. Other pools might be auto glass and
sliding door glass. A lumber company might pool its inventory
into hardwood, framing lumber, paneling, and so on. LIFO
pools allow companies to account for a few inventory pools
rather than every specific type of inventory separately.
Methods of Simplifying LIFO
Dollar-Value LIFO (DVL)
DVL inventory pools are viewed as layers
of value, rather than layers of similar units.
DVL simplifies LIFO
recordkeeping.
DVL minimizes the
probability of layer
liquidation.
At the end
of the period,
Example
we determine if a new
The replacement
inventory
layer was
inventory
from
added bydiffers
comparing
the oldinventory
inventorydollar
on
ending
hand.
Wetojust
create a
amount
beginning
newdollar
layer.amount.
inventory
Methods of Simplifying LIFO
Dollar-Value LIFO (DVL)
We need to determine if the increase in
ending inventory over beginning inventory
was due to a cost increase or an increase
in inventory quantity.
1a. Compute a
Cost Index for the
year.
Cost index
in layer
=
year
Cost in
layer
year
÷
Cost in
base
year
Methods of Simplifying LIFO
1b. Deflate the
ending
inventory
value using
the cost index.
1c. Compare
ending
inventory at
base year cost
to beginning
inventory at
base year
cost.
Dollar-Value LIFO (DVL)
Ending
Ending
inventory
inventory
=
÷
at base
at yearyear cost
end cost
Change in
inventory
Cost
index
Beg.
Ending Inv.
Inventory
= at base
–
at base
year cost
year cost
Methods of Simplifying LIFO
Dollar-Value LIFO (DVL)
Next, identify the layers in ending
inventory and the years they were created.
Convert each layer’s
base year cost to layer
year cost by
multiplying times the
cost index.
Sum all the layers to
arrive at ending
inventory at DVL
cost.
Methods of Simplifying LIFO
Dollar-Value LIFO (DVL)
Masterwear reports the following inventory
and cost index information. Let’s look at the
solution to this example.
12/31
2013
2014
Ending
inventory
$ 150,000
168,000
Cost
index
100%
105%
Inventory as
base-year
prices
$ 150,000
160,000
Methods of Simplifying LIFO
Dollar-Value LIFO (DVL)
Masterwear reports the following inventory
and general price information.
12/31
2013
2014
Ending
inventory
$ 150,000
168,000
Cost
index
100%
105%
168,000 ÷ 1.05 = 160,000
Inventory at
base-year
cost
$ 150,000
160,000
Methods of Simplifying LIFO
Dollar-Value LIFO (DVL)
First, determine the LIFO layer for the current year:
Inventory at
base-year
December 31,
costs
2013
$ 150,000
2014
160,000
2014 LIFO Layer $
10,000
Inventory
Price
index
Ending
I\inventory
$ 150,000
105%
$
10,500
160,500
Methods of Simplifying LIFO
Dollar-Value LIFO (DVL)
At the LIFO layer at end of period prices to the
ending LIFO inventory from last period.
December 31,
2013
2014
2014 LIFO Layer
Inventory
Inventory at
base-year
costs
$ 150,000
160,000
10,000
$
Cost
index
100%
Ending
inventory
$ 150,000
105%
10,500
160,500
$
10,000  1.05 = 10,500