CHAPTER 8
INVENTORIES
Presenter’s name
Presenter’s title
dd Month yyyy
COSTS INCLUDED IN INVENTORIES
Costs included in Inventories and
recognized as expenses when
goods are sold:
• Costs of purchase, e.g.
- purchase price, net of
discounts
- import duties and taxes
- transport and handling
- insurance during transport
• Costs of conversion
• Other costs incurred in bringing
the inventories to their present
location and condition
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Costs excluded from Inventories
and recognized as expenses in
period incurred:
• Abnormal costs incurred as a
result of waste of materials,
labor or other production
conversion inputs
• Storage costs (unless required
as part of the production
process)
• All administrative overhead
and selling costs
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COSTS INCLUDED IN INVENTORIES: EXAMPLE
Assume that during a year, a table manufacturing company
- produced 900,000 finished tables incurring
- raw material costs of €9 million,
- direct labour conversion costs of €18 million, and
- production overhead costs of €1.8 million.
- scrapped 1,000 tables (attributable to abnormal waste) incurring
- raw material costs of €10,000 and
- labor and overhead conversion costs of €20,000.
- spent
- €1 million for freight delivery charges on raw materials and
- €500,000 for storing the finished goods as inventory.
The company does not have any work-in-progress inventory at year end.
• What costs should be expensed in the period incurred?
• What costs should be included in inventory and expensed when the goods are
sold?
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COSTS INCLUDED IN INVENTORIES: EXAMPLE
Assume that during a year, a table manufacturing company
- produced 900,000 finished tables incurring
- raw material costs of €9 million,
- direct labour conversion costs of €18 million, and
Total costs that
- production overhead costs of €1.8 million.
should be expensed
- scrapped 1,000 tables (attributable to abnormal waste)
€30,000
incurring
500,000
- raw material costs of €10,000 and
€530,000
- labor and overhead conversion costs of €20,000.
- spent
- €1 million for freight delivery charges on raw
materials and
- €500,000 for storing the finished goods as
inventory.
What costs should be expensed in the period incurred?
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COSTS INCLUDED IN INVENTORIES: EXAMPLE
Assume that during a year, a table manufacturing company
- produced 900,000 finished tables incurring
- raw material costs of €9 million,
- direct labour conversion costs of €18 million, and
- production overhead costs of €1.8 million.
- scrapped 1,000 tables (attributable to abnormal waste)
incurring
- raw material costs of €10,000 and
- labor and overhead conversion costs of €20,000.
- spent
- €1 million for freight delivery charges on raw materials
and
- €500,000 for storing the finished goods as inventory.
Total inventory costs
€9,000,000
18,000,000
1,800,000
1,000,000
€29,800,000
The company does not have any work-in-progress inventory at
year end.
What costs should be included in inventory and expensed
when the goods are sold?
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INVENTORY COST FLOW
Beginning
Inventory
Goods
Purchased
Balance Sheet
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Goods
Available
For
Sale
Ending
Inventory
Cost of
Goods Sold
Income Statement
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SUMMARY TABLE ON INVENTORY
VALUATION METHODS
Method
Description
Specific Identification
Actual costs of items specifically identified as sold
allocated to COGS.
FIFO (First in-First out)
Assumes that earliest items purchased were sold
first. First in to inventory = first out to COGS.
LIFO (Last In-First Out)*
Assumes most recent items purchased were sold
first. Last in to inventory = first out to COGS.
Weighted Average Cost
Averages total costs over total units available.
*LIFO not permitted under IFRS
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INVENTORY VALUATION METHODS: SPECIFIC
IDENTIFICATION
Purchases
100 kg @
¥110/kg
Goods Available
600 kg @
¥58,000 total
100 kg @ ¥110/kg
180 kg @ ¥100/kg
240 kg @ ¥90/kg
520 kg @ ¥50,600
Total =
600 kg @
¥58,000
Ending inventory
(cost)
200 kg @
¥100/kg
300 kg @
¥90/kg
Sales: 520 kg @ ¥240/kg
Cost of Goods Sold
20 kg @ ¥100/kg
60 kg @ ¥90/kg
80 kg @ ¥7,400
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INVENTORY VALUATION METHODS: WEIGHTED
AVERAGE COST
Purchases
100 kg @
¥110/kg
Goods Available
600 kg @
¥58,000 total.
AVERAGE
¥96.667/kg
Sales: 520 kg @ ¥240/kg
Cost of Goods Sold
520 kg @
¥96.667/kg
= ¥50,267
200 kg @
¥100/kg
300 kg @
¥90/kg
Total =
600 kg @
¥58,000
Ending inventory
(cost)
80 kg @
¥96.667/kg
= ¥7,733
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INVENTORY VALUATION METHODS: FIFO
Purchases
100 kg @
¥110/kg
Goods Available
600 kg @
¥58,000 total
100 kg @ ¥110/kg
200 kg @ ¥100/kg
220 kg @ ¥90/kg
520 kg @ ¥50,800
Total =
600 kg @
¥58,000
Ending inventory
(cost)
200 kg @
¥100/kg
300 kg @
¥90/kg
Sales: 520 kg @ ¥240/kg
Cost of Goods Sold
80 kg @ ¥90/kg
80 kg @ ¥7,200
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INVENTORY VALUATION METHODS: LIFO
Purchases
100 kg @
¥110/kg
Goods Available
600 kg @
¥58,000 total
20 kg @ ¥110/kg
200 kg @ ¥100/kg
300 kg @ ¥90/kg
520 kg @ ¥49,200
Total =
600 kg @
¥58,000
Ending inventory
(cost)
200 kg @
¥100/kg
300 kg @
¥90/kg
Sales: 520 kg @ ¥240/kg
Cost of Goods Sold
80 kg @ ¥110/kg
80 kg @ ¥8,800
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INVENTORY VALUATION METHODS: SUMMARY
Inventory Valuation Method
Specific
ID
Weighted
Average Cost
FIFO
LIFO
Cost of sales
50,600
50,267
50,800
49,200
Ending inventory
7,400
7,733
7,200
8,800
Goods available for sale
58,000
58,000
58,000
58,000
Gross profit
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74,200
74,533
74,000
75,600
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PERIODIC AND PERPETUAL INVENTORY
SYSTEMS
• Periodic inventory system: inventory values and costs of sales are
determined at the end of an accounting period.
- Purchases are recorded in a purchases account.
- The total of purchases and beginning inventory is the amount of
goods available for sale during the period.
- The ending inventory amount is subtracted from the goods available
for sale to arrive at the cost of sales. The quantity of goods in ending
inventory is usually obtained or verified through a physical count of
the units in inventory.
• Perpetual inventory system: inventory values and cost of sales are
continuously updated to reflect purchases and sales.
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PERIODIC AND PERPETUAL INVENTORY
SYSTEMS: EXAMPLE
Cost of Goods Sold Using LIFO valuation method
Perpetual versus Periodic Inventory Systems
Purchased
Sold Remaining
Units Cost
Units
Units
Jan 100
$110
100
Apr
80
20
July 200
$100
220
Nov
100
120
COGS
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COGS - perpetual
=80@$110 = $8,800
=100 @$100 = $10,000
=$8,800+$10,000=$18,800
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PERIODIC AND PERPETUAL INVENTORY
SYSTEMS: EXAMPLE
Cost of Goods Sold Using LIFO valuation method
Perpetual versus Periodic Inventory Systems
Jan
Apr
July
Nov
Purchased Sold Remaining
Units Cost Units
Units
100 $110
100
80
20
200 $100
220
100
120
COGS -periodic
NA
Goods
available
Ending
inventory
COGS
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NA
= 0+ 100 *$110 + 200*$100
=$31,000
= 100 *$110 + 20*$100
= $13,000
= $31,000 - $13,000
= $18,000
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EFFECTS OF INFLATION OF INVENTORY
COSTS ON THE FINANCIAL STATEMENTS
Costs
FIFO
FIFO:
Earlier,
lower
costs in
COGS
FIFO:
Later,
higher
costs in
inventory
Time
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Period end
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LIFO RESERVE
• LIFO reserve is the difference between inventory amount
as reported using LIFO and the inventory amount that
would have been reported using FIFO.
FIFO inventory value - LIFO inventory value = LIFO
reserve.
• Companies using the LIFO method must disclose the
amount of the LIFO reserve.
• An analyst can use the disclosure to adjust a company’s
reported cost of goods sold and ending inventory from
LIFO to FIFO.
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LIFO RESERVE EXAMPLE: DISCLOSURE
Inventories
Inventories are stated at the lower of cost or market. Cost is principally
determined using the last-in, first-out (LIFO) method. The value of inventories
on the LIFO basis represented about 70% of total inventories at December 31,
2008 and about 75% of total inventories at December 31, 2007 and 2006.
If the FIFO (first-in, first-out) method had been in use, inventories would have
been $3,183 million, $2,617 million and $2,403 million higher than reported at
December 31, 2008, 2007 and 2006, respectively.
Caterpillar Inc. 2008 Annual Report
Note 1. D.
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LIFO RESERVE EXAMPLE: ADJUST INVENTORY
• Caterpillar disclosed: “If the FIFO (first-in, first-out) method had been in
use, inventories would have been $3,183 million, $2,617 million and
$2,403 million higher than reported on December 31, 2008, 2007 and
2006, respectively.”
• Caterpillar’s balance sheet shows inventories of $8,781 million, $7,204
million, and $6,351 million, at December 31, 2008, 2007, and 2006,
respectively.
• Adjust inventory from LIFO to FIFO by adding the amount of the LIFO
reserve to the reported inventory.
31 December ($ millions)
Total inventories as reported (LIFO)
From Note 1. D disclosure (LIFO reserve)
Total inventories adjusted (FIFO)
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2008 2007 2006
8,781 7,204 6,351
3,183 2,617 2,403
11,964 9,821 8,754
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LIFO RESERVE EXAMPLE: ADJUST COST OF
GOODS SOLD
• Caterpillar disclosed: “If the FIFO (first-in, first-out) method had been in
use, inventories would have been $3,183 million, $2,617 million and
$2,403 million higher than reported at December 31, 2008, 2007 and
2006, respectively.”
• Caterpillar’s income statement shows Cost of Goods Sold of $38,415
million and $32,626 million for the years ending December 31, 2008
and 2007, respectively.
• Adjust Cost of Goods Sold from LIFO to FIFO by deducting the amount
of change in LIFO reserve.
31 December ($ millions)
Cost of goods sold as reported (LIFO)
Less: Increase in LIFO reserve*
Cost of goods sold as adjusted (FIFO)
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2008
2007
38,415 32,626
−566
−214
37,849 32,412
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LIFO RESERVE EXAMPLE: ADJUST NET
INCOME
• Caterpillar disclosed: “If the FIFO (first-in, first-out) method had been in use,
inventories would have been $3,183 million, $2,617 million and $2,403 million
higher than reported at December 31, 2008, 2007 and 2006, respectively.”
• Caterpillar’s income statement shows net Income of $3,557 million and
$32,626 million for the years ending December 31, 2008 and 2007,
respectively.
• Caterpillar’s effective tax rates were approximately 20% for 2008 and 30% for
2007 and earlier.
• Adjust net income from LIFO to FIFO by incorporating the adjustment in Cost
of Goods Sold (COGS), on an after-tax basis.
31 December ($millions )
Net income as reported (LIFO)
Reduction in COGS (increase in operating profit)
2008
3,557
566
2007
3,541
214
Taxes on increased operating profit
Net income as adjusted (FIFO)
−113
4,010
−64
3,691
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LIFO RESERVE EXAMPLE: ADJUST LIABILITIES
AND EQUITY
• Caterpillar disclosed: “If the FIFO (first-in, first-out) method had been in
use, inventories would have been $3,183 million, $2,617 million and
$2,403 million higher than reported at December 31, 2008, 2007 and
2006, respectively.”
• Caterpillar’s December 31, 2008 balance sheet shows total liabilities of
$61,171 million, and total equity of $6,087 million.
• Caterpillar’s effective tax rates were approximately 20% for 2008 and
30% for 2007 and earlier.
• Adjust liabilities from LIFO to FIFO by incorporating a tax liability for the
amount of accumulated tax savings over the years. Adjust equity by
including the cumulative after-tax gross profits.
31 December ($millions )
Liabilities as reported (LIFO)
Accumulated deferred taxes
Liabilities as adjusted (FIFO)
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2008
$61,171
$898
$62,069
31 December ($millions )
Equity as reported (LIFO)
Retained earnings
Equity as adjusted (FIFO)
2008
$6,087
$2,285
$8,372
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COMPARATIVE RATIOS
• Calculate Caterpillar’s Inventory Turnover, Gross Profit margin, and
Net Profit margin for 2008 under the LIFO and FIFO methods.
• Caterpillar’s 2008 revenues were $48,044 million from machinery
sales and $3,280 from financial products.
Inventory turnover
LIFO
FIFO
4.81
3.47
= 37,849 ÷
= 38,415 ÷
[(8,781 + 7,204) ÷ 2] [(11,964 + 9,821) ÷ 2]
Gross profit margin
20.04%
21.22%
= [(48,044 – 38,415) ÷ = [(48,044 – 37,849) ÷
48,044]
48,044]
Net profit margin
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6.93%
7.81%
= (3,557 ÷ 51,324)
= (4,010 ÷ 51,324]
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COMPARATIVE RATIOS
• Calculate Caterpillar’s Current Ratio and Total liabilities-toequity for 2008 under the LIFO and FIFO methods.
• In 2008, Caterpillar reported $31,633 million current assets,
$26,069 million current liabilities, 61,171 million total liabilities,
and $6,087 million total equity.
Current ratio
Total liabilities-to-equity ratio
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LIFO
FIFO
1.21
1.34
= (31,633 ÷ 26,069)
= [(31,633 + 3,183) ÷
26,069]
10.05
7.41
= (61,171 ÷ 6,087)
= [(61,171 +898) ÷
(6,087 + 2,285)]
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LIFO LIQUIDATION
Units in to
inventory:
Purchase or
Manufacture
Units out of
inventory:
Sales
Inventory
When the number of inventory units manufactured or purchased in
a period exceeds the number of units sold, the LIFO reserve may
increase with each increase in quantity creating a new LIFO
“layer.”
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LIFO LIQUIDATION
Units in to
inventory:
Purchase or
Manufacture
Units out of
inventory:
Sales
Inventory
When the number of units sold in a period exceeds the number of
units purchased or manufactured, the costs from older LIFO layers
will flow to COGS (some of the older units held in inventory are
assumed to have been sold), called “LIFO liquidation.”
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EXAMPLE: LIFO LAYERS AND LIFO
LIQUIDATION
Assume a three year scenario during which a company’s
• cost of goods increased by $1 per unit each year from $5 to $6 to $7.
• priced its goods to achieve a 50% gross profit per unit (i.e. 100%
markup).
In years 1 and 2, the company buys 10,000 units but sells only 9,000
units. In year 3, the company buys 8,000 units, sells 10,000.
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EXAMPLE: LIFO LAYERS AND LIFO
LIQUIDATION
Units
Beginning inventory
Units purchased
Units sold
Ending inventory Year 1
Beginning inventory Year 2
Units purchased
Units sold
Ending inventory Year 2
0
10,000
9,000
1,000
1,000
10,000
9,000
2,000
Cost per unit Total costs
$5
$5
$6
$6
$50,000
$45,000
$5,000
$5,000
$60,000
$54,000
$11,000
The ending inventory includes a “layer” of old
costs at $5 per unit x 1,000 units and another
“layer” of costs at $6 per unit x 1,000.
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EXAMPLE: LIFO LAYERS AND LIFO
LIQUIDATION
Units
Beginning inventory
Units purchased
Units sold
Ending inventory Year 1
Beginning inventory Year 2
Units purchased
Units sold
Ending inventory Year 2
Beginning inventory Year 3
Units purchased
Units sold
Ending inventory Year 3
0
10,000
9,000
1,000
1,000
10,000
9,000
2,000
2,000
8,000
10,000
0
Cost per unit
$5
$5
$6
$6
$7
Total costs
$50,000
$45,000
$5,000
$ 5,000
$60,000
$54,000
$11,000
$11,000
$56,000
$67,000
0
In Year 3, the old layers at $5 from Year 1 and
$6 from Year 2 flow to cost of goods sold
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EXAMPLE: LIFO LAYERS AND LIFO
LIQUIDATION
Year
Revenue
per unit Total revenue
COGS
Gross
profit
Gross
margin
1
$10
$ 90,000
$ 45,000
$ 45,000
50%
2
$12
$ 108,000
$ 54,000
$ 54,000
50%
3
$14
$ 140,000
$ 67,000
$ 73,000
52%
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INVENTORY ADJUSTMENTS
Inventory is measured and carried on the balance sheet at the lower of
cost of market.
- IFRS:
- Lower of cost or net realizable value
- Subsequent reversals allowed
- U.S. GAAP:
- Lower of cost or market, defined as current replacement cost
subject to upper and lower limits
- Upper limit of market: net realizable value
- Lower limit of market: net realizable value less a normal profit
margin
- Subsequent reversals prohibited
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INVENTORY ADJUSTMENTS
The Volvo Group reported:
• Total inventories (net of allowance) at year end 2008 and 2007,
respectively, as reported on Balance Sheet: SEK 55,045 million and
SEK 43,645 million.
• Cost of sales for 2008, as reported on Income Statement: SEK 237,578
• Allowance for inventory obsolescence at year end 2008 and 2007,
respectively, as disclosed in footnote: SEK 3,522 million and SEK
2,837 million
• Compare inventory turnover
- Using numbers reported
- Assuming all past inventory write downs were reversed in 2008.
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INVENTORY ADJUSTMENTS
The Volvo Group reported:
• Total inventories (net of allowance) at year end 2008 and 2007,
respectively, as reported on Balance Sheet: SEK 55,045 million and
SEK 43,645 million.
• Cost of sales for 2008, as reported on Income Statement: SEK 237,578
• Allowance for inventory obsolescence at year end 2008 and 2007,
respectively, as disclosed in footnote: SEK 3,522 million and SEK
2,837 million
• Compare inventory turnover
• Inventory Turnover = Cost of Goods Sold/ Average Inventory
• Using numbers reported, 4.81 = 237,578 ÷ [(55,045 + 43,645) ÷ 2]
• Assuming all past inventory write downs were reversed, using adjusted
numbers = 4.51 = 236,893 ÷ [(58,567 + 46,482) ÷ 2]
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INVENTORY DISCLOSURES: ANALYTICAL
CONSIDERATIONS
• Examine changes in inventory ratios relative to sales growth.
- High turnover + sales growth slower than industry: Is the company’s
level of inventory adequate?
- High turnover + sales growth same or faster than industry: Probably
indicates efficient inventory management
• Examine changes in inventory components relative to other
components and relative to sales growth.
- Significant increase in finished goods inventories while raw materials
and work-in-progress inventories are declining could signify a
possible decline in demand
- Growth of finished goods inventory higher than sales growth could
also signify a possible decline in demand
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SUMMARY
• Total cost of inventories comprises all costs of purchase, costs of
conversion, and other costs incurred in bringing the inventories to their
present location and condition.
• The choice of inventory valuation method determines how the cost of
goods available for sale during the period is allocated between inventory
and cost of sales. It affects the financial statements and any financial ratios
that are based on them.
• IFRS allow three inventory valuation methods (cost formulas): first-in, firstout (FIFO); weighted average cost; and specific identification.
• U.S. GAAP allow the three methods above plus the last-in, first-out (LIFO)
method.
• Companies that use the LIFO method must disclose in their financial notes
the amount of the LIFO reserve. This information can be used to adjust
reported LIFO inventory and cost of goods sold balances to the FIFO
method for comparison purposes.
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