©2009 The McGraw-Hill Companies, Inc.
Chapter 6
Inventory and Cost of Goods Sold
6-2
Inventory
o
Includes items a company intends for sale to
customers clothes at The Limited, shoes at
Payless ShoeSource, building supplies at Home
Depot, and so on.
o
Also includes items that are not yet finished
products. For instance, lumber at a cabinet
manufacturer and rubber at a tire manufacturer are
part of inventory because the firm will use them to
make a finished product for sale to customers
©2009 The McGraw-Hill Companies, Inc.
Part A
Understanding Inventory and Cost
of Goods Sold
6-4
LOB1 Trace the flow of inventory costs from
manufacturing companies to merchandising
companies
Inventory
Merchandise company
Wholesaler
Retailer
Manufacturing company
Raw material
Work in
progress
Finished
goods
6-5
Merchandising Companies
Merchandising companies purchase inventories that are
primarily in finished form for resale to customers
Wholesalers resell
inventory to retail
companies or to
professional users.
Retailers purchase inventory
from manufacturers or
wholesalers and then sell this
inventory to end users.
6-6
Manufacturing Companies
o
Companies manufacture the inventories they sell, rather
than buying them from suppliers in finished form.
o
We classify inventory into three categories
o
Raw materials inventory: Includes the cost of components
that will become part of the finished product but have not yet
been used in production.
o
Work-in-process inventory: Refers to the products that have
started the production process but are not yet complete at the
end of the period.
o
Finished goods inventory: Once the manufacturing process is
complete, transfer these costs to finished goods inventory.
6-7
Types of Companies and Flow of
Inventory Costs
Flow of Inventory Costs
Raw material
Manufacturing
Companies
Direct labor
Work in process
Finished goods
Merchandising
Companies
Products
Service Companies
Services
E
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e
O
v
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r
h
e
a
d
6-8
LO2 Calculate cost of goods
sold
Inventory represents the cost of
inventory not sold, while cost of goods
sold represents the cost of inventory
sold.
Also referred to as cost of sales, cost of
merchandise sold, or cost of products
sold.
The costs of beginning inventory plus
additional purchases make up the cost
of goods (or inventory) available for
sale.
6-9
Relationship between Inventory and
Cost of Goods Sold
LO3 Determine the cost of goods sold
and ending inventory using different
inventory cost methods
Inventory cost method
Specific
Identification
First in,
First out
(FIFO)
Last in,
First out
(LIFO)
Average
Cost
Specific Identification Method
This method you might think of as the most logical.
It matches or identifies each unit of inventory with its actual cost.
Practicable only for companies selling unique, expensive products.
6-10
6-11
Inventory Transactions for Mario’s
Game Shop
o
o
o
It has 100 units of inventory at the beginning of the year and then
makes two purchases during the year—one on April 25 and one on
October 19.
There are 1,000 game cartridges available for sale.
During the year, it sells 800 video game cartridges for $10 each. This
means that 200 cartridges remain in ending inventory at the end of
the year.
6-12
First-In, First-Out (FIFO)
o
o
o
First units purchased are the first ones sold. Beginning
inventory sells first, followed by the inventory from the first
purchase during the year, followed by the inventory from the
second purchase during the year, and so on.
Mario’s Game Shop, which 800 units were sold?
They were the first 800 units purchased, and that all other units
remain in ending inventory.
6-13
Last-In, First-Out (LIFO)
o
o
Last units purchased are the first ones sold.
Mario’s, If 800 units were sold, all the 600 units purchased on
October 19 were sold, along with 200 units from the April 25
purchase. That leaves 100 of the units from the April 25
purchase and all 100 units from beginning inventory assumed to
remain in ending inventory .
6-14
Average Cost Method
o
o
Both cost of goods sold and ending inventory consist of a
random mixture of all the goods available for sale.
Each unit of inventory has a cost equal to the weightedaverage cost of all inventory items.
6-15
Comparison of Cost of Goods Sold Under
The Three Inventory Cost Flow Assumptions
A company purchases three units of inventory and sells two.
 FIFO: Inventory is sold in the order purchased.
 LIFO: Inventory is sold in the opposite order that we purchased it.
 Weighted average cost: Inventory is sold using an average of all
inventory purchased.
LO4 Explain the financial statement effects
and tax effects of inventory cost flow
assumptions
Effects of Managers’ Choice of Inventory
Reporting Methods
Why Choose FIFO?
o
o
o
Matches physical flow
for most companies.
Results in higher assets
and net income when
inventory costs are rising.
Has a balance sheet
focus.
Why Choose LIFO?
o
o
Results in tax savings.
Has an income statement
focus.
6-16
6-17
Comparison of Inventory Cost Flow
Assumptions When Prices Are Rising
A comparison of FIFO, LIFO, and average cost for Mario’s
Game Shop is provided below.
6-18
LIFO Reserve
o
Choice between FIFO and LIFO results in different amounts
for ending inventory and cost of goods sold.
o
It complicates the investment decisions of stockholders.
o
Due to financial statement effects of different inventory
methods, companies that choose LIFO must report what’s
called their LIFO reserve.
o It is the additional amount of inventory a company would
report if it used FIFO instead of LIFO.
o
o
Companies that have been using LIFO for a long time or that
have seen dramatic increases in inventory costs, the LIFO
reserve can be substantial.
The effect of the LIFO reserve for Lone Star Technologies,
which uses LIFO to account for most of its inventory follows.
©2009 The McGraw-Hill Companies, Inc.
Part B
Recording Inventory Transactions
6-20
LO5 Explain the differences between a
perpetual inventory system and a periodic
inventory system
Perpetual Inventory
System
It maintains a continual—or
perpetual—record of
inventory purchased and sold.
A continual tracking of
inventory has the advantage
of helping a company to
better manage its inventory
levels.
Periodic Inventory
System
It does not continually
modify inventory amounts,
but instead periodically
adjusts for purchases and
sales of inventory at the
end of the reporting period
based on a physical count
of inventory on hand.
6-21
Inventory Information for Incredible
Electronics for 2010
To record inventory transactions under the perpetual system and
periodic system. We keep the amount of inventory small to make
the calculations easy, but both systems can be applied to
inventory of any size. Consider the given information below
during 2010:
6-22
Inventory Purchases


o
Perpetual inventory system
Debit inventory when we
purchase inventory .
Credit cash if the purchase
was paid in cash or, credit
accounts payable if the
purchase was on account,
increasing total liabilities.
FOB shipping point
Title passes when the seller
ships the inventory, not when
the buyer receives it.


o
Periodic Inventory system
Debit purchases account
instead of inventory.
We use the purchases account
to temporarily track increases in
inventory. We close this
account to cost of goods sold at
the end of the period.
FOB destination
Title would not transfer to the
buyer and the purchase
transaction would not be
recorded until the shipped
inventory reached its destination.
6-23
Freight Charges
o
Under the perpetual system,
we add the cost of freight-in
to inventory.
o
Under the periodic system,
it also eventually becomes
part of the cost of
inventory, but we initially
record it in a separate
freight-in account. Like
purchases, the freight-in
account is closed to cost
of goods sold at the end of
the period.
6-24
Purchase Returns
o
Under the perpetual system,
the company records the
purchase returns as a
reduction in both inventory and
accounts payable.
o
Under the periodic system,
the company credits an
account called purchase
returns, a contra purchases
account, instead of inventory.
Purchase returns is a
temporary account that will be
closed to (and become part
of) cost of goods sold at the
end of the period.
6-25
Purchase Discounts
Digital Wholesale, offers terms 2/10, n/30 for purchases on account,
and Incredible Electronics takes advantage of the discount. Incredibles’
purchases on account were $55,000, purchases returns were $5,000,
the balance of account payable is $50,000. Subtracting the 2%
purchase discount, Incredible owes only $49,000.
o
Incredible Electronics reduces
its inventory balance by the
amount of the discount. The true
cash price for inventory is
$49,000, not $50,000.
o
o
The company will record the
discount in purchase
discounts.
Purchase discounts, like
returns, is a temporary
account that will be closed
to cost of goods sold at the
end of the period.
6-26
Inventory Sales
Incredible sales $80,000. What is the cost of this inventory?
o
Cost of goods sold = $53,000 ($61,000 - $8000).
o
Record cost of goods sold of $53,000 only when using perpetual system.
o
Periodic system we record the reduction in inventory and increase in cost
of goods sold only periodically, as part of the period-end adjustment.
6-27
Period End Adjustment
o
It is needed only under the periodic system.
o
The entry serves the following purposes:
o
o
o
Adjusts the balance of inventory to its proper ending balance.
Records the cost of goods sold for the period to match
inventory costs with the related revenues.
Closes (or zeros out) the temporary purchases accounts
(purchases, freight-in, returns, and discounts).
6-28
LO6 Prepare a multiple-step income
statement



Sales and purchases of inventory are most important set of transactions ,
companies report revenues and expenses from these separately from
other revenues and expenses.
It makes easier for investors and other financial statement users to
determine the profitability of a company’s inventory transactions.
Use the information for Incredible to calculate gross profit on the sale and
purchase of inventory.
6-29
Multiple-step Income Statement
©2009 The McGraw-Hill Companies, Inc.
Part C
Other Inventory Reporting Issues
6-31
LO7 Apply the lower-of-cost-ormarket rule for inventories
o
o
When the value of inventory falls below its cost, companies are
required to report inventory at the lower market value. And it is
considered to be the replacement cost .
Once it has determined both the cost and market value of inventory,
Inventory is reported at the lower of the two amounts
6-32
Calculating the Lower of Cost or Market
1. Mario’s reports the FunStation 2 in ending inventory at market value.
2. The 15 FunStation 2s were originally reported in inventory at their cost of
$4,500.
3. To reduce the inventory from that original cost of $4,500 to its lower
market value of $3,000, Mario records the following year-end adjustment.
6-33
LO8 Analyze management of inventory
using the inventory turnover ratio and gross
profit ratio
o If managers purchase too much inventory, the company runs the risk of
the inventory becoming obsolete and market value falling below cost.
o Analysts as well as managers often use the inventory turnover ratio to
evaluate a company’s effectiveness in managing its investment in
inventory.
o Investors often rely on the gross profit ratio to determine the core
profitability of a company’s operations.
Inventory turnover ratio is cost of goods sold divided by average inventory.
It shows the number of times the firm sells its average inventory balance
during a reporting period.
Inventory turnover ratio
Average days in inventory
Cost of goods sold
=
Average inventory
=
365
Inventory turnover ratio
6-34
Analyze the inventory of Best Buy and
Sharper Image Corporation
1. We can analyze the inventory of Best Buy and Sharper Image
Corporation by calculating these ratios for both companies.
2. Best Buy sells a large volume of commonly purchased
products.
3. Sharper Image sells a variety of high-end specialty products,
including electronics, toys and other home and personal care
products that typically are not carried by most other retailers.
4. Below are relevant amounts for each company.
6-35
Computation of the Inventory Turnover
Ratio
The turnover ratio is more than twice as high for Best Buy. On average, it
takes Sharper Image an additional 73 days to sell its inventory.
6-36
LO8 Analyze management of inventory
using the inventory turnover ratio and gross
profit ratio
Gross profit ratio: Important indicator of the company’s
successful management of inventory.
Gross profit ratio =
Gross profit
Net sales
1. Measures the amount by which the sale price of inventory
exceeds its cost per dollar of sales.
2. Higher the ratio, higher is the “markup” a company is able to
achieve on its inventories.
6-37
Calculation of Gross Profit Ratio for
Best buy and Sharper Image
For Best Buy, the gross profit ratio is 25% This means
that for every $1 of sales revenue, the company spends
$0.75 on inventory, resulting in a gross profit of $0.25.
For Sharper Image gross profit ratio is 49%
LO9 Calculate inventory amounts using
FIFO and LIFO under a perpetual
inventory system



We can calculate the amount of ending inventory by one of
several methods.
We saw in Part B, the periodic and perpetual inventory
systems determine when to report inventory transactions
Mario’s Game Shop. It sold 800 games to customers. Modify
it by giving exact dates for the sale of the 800 games—250 on
July 17 and 550 on December 15. The chronological order of
inventory transactions follows.
6-38
6-39
FIFO with Perpetual System
FIFO AND LIFO WITH PERIODIC SYSTEM
FIFO, the first 800 units purchased for the period are those we assume
were sold first. LIFO the last 800 units purchased for the period are those
we assume were sold first.
FIFO WITH PERPETUAL SYSTEM
First units sold at the time of the sale, consistent with the perpetual
systems approach to continually recording transactions.
6-40
LIFO with Perpetual System



Last units purchased at the time of the sale are the ones were
sold first.
What are the last 250 units purchased at the time of the July 17
sale?
What are the last 550 units purchased at the time of the
December 15 sale?
6-41
LO10 Determine the financial
statement effects of inventory errors
Inventory Errors
o
o
Errors can unknowingly occur in inventory amounts if
there are mistakes in a physical count of inventory or in
the pricing of inventory quantities.
The formula for cost of goods sold, follows
6-42
Determine the financial statement
effects of inventory errors
Summary of Effects of Inventory Error in the Current Year.
Relationship between Cost of Goods Sold in the Current Year
and the Following Year
6-43
Inventory Amounts
Correct Inventory Amounts
Incorrect Inventory Amounts
©2009 The McGraw-Hill Companies, Inc.
End of chapter 6