Chapter 6

Inventories and Cost of Sales

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 Conceptual Chapter Objectives

C1: Identify the items making up

merchandise inventory
C2: Identify the costs of merchandise
inventory

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 Analytical Chapter Objectives

A1: Analyze the effects of inventory methods

for both financial and tax reporting
A2: Analyze the effects of inventory errors on
current and future financial statements
A3: Assess inventory management using both
inventory turnover and days’ sales in
inventory

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 Procedural Chapter Objectives

P1: Compute inventory in a perpetual system using the

methods of specific identification, FIFO, LIFO, and
weighted average
P2: Compute the lower of cost or market amount of
inventory
P3: Appendix 6A: Compute inventory in a periodic
system using the methods of specific identification,
FIFO, LIFO, and weighted average
P4: Appendix 6B: Apply both the retail inventory and
gross profit methods to estimate inventory.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 C1

Determining Inventory Items

Merchandise inventory includes all goods that

a company owns and holds for sale, regardless
of where the goods are located when inventory
is counted.
Items requiring special attention include:
Goods
Goods in
Damaged or
Transit Goods on Obsolete
Consignment

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 C1

Goods in Transit
FOB Shipping Point
Public
Carrier

Seller Buyer

Ownership passes
to the buyer here.

Public
Carrier

Seller FOB Destination Point Buyer

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007
 C1

Goods on Consignment

Merchandise is included in the inventory of

the consignor, the owner of the inventory.

Thanks for selling

my inventory in
your store.
Consignee

Consignor
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007
 C1

Goods Damaged or Obsolete

Damaged or obsolete goods are not counted in

inventory if they cannot be sold.

Cost should be reduced to net realizable value if

they can be sold.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007
 C2

Determining Inventory Costs

Include all expenditures necessary to bring an

item to a salable condition and location.

Minus
Discounts Invoice Plus
and
Allowances Cost Insurance

Plus Import Plus

Duties Plus Storage
Freight
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007
 C2 Internal Controls and Taking a Physical
Count


 Most
Most companies
companies take take
aa physical
physical count
count ofof
inventory
inventory at
at least
least once
once
each
each year.
year.

Inv

 When
When the
the physical
physical Cou entory
count nt
count does
does not
not match
match Qua
nt
Tag
the
the Merchandise
Merchandise Cou ity
nte
Cou d_
Inventory
Inventory account,
account, an
an by n te
__
___ d
adjustment
adjustment must
must be
be ___
_
made.
made.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007
 P1 Inventory Costing Under a Perpetual
System

Inventory
affects . . .
Balance Income
Sheet Statement

The matching
principle requires
matching cost of
sales with sales.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007
 P1 Inventory Costing Under a Perpetual
System

Accounting for
inventory 
 Costing
Costing Method
Method
requires several
 Specific
 Specific Identification,
Identification, FIFO,
FIFO, LIFO,
LIFO,
decisions . . . or
or Weighted
Weighted Average
Average


 Inventory
Inventory System
System
 Perpetual
 Perpetual or
or Periodic
Periodic

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 P1
Frequency in Use of Inventory
Methods

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 P1
Inventory Cost Flow
Assumptions
First-In, First-Out Assumes costs flow in the order
(FIFO) incurred.

Last-In, First-Out Assumes costs flow in the

(LIFO) reverse order incurred.

Weighted Assumes costs flow at an

Average average of the costs available.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 P1
Inventory Costing Illustration

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 P1
Specific Identification

When
When units
units are
are sold,
sold, the
the
specific
specific cost
cost of
of the
the unit
unit
sold
sold is
is added
added to
to cost
cost of
of
goods
goods sold.
sold.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 P1

Specific Identification

The
The above
above purchases
purchases were
were
made
made inin August.
August. OnOn August
August 14,
14,
aa company
company sold
sold eight
eight bikes
bikes
originally
originally costing
costing $91
$91 and
and 12
12
bikes
bikes originally
originally costing
costing $106.
$106.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 P1
Specific Identification

The
TheCost
CostofofGoods
GoodsSold
Soldfor
forthe
theAugust
August14
14sale
sale
is
is$2,000.
$2,000.
88bikes
bikes@@91
91 == $$ 728
728
12
12bikes
bikes@@106
106== $1,272
$1,272
After
Afterthis
thissale,
sale,there
thereare
arefive
fiveunits
unitsin
ininventory
inventory
at
at$500:
$500:
22bikes
bikes@ @$91
$91 == $$182
182
33bikes
bikes@ @$106
$106== $$318
318

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 P1
Specific Identification

Additional
Additionalpurchases
purchaseswere
weremade
madeon
onAugust
August17
17and
and28.
28.
The
Thecost
costof
ofthe
the23
23items
itemssold
soldon
onAugust
August31
31were
wereas
asfollows:
follows:
22@
@$91
$91
33@
@$106
$106
15
15@@$115
$115
33@
@$119
$119
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007
 P1
Specific Identification

Cost
Cost of
of Goods
Goods Sold
Sold for
for
August
August 31
31 == $2,582
$2,582
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007
 P1
Specific Identification

After
Afterthe theAugust
August3131sale,
sale,there
thereare
are
12
12units
unitsinininventory
inventoryat
at$1,408:
$1,408:
55@
@$115
$115
McGraw-Hill/Irwin 77@@$119
$119 © The McGraw-Hill Companies, Inc., 2007
 P1
Specific Identification

Income
Statement COGS
= $4,582

Balance Sheet
McGraw-Hill/Irwin
Inventory = $1,408
© The McGraw-Hill Companies, Inc., 2007
 P1
Specific Identification
Here are the entries to record the purchases and sales. The
numbers in red are determined by the cost flow assumption
used.

All purchases Aug. 3 Merchandise inventory 1,590

and sales are Accounts payable 1,590
Aug. 14 Accounts receivable 2,600
made on
Sales 2,600
credit. Aug. 14 Cost of goods sold 2,000
The selling Merchandise inventory 2,000
price of Aug. 17 Merchandise inventory 2,300
inventory was Accounts payable 2,300
Aug. 28 Merchandise inventory 1,190
as follows: Accounts payable 1,190
8/14 $130 Aug. 31 Accounts receivable 3,450
Sales 3,450
8/31 150 Aug. 31 Cost of goods sold 2,582
McGraw-Hill/Irwin Merchandise inventory 2,582
© The McGraw-Hill Companies, Inc., 2007
 P1
First-In, First-Out (FIFO)

Oldest
Oldest Cost
Cost of
of
Costs
Costs Goods
Goods Sold
Sold

Recent
Recent Ending
Ending
Costs
Costs Inventory
Inventory

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 P1
First-In, First-Out (FIFO)

The
The above
above purchases
purchases were
were
made
made in
in August.
August.
On
On August
August 14,
14, the
the company
company
sold
sold 20
20 bikes.
bikes.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 P1
First-In, First-Out (FIFO)

The
The Cost
Cost of
of Goods
Goods Sold
Sold for
for the
the
August
August 14
14 sale
sale is
is $1,970.
$1,970.
After
After this
this sale,
sale, there
there are
are five
five units
units in
in
inventory
inventory at at $530:
$530:
55 @
@ $106
$106
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007
 P1
First-In, First-Out (FIFO)

Additional
Additionalpurchases
purchaseswere
weremade
madeon
onAugust
August 17
17and
and28.
28.
Twenty-three
Twenty-threebikes
bikeswere
weresold
soldon
onAugust
August31.
31.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 P1
First-In, First-Out (FIFO)

Cost
Cost of
of Goods
Goods Sold
Sold for
for
August
August 31
31 == $2,600
$2,600
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007
 P1
First-In, First-Out (FIFO)

After
Afterthe
theAugust
August31 31sale,
sale,there
thereare
are
12
12units
unitsin
ininventory
inventoryat
at$1,420:
$1,420:
22@
@$115
$115
10
10@@$119
$119
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007
 P1
First-In, First-Out (FIFO)

Income Statement
COGS = $4,570

Balance Sheet
Inventory = $1,420
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007
 P1
First-In, First-Out (FIFO)
Here are the entries to record the purchases and sales
entries. The numbers in red are determined by the cost flow
assumption used.

All purchases Aug. 3 Merchandise inventory 1,590

and sales are Accounts payable 1,590
Aug. 14 Accounts receivable 2,600
made on
Sales 2,600
credit. Aug. 14 Cost of goods sold 1,970
The selling Merchandise inventory 1,970
price of Aug. 17 Merchandise inventory 2,300
inventory was Accounts payable 2,300
Aug. 28 Merchandise inventory 1,190
as follows: Accounts payable 1,190
8/14 $130 Aug. 31 Accounts receivable 3,450
Sales 3,450
8/31 150 Aug. 31 Cost of goods sold 2,600
McGraw-Hill/Irwin Merchandise inventory 2,600
© The McGraw-Hill Companies, Inc., 2007
 P1
Last-In, First-Out (LIFO)

Recent
Recent Cost
Cost of
of
Costs
Costs Goods
Goods Sold
Sold

Oldest
Oldest Ending
Ending
Costs
Costs Inventory
Inventory

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 P1
Last-In, First-Out (LIFO)

The
The above
above purchases
purchases were
were
made
made in
in August.
August.
On
On August
August 14,
14, the
the company
company
sold
sold 20
20 bikes.
bikes.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 P1
Last-In, First-Out (LIFO)

The
The Cost
Cost of
of Goods
Goods Sold
Sold for
for the
the
August
August 14
14 sale
sale is
is $2,045.
$2,045.
After
After this
this sale,
sale, there
there are
are five
five units
units in
in
inventory
inventory at
at $455:
$455:
55 @@ $91
$91
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007
 P1
Last-In, First-Out (LIFO)

Additional
Additionalpurchases
purchaseswere
weremade
madeon
onAugust
August 17
17and
and28.
28.
Twenty-three
Twenty-threebikes
bikeswere
weresold
soldon
onAugust
August31.
31.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 P1
Last-In, First-Out (LIFO)

Cost
Cost of
of Goods
Goods Sold
Sold for
for
August
August 31
31 == $2,685
$2,685
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007
 P1
Last-In, First-Out (LIFO)

After
Afterthe
theAugust
August31 31sale,
sale,there
thereare
are
12
12units
unitsin
ininventory
inventoryatat$1,260:
$1,260:
55@
@$91
$91
77@@$115
$115
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007
 P1
Last-In, First-Out (LIFO)

Income
Statement COGS
= $4,730

Balance Sheet
Inventory = $1,260
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007
 P1
Last-In, First-Out (LIFO)
Here are the entries to record the purchases and sales
entries. The numbers in red are determined by the cost flow
assumption used.

All purchases Aug. 3 Merchandise inventory 1,590

and sales are Accounts payable 1,590
Aug. 14 Accounts receivable 2,600
made on
Sales 2,600
credit. Aug. 14 Cost of goods sold 2,045
The selling Merchandise inventory 2,045
price of Aug. 17 Merchandise inventory 2,300
inventory was Accounts payable 2,300
Aug. 28 Merchandise inventory 1,190
as follows: Accounts payable 1,190
8/14 $130 Aug. 31 Accounts receivable 3,450
Sales 3,450
8/31 150 Aug. 31 Cost of goods sold 2,685
McGraw-Hill/Irwin Merchandise inventory 2,685
© The McGraw-Hill Companies, Inc., 2007
 P1
Weighted Average

When
When aa unit
unit is
is sold,
sold, the
the
average
average costcost ofof each
each unit
unit
in
in inventory
inventory is
is assigned
assigned
to
to cost
cost of
of goods
goods sold.
sold.

Cost of Goods Units on hand

Available for ÷ on the date of
Sale sale

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 P1
Weighted Average

The
The above
above purchases
purchases were
were
made
made in
in August.
August.
On
On August
August 14,
14, 20
20 bikes
bikes were
were
sold.
sold.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 P1
Weighted Average

First, we need to compute the weighted

average cost per unit of items in inventory.

Cost of goods available for sale $ 2,500

Total units in inventory ÷ 25
Weighted average cost per unit $ 100

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 P1
Weighted Average

The
TheCost
Costof
of Goods
GoodsSold
Sold for
forthe
theAugust
August14
14
sale
saleis
is$2,000.
$2,000.
After
Afterthis
thissale,
sale,there
thereare
arefive
fiveunits
unitsin
in
inventory
inventoryatat $500:
$500:

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 P1
Weighted Average

Additional
Additionalpurchases
purchaseswere
weremade
madeon
onAugust
August 17
17and
and28.
28.
Twenty-three
Twenty-threebikes
bikeswere
weresold
soldon
onAugust
August31.
31.

What is the weighted average cost per unit

of items in inventory?
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007
 P1
Weighted Average

Units
Units
Inventory
Inventory 8/14
8/14 55 Cost of goods available for sale $ 3,990
Purchase
Purchase 8/17
8/17 20
20 Total units in inventory ÷ 35
Purchase
Purchase 8/28
8/28 10
10
Units
Weighted average cost per unit $ 114
Units available
available for
for sale
sale 35
35

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 P1
Weighted Average

Cost
Cost of
of Goods
Goods Sold
Sold for
for
August
August 31
31 == $2,622
$2,622

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 P1
Weighted Average

After
Afterthe
theAugust
August31 31sale,
sale,there
thereare
are
12
12units
unitsin
ininventory
inventoryat
at$1,368:
$1,368:
12
12@@$114
$114

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 P1
Weighted Average

Income
Statement COGS
= $4,622

Balance Sheet
Inventory = $1,368

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 P1
Weighted Average
Here are the entries to record the purchases and sales
entries for Trekking. The numbers in red are determined by
the cost flow assumption used.

All purchases Aug. 3 Merchandise inventory 1,590

and sales are Accounts payable 1,590
Aug. 14 Accounts receivable 2,600
made on
Sales 2,600
credit. Aug. 14 Cost of goods sold 2,000
The selling Merchandise inventory 2,000
price of Aug. 17 Merchandise inventory 2,300
inventory was Accounts payable 2,300
Aug. 28 Merchandise inventory 1,190
as follows: Accounts payable 1,190
8/14 $130 Aug. 31 Accounts receivable 3,450
Sales 3,450
8/31 150 Aug. 31 Cost of goods sold 2,622
McGraw-Hill/Irwin Merchandise inventory 2,622
© The McGraw-Hill Companies, Inc., 2007
 A1 Financial Statement Effects of Costing
Methods

Because
Because prices
prices change,
change, inventory
inventory methods
methods nearly
nearly
always
always assign
assign different
different cost
cost amounts.
amounts.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 A1 Financial Statement Effects of Costing
Methods

Advantages
Advantages of
of Methods
Methods

Weighted First-In, Last-In,

Average First-Out First-Out

Ending
Ending inventory
inventory Better
Better matches
matches
Smoothes
Smoothes out
out approximates
approximates current
current costs
costs in
in cost
cost
price
price changes.
changes. current
current of
of goods
goods sold
sold with
with
replacement
replacement cost.
cost. revenues.
revenues.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007
 A1
Tax Effects of Costing
Methods
The
The Internal
Internal Revenue
Revenue Service
Service (IRS)
(IRS)
identifies
identifies several
several acceptable
acceptable
methods
methods for for inventory
inventory costing
costing for
for
reporting
reporting taxable
taxable income.
income.

If LIFO is used for tax

purposes, the IRS requires
it be used in financial
statements.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007
 A1
Consistency in Using Costing
Methods

The
The consistency
consistency principle
principle requires
requires aa
company
company to to use
use the
the same
same accounting
accounting
methods
methods period
period after
after period
period so
so that
that
financial
financial statements
statements areare comparable
comparable
across
across periods.
periods.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 P2
Lower of Cost or Market

Inventory
Inventory must
must be
be reported
reported atat market
market
value
value when
when market
market is
is lower
lower than
than
cost.
cost.

Defined
Defined asas current
current Can
Can be
be applied
applied three
three ways:
ways:
replacement
replacement cost
cost (1)
(1) separately
separately to to each
each
(not
(not sales
sales price).
price). individual
individual item.
item.
Consistent
Consistent with
with (2)
(2) to
to major
major categories
categories of of
the
the conservatism
conservatism assets.
assets.
principle.
principle. (3)
(3) to
to the
the whole
whole inventory.
inventory.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007
 P2
Lower of Cost or Market

A
A motorsports
motorsports retailer
retailer has
has the
the following
following items
items in
in
inventory:
inventory:

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 P2
Lower of Cost or Market

Here
Here is
is how
how to
to compute
compute lower
lower of
of cost
cost or
or
market
market for
for individual
individual inventory
inventory items
items..

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 P2
Lower of Cost or Market

Here
Here is
is how
how to
to compute
compute lower
lower of
of cost
cost or
or market
market
for
for the
the two
two groups
groups of
of inventory
inventory items
items..

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 P2
Lower of Cost or Market

Here
Here is
is how
how to
to compute
compute lower
lower of
of cost
cost or
or market
market
for
for the
the entire
entire inventory
inventory..

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 Exh.
5.10
A2 Financial Statement Effects of Inventory
Errors

Income Statement Effects

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 A2 Financial Statement Effects of Inventory
Errors

Balance Sheet Effects

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 A3
Inventory Turnover
Shows
Shows how
how many
many times
times aa company
company turns
turns over
over its
its
inventory
inventory during
during aa period.
period. Indicator
Indicator of
of how
how well
well
management
management is is controlling
controlling the
the amount
amount ofof inventory
inventory
available.
available.

Inventory Cost of goods sold

Turnover = Avg. inventory

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 A3
Days’ Sales in Inventory

Reveals
Reveals how
how much
much inventory
inventory is
is available
available in
in
terms
terms of
of the
the number
number of
of days’
days’ sales.
sales.

Days' Sales in Ending Inventory

Inventory = Cost of goods sold
× 365

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007

 End of Chapter 6

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007