Chapter 6

Inventory & Merchandising

Operations
 Learning Objectives

• Understand the nature of inventory

• Record inventory related transactions

• Understand different inventory cost assumptions

• Analyze effects of inventory errors

• Evaluate a company's retailing operations

 Inventory

• Inventory is the heart of a merchandising

business.

• The basic concept of identifying inventory is

through cost of goods sold or cost of sales.
Contrasting a Service company with a
Merchandiser
Inventory for Manufacturers
 Sales Price Vs Cost of Inventory
• Sales revenue is based on the sale price of
inventory sold.

• Cost of goods sold is based on the cost of

inventory sold.

• Inventory on the Balance Sheet is based on the

cost of inventory still on hand.
 Gross profit
• Also called as gross margin, is the excess of
sales revenue over cost of goods sold.
• It is called gross profit because operating
expenses have not yet been subtracted.
Inventory = Number of units of * Cost per unit
(Balance Sheet) inventory on hand of inventory

Cost of goods sold = Number of units of * Cost per unit

(Income Statement) inventory sold of inventory
 Number of Units of Inventory
 It is determined from the accounting records.
 Companies do not include any goods in their
inventory that they hold on consignment
(because they belong to another entity).
 Entity will include their own inventory that is
held by the other company.
 Includes inventory in transit from suppliers or
to consumers.
 Basic Inventory Relationship

Beginning Ending
Inventory $20 Inventory $30

Cost of goods
available for sale
$120

Purchases $100 Cost of goods

sold $90
 Question
ACS started & completed the financial year with
inventory valued $15,000 and $20,000
respectively. Its cost of goods sold for the period
$160,000. How much was the total inventory
purchased during the period?
 Solution
Remember!
Beginning inventory + Purchases =
Ending Inventory + Cost of Goods sold
 Different Inventory Cost
Assumptions
Inventory that are
not ordinarily Specific Identification
interchangeable Methods

First In First Out

Inventory that are

ordinarily Last In First Out
interchangeable

Weighted average cost

method
Overview of Costing Methods
 Specific Identification
• Some businesses deal in unique inventory items such
as automobiles, antique furniture, jewelry and real
estate.
• These businesses cost their inventories at the specific
cost of the particular unit.
• This method is also called as specific-unit-cost
method.
 First In First Out (FIFO)
• Under this method the first costs into inventory are
the first costs assigned to the cost of goods sold,
therefore it is referred as First In First Out.
 Last In First Out (LIFO)
• LIFO costing is just opposite to FIFO costing.
• Under this, the last costs into inventory go
immediately to cost of goods sold.
 Average Cost Method
• Sometimes called weighted average method.
• It is based on the average cost of inventory during the
period.
• Unlike LIFO and FIFO, the inventory costs are no
longer relevant when the inventory is sold.
Average cost per unit is determined
as follows
Uses of various inventory methods
Effects of FIFO, LIFO & Average Cost
on COGS, Gross Profit & Ending
Inventory
Contrasts among FIFO & LIFO when
inventory costs are increasing
When inventory costs are decreasing…
 Comparison of the Inventory
Methods
• Measuring Cost of Goods sold
– LIFO assigns the most recent inventory costs to expense.
– FIFO matches older inventory costs against revenue.
– LIFO income is more realistic.

• Measuring Ending Inventory

– FIFO measures the most up-to-date inventory cost on the
Balance Sheet.
– LIFO can value inventory at very old costs.
 Inventory Issues
Comparability
– It states that the business should use the same accounting methods &
procedure from period to period.
– Changes if any should be able reflect a more relevant & faithful
representation of an underlying phenomenon.
 LIFO not allowed under IFRS?
• Latest costs is a better measure of income, on the
other hand using older costs results in more
appropriate inventory values on the Balance Sheet.
• LIFO prioritizes income measurements over that of
assets & liabilities.
• IAS 2 states that; “It is not appropriate to allow an
approach that results in a measurement of profit or
loss for the period that is inconsistent with the
measurement of inventories for Balance Sheet
purpose”
 Net Realizable Value (NRV)
• IAS 2 requires inventories to be measured at the lower of cost or Net
Realizable Value (LCNRV)

• NRV is the estimated Selling Price in the ordinary course of business less
the estimated costs of completion & the estimated costs necessary to make
the sale.

Estimated Estimated cost Estimated cost

NRV= Selling price of Completion to sell
 Evaluating company’s retailing
operations
• Owners, managers & investors use ratios to
evaluate a business.
2 ratios directly related to
inventory

Gross Profit Percentage Inventory turnover =

=Gross Profit/Sales COGS/Average inventory

Average inventory=(beginning balance

Gross Profit= Sales- cost of goods sold
+ending balance )/2
 Question
How is the inventory classified in the financial
statements?
A) As a liability
B) As an expense
C) As an asset
D) As a revenue
 Solution
As an asset
 Question
When applying the lower of cost or Net
Realizable Value, NRV means

a) Selling price less discounts

b) Original cost plus profit margin
c) Selling price less cost to sell
d) Original cost less physical deterioration
 Solution
Selling price less cost to sell
 Question
During a period of rising prices, the inventory
method that will yield higher net income and
asset value is

a) LIFO
b) Specific Identification
c) FIFO
d) Average Cost
 Solution
c) FIFO
 Question
The overstatement of ending inventory in one
period results in
a) An understatement of beginning inventory of
the next period.
b) An understatement of net income of the next
period.
c) An overstatement of net income of the next
period.
d) No effect on net income of the next period.
 Solution
B) An understatement of net income of the next
period.
END OF CHAPTER 6