Slide

8-1

Chapter
INVENTORIES AND THE
8 COST OF GOODS SOLD

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-2

Inventory Defined

Inventory

Goods owned Current

and held for sale asset
to customers

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-3

The Flow of Inventory Costs

BALANCE SHEET

As purchase costs
Current assets:
(or manufacturing Inventory
costs) are incurred $ $
as goods
INCOME STATEMENT are sold
Revenue $
Cost of goods sold
Gross profit
Expenses
Net income
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
Slide
8-4

The Flow of Inventory Costs

In a perpetual inventory system, inventory entries
parallel the flow of costs.

GENERAL JOURNAL
P
Date Account Titles and Explanation R Debit Credit
Entry on Purchase Date
Inventory $$$$
Accounts Payable $$$$

Entry on Sale Date

Cost of Goods Sold $$$$
Inventory $$$$
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
Slide
8-5

Which Unit Did We Sell?

When identical units of inventory have

different unit costs, a question naturally
arises as to which of these costs should be
used in recording a sale of inventory.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-6

Inventory Subsidiary Ledger

A separate subsidiary account is maintained

for each item in inventory.
Item LL002 Primary supplier Electronic City
Description Laser Light Secondary supplier Electric Company
Location Storeroom 2 Inventory level: Min: 25 Max: 200
Purchased Sold Balance
Cost of
Unit Unit Goods Unit
Date Units Cost Total Units Cost Sold Units Cost Total
Sept. 5 100 $ 30 $ 3,000 100 $ 30 $ 3,000
Sept. 9 75 50 3,750 100 30 3,000
75 50 3,750
Sept. 10 10 ? ? ? ? ?
? ? ?

How can we determine the unit cost for the Sept. 10 sale?
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
Slide
8-7

Inventory Cost Flows

We use one of these inventory valuation
methods to determine cost of inventory sold.

Specific Average
identification cost

FIFO LIFO
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
Slide
8-8
Information for the Following
Inventory Examples
The Bike Company (TBC)

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-9

Specific Identification

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

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-10

Specific Identification – Example

On August 14, TBC sold 20 bikes for $130 each.

Nine bikes originally cost $91 and 11 bikes
originally cost $106.

Continue
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
Slide
8-11

Specific Identification – Example

The Cost of Goods Sold for the August 14 sale is

$1,985, leaving $515 and 5 units in inventory.

Let’s look at the entries for

Continue the Aug. 14 sale.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
Slide
8-12

Specific Identification – Example

Retail

Cost

A similar entry is
made after each sale. Continue

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-13

Specific Identification – Example

Cost of Goods
Sold for
August 31 =
$2,610
Additional purchases were made on August 17 and 28.
Costs associated with sales on August 31 were as follows: 1 @ $91,
3 @ $106, 15 @ $115, & 4 @ $119.

McGraw-Hill/Irwin
Continue © The McGraw-Hill Companies, Inc., 2002
Slide
8-14

Specific Identification – Example

Income Statement
COGS = $4,595

Balance Sheet
Inventory = $1,395 1 @ $ 106 = $ 106
5 @ $ 115 = 575
6 @ $ 119 = 714
End. Inv. © The$McGraw-Hill
1,395 Companies, Inc., 2002
McGraw-Hill/Irwin
Slide
8-15
Not really. Specific
Since specific identification is hard to use
identification is so when we sell a lot of
easy, can’t we use it inventory that has lots of
all the time? different costs.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-16

Average-Cost Method

When a unit is sold,

the average cost of each unit
in inventory is assigned to
cost
of goods sold.

Cost of Goods Units on hand

Available for ÷ on the date of
Sale sale

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-17

Average-Cost Method – Example

The average cost per unit

must be computed prior
to each sale. $100 = $2,500  25

On August 14, TBC sold 20 bikes for $130 each.

Continue
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
Slide
8-18

Average-Cost Method – Example

The average cost per

unit is $100. $100 = $2,500  25

Let’s look at the entries

Continue for the Aug. 14 sale.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
Slide
8-19

Average-Cost Method – Example

Retail

Cost

A similar entry is
made after each sale. Continue

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-20

Average-Cost Method – Example

Additional purchases were made on August 17 and

August 28.
On August 31, an additional 23 units were sold.

Continue
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
Slide
8-21

Average-Cost Method – Example

$114 = $3,990  35

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-22

Average-Cost Method – Example

The average cost per $114 = $3,990  35

unit is $114.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-23

Average-Cost Method – Example

Income Statement
COGS = $4,622

Balance Sheet
Inventory = $1,368
$114 × 12 = $1,368
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
Slide
8-24

First-In, First-Out Method (FIFO)

Oldest Costs of
Costs Goods Sold

Recent Ending
Costs Inventory

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-25

FIFO – Example

The Cost of Goods Sold for the August 14 sale is $1,970,

leaving $530 and 5 units in inventory.

On August 14, TBC sold 20 bikes for $130 each.

Continue
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
Slide
8-26

FIFO – Example

Retail

Cost

A similar entry is
made after each sale. Continue

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-27

FIFO – Example

Additional purchases were made on Aug. 17 and Aug. 28.

CostOn
ofAugust
Goods Sold for August 31 = $2,600
31, an additional 23 units were sold.

McGraw-Hill/Irwin
Continue © The McGraw-Hill Companies, Inc., 2002
Slide
8-28

FIFO – Example

Income Statement
COGS = $4,570

Balance Sheet
2 @ $ 115 = $ 230
10 @ $ 119 = 1,190
Inventory = $1,420
End. Inv. $ 1,420

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-29

Last-In, First-Out Method (LIFO)

Recent Costs of
Costs Goods Sold

Oldest Ending
Costs Inventory

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-30

LIFO – Example

The Cost of Goods Sold for the August 14 sale is

$2,045, leaving $455 and 5 units in inventory.

On August 14, TBC sold 20 bikes for $130 each.

Continue
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
Slide
8-31

LIFO – Example

Retail

Cost

A similar entry is
made after each sale. Continue

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-32

LIFO – Example

Additional purchases were made on Aug. 17 and Aug. 28.

Cost of Goods Sold for August 31 = $2,685
On Aug. 31, an additional 23 units were sold.

Continue © The McGraw-Hill Companies, Inc., 2002

McGraw-Hill/Irwin
Slide
8-33

LIFO – Example

Income Statement
COGS = $4,730

Balance Sheet 5 @ $ 91 = $ 455

Inventory = $1,260 7 @ $ 115 = 805
End. Inv. $ 1,260

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide Inventory Valuation Methods: A Summary
8-34 Costs Allocated to:
Valuation Cost of Goods
Method Sold Inventory Comments
Specific Actual cost of Actual cost of units Parallels physical flow
identification the units sold remaining Logical method when units
are unique
May be misleading for
identical units
Average cost Number of units Number of units on Assigns all units the same
sold times the hand times the average unit cost
average unit cost average unit cost Current costs are averaged
in with older costs
First-in, First-out Cost of earliest Cost of most Cost of goods sold is based
(FIFO) purchases on recently on older costs
hand prior to the purchased units Inventory valued at current
sale costs
May overstate income during
periods of rising prices; may
increase income taxes due
Last-in, First-out Cost of most Cost of earliest Cost of goods sold shown at
(LIFO) recently purchases recent prices
purchased units (assumed still in Inventory shown at old (and
inventory) perhaps out of date) costs
Most conservative method
during periods of rising
prices; often results in lower
McGraw-Hill/Irwin © The McGraw-Hill
income taxes Companies, Inc., 2002
Slide
8-35

The Principle of Consistency

Once a company has

adopted a particular
accounting method, it
should follow that
method consistently,
rather than switch
methods from one
year to the next.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
Slide
8-36
Just-In-Time (JIT) Inventory
Systems

This inventory arrived

just in time for us to use
in the manufacturing
process.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-37

Taking a Physical Inventory

The primary reason for taking a physical inventory

is to adjust the perpetual inventory records for
unrecorded shrinkage losses, such as theft,
spoilage, or breakage.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-38
LCM and Other Write-Downs
of Inventory

Reduces the value

Obsolescence
of the inventory.

Lower of Cost Adjust inventory

or Market value to the lower
(LCM) of historical cost or
current
replacement cost
(market).

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-39

Goods In Transit

A sale should be recorded when title

to the merchandise passes to the
buyer.

F.O.B. F.O.B.
shipping destination
point  title point  title
passes to passes to
buyer at the Year buyer at the
point of End point of
shipment. destination.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
Slide
8-40

Periodic Inventory Systems

In a periodic inventory system, inventory entries
are as follows.

Note that an entry is not

made to inventory.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
Slide
8-41

Periodic Inventory Systems

In a periodic inventory system, inventory entries
are as follows.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-42

Periodic Inventory Systems

The inventory on
hand and the
cost of goods
sold for the year
are not
determined until
year-end.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
Slide
8-43

Periodic Inventory Systems

We use one of these inventory valuation
methods in a periodic inventory system.

Specific Average
identification cost

FIFO LIFO
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
Slide
8-44
Information for the Following
Inventory Examples
Computers, Inc.
Mouse Pad Inventory
Date Units $/Unit Total
Beginning
Inventory 1,000 $ 5.25 $ 5,250.00
Purchases:
Jan. 3 300 5.30 1,590.00
June 20 150 5.60 840.00
Sept. 15 200 5.80 1,160.00
Nov. 29 150 5.90 885.00
Goods
Available
for Sale 1,800 $ 9,725.00
Ending
Inventory 1,200 ?
Cost of
Goods Sold 600 ?
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
Slide
8-45

Specific Identification – Example

By reviewing actual
purchase invoices,
Computers, Inc. determines
that the 1,200 mouse pads
on hand at year-end have
an actual total cost of
$6,400.
Determine the cost of
goods sold for the year.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-46

Specific Identification – Example

Computers, Inc.
Mouse Pad Inventory
Date Units $/Unit Total
Beginning
Inventory 1,000 $ 5.25 $ 5,250.00
Purchases:
Jan. 3 300 5.30 1,590.00
June 20 150 5.60 840.00
Sept.
Cost15 200
of Goods Sold 5.80 1,160.00
Nov. 29 150 5.90 885.00
$9,725 -
Goods $6,400 = $3,325
Available
for Sale 1,800 $ 9,725.00
Ending
Inventory 1,200 $ 6,400.00
Cost of
Goods Sold 600 $ 3,325.00
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
Slide
8-47

Average-Cost Method

The average cost is

calculated at year-
end as follows:

Total Cost of Total Number

Goods of Units
Available for ÷ Available for
Sale Sale

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-48

Average-Cost Method – Example

Computers, Inc.
Mouse Pad Inventory
Avg. Cost $9,725  1,800 =
Date Units $/Unit Total
$5.40278 Beginning
Ending Inventory Inventory 1,000 $ 5.25 $ 5,250.00
Avg. Cost $5.40278 1,200 = Purchases:
$6,483 Jan. 3 300 5.30 1,590.00
June 20 150 5.60 840.00
Cost of Goods Sold
Sept. 15 200 5.80 1,160.00
Avg. Cost $5.40278 600 =
Nov. 29 150 5.90 885.00
$3,242 Goods
Available
for Sale 1,800 $ 9,725.00
Ending
Inventory 1,200
1,200 $ 6,483.00
?
Cost of
Goods Sold 600 $ 3,242.00
?

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-49

First-In, First-Out Method (FIFO)

Oldest Costs of
Costs Goods Sold

Recent Ending
Costs Inventory

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-50

FIFO – Example
Remember: Start Computers, Inc.
Mouse Pad Inventory
with the 11/29 Date Units $/Unit Total
purchase and then Beginning
add other purchases Inventory 1,000 $ 5.25 $ 5,250.00
until you reach the Purchases:
number of units in Jan. 3 300 5.30 1,590.00
ending inventory. June 20 150 5.60 840.00
Sept. 15 200 5.80 1,160.00
Nov. 29 150 5.90 885.00
Goods
Available
for Sale 1,800 $ 9,725.00
Ending
Inventory 1,200 ?
Cost of
Goods Sold 600 ?

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-51

FIFO – Example
Cost of
Date Beg. Inv. Purchases End. Inv. Goods Sold
1,000@$5.25 600@$5.25
400@$5.25
Jan. 3 300@$5.30 300@$5.30
June 20 150@$5.60 150@$5.60
Sept. 15 200@$5.80 200@$5.80
Nov. 29 150@$5.90 150@$5.90
Units 1,200
150 600

Now, we have allocated

Costs $6,575 $3,150
the cost to allNow,
1,200 let’s
units complete the
Cost in
of ending inventory.
Goods Available table.
for Sale $9,725

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-52

FIFO – Example
Completing the table Computers, Inc.
Mouse Pad Inventory
summarizes the Date Units $/Unit Total
computations just Beginning
made. Inventory 1,000 $ 5.25 $ 5,250.00
Purchases:
Jan. 3 300 5.30 1,590.00
June 20 150 5.60 840.00
Sept. 15 200 5.80 1,160.00
Nov. 29 150 5.90 885.00
Goods
Available
for Sale 1,800 $ 9,725.00
Ending
Inventory 1,200 $ 6,575.00
Cost of
Goods Sold 600 $ 3,150.00

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-53

Last-In, First-Out Method (LIFO)

Recent Costs of
Costs Goods Sold

Oldest Ending
Costs Inventory

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-54

LIFO – Example
Remember: Start with Computers, Inc.
Mouse Pad Inventory
beginning inventory
Date Units $/Unit Total
and then add other Beginning
purchases until you Inventory 1,000 $ 5.25 $ 5,250.00
reach the number of Purchases:
units in ending Jan. 3 300 5.30 1,590.00
inventory. June 20 150 5.60 840.00
Sept. 15 200 5.80 1,160.00
Nov. 29 150 5.90 885.00
Goods
Available
for Sale 1,800 $ 9,725.00
Ending
Inventory 1,200 ?
Cost of
Goods Sold 600 ?

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-55

LIFO – Example
Cost of
Date Beg. Inv. Purchases End. Inv. Goods Sold
1,000@$5.25 1,000@$5.25
Jan. 3 300@$5.30 200@$5.30
100@$5.30
June 20 150@$5.60 150@$5.60
Sept. 15 200@$5.80 200@$5.80
Nov. 29 150@$5.90 150@$5.90
Units 1,000
1,200 100
600

Now, we have allocated

Costs $6,310 $3,415
Next, let’s
the cost to all 1,200 units complete the
Cost in
of ending inventory.
Goods Available for Sale $9,725
table.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-56

LIFO – Example
Completing the table Computers, Inc.
Mouse Pad Inventory
summarizes the Date Units $/Unit Total
computations just Beginning
made. Inventory 1,000 $ 5.25 $ 5,250.00
Purchases:
Jan. 3 300 5.30 1,590.00
June 20 150 5.60 840.00
Sept. 15 200 5.80 1,160.00
Nov. 29 150 5.90 885.00
Goods
Available
for Sale 1,800 $ 9,725.00
Ending
Inventory 1,200 $ 6,310.00
Cost of
Goods Sold 600 $ 3,415.00

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-57
Importance of an Accurate
Valuation of Inventory
Errors in Measuring Inventory
Beginning Inventory Ending Inventory
Effect on Income Statement Overstated Understated Overstated Understated
Goods Available for Sale + - 0 0
Cost of Goods Sold + - - +
Gross Profit - + + -
Net Income - + + -
Effect on Balance Sheet
Ending Inventory 0 0 + -
Retained Earnings - + + -

An error in ending inventory in a year will result in the

same error in the beginning inventory of the next year.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
Slide
8-58

For interim fi
nancial
statements, w
e may need
to estimate e
nding
inventory an
d cost of
goods sold.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-59

The Gross Profit Method

 Determine cost of goods

available for sale.
 Estimate cost of goods sold
by multiplying the net sales
by the cost ratio.
 Deduct cost of goods sold
from cost of goods available
for sale to determine ending
inventory.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-60

Gross Profit Method – Example

In March of 2003, Chemico’s inventory was

destroyed by fire. Chemico’s normal gross profit
ratio is 30% of net sales. At the time of the fire,
Chemico showed the following balances:

Sales $ 31,500
Sales returns 1,500
Beginning Inventory 12,000
Net cost of goods purchased 20,500

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-61

Gross Profit Method – Example

× 70%




McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-62

Inventory Turnover Rate

Measures how quickly a company

sells its merchandise inventory.

Average Inventory = (Beg. Inv. + End. Inv.) ÷ 2

A ratio that is low compared to competitors

suggests inefficient use of assets.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
Slide
8-63
Accounting Methods Can Affect
Analytical Ratios
Remember that identical
companies that use different
inventory methods (e.g.,
FIFO and LIFO) will have
different inventory turnover
ratios.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

Slide
8-64

End of Chapter 8
Careful! If you
drop the inventory
we will have another
write down.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002