CHAPTER 9
COST OF GOODS SOLD
AND INVENTORY
1
WHAT IS REPORTED AS
INVENTORY?
• Inventory represents
goods that are either
manufactured or
purchased for resale
in the normal course
of business
• Inventory is
classified as an
asset on the balance
sheet
2
WHAT IS INVENTORY?
• There are three types of inventory
for a manufacturing firm:
– Raw materials
• Goods acquired in a raw state that
will eventually be finished products
– Work in process
• Partially finished products
– Finished goods
• Completed products waiting for sale
3
1
INVENTORY COST FLOW FOR
A MANUFACTURING FIRM
Balance Sheet
Raw
Materials
Work in
Process
Manufacturing
Overhead
Income Statement
Finished
Goods
Cost of
Goods Sold
Labor
4
INVENTORY OWNERSHIP
• Legal title rule
– Goods should be reported in the
balance sheet of the business
holding legal title to the goods
• Goods in transit
– Legal title depends upon the
shipping terms
5
GOODS IN TRANSIT
• Shipping terms:
– FOB (free-on-board) destination
• The seller is paying the shipping cost
• The seller owns the inventory until it
is delivered
– FOB shipping point
• The buyer is paying the shipping cost
• The buyer owns the inventory during
transit
6
2
GOODS ON CONSIGNMENT
• The dealer does not pay for the
inventory unless it is sold
• Although the dealer has
possession of the inventory, the
supplier still owns the inventory at
the balance sheet date
7
THE COST OF INVENTORY
• The cost of inventory includes all
costs of acquisition and preparation
for sale
– Purchase price
– Freight
– Receiving and storage costs
8
THE COST OF INVENTORY
• The cost of work in process and
finished goods inventory includes
– Raw materials
– Production labor
– Some allocation of factory overhead
• Activity-based cost (ABC) systems
allocate overhead based on some
clearly identified cost drivers
9
3
COST OF GOODS SOLD
Beginning Inventory
Add: Inventory Purchases
= Goods Available for Sale
Less: Ending Inventory
= Cost of Goods Sold
10
OVERVIEW OF PERPETUAL
AND PERIODIC SYSTEMS
• Perpetual system
– Inventory records are updated
whenever a purchase or a sale is made
– Advances in information technology
have made the cost of using this
system practical
• Periodic system
– Inventory records are not updated
when a sale is made
11
TAKING A PHYSICAL
COUNT OF INVENTORY
• The actual quantity on hand is
determined by taking a physical
count
• A cost is attached to the quantity
counted
• With a perpetual system, a physical
count can reveal inventory shrinkage
12
4
ENDING INVENTORY ERRORS
• When inventory is
overstated
• When inventory is
understated
– Cost of good sold
is understated
– Net income is
– Cost of good sold
is overstated
– Net income is
overstated
understated
13
INVENTORY VALUATION
METHODS
• Where specific identification is not
possible, an assumption must be made
about which cost is associated with the
units remaining
• Three assumptions are generally
accepted:
– FIFO (first-in, first-out)
– LIFO (last-in, first-out)
– Average cost
14
SPECIFIC IDENTIFICATION
• Requires no assumption about the
flow of inventory units
• Inventory items are specifically
identified and valued
• The actual cost of goods sold can
be computed as inventory is sold
15
5
INVENTORY VALUATION
METHODS
Assume the following data:
Units
January 1
200
March 23
300
July 15
500
November 6
100
1,100
Unit
Cost
$10
$12
$11
$13
Total
Cost
$2,000
3,600
5,500
1,300
$12,400
Sales: 700 units @ $15
16
AVERAGE COST METHOD
Cost of Goods Available for Sale
Units Available for Sale
= Average Cost/Unit
$12,400
1,100 units
= $11.27 Average Cost/Unit
=
$4,510
Cost of Goods Sold = 700 Units x $11.27 =
7,890
Ending Inventory = 400 Units x $11.27
$12,400
Cost of Goods Available for Sale
17
FIFO
Goods Available
for Sale
1,100 units
Nov. 6
Purchase
July 15
Purchase
March 23
Purchase
Jan. 1
Purchase
$12,400
=
its
un it
0 /un
10 13
$
@
Ending Inventory
400 units
$1,300
its
un it
0 /un
50 11
$
@
s
it
un it
0 /un
30 12
$
@
$3,300
+
Goods Sold
700 units
its
un it
0 /un
10 13
$
@
ts
ni it
0u n
30 1/u
$1
SOLD
$2,200
@
SOLD
$3,600
its
un it
0 /un
20 10
$
@
SOLD
$2,000
=
$4,600
+
its
un it
0 /un
20 11
$
@
its
un it
0 /un
30 12
$
@
its
un it
0 /un
20 10
$
@
$7,800
18
6
LIFO
Goods Available
for Sale
1,100 units
Nov. 6
Purchase
July 15
Purchase
March 23
Purchase
Jan. 1
Purchase
=
Ending Inventory
400 units
+
SOLD
its
un it
0 /un
10 13
$
@
$1,300
its
un it
0 /un
50 11
$
@
its
un it
0 /un
30 12
$
@
SOLD
$5,500
$2,400
its
un it
0 /un
20 10
$
@
$12,400
Goods Sold
700 units
$2,000
=
$4,400
its
un it
0 /un
20 12
$
@
SOLD
$1,200
its
un it
0 /un
10 13
$
@
its
un it
0 /un
50 11
$
@
its
un it
0 /un
10 12
$
@
ts
ni it
0u n
20 0/u
$1
@
+
$8,000
19
COMPARISON OF METHODS
• FIFO
– Advantages:
• Inventories are reported on the
balance sheet near current costs
• Cost flow often matches the physical
flow of goods in a business
– Disadvantages:
• Current costs are not matched with
current revenues
• Choosing FIFO for financial reporting
prohibits the use of LIFO on the tax
return (LIFO conformity rule)
20
COMPARISON OF METHODS
• LIFO
– Advantages:
• Current costs are matched with
current revenues (matching principle)
• Income taxes are minimized during
periods of rising prices
– Disadvantages:
• Inventory is valued at old prices
• Cost flow may not match the physical
flow of goods in the business
21
7
MORE LIFO ISSUES
• Any year in which the number of
units purchased exceeds the
number of units sold, a new LIFO
layer is created in ending
inventory
• The creation of LIFO layers results
in ending inventory at very old
prices
22
INVENTORY ESTIMATION
AND VALUATION
• The gross profit method is used to
estimate inventory without actually
taking a physical count
• The gross profit percentage is
applied to estimate cost of goods
sold, and ultimately gross profit
23
GROSS PROFIT METHOD
Gross Profit % = (Sales - Cost of Goods Sold) / Sales
Assume the following data:
Beginning inventory, January 1
$25,000
Purchases, January 1 through January 31
40,000
Sales, January 1 through January 31
50,000
Historical gross profit percentage
40%
24
8
GROSS PROFIT METHOD
Sales (actual)
Gross profit (estimate)
Cost of goods sold (estimate)
$50,000
100%
20,000
40%
$30,000
60%
Beginning inventory (actual)
+ Purchases (actual)
= Cost of goods available for sale (actual)
$25,000
40,000
$65,000
- Cost of goods sold (estimate)
$30,000
= Ending inventory (estimate)
$35,000
25
INVENTORY ESTIMATION
AND VALUATION
• The lower of cost or market
method recognizes inventory price
declines, but not price increases
until the inventory is sold
• Market value is defined as
– Replacement cost or
– Net realizable value
26
INVENTORY ESTIMATION
AND VALUATION
• Replacement cost is the cost to buy
equivalent new inventory items
• Net realizable value is the amount
expected to be received when the
inventory is sold
• Rule of thumb: Inventory is valued
on the balance sheet at the lowest of
(1) historical cost, (2) replacement
cost, or (3) net realizable value
27
9
INVENTORY ESTIMATION
AND VALUATION
• An inventory write-down when
market value is lower than cost
recognizes the economic loss
when it happens rather than when
the inventory is sold
• This is another example of the
principle of conservatism
28
EVALUATING THE LEVEL
OF INVENTORY
• Two widely used measurements:
– Inventory turnover
• Measures how many times a
company turns over its inventory
during the year
– Number of days’ sales in inventory
• Measures the number of days’ sales
represented in the inventory value
29
EVALUATING THE LEVEL
OF INVENTORY
Inventory Turnover = Cost of Goods Sold
Average Inventory
Number of Days’
Days’ Sales = 365 / Inventory Turnover
in Inventory
These ratios are compared with those of other
firms in the same industry and with comparable
ratios for the same firm in previous years.
30
10
EVALUATING THE LEVEL
OF INVENTORY
• The number of days’ purchases in
accounts payable indicates how
long it takes for a company to pay
its suppliers
Number of Days’
Days’
365 days
Purchases in = _______________________________
Purchases/Average Accounts Payable
Accounts Payable
31
11