McGraw-Hill/Irwin

Chapter 6

Cost of Sales and Inventories

Copyright © 2011. The McGraw-Hill Companies. All Rights Reserved.

6-2

What is Inventory?

Asset items held for sale in the ordinary course of business, or

Goods that will be used or consumed in the production of goods or services to be sold.

6-3

Supplies

Tangible items that will be consumed in the course of normal operations. E.g., office and janitorial supplies,

lubricants, repair parts. Will be consumed, not sold as

merchandise. Therefore, not accounted for as part of

inventory or cost of goods sold.

6-4

Types of Companies

• Merchandising company.– Sells goods in same form as acquired.– Merchandising inventory.

• Manufacturing company.– Converts raw material into finished goods.– Materials inventory, work in process inventory,

finished goods inventory.• Service company.

– Provides intangible services.– Supplies, parts inventory, jobs in progress.

6-5

Net Purchase Cost

Cost of merchandise, and Expenditures necessary to make goods

ready for sale: Freight (i.e., freight-in). Handling, processing , assembling, etc.

Adjust for returns and allowances. Adjust for cash (purchase) discounts from

supplier. NOTE: Record purchases when received

(i.e., title transfers) not when ordered.

6-6

Inventory Cost FlowInventory

Beginning (+)

(=) Ending

Net purchases (+)Cost of goods

sold (-)

Net purchases. Gross purchases - purchase returns & allowances + freight-in.

Goods available for sale. Beginning inventory + net purchases.

Cost of goods sold. Goods available for sale – ending inventory. Beginning inventory + net purchases – ending inventory.

6-7

Measurement Issue

• Goods available for sale (i.e., beginning inventory plus purchases).– How much becomes cost of goods sold?– How much becomes ending inventory?

• Two approaches:1.Periodic inventory method.2.Perpetual inventory method.

6-8

Periodic Inventory Method

Goods available for sale. Beginning inventory + Purchases. NOTE: Beginning inventory is the ending

inventory from the previous period. Determine ending inventory.

Physical inventory (count) is taken. Deduce cost of goods sold.

Good available for sale – Ending inventory.

6-9

Perpetual Inventory Method Perpetual (continuous) record is kept for

each item in inventory. When sale is made, cost of goods sold is

immediately updated. Merchandise inventory account is reduced,

cost of goods sold account is increased. Balance in Merchandise Inventory:

Is goods available for sale at all times. Is also ending inventory at all times.

6-10

Periodic vs. Perpetual

Periodic method. Less recordkeeping.

Perpetual method. Detailed record is useful for reordering. Built in check (i.e., identifies shrinkage by

inventory item during physical inventory). Income statement can be prepared

without taking a physical inventory.

6-11

Retail Method

• Approximates use of perpetual method. Steps:

1. Record purchases at both cost and retail. 2. Calculate gross margin (mark-up) percent.3. 100% - Gross margin % = Cost %.4. Cost of goods sold = Cost % x Retail sales.

Variation is gross profit method. Difference is use of an average or normal

gross margin percentage in calculation.

6-12

Manufacturing Inventory Accounts

Materials inventory. Not yet used in production. Adjusted for returns and freight-in.

Work-in-process inventory. Goods started, but not yet finished. Materials + conversion costs.

Finished goods inventory. Manufactured, but not yet shipped.

6-13

Manufacturing Companies

Materials Inventory

Work in Process

Inventory

Direct Labor

Overhead

Finished Goods

Inventory

Cost of Goods Sold

Cost of GoodsManufactured

6-14

Flow Through Accounts

Materials InventoryBeginning (+)

(=) Ending Net purchases (+)

MaterialsUsed (-)

Work in Process Inventory

Beginning (+)

(=) Ending

Cost of Goods Manufactured

(-)

MaterialsUsed (+)

ConversionCosts (+)

6-15

Flow Through Accounts

Work in Process Inventory

Beginning (+)

(=) Ending

Cost of Goods Manufactured

(-)

MaterialsUsed (+)

ConversionCosts (+)

Finished Goods Inventory

Beginning (+)

(=) Ending

Cost of Goods Sold (-)

Cost of Goods Manufactured

(+)

6-16

Manufacturing Companies: Additional Items

• Product costing systems.– Perpetual inventory system for

manufacturing companies (covered in Chapters 17-19).

• Product (inventoriable) costs.– Items of cost used to produce goods (i.e.,

materials, labor, overhead).– Do not impact income until product is

sold.

6-17

Service Companies

Personal services organizations. E.g., hotels, beauty salons, dentists. No inventories, just supplies.

Building trade and repair businesses. May have parts inventory.

Professional service firms. E.g., law and accounting firms. Jobs in progress account (similar to work in

process inventory).

6-18

Inventory Costing Methods(Cost Flow Assumptions)

What if inventory prices fluctuate?• Goods available for sale:• How much becomes cost of goods sold?• How much becomes ending inventory?

Will need to choose a cost flow assumption:• Specific identification.• Average cost.• First-in, first-out (FIFO).• Last-in, last-out (LIFO).

6-19

Specific Identification

Track purchase cost of each item. Used for:

Big ticket items (e.g., automobile). Uniquely identified items (e.g., jewelry).

May offer opportunity to manipulate costs.

6-20

Average Cost

Beginning inventory + PurchasesUnits available for sale

AverageUnit Cost

=

Compute an average cost for all units. Periodic method.

Computed for the entire period.

Multiply average unit cost by units sold (and units in ending inventory) to get total amounts.

For perpetual method, a new unit average cost is calculated after each purchase.

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First-In, First-Out (FIFO)

Expenses costs of oldest purchases first. Most recently purchased goods are in

inventory. Likely to approximate the physical flow of

goods. Ending inventory approximates current cost

of goods. Periodic/perpetual methods produce

identical results.

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Last-In, Last-Out (LIFO)

Assumes most recently purchased goods are sold first.

Inventory based on costs of oldest purchases. Cost of goods sold usually does not reflect

physical flow. Ending inventory may be costed at amounts of

years ago. Not permitted by IFRS.

6-23

Other LIFO Features

Dollar value LIFO. LIFO method that uses inventory pools with dollar

instead of unit calculations. LIFO layers.

Can distort income if company reduces level of inventory (i.e., old costs being expensed).

LIFO Reserve. Difference between LIFO valuation and FIFO (or

average cost) valuation. Disclosed in financial statements.

6-24

Arguments for FIFO

Usually follows physical flow of goods. More realistic for pricing products.

When using cost-plus pricing, these are the units being sold.

Therefore, better matching. More accurate balance sheet valuation.

6-25

Arguments for LIFO

• Conceptually better for pricing products. When using cost-plus pricing, prices will be based

on current costs. Therefore, better matching and a more useful

income statement (i.e., closest to reflecting current or replacement cost of goods sold).

NOTE: LIFO amounts are still historical costs and could differ from current costs.

6-26

Arguments for LIFO

During periods of price increases: Higher costs of goods sold. Lower taxable income. Lower income taxes. Higher cash flows.

NOTE: If LIFO is used for tax purposes, than must also be used for financial reporting (i.e., LIFO conformity rule).

6-27

Why Not More LIFO?

Most countries use IFRS (therefore, do not permit use of LIFO).

Only beneficial in periods of rising prices. Because of LIFO conformity rule, lower

earnings will also be reported to shareholders.

6-28

Lower of Cost or Market (LCM)

Market price may be below cost due to: Physical deterioration. Change in consumer tastes. Technological obsolescence.

LCM is a reflection of the conservatism concept.

Market is defined as replacement cost.

6-29

LCM: Upper and Lower Bounds

Ceiling or upper bound: Net realizable value (i.e., Estimated selling

price – Estimated costs of selling). Reasoning: Inventory not above cash that will

be received. Floor or lower bound:

Net realizable value - normal profit margin. Reasoning: Inventory not written down

artificially low (which could overstate income).

6-30

Steps in Applying LCM

Determine replacement cost; compute floor and ceiling amounts. Select the middle amount as market.

Select lower of cost or market.

6-31

Analysis of Inventory Inventory turnover.

Cost of goods sold ÷ Inventory. For inventory, can use period average or ending. Measures velocity with which merchandise moves

through business. Days’ inventory.

Inventory turnover expressed in number of days. Inventory ÷ (Cost of goods sold 365).

Gross margin percentage. Gross margin as % of net sales. Profitability measure, earnings before period costs.