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Chapter 7
Reporting and Interpreting Cost of Goods Sold and Inventory
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Business Background
Provides accurate information.
Provides accurate information.
Provides up-to-date information.
Provides up-to-date information.
Provides information to help protect assets. Provides information
to help protect assets.
Roles of the Accounting
System
Roles of the Accounting
System
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Nature of Inventory and Cost of Goods Sold
BeginningInventory
BeginningInventory
Purchasesfor the PeriodPurchases
for the Period
Ending Inventory(Balance Sheet)
Ending Inventory(Balance Sheet)
Goods availablefor Sale
Goods availablefor Sale
Cost of Goods Sold(Income Statement)
Cost of Goods Sold(Income Statement)
Beginning inventory + Purchases – Ending inventory = Cost of goods soldBeginning inventory + Purchases – Ending inventory = Cost of goods sold
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Flow of Inventory Costs
MerchandisePurchases
MerchandisePurchases
Cost ofGoods Sold
Cost ofGoods Sold
MerchandiseInventory
MerchandiseInventory
RawMaterials
RawMaterials
DirectLaborDirectLabor
FactoryOverheadFactory
Overhead
Raw MaterialsInventory
Raw MaterialsInventory
Work in ProcessInventory
Work in ProcessInventory
Finished GoodsInventory
Finished GoodsInventory
Cost ofGoods Sold
Cost ofGoods Sold
Merchandiser
Manufacturer
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Inventory Cost
The cost principlecost principlerequires that inventory be
recorded at the price paid or the
consideration given up.
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Inventory Cost
Include all costsincurred to bring
the asset to useable or saleable condition, such as:
Invoice priceFreight chargesInspection costsPreparation costs.
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Errors in Measuring InventoryErrors in Measuring Inventory
Beginning Inventory Ending InventoryOverstated Understated Overstated Understated
Effect on Income StatementGoods Available for Sale + - N/A N/ACost of Goods Sold + - - +Gross Profit - + + -Net Income - + + -Effect on Balance SheetInventory (12/31) N/A N/A + -Retained Earnings - + + -
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Question
If the 2000 ending inventory is understated by $3,000, which of the
following is true for 2000?
a. Beginning Inventory was understated.b. Cost of Goods Sold will be understated.c. Gross Profit will be overstated.d. Net Income will be understated.
If the 2000 ending inventory is understated by $3,000, which of the
following is true for 2000?
a. Beginning Inventory was understated.b. Cost of Goods Sold will be understated.c. Gross Profit will be overstated.d. Net Income will be understated.
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
If the 2000 ending inventory is understated by $3,000, which of the
following is true for 2000?
a. Beginning Inventory was understated.b. Cost of Goods Sold will be understated.c. Gross Profit will be overstated.d. Net Income will be understated.
If the 2000 ending inventory is understated by $3,000, which of the
following is true for 2000?
a. Beginning Inventory was understated.b. Cost of Goods Sold will be understated.c. Gross Profit will be overstated.d. Net Income will be understated.
QuestionErrors in Measuring Inventory
Ending InventoryOverstated Understated
Effect on Income StatementGoods Available for Sale N/A N/ACost of Goods Sold - +Gross Profit + -Net Income + -Effect on Balance SheetInventory (12/31) + -Retained Earnings + -
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Question
If the 2000 ending inventory is understated by $3,000, which of the
following is true for 2001?
a. Beginning Inventory was understated.b. Cost of Goods Sold will be understated.c. Gross Profit will be overstated.d. All of the above.
If the 2000 ending inventory is understated by $3,000, which of the
following is true for 2001?
a. Beginning Inventory was understated.b. Cost of Goods Sold will be understated.c. Gross Profit will be overstated.d. All of the above.
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
If the 2000 ending inventory is understated by $3,000, which of the
following is true for 2001?
a. Beginning Inventory was understated.b. Cost of Goods Sold will be understated.c. Gross Profit will be overstated.d. All of the above.
If the 2000 ending inventory is understated by $3,000, which of the
following is true for 2001?
a. Beginning Inventory was understated.b. Cost of Goods Sold will be understated.c. Gross Profit will be overstated.d. All of the above.
Question
Errors in Measuring InventoryBeginning Inventory
Overstated UnderstatedEffect on Income StatementGoods Available for Sale + -Cost of Goods Sold + -Gross Profit - +Net Income - +Effect on Balance SheetInventory (12/31) N/A N/ARetained Earnings - +
Remember: The ending inventory for 2000 becomes the beginning inventory for 2001.
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Inventory Costing Methods
FIFO LIFO
Weighted Average
Specific Identification
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Applying the Four Methods
Total Dollar Amount of Goods Available for Sale
Total Dollar Amount of Goods Available for Sale
Ending InventoryEnding Inventory Cost of Goods SoldCost of Goods Sold
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First-In, First-Out
Costs of Goods Sold
Costs of Goods SoldOldest CostsOldest Costs
Ending InventoryEnding
InventoryRecent CostsRecent Costs
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First-In, First-Out
The schedule on the next screen shows the mouse pad inventory for Computers, Inc.
The physical inventory count shows 1,200 mouse pads in ending inventory.
Use the FIFO inventory method to determine:
(1) Ending inventory cost.
(2) Cost of goods sold.
The schedule on the next screen shows the mouse pad inventory for Computers, Inc.
The physical inventory count shows 1,200 mouse pads in ending inventory.
Use the FIFO inventory method to determine:
(1) Ending inventory cost.
(2) Cost of goods sold.
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First-In, First-OutC o m p u t e r s , In c .
M o u s e P a d In v e n t o r yD a t e U n it s $ /U n it T o t a l
B e g in n in g In v e n t o r y 1 ,0 0 0 5 .2 5$ 5 ,2 5 0 .0 0$ P u r c h a s e s :J a n . 3 3 0 0 5 .3 0 1 ,5 9 0 .0 0 J u n e 2 0 1 5 0 5 .6 0 8 4 0 .0 0 S e p t . 1 5 2 0 0 5 .8 0 1 ,1 6 0 .0 0 N o v . 2 9 1 5 0 5 .9 0 8 8 5 .0 0 G o o d s A v a ila b le f o r S a le 1 ,8 0 0 9 ,7 2 5 .0 0$
E n d in g In v e n t o r y 1 2 0 0 ?
C o s t o f G o o d s S o ld 6 0 0 ?
Remember:The costs of most recent
purchases are in ending inventory. Start with
11/29 and add units
purchased until you reach the number in
ending inventory.
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First-In, First-Out
Date Beg. Inv. Purchases End. Inv.Cost of
Goods Sold
Nov. 29 150@$5.90 150@$5.90Units 150
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Date Beg. Inv. Purchases End. Inv.Cost of
Goods Sold
Sept. 15 200@$5.80 200@$5.80Nov. 29 150@$5.90 150@$5.90Units 350
First-In, First-Out
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Date Beg. Inv. Purchases End. Inv.Cost of
Goods Sold
June 20 150@$5.60 150@$5.60Sept. 15 200@$5.80 200@$5.80Nov. 29 150@$5.90 150@$5.90Units 500
First-In, First-Out
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Date Beg. Inv. Purchases End. Inv.Cost of
Goods Sold
Jan. 3 300@$5.30 300@$5.30June 20 150@$5.60 150@$5.60Sept. 15 200@$5.80 200@$5.80Nov. 29 150@$5.90 150@$5.90Units 800
First-In, First-Out
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Date Beg. Inv. Purchases End. Inv.Cost of
Goods Sold1,000@$5.25 600@$5.25
400@$5.25Jan. 3 300@$5.30 300@$5.30June 20 150@$5.60 150@$5.60Sept. 15 200@$5.80 200@$5.80Nov. 29 150@$5.90 150@$5.90Units 1,200 600
First-In, First-Out
Now, we have allocated the cost to all 1,200
units in ending inventory.
Now, we have allocated the cost to all 1,200
units in ending inventory.
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Date Beg. Inv. Purchases End. Inv.Cost of
Goods Sold1,000@$5.25 600@$5.25
400@$5.25Jan. 3 300@$5.30 300@$5.30June 20 150@$5.60 150@$5.60Sept. 15 200@$5.80 200@$5.80Nov. 29 150@$5.90 150@$5.90Units 1,200 600
Costs $6,575 $3,150
Cost of Goods Available for Sale $9,725
First-In, First-Out
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ANY QUESTIONS BEFORE WE
DISCUSS LIFO?
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Last-In, First-Out
??
??
Oldest CostsOldest Costs
Recent CostsRecent Costs
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Last-In, First-Out
Ending InventoryEnding
Inventory
Cost of Goods Sold
Cost of Goods Sold
Oldest CostsOldest Costs
Recent CostsRecent Costs
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Last-In, First-Out
The schedule on the next screen shows the mouse pad inventory for Computers, Inc.
The physical inventory count shows 1,200 mouse pads in ending inventory.
Use the LIFO inventory method to determine:
(1) Ending inventory cost.
(2) Cost of goods sold.
The schedule on the next screen shows the mouse pad inventory for Computers, Inc.
The physical inventory count shows 1,200 mouse pads in ending inventory.
Use the LIFO inventory method to determine:
(1) Ending inventory cost.
(2) Cost of goods sold.
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Last-In, First-OutC o m p u te r s , In c .
M o u s e P a d In v e n to r yD a te U n its $ /U n it T o ta l
B e g in n in g In v e n t o r y 1 ,0 0 0 5 .2 5$ 5 ,2 5 0 .0 0$ P u r c h a s e s :J a n . 3 3 0 0 5 .3 0 1 ,5 9 0 .0 0 J u n e 2 0 1 5 0 5 .6 0 8 4 0 .0 0 S e p t . 1 5 2 0 0 5 .8 0 1 ,1 6 0 .0 0 N o v . 2 9 1 5 0 5 .9 0 8 8 5 .0 0 G o o d s Av a ila b le fo r S a le 1 ,8 0 0 9 ,7 2 5 .0 0$
E n d in g In v e n t o r y 1 2 0 0 ?
C o s t o f G o o d s S o ld 6 0 0 ?
Remember:The costs of
the oldestpurchases are
in ending inventory. Start with beginning inventory and
add units purchased until you reach the
number in ending
inventory.
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Date Beg. Inv. Purchases End. Inv.Cost of
Goods Sold1,000@$5.25 1,000@$5.25
Units 1,000
Last-In, First-Out
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Date Beg. Inv. Purchases End. Inv.Cost of
Goods Sold1,000@$5.25 1,000@$5.25
Jan. 3 300@$5.30 200@$5.30
Units 1,200
Last-In, First-Out
Now, we have allocated the cost to all 1,200
units in ending inventory.
Now, we have allocated the cost to all 1,200
units in ending inventory.
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Date Beg. Inv. Purchases End. Inv.Cost of
Goods Sold1,000@$5.25 1,000@$5.25
Jan. 3 300@$5.30 200@$5.30100@$5.30
Units 1,200 100
Last-In, First-Out
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Date Beg. Inv. Purchases End. Inv.Cost of
Goods Sold1,000@$5.25 1,000@$5.25
Jan. 3 300@$5.30 200@$5.30100@$5.30
June 20 150@$5.60 150@$5.60Sept. 15 200@$5.80 200@$5.80Nov. 29 150@$5.90 150@$5.90Units 1,200 600
Costs $6,310 $3,415
Cost of Goods Available for Sale $9,725
Last-In, First-Out
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Now let’s move on to the weighted-average inventory costing method.
Weighted-Average
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Weighted-Average
Weighted-average cost (WAC) per unitCost of goods available for sale
Number of units available for sale
Ending InventoryUnits in Ending Inventory × WAC per Unit
Cost of Good SoldUnits Sold × WAC per Unit
Weighted-average cost (WAC) per unitCost of goods available for sale
Number of units available for sale
Ending InventoryUnits in Ending Inventory × WAC per Unit
Cost of Good SoldUnits Sold × WAC per Unit
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Weighted-Average
The schedule on the next screen shows the mouse pad inventory for Computers, Inc.
The physical inventory count shows 1,200 mouse pads in ending inventory.
Use the weighted-average inventory method to determine:
(1) Ending inventory cost.
(2) Cost of goods sold.
The schedule on the next screen shows the mouse pad inventory for Computers, Inc.
The physical inventory count shows 1,200 mouse pads in ending inventory.
Use the weighted-average inventory method to determine:
(1) Ending inventory cost.
(2) Cost of goods sold.
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Weighted-AverageC o m p u t e r s , In c .
M o u s e P a d In v e n t o r yD a t e U n it s $ /U n it T o t a l
B e g in n in g In v e n t o r y 1 ,0 0 0 5 .2 5$ 5 ,2 5 0 .0 0$ P u r c h a s e s :J a n . 3 3 0 0 5 .3 0 1 ,5 9 0 .0 0 J u n e 2 0 1 5 0 5 .6 0 8 4 0 .0 0 S e p t . 1 5 2 0 0 5 .8 0 1 ,1 6 0 .0 0 N o v . 2 9 1 5 0 5 .9 0 8 8 5 .0 0 G o o d s A v a i la b le f o r S a le 1 ,8 0 0 9 ,7 2 5 .0 0$
E n d in g In v e n t o r y 1 2 0 0 ?
C o s t o f G o o d s S o ld 6 0 0 ?
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Weighted-Average
Weighted-Average Cost per Unit:$9,7251,800
Ending Inventory:
1,200 Units × $5.40278 = $6,483*
Cost of Goods Sold:
600 Units × $5.40278 = $3,242*
* Rounded
Weighted-Average Cost per Unit:$9,7251,800
Ending Inventory:
1,200 Units × $5.40278 = $6,483*
Cost of Goods Sold:
600 Units × $5.40278 = $3,242*
* Rounded
= $5.40278
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Specific Identification
• Specific cost of each inventory item is known.
• Used with small volume, high dollar inventory.
• Specific cost of each inventory item is known.
• Used with small volume, high dollar inventory.
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Comparison of MethodsComputers, Inc.
Income StatementFor Year Ended December 31, 2001
Weighted Average FIFO LIFO
Net sales 25,000$ 25,000$ 25,000$ Cost of goods sold:Merchandise inventory, 12/31/98 5,250$ 5,250$ 5,250$ Net purchases 4,475 4,475 4,475 Goods available for sale 9,725$ 9,725$ 9,725$ Merchandise inventory, 12/31/99 6,483 6,575 6,310 Cost of goods sold 3,242$ 3,150$ 3,415$ Gross profit from sales 21,758$ 21,850$ 21,585$ Operating expenses: 750 750 750 Income before taxes 21,008$ 21,100$ 20,835$ Income taxes expense (30%) 6,302 6,330 6,251 Net income 14,706$ 14,770$ 14,585$
* Tax expense amounts were rounded.
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Comparison of MethodsComputers, Inc.
Income StatementFor Year Ended December 31, 2001
Weighted Average FIFO LIFO
Net sales 25,000$ 25,000$ 25,000$ Cost of goods sold:Merchandise inventory, 12/31/98 5,250$ 5,250$ 5,250$ Net purchases 4,475 4,475 4,475 Goods available for sale 9,725$ 9,725$ 9,725$ Merchandise inventory, 12/31/99 6,483 6,575 6,310 Cost of goods sold 3,242$ 3,150$ 3,415$ Gross profit from sales 21,758$ 21,850$ 21,585$ Operating expenses: 750 750 750 Income before taxes 21,008$ 21,100$ 20,835$ Income taxes expense (30%) 6,302 6,330 6,251 Net income 14,706$ 14,770$ 14,585$
* Tax expense amounts were rounded.
In periods of rising prices, FIFO results in the highest ending
inventory, gross profit, tax expense, and net income, and the lowest cost
of goods sold.
In periods of rising prices, FIFO results in the highest ending
inventory, gross profit, tax expense, and net income, and the lowest cost
of goods sold.
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Comparison of MethodsComputers, Inc.
Income StatementFor Year Ended December 31, 2001
Weighted Average FIFO LIFO
Net sales 25,000$ 25,000$ 25,000$ Cost of goods sold:Merchandise inventory, 12/31/98 5,250$ 5,250$ 5,250$ Net purchases 4,475 4,475 4,475 Goods available for sale 9,725$ 9,725$ 9,725$ Merchandise inventory, 12/31/99 6,483 6,575 6,310 Cost of goods sold 3,242$ 3,150$ 3,415$ Gross profit from sales 21,758$ 21,850$ 21,585$ Operating expenses: 750 750 750 Income before taxes 21,008$ 21,100$ 20,835$ Income taxes expense (30%) 6,302 6,330 6,251 Net income 14,706$ 14,770$ 14,585$
* Tax expense amounts were rounded.
In periods of rising prices, LIFO results in the lowest ending inventory, gross profit, tax expense, and net income, and the highest cost of goods sold.
In periods of rising prices, LIFO results in the lowest ending inventory, gross profit, tax expense, and net income, and the highest cost of goods sold.
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Choosing Inventory Costing Methods
54% of firms in a study used LIFO for some
portion of inventories.
54% of firms in a study used LIFO for some
portion of inventories.
Only 17% of firms used LIFO for all inventories.Only 17% of firms used LIFO for all inventories.
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Choosing Inventory Costing Methods
LIFO for books
LIFO for taxes
If . . . Then . . .LIFO Conformity
Rule
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Lower of Cost or Market
Ending inventory is reported at the lower of cost or market (LCM).
Ending inventory is reported at the lower of cost or market (LCM).
Net Realizable ValueThe expected sales price
less selling costs.
Net Realizable ValueThe expected sales price
less selling costs.
Replacement CostThe current purchase
price of identical goods.
Replacement CostThe current purchase
price of identical goods.
Market is either . . .
or
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Perpetual and Periodic Inventory Systems
Provides up-to-date inventory records.
Provides up-to-date inventory records.
Provides up-to-date CGS records.
Provides up-to-date CGS records.
Perpetual System
Perpetual System
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Comparison of Perpetual and Periodic Systems
Source of InformationModel Periodic System Perpetual System
Beginning Inventory Carried over from prior period
Carried over from prior period
Add: PurchasesAccumulated in the Purchases
account
Accumulated in the Inventory
account
Less: Ending Inventory
Measured at end of period by
physical inventory count
Perpetual record updated at every
sale
Cost of Goods Sold
Computed as a residual amount at end of period
Measured at every sale based
on perpetual record
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Now, let’s compare the
various entries that are made
when using the periodic and
perpetual inventory systems.
Now, let’s compare the
various entries that are made
when using the periodic and
perpetual inventory systems.
Comparison of Perpetual and Periodic Systems
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Transaction Periodic PerpetualMerchandise purchased from supplier on account. Purchases XX Inventory XX
Accounts Payable XX Accounts Payable XXMerchandise returned to supplier. Accounts Payable XX Accounts Payable XX
Purchases Returns & Allow. XX Inventory XXMerchandise sold to customer on account. Accounts Receivable XX Accounts Receivable XX
Sales XX Sales XX
Cost of Goods Sold XX Inventory XX
Purchases Returns and Allowances is subtracted from Purchases on the income
statement.
Purchases Returns and Allowances is subtracted from Purchases on the income
statement.
Comparison of Periodic and Perpetual Systems
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Transaction Periodic PerpetualMerchandise purchased from supplier on account. Purchases XX Inventory XX
Accounts Payable XX Accounts Payable XXMerchandise returned to supplier. Accounts Payable XX Accounts Payable XX
Purchases Returns & Allow. XX Inventory XXMerchandise sold to customer on account. Accounts Receivable XX Accounts Receivable XX
Sales XX Sales XX
Cost of Goods Sold XX Inventory XX
Comparison of Periodic and Perpetual Systems
This entry is recorded at retail.
This entry is recorded at cost.
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Transaction Periodic PerpetualMerchandise returned by customer. Sales Returns and Allow. XX Sales Returns and Allow. XX
Accounts Receivable XX Accounts Receivable XX
Inventory XX Cost of Goods Sold XXThis is recorded at
retail.
This entry is recorded at cost.
Comparison of Periodic and Perpetual Systems
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Transaction Periodic PerpetualMerchandise returned by customer. Sales Returns and Allow. XX Sales Returns and Allow. XX
Accounts Receivable XX Accounts Receivable XX
Inventory XX Cost of Goods Sold XX
At end of accounting period. Cost of Goods Sold XX No entry.
Inventory (beginning) XX Purchases XX
Inventory (ending) XX Cost of Goods Sold XX
Comparison of Periodic and Perpetual Systems
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Methods for Estimating Inventory
I use the periodicinventory method.Can you help me
estimate inventory?
I sure can, if you can give
me some information.
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Methods for Estimating Inventory
I know sales,beginning inventory,
purchases, and my gross margin
is 30%.
Let’s constructan income
statement using your gross
margin.
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Methods for Estimating Inventory
Sales 100%Cost of goods sold 70%Gross margin 30%
You told me that your sales are $200,000, beginning inventory is $4,500, and purchases are $150,000, so your income statement looks like this . . .
Sales 200,000$ Beginning inventory 4,500$ Purchases 150,000 Goods available for sale 154,500 Ending inventory ?Cost of goods sold 140,000 Gross margin 60,000$
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Methods for Estimating Inventory
Estimated ending inventory must be $14,500 ($154,500 - $140,000).
Sales 200,000$ Beginning inventory 4,500$ Purchases 150,000 Goods available for sale 154,500 Ending inventory 14,500 Cost of goods sold 140,000 Gross margin 60,000$
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
The End of Chapter 7