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CHAPTER 9
CHAPTER 9
COST OF GOODS SOLD COST OF GOODS SOLD AND INVENTORY AND INVENTORY
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WHAT IS REPORTED AS
WHAT IS REPORTED AS
INVENTORY?
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
WHAT IS INVENTORY?
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
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Raw Materials
Work in Process
Finished Goods
Cost of Goods Sold
INVENTORY COST FLOW FOR
INVENTORY COST FLOW FOR
A MANUFACTURING FIRM
A MANUFACTURING FIRM
Balance Sheet
Balance Sheet Income StatementIncome Statement
Manufacturing Overhead
Labor
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INVENTORY OWNERSHIP
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
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GOODS IN TRANSIT
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
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GOODS ON CONSIGNMENT
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
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THE COST OF INVENTORY
THE COST OF INVENTORY
• The cost of inventory includes all costs of acquisition and preparation for sale
– Purchase price – Freight
– Receiving and storage costs
THE COST OF INVENTORY
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
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Beginning Inventory Beginning Inventory Add: Inventory Purchases Add: Inventory Purchases
= Goods Available for Sale
= Goods Available for Sale Less: Ending Inventory Less: Ending Inventory
= Cost of Goods Sold
= Cost of Goods Sold
COST OF GOODS SOLD
COST OF GOODS SOLD
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OVERVIEW OF PERPETUAL
OVERVIEW OF PERPETUAL
AND PERIODIC SYSTEMS
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
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TAKING A PHYSICAL
TAKING A PHYSICAL
COUNT OF INVENTORY
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
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ENDING INVENTORY ERRORS
ENDING INVENTORY ERRORS
• When inventory is overstated
– Cost of good sold is understated – Net income is
overstated
• When inventory is understated
– Cost of good sold is overstated – Net income is understated
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INVENTORY VALUATION
INVENTORY VALUATION
METHODS
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
SPECIFIC IDENTIFICATION
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
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INVENTORY VALUATION
INVENTORY VALUATION
METHODS
METHODS
Assume the following data:
Unit Total Units Cost Cost January 1 200 $10 $2,000
March 23 300 $12 3,600
July 15 500 $11 5,500
November 6 100 $13 1,300
1,100 $12,400
Sales: 700 units @ $15
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AVERAGE COST METHOD
AVERAGE COST METHOD
Cost of Goods Available for Sale Units Available for Sale
$12,400 1,100 units Ending Inventory = 400 Units x $11.27 Ending Inventory = 400 Units x $11.27 Cost of Goods Sold = 700 Units x $11.27 Cost of Goods Available for Sale
= Average Cost/Unit
= $11.27 Average Cost/Unit
= $4,510
= $4,510
= 7,890
$12,400
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Goods Available Goods Available
for Sale for Sale 1,100 units
1,100 units == Ending InventoryEnding Inventory 400 units
400 units ++ Goods SoldGoods Sold700 units700 units
$12,400
$12,400 =
$2,000
$2,000 20
0 units
@ $10/unit
$3,600
$3,600 30
0 units
@ $12/unit
$2,200
$2,200
SOLD 200 units
@ $11/unit
$4,600
$4,600 $7,800$7,800
SOLD
SOLD
$3,300
$3,300 30
0units
@ $11/unit 100 units
@ $13/unit
$1,300
$1,300
+
Purchase Purchase Jan. 1
200 units
@ $10/unit
Purchase Purchase March 23
300 units
@ $12/unit
Purchase Purchase July 15
500 units
@ $11/unit
Purchase Purchase Nov. 6
100 units
@ $13/unit
FIFO FIFO
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$12,400
$12,400 =
$1,200
$1,200 10
0 units
@ $12/unit
$5,500
$5,500 50
0 units
@ $11/unit
$1,300
$1,300
SOLD 100 units
@ $13/unit
$4,400
$4,400 $8,000$8,000
SOLD
SOLD
$2,000
$2,000 20
0units
@ $10/unit 200 units
@ $12/unit
$2,400
$2,400
+
Purchase Purchase Jan. 1
200 units
@ $10/unit
Purchase Purchase March 23
300 units
@ $12/unit
Purchase Purchase July 15
500 units
@ $11/unit
Purchase Purchase Nov. 6
100 units
@ $13/unit
Goods Available Goods Available
for Sale for Sale 1,100 units
1,100 units == Ending InventoryEnding Inventory 400 units
400 units ++ Goods SoldGoods Sold700 units700 units
LIFO
LIFO
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• 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)
COMPARISON OF METHODS
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
COMPARISON OF METHODS
COMPARISON OF METHODS
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MORE LIFO ISSUES
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
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INVENTORY ESTIMATION
INVENTORY ESTIMATION
AND VALUATION
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
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GROSS PROFIT METHOD
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%
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GROSS PROFIT METHOD
GROSS PROFIT METHOD
Sales (actual) $50,000 100%
Gross profit (estimate) 20,000 40%
Cost of goods sold (estimate) $30,000 60%
Beginning inventory (actual) $25,000
+ Purchases (actual) 40,000
= Cost of goods available for sale (actual) $65,000 - Cost of goods sold (estimate) $30,000
= Ending inventory (estimate) $35,000
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INVENTORY ESTIMATION
INVENTORY ESTIMATION
AND VALUATION
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
INVENTORY ESTIMATION
INVENTORY ESTIMATION
AND VALUATION
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
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INVENTORY ESTIMATION
INVENTORY ESTIMATION
AND VALUATION
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
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EVALUATING THE LEVEL
EVALUATING THE LEVEL
OF INVENTORY
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
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EVALUATING THE LEVEL
EVALUATING THE LEVEL
OF INVENTORY
OF INVENTORY
Inventory Turnover =
Inventory Turnover = Cost of Goods SoldCost of Goods Sold Average Inventory Average Inventory Number of Days
Number of Days’’Sales = 365 / Inventory TurnoverSales = 365 / Inventory Turnover in Inventory
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.
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EVALUATING THE LEVEL
EVALUATING THE LEVEL
OF INVENTORY
OF INVENTORY
• The number of days’ purchases in accounts payable indicates how long it takes for a company to pay its suppliers
365 days 365 days
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Purchases/Average Accounts Payable Purchases/Average Accounts Payable Number of Days
Number of Days’’ Purchases in Purchases in Accounts Payable Accounts Payable==