ACC 471 WINTER 2007 In-class Exercise: Inventory Systems and Inventory Costing Methods

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ACC 471 WINTER 2007

In-class Exercise: Inventory Systems and Inventory Costing Methods Objective

At the end of the exercise, students should be able to account for cost of goods sold and ending inventory under the different inventory systems and inventory costing methods. Students should also be able to understand the impact the alternative costing methods have on the financial statements.

Accounting for Inventory

You are in charge of accounting for inventory at a chocolate factory for the month of January. It is now the end of January (end of the period). Your boss, Charlie, has some questions regarding inventory system (periodic and perpetual) and inventory costing methods (specific cost, average cost, FIFO and LIFO). He provides you with the following information before entering the great glass elevator.

• The chocolates are homogeneous and the color of the foil serves only as an indication of which batch they are from. It is important to note that all units in the inventory are identical.

Color Cost per unit ($)

No. of units

Date of purchase Beginning inventory Gold 0.2 16 - (before Jan)

Purchase #1 Purple 0.3 8 1/15/2007

Purchase #2 Silver 0.4 8 1/30/2007

• The factory made the following sales in January: Invoice No. Date of Sale Description

1 1/7/2007 8 units of “gold” 2 1/19/2007 4 units of “gold”

2 units of “purple” 3 1/25/2007 1 unit of “gold”

5 units of “purple” Assume all sales were made at $0.5 per unit.

*Note to student: Whenever necessary, make use of the chocolates to help you visualize the inventory flow.

1. Periodic Inventory System

Recall that the periodic inventory system keeps track of inventory quantities and costs only on a periodic basis. In this case, assume that each period is one month (specifically, for the month of January). This implies that the dates of each sale and each purchase are not critical as long as the purchases and sales are made in January (same accounting period).

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1.1 Specific Identification Method

As the name suggests, this method specifically assigns the actual cost to each item of inventory and determines the ending inventory and cost of goods sold based on whether the specific item was sold during the period.

What is the cost of goods sold ($)?

No. of units Cost per unit $

“Gold” chocolates 0.2

“Purple” chocolates 0.3

“Silver” chocolates 0.4

Cost of goods sold

What is the ending inventory value ($)?

Ending inventory value

1.2 Average Cost Method

The average cost method considers the total cost of all units available for sale in the period and divides that by the total number of units available for sale in the period. Compute the cost of goods available for sale:

Beginning inventory ( units @ $0.2 each) $ Purchases:

#1 ( units @ $0.3 each) #2 ( units @ $0.4 each) Total Purchases

Cost of good available for sale

Cost of goods available for sale Average cost

per unit = Units available for sale =

Note that the cost per unit of ending inventory and the cost per unit of cost of goods sold are the same.

What is the total number of units sold in January? What is the cost of goods sold ($)?

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1.3 FIFO Method

FIFO (first-in-first-out) describes the flow of goods from inventory to cost of goods sold. The goods that are booked into inventory earlier are assumed to be the first goods out In this case, under the FIFO method, the goods are assumed to be sold in the following order: beginning inventory (gold), purchase #1 (purple) and lastly, purchase #2 (silver). Note that this is in contrast to the specific identification method. It does not matter how many units of “gold” or “purple” or “silver” chocolates were actually sold. The key is to consider the number of units sold in the current period (January) and assume that they were sold in the order which they were booked into inventory (i.e. beginning inventory, purchase #1, purchase #2).

Since the first goods into inventory are assumed to be the first goods out (sold), the ending inventory consist of the most recent goods that are booked into inventory. In this case, if there is an ending inventory balance, at least part or all of purchase #2 (silver) inventory should still remain.

1.4 LIFO Method

LIFO (last-in-first-out) is the exact opposite of FIFO in terms of the flow of goods from inventory to cost of goods sold. The goods that are booked into inventory last are assumed to be the first goods out.

In this case, under the LIFO method, the goods are assumed to be sold in the following order: purchase #2 (silver), purchase #1 (purple) and lastly, beginning inventory (gold). Note that the order is the exact opposite of the order under the FIFO method.

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Since the last goods into inventory are assumed to be the first goods out (sold), the ending inventory consist of the oldest goods that are booked into inventory. In this case, if there is an ending inventory balance, at least part or all of the beginning inventory (gold) should still remain.

Note that under the periodic inventory system, the adjustments are made at the end of the period. This combined with the last-in-first-out cost flow assumption means that we end up assigning cost that has not yet occurred to sales that took place before the purchase. For example, we assign cost of purchase #2 (date of purchase: 1/30/2007) to the first sale (date of sale: 1/7/2007). This seems counterintuitive but we must remember that the LIFO method is based on cost flow assumptions, not actual cost flows.

2. Perpetual Inventory System

The perpetual inventory system keeps an ongoing record of the quantity and cost of the inventory. In this case, this means that unlike the periodic inventory system, the dates of each sale and each purchase within the month of January (the current accounting period) matters. In other words, you cannot assign cost that has yet occurred to sales that took place before the purchase.

2.1 Specific Identification Method What is the ending inventory value ($)?

Ending inventory value

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2.2 Average Cost Method

What is the cost of goods sold associated with each sale? Start off by computing the average cost per unit at each point in time. Remember to take note of the dates of each sale and each purchase. For each sale, think about what is the cost of goods available for sale and the total units available for sale at that point in time.

Date of Sale Average cost per unit Cost of goods sold 1/7/2007

1/19/2007 1/25/2007

What is the cost of goods sold at the end of the period?

What is the ending inventory value?

2.3 FIFO Method

For each sale, the goods that are booked into inventory first are assumed to be sold first. What is the cost of goods sold associated with each sale?

Date of Sale Cost of goods sold

1/7/2007 1/19/2007 1/25/2007

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2.4 LIFO Method

For each sale, the goods that are booked into inventory last (at the point in time) are assumed to be sold first. What is the cost of goods sold associated with each sale?

Date of Sale Cost of goods sold

1/7/2007 1/19/2007 1/25/2007

What is the ending inventory value?

3. Comparing inventory cost systems and costing methods.

Complete the following table using the information that you have gathered earlier. Periodic Inventory System Perpetual Inventory System Costing

Method COGS Ending

Inventory COGS Ending Inventory Specific Identification Average Cost FIFO LIFO

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Answer the following questions:

(a) Do the periodic system and perpetual system give the same COGS and ending inventory balances for each costing method?

(b) What do you notice about the sum of cost of goods sold and ending inventory for each costing method and inventory system?

(c) Focusing on the periodic system, which costing method would you choose if: • you want to minimize tax expense?

• your compensation is a percentage of net income?

• you want to impress investors with a high ROA?

(d) Notice that in this case, the per unit cost price increases over time ($0.2 for the beginning inventory, $0.3 for the first purchase and $0.4 for the second purchase). How would your answers to part (b) above change if the per unit cost price

decreases over time instead?

• you want to minimize tax expense?

• your compensation is a percentage of net income?