Reporting and Interpreting Cost

of Goods Sold and Inventory

Chapter 7

McGraw-Hill/Irwin

2009 The McGraw-Hill Companies, Inc.

Understanding the Business

Primary
Primary Goals
Goals of
of
Inventory
Inventory
Management
Management

Provide
Provide sufficient
sufficient
quantities
quantities of
of highhighquality
quality inventory.
inventory.

Minimize
Minimize the
the costs
costs of
of
carrying
carrying inventory.
inventory.

7-2

Items Included in Inventory

Inventory

Tangible

Held for Sale

Used to
Produce
Goods or
Services

Merchandise Inventory
Raw Materials Inventory
Work in Process Inventory
Finished Goods Inventory
7-3

Costs Included in Inventory Purchases

The cost principle requires that inventory
be recorded at the price paid or the
consideration given.

Invoice
Price

Freight

Inspection
Costs

Preparation
Costs
7-4

Flow of Inventory Costs

Merchandiser
Merchandise
Merchandise
Purchases
Purchases

Manufacturer
Raw
Raw
Materials
Materials
Direct
Direct
Labor
Labor
Factory
Factory
Overhead
Overhead

Merchandise
Merchandise
Inventory
Inventory

Raw
Raw Materials
Materials
Inventory
Inventory

Work
Work in
in Process
Process
Inventory
Inventory

Cost
Cost of
of
Goods
Goods Sold
Sold

Finished
Finished Goods
Goods
Inventory
Inventory

Cost
Cost of
of
Goods
Goods Sold
Sold
7-5

Nature of Cost of Goods Sold

Beginning
Beginning
Inventory
Inventory

Purchases
Purchases
for
for the
the Period
Period

Goods
Goods available
available
for
for Sale
Sale
Ending
Ending Inventory
Inventory
(Balance
(Balance Sheet)
Sheet)

Cost
Cost of
of Goods
Goods Sold
Sold
(Income
(Income Statement)
Statement)

Beginning
Beginning inventory
inventory ++ Purchases
Purchases == Goods
Goods Available
Available for
for Sale
Sale
Goods
Goods Available
Available for
for Sale
Sale Ending
Ending inventory
inventory == Cost
Cost of
of goods
goods sold
sold
7-6

Inventory Costing Methods

Inventory Costing
Methods
1.Specific
Identification
2.First-in, First-out
3.Last-in, First-out
4.Weighted Average
Total
Total Dollar
Dollar Amount
Amount of
of Goods
Goods
Available
Available for
for Sale
Sale

Inventory Costing
Method

Ending
Ending Inventory
Inventory

Cost
Cost of
of Goods
Goods Sold
Sold
7-7

Specific Identification

When
When units
units
are
are sold,
sold, the
the
specific
specific cost
cost
of
of the
the unit
unit
sold
sold is
is added
added
to
to cost
cost of
of
goods
goods sold.
sold.
7-8

Cost Flow Assumptions

The choice of an inventory

costing method is not based
on the physical flow of goods
on and off the shelves.

FIFO
LIFO

Weighted
Average

7-9

First-In, First-Out Method

Oldest
Oldest Costs
Costs

Cost
Cost of
of
Goods
Goods Sold
Sold

Recent
Recent Costs
Costs

Ending
Ending
Inventory
Inventory

7-10

First-In, First-Out
Date
Beginning
Inventory
Purchases:
Jan. 3
June 20
Sept. 15
Nov. 29
Goods
Available
for Sale

Computers, Inc.
Mouse Pad Inventory
Units
$/Unit

Total

1,000

$ 5.25

$ 5,250.00

500
300
250
200

5.30
5.60
5.80
5.90

2,650.00
1,680.00
1,450.00
1,180.00

2,250

$ 12,210.00

Ending
Inventory

1,200

Cost of
Goods Sold

1,050

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.

7-11

First-In, First-Out
Given Information
Ending Inventory
Beg. Inv. 1,000 @ $ 5.25
Jan. 3
500 @ 5.30
450 @ $5.30
June 20
300 @ 5.60
300 @ $5.60
Sept. 15
250 @ 5.80
250 @ $5.80
Nov. 29
200 @ 5.90
200 @ $5.90
1,200 Units

Cost of Goods
Sold

Units

$ 6,695 Cost

Now,
Now, we
we have
have allocated
allocated the
the cost
cost to
to all
all
1,200
1,200 units
units in
in ending
ending inventory.
inventory.
7-12

First-In, First-Out
Given Information
Ending Inventory
Beg. Inv. 1,000 @ $ 5.25
Jan. 3
500 @ 5.30
450 @ $5.30
June 20
300 @ 5.60
300 @ $5.60
Sept. 15
250 @ 5.80
250 @ $5.80
Nov. 29
200 @ 5.90
200 @ $5.90
1,200 Units
$ 6,695 Cost

Cost of Goods
Sold
1,000 @ $ 5.25
50 @ 5.30

1,050 Units
$ 5,515 Cost

Now,
Now, we
we have
have allocated
allocated the
the cost
cost
to
to all
all 1,050
1,050 units
units sold.
sold.
7-13

First-In, First-Out
Date
Beginning
Inventory
Purchases:
Jan. 3
June 20
Sept. 15
Nov. 29
Goods
Available
for Sale

Computers, Inc.
Mouse Pad Inventory
Units
$/Unit
1,000
500
300
250
200

5.25

Total
$

5.30
5.60
5.80
5.90

5,250.00
2,650.00
1,680.00
1,450.00
1,180.00

2,250

$ 12,210.00

Ending
Inventory

1,200

6,695.00

Cost of
Goods Sold

1,050

5,515.00

Here is the
cost of
ending
inventory
and cost
of goods
sold using
FIFO.

7-14

Last-In, First-Out Method

Oldest
Oldest Costs
Costs

Ending
Ending
Inventory
Inventory

Recent
Recent Costs
Costs

Cost
Cost of
of
Goods
Goods Sold
Sold

7-15

Last-In, First-Out
Date
Beginning
Inventory
Purchases:
Jan. 3
June 20
Sept. 15
Nov. 29
Goods
Available
for Sale

Computers, Inc.
Mouse Pad Inventory
Units
$/Unit
1,000
500
300
250
200

Total

5.25

$ 5,250.00

5.30
5.60
5.80
5.90

2,650.00
1,680.00
1,450.00
1,180.00

2,250

$ 12,210.00

Ending
Inventory

1,200

Cost of
Goods Sold

1,050

Remember:
The costs of the
oldest
purchases are
in ending
inventory. Start
with beginning
inventory and
add units
purchased until
you reach the
number in
ending
inventory.
7-16

Last-In, First-Out
Given Information
Ending Inventory
Beg. Inv. 1,000 @ $ 5.25
1,000 @ $5.25
Jan. 3
500 @ 5.30
200 @ 5.30
June 20
300 @ 5.60
Sept. 15
250 @ 5.80
Nov. 29
200 @ 5.90
1,200 Units

Cost of Goods
Sold

Units

$ 6,310 Cost

Now,
Now, we
we have
have allocated
allocated the
the cost
cost to
to all
all
1,200
1,200 units
units in
in ending
ending inventory.
inventory.
7-17

Last-In, First-Out
Given Information
Ending Inventory
Beg. Inv. 1,000 @ $ 5.25
1,000 @ $5.25
Jan. 3
500 @ 5.30
200 @ 5.30
June 20
300 @ 5.60
Sept. 15
250 @ 5.80
Nov. 29
200 @ 5.90
1,200 Units
$ 6,310 Cost

Cost of Goods
Sold
300
300
250
200
1,050

@ $ 5.30
@ 5.60
@ 5.80
@ 5.90
Units

$ 5,900 Cost

Now,
Now, we
we have
have allocated
allocated the
the cost
cost
to
to all
all 1,050
1,050 units
units sold.
sold.
7-18

Last-In, First-Out
Date
Beginning
Inventory
Purchases:
Jan. 3
June 20
Sept. 15
Nov. 29
Goods
Available
for Sale

Computers, Inc.
Mouse Pad Inventory
Units
$/Unit
1,000
500
300
250
200

5.25

Total
$

5.30
5.60
5.80
5.90

5,250.00
2,650.00
1,680.00
1,450.00
1,180.00

2,250

$ 12,210.00

Ending
Inventory

1,200

6,310.00

Cost of
Goods Sold

1,050

5,900.00

Here is the
cost of
ending
inventory
and cost of
goods sold
using LIFO.

7-19

Average Cost Method

When
When aa unit
unit is
is sold,
sold, the
the
average
average cost
cost of
of each
each
unit
unit in
in inventory
inventory is
is
assigned
assigned to
to cost
cost of
of
Number of
goods
sold.
goods
sold.
Cost of Goods
Units
Available for
Available for
Sale

Sale

7-20

Average Cost Method

Weighted Average Cost

$ 12,210
= $5.42667
2,250

1,200 $ 5.42667
1,050 $ 5.42667
7-21

Comparison of Methods

7-22

Financial Statement Effects of Costing

Methods
Advantages
Advantages of
of Methods
Methods
First-In,
First-Out

Last-In,
First-Out

Weighted
Average

Ending
Ending inventory
inventory
approximates
approximates
current
current
replacement
replacement cost.
cost.

Better
Better matches
matches
current
current costs
costs in
in cost
cost
of
of goods
goods sold
sold with
with
revenues.
revenues.

Smoothes
Smoothes out
out
price
price changes.
changes.
7-23

Managers Choice of Inventory Methods

Net
Net Income
Income Effects
Effects
Managers
Managers prefer
prefer to
to report
report
higher
higher earnings
earnings for
for their
their
companies.
companies.

Income
Income Tax
Tax Effects
Effects
Managers
Managers prefer
prefer to
to pay
pay the
the
least
least amount
amount of
of taxes
taxes
allowed
allowed by
by law
law as
as late
late as
as
possible.
possible.

LIFO Conformity Rule

If last-in, first-out is used on the
income tax return, it must also be
used to calculate inventory and cost
of goods sold for financial
statements.
7-24

Valuation at Lower of Cost or Market

Ending
Ending inventory
inventory is
is reported
reported at
at the
the
lower
lower of
of cost
cost or
or market
market (LCM)
(LCM)..
Replacement
Replacement Cost
Cost
The
The current
current purchase
purchase price
price
for
for identical
identical goods.
goods.
The company will recognize a holding loss in the
current period rather than the period in which the
item is sold.
This practice is conservative.
7-25

Valuation at Lower of Cost or Market

Item
Pentium chips
Disk drives

Quantity
1,000
400

Cost
$ 250
100

Replacement
Cost
$
200
110

LCM
$ 200
100

Total LCM
$ 200,000
40,000

7-26

Inventory Turnover
Inventory
=
Turnover

Cost of Goods Sold

Average Inventory

Average
Average Inventory
Inventory is
is .. .. ..

(Beginning
(Beginning Inventory
Inventory ++ Ending
Ending Inventory)
Inventory) 22

This
This ratio
ratio reflects
reflects how
how many
many times
times
average
average inventory
inventory was
was produced
produced and
and
sold
sold during
during the
the period.
period. A
A higher
higher ratio
ratio
indicates
indicates that
that inventory
inventory moves
moves more
more
quickly
quickly thus
thus reducing
reducing storage
storage and
and
obsolescence
obsolescence costs.
costs.
7-27

Inventory and Cash Flows

Add Decrease in Inventory

Increase in Accounts
Payable

Net Income

Cash Flows
from
Operations

Increase in Inventory
Decrease in Accounts
Subtract
Payable

7-28

Inventory Methods and Financial

Statement Analysis
U.S. public companies using LIFO also report beginning
and ending inventory on a FIFO basis if the FIFO values
are materially different.
Beginning
Beginning inventory
inventoryFIFO
FIFO
-- Beginning
Beginning inventory
inventoryLIFO
LIFO
Beginning
Beginning LIFO
LIFO Reserve
Reserve
(Excess
(Excess of
of FIFO
FIFO over
over LIFO)
LIFO)

Ending
Ending inventory
inventoryFIFO
FIFO
-- Ending
Ending inventory
inventoryLIFO
LIFO
Ending
Ending LIFO
LIFO Reserve
Reserve
(Excess
(Excess of
of FIFO
FIFO over
over LIFO)
LIFO)

7-29

LIFO and International Comparisons

LIFO Permitted?
No

Yes

Singapore

China

Canada
Australia
Great Britain
7-30

Internal Control of Inventory

Separation of inventory
accounting and physical
handling of inventory.

Storage in a manner that

protects from theft and
damage.

Limiting access to
authorized employees.

Maintaining perpetual
inventory records.

Comparing perpetual
records to periodic
physical counts.
7-31

Perpetual and Periodic Inventory

Systems
Provides
Provides up-to-date
up-to-date
inventory
inventory records.
records.

Perpetual
Perpetual
System
System
Provides
Provides up-to-date
up-to-date
cost
cost of
of sales
sales records.
records.
In a periodic inventory system, ending inventory and cost of
goods sold are determined at the end of the accounting
period based on a physical count.
7-32

Perpetual and Periodic Inventory

Systems
Inventory System
Periodic System
Carried over
Beginning Inventory
from prior period
Accumulated in
Add: Purchases
the Purchases
account
Measured at end
of period by
Less: Ending Inventory
physical
inventory count
Computed as a
residual amount
Cost of Goods Sold
at end of period
Item

Perpetual System
Carried over from
prior period
Accumulated in
the Inventory
account
Perpetual record
updated at every
sale
Measured at
every sale based
on perpetual
record
7-33

Errors in Measuring Ending Inventory

Errors in Measuring Inventory
Ending Inventory

Beginning Inventory

Overstated Understated Overstated Understated

Effect on Current Period's Balance Sheet
Ending Inventory
Retained Earnings

+
+

N/A

N/A

N/A

N/A

+
+

+
-

+
+
-

+
+

Effect on n Current Period's Income Statement

Goods Available for Sale
Cost of Goods Sold
Gross Profit
Net Income

7-34

Supplement A: LIFO Liquidations

When a LIFO company sells more inventory than it
purchases or manufactures, items from beginning
inventory become part of cost of goods sold.
This is called a LIFO liquidation.
When inventory costs are rising,
these lower cost items in
beginning inventory produce a
higher gross profit, higher
taxable income, and higher
taxes when they are sold.
7-35

Supplement B: Additional Issues in

Measuring Purchases
Purchase returns and
allowances are a reduction
in the cost of purchases
associated with
unsatisfactory goods.

A purchase discount is
a cash discount
received for prompt
payment of an account.

7-36

Supplement B: Additional Issues in

Measuring Purchases
Terms
Time
Due

Discount Period

Credit Period

Full amount
less discount

Full amount due

Purchase or Sale

2/10,n/30
Discount
Discount
Percent
Percent

Number
Number of
of
Days
Days Discount
Discount
Is
Is Available
Available

Credit
Credit
Period
Period
7-37

Supplement C: Comparison of
Perpetual and Periodic Inventory
Systems
Perpetual Inventory System
Jan. 1
Apr. 14

Nov. 30

Dec. 31

Had beginning inventory of 800 units at a unit cost of

$50.
Purchased 1,100 units at a unit cost of $50.
Inventory
55,000
Accounts payable
55,000
Sold 1,300 units at a sales price of $83.
Accounts receivable
107,900
Sales revenue
107,900
Cost of goods sold
65,000
Inventory
65,000
Use cost of goods sold and inventory amounts.
7-38

Supplement C: Comparison of
Perpetual and Periodic Inventory
Periodic Inventory System
Systems

7-39

End of Chapter 7

McGraw-Hill/Irwin

2009 The McGraw-Hill Companies, Inc.