Chapter 6: Cost of Goods Sold and Inventories

COGS

cost of goods sold (also called “Cost of Sales)”

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operating expense

Inventory

current asset

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Merchandising Company (Retailer)

Include Freight-in, sales tax, insurance during transit, etc.

Freight in

buyers responsibility

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transportation cost/delivery expense

when the buyer is responsible for delivery (net purchases, shipping cost)

Freight out

seller is responsible (operating expense)

transportation cost/delivery expense when the seller is responsible for delivery (operating expense)

Periodic System

debits all inventory items to “Purchases” account

make no entry to update “COGS” and “Inventory” accounts with each sell

Make a physical count at year end to determine “COGS” using formula:

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Beginning Inventory

Net Purchases

= Gas

(Ending Inventory)

= COGS

Net Purchases

Purchases

(Purchase Discounts)

(Purchase Returns and Allowances)

Freight In

Perpetual System

Debits all inventory items to “Inventory” account

updates “COGS” and “Inventory” account with each sale

Uses physical count at year end to determine “loss on shrinkage”

Ending inventory

all goods in which the company has legal title (regardless of location)

Goods in transit

goods ordered but not yet received

FOB

free on board

FOB Shipping point

title transfers to buyer when goods are accepted by common carrier

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buyer owns in transit and the buyer pays for shipping

FOB destination

title transfers when goods are delivered to destination of buyer

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seller owns in transit and the seller pays for shipping

Consigned goods

the owner (consignor) transfers physical goods to agent (consignee) for purposes of selling without giving up legal title

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does not count as inventory

Goods called in

if goods are ordered, as long as goods are identified and separate, they belong to buyer

Inventory Cost Flow Methods

specific identification, average cost method, FIFO, LIFO

Specific identification

small quantity of inventory, high-priced items. Impractical for most businesses

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ex: cars, art, custom jewelry, handmade furniture

Average cost method

uses weighted average of all costs for GAS

assigns average cost to both ending inventory and COGS

uses periodic inventory method

FIFO

cost of first item purchased = cost of first item sold (COGS)

perpetual

used for perishables

Advantages of FIFO

assigns current cost to ending inventory (end invt = most recent purchases)

good method when inventory turnover is rapid (bakery)

balance sheet in step with current world

Disadvantages of FIFO

fails to match most recent costs with revenues

if prices are rising, matches oldest unit costs with current revenues, therefore making net income higher (or overstated). these are called “inventory profits”

COGS out of step with world

LIFO

cost of last item purchased = cost of first item sold

perpetual

mulch, bricks

Advantages of LIFO

matches current costs with current revenues

in periods of rising prices, net income is always less (reduces income taxes). Because of the effect on taxes, companies must follow the LIFO Conformity rule

LIFO conformity rule

if you use LIFO for tax purposes, you must also use this method for financial reporting purposes

Disadvantages of LIFO

gives non-current value to inventory on balance sheet

not allowed by IFRS

LIFO

price increase leads to higher COGS

price decrease leads to lower COGS

Inventory turnover ratio

measures if company keeps excess stock of inventory. excess stock is not productive. want high inventory turnover to keep to a minimum inventory carrying costs, risk of loss, and obsolescense

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high is better

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=COGS/Average Inventory

Average inventory

(beginning inventory + ending inventory)/2