Chapter 7- Inventory

What does the inventory turnover ratio measure?

It measures how efficiently a company manages its inventory by indicating how many times inventory is sold and replaced over a period.

Why is inventory a crucial asset for a company?

Inventory is a key current asset that:

• directly influences a company's cash flow

• overall financial position

• it’s central to fulfilling customer demand

• generating sales

What is the role of internal controls in inventory management?

• Internal controls help prevent inventory loss and ensure proper tracking

• using physical controls, separation of duties, and independent verification

What is inventory?

• Items purchased for resale or used in manufacturing products for resale.

• It is often the company’s largest current asset.

What are the three types of inventory for manufacturers?

Raw Materials, Work-in-process, Finished Goods

What is the inventory classification for retailers and merchandisers?

All goods purchased for resale are included in a single inventory classification.

How do FOB shipping terms affect inventory ownership?

FOB Shipping Point:

• Buyer owns inventory once it leaves the seller's premises.

FOB Destination:

• Buyer owns inventory once it reaches the buyer's premises.

What happens to goods on consignment?

Goods on consignment remain the inventory of the consignor (owner), not the consignee (who is holding the goods for sale).

What is a perpetual inventory system?

• continuously updates inventory and COGS with each purchase or sale

• tracking inventory levels

• shrinkage automatically

What are the advantages of a perpetual inventory system?

• Companies know COGS and ending inventory at all times

• can track inventory shrinkage

• enable automatic reordering

What is a periodic inventory system?

Inventory is updated at the end of the accounting period after a physical count, and COGS is calculated at that time.

What are the disadvantages of a periodic inventory system?

• The system cannot track units sold or inventory levels in real-time

• requires a physical count at the end of the period to calculate COGS and ending inventory

What costs are included in inventory?

Inventory costs include:

• purchase price

• non-refundable taxes

• shipping

• import duties

Why are cost formulas necessary in inventory management?

Cost formulas help allocate the varying costs of inventory consistently between COGS and ending inventory.

What are the three main inventory cost formulas?

Specific Identification, Weighted-average, First-in, First-out (FIFO)

When is the specific identification method used?

Unique items where each unit’s cost can be specifically identified, such as cars or jewelry.

How does the FIFO method allocate costs?

• assigns the oldest inventory to COGS first

• with ending inventory valued at the most recent purchase costs

How does the weighted-average method differ between periodic and perpetual systems?

• perpetual system: the weighted-average cost is recalculated after each purchase

• periodic system: it is calculated only at the end of the period

How do FIFO results differ between periodic and perpetual inventory systems?

The allocations under FIFO are the same regardless of whether a periodic or perpetual system is used.

How is inventory valued on the statement of financial position (balance sheet) & income statement?

• Inventory is carried at the lower of cost or net realizable value (NRV)

• If NRV < cost, inventory is written down and the loss is recorded in COGS or inventory loss expense

What is net realizable value (NRV)?

• Cash expected from selling inventory

• expected selling price - any costs to complete and sell the item

What is an inventory writedown?

A writedown occurs when:

• the inventory's value is reduced to its NRV

• recorded as an expense in COGS

• on the income statement

What are common examples of inventory errors?

• Counting mistakes

• incorrect inclusion/exclusion of consigned or in-transit goods

• data entry errors

• failure to apply inventory writedowns

How long do inventory errors offset?

Inventory errors typically offset over a two-year period.

How is the inventory turnover ratio calculated and interpreted?

• Inventory Turnover Ratio = COGS / Average Inventory

• It measures how efficiently a company sells and replaces inventory.

  • High turnover: efficient sales

  • Very high: risk of stockouts

What does a high inventory turnover ratio indicate?

It indicates that inventory is sold and replaced quickly, reflecting efficient inventory management and sales.

What is the downside of very high inventory turnover?

Very high turnover can lead to stockouts, where inventory is sold out before new stock arrives, potentially resulting in lost sales.

How is the days to sell inventory calculated?

Days to Sell Inventory = 365 / Inventory Turnover Ratio

Why is the days to sell inventory ratio important?

It shows how quickly a company converts inventory into sales, with a lower number being favorable.

How can inventory turnover ratios help estimate freed-up capital?

Shortening the inventory period reduces the amount of inventory a company needs to maintain, thus freeing up capital for other uses.

What is gross margin?

Gross margin is the difference between sales revenue and cost of goods sold (COGS), also known as gross profit.

How is the gross margin percentage calculated?

Gross Margin % = (Gross Margin / Sales Revenue) * 100%

What is the gross margin estimation method and when is it used to estimate inventory?

• The method estimates COGS by using a ratio of historical gross margin

• It is used when a physical inventory count is unavailable, such as after:

  • a fire

  • flood

  • theft

  • disaster

  • or for quick internal estimates

Weighted-Average Formula?

• Weighted-Average Cost per Unit =  Total Cost of Goods Available for Sale (COGAS) ÷ Total Units Available for Sale

How do situational inventory differences affect inventory turnover ratios?

• Businesses with fast-moving goods (groceries) have higher turnover, lower days-to-sell.

• Businesses with slow-moving or high-value goods (jewelry) have lower turnover, higher days-to-sell.

How is Cost of Goods Sold calculated in a periodic system?

COGS = Beginning Inventory + Purchases – Ending Inventory.

Which inventory cost formulas are commonly used?

• Weighted-average and FIFO are standard

• specific identification is used for unique/high-cost items

• LIFO is not used in Canada.

Which cost formula is most appropriate for exotic car dealerships?

Specific Identification – each car is unique and tracked individually; FIFO or weighted-average are inappropriate.

Which inventory cost formula gives highest COGS when inventory is near zero?

• FIFO – with minimal inventory

• oldest (cheaper) items sold first → remaining newest items expensive → COGS higher

If inventory cost drops from $10,000 to $8,000, what value is reported?

• Inventory is written down to $8,000

• recorded as NRV

Which type of business has higher inventory turnover, grocery vs jewelry?

Grocery retailers have **higher turnover** due to faster sales; jewelry stores have lower turnover.

How do you estimate ending inventory using the gross margin method?

Steps:

1. Calculate historical gross margin ratio: Gross Margin ÷ Sales Revenue

2. Estimate COGS: Sales Revenue × (1 – Gross Margin Ratio).

3. Determine ending inventory: Goods Available for Sale – Estimated COGS.

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Estimated COGS = Sales × (1 − Gross Margin)

• Estimated COGS = 607,000 × (1 – 0.40) = 364,200

Goods Available = Beginning Inventory + Purchases

• Goods Available = 25,000 + 398,000 = 423,000

Ending Inventory = Beginning Inventory + Purchases − COGS

• Ending Inventory = 423,000 – 364,200 = 58,800

Can weighted-average or FIFO be used for unique items?

❌ No. They are for interchangeable goods

How does inventory differ across business types?

Inventory depends on business type:

• Manufacturers: Raw Materials, Work-in-Process, Finished Goods

• Retailers/Merchandisers: All goods for resale in a single category

• Service Companies: Consumable supplies only (fuel, packaging)

• Consignment Goods: Remain with consignor until sold.

What is inventory shrinkage & how is inventory shrinkage recorded in a perpetual inventory system?

• Loss of inventory due to theft, damage, or loss

• Physical count required

• perpetual system does not auto-update

• Debit: Inventory Shrinkage Expense

• Credit: Inventory.

How are additional acquisition costs treated in inventory valuation?

Total inventory cost = Purchase price + Freight-in + Import duties + Non-refundable taxes + Insurance (if applicable).

How is inventory affected by markups in retail for cost conversion formula?

Cost = Sales ÷ (1 + Markup %).

Example: Sales=150,000, Markup=50% → Cost = 150,000 ÷ 1.5 = 100,000.

What financial statements does inventory affect?

• Balance Sheet: Inventory (asset)

• Income Statement: COGS

(Cheat Sheet)

What are the steps for weighted-average inventory?

1. Goods Available = Beginning Inventory + Purchases

2. Avg Cost = Total Cost ÷ Total Units

3. COGS = Units Sold × Avg Cost

4. Ending Inventory = Units Left × Avg Cost

What happens under FIFO when prices rise?

• Lower COGS

• Higher Ending Inventory

• Higher Net Income because oldest (cheaper) units are sold first

What happens if ending inventory is overstated?

COGS understated and Net Income overstated

What happens if ending inventory is understated?

COGS overstated and Net Income understated

Do inventory errors fix themselves?

Yes. Inventory errors usually reverse in the next period because ending inventory becomes beginning inventory

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Periodic: updated at period end using physical count. Perpetual: continuously updated with each purchase and sale

When is Weighted-Average used?

• Used for interchangeable goods

• average cost assigned to all units

What assumption does FIFO use?

Oldest inventory costs are assigned to COGS first

Is LIFO allowed under IFRS (Canada)?

No. LIFO is not permitted under IFRS

What is Goods Available for Sale?

• Total inventory available to sell.

• Formula: Goods Available = Beginning Inventory + Purchases

How is COGS calculated in a perpetual system?

COGS = Units sold × cost per unit at that moment

Which inventory account receives manufacturing overhead costs during production?
(cheat sheet)

• Manufacturing overhead costs are added to the Work-in-Process (WIP) inventory account while goods are being produced.

• Overhead includes factory rent, utilities, depreciation, and indirect labour.

What is the cost flow of inventory in a manufacturing company?

Raw Materials → Work-in-Process → Finished Goods → Cost of Goods Sold (COGS).

What is the cost-to-sales ratio and how is it used?

• Cost-to-Sales Ratio = COGS ÷ Sales Revenue.

• It is used to estimate Cost of Goods Sold when applying the gross margin estimation method.

What is the relationship between inventory turnover and days to sell inventory?

• They are inversely related.

• Higher inventory turnover —→ fewer days to sell inventory

• lower inventory turnover ——> more days to sell inventory

Why is separation of duties important in inventory internal controls?

Separation of duties prevents fraud and errors by assigning different employees to ordering inventory, receiving inventory, and recording inventory transactions.

How do you calculate Ending Inventory?

Ending Inventory = Goods Available − Estimated COGS

How do you calculate Estimated COGS using gross margin?

Estimated COGS = Sales × (1 − Gross Margin %)

• only use for gross margin

What happens when a company pays within the discount period?

• Pays less cash

• Records a purchase discount

How is the journal entry recorded when paying within the discount period?

• Debit Accounts Payable for full invoice amount

• Credit Cash for amount paid

• Credit Purchase Discounts (or Inventory) for the discount received