MGMT 200 Chapter 6: Inventory and Cost of Goods Sold

Inventory

includes items a company intends for sale to customers in the ordinary course of business, also includes items that are not yet finished products, reported as a current asset in the balance sheet

Recording revenues as companies

service companies record revenues when providing services to customers, merchandising and manufacturing companies record revenues when selling inventory to customers

Cost of goods sold

an expense reported in the income statement and represents the cost of inventory sold during the period

Multiple-step income statement

reports multiple levels of profitability; gross profits, operating income, income before income taxes, and net income

Gross profit

net revenues (or net sales) minus cost of goods sold

Operating income

gross profit minus operating expenses

Income before income taxes

operating income plus nonoperating revenues minus nonoperating expenses

Net income

all income before income taxes minus income tax expense (or all revenues minus all expenses)

Specific identification inventory cost method

matches each unit of inventory with its actual cost, not practical for most companies, used primarily by companies with unique and expensive products with low sales volume

First-in first-out (FIFO) inventory method

assumes first units purchased are first ones sold, matches physical flow for most companies, ending inventory reflects current cost, balance-sheet approach

Last-in first-out (LIFO) inventory cost method

assumes last units purchased are first ones sold, cost of goods sold reflects current cost, income-statement approach

Weighted-average cost inventory cost method

assumes each unit of inventory has a cost equal to the weighted-average unit cost of all inventory items, weighted-average cost is calculated as cost of goods available for sale divided by number of units available for sale

LIFO conformity rule

companies that use LIFO for tax reporting must use LIFO for financial reporting

The choice of inventory method affects

reporting ending inventory (asset) and reported cost of goods sold (expense; and therefore profit)

Why choose FIFO?

most closely approximates its actual physical flow of inventory; during periods of rising costs, FIFO results in a higher ending inventory, lower cost of goods sold, and higher reported profit than LIFO

Why choose LIFO?

results in lowest amount of reported profits when inventory costs are rising, which helps with tax savings

LIFO reserve

companies that report using LIFO must also report the difference between the LIFO amount and what that amount would have been if they had used FIFO

Perpetual inventory system

maintains a continual record of inventory on hand and inventory purchased and sold, helps managers make good decisions, most often used in practice

Periodic inventory system

does not continually record inventory amounts, calculates balance of inventory at end of period based on physical count, adjusts for purchases and sales of inventory

When companies purchase inventory using a perpetual inventory system

they increase the Inventory account and either decrease Cash or increase Accounts Payable

When companies sell inventory, they make two entries

1. They increase an asset account (Cash or Accounts Receivable) and increase Sales Revenue

2. They increase Costs of Goods Sold and decrease Inventory

LIFO adjustment

an adjustment used to convert a company’s own inventory records maintained throughout the year on a FIFO basis to LIFO basis for preparing financial statements at the end of the year

FOB shipping point

title passes when the seller ships the inventory

FOB destination

title passes when the inventory reaches the buyer’s destination

Purchase discounts

discount offered by seller to buyer for quick payment

Purchase returns

buyer returns unwanted or defective inventory

When net realizable value falls below cost

we adjust downward the balance of inventory from cost to net realizable value

We report inventory at the lower of cost and net realizable value

at cost (specific identification, FIFO, or weighted-average cost) or net realizable value (selling price minus cost of completion, disposal, and transportation), whichever is lower

Inventory turnover ratio

number of times during a year the firm sells its average inventory balance during the period; Inventory Turnover Ratio = (costs of goods sold)/(average inventory)

Average days in inventory

indicated the approximate number of days the average inventory is held; Average Days in Inventory = 365/(inventory turnover ratio)

Gross profit ratio

indication of the company’s successful management of inventory, measures the amount by which the sale price of inventory exceeds its cost per dollar of sales; Gross Profit Ratio = (gross profit)/(net sales)