Inventory Management and Cost of Goods Sold

Chapter 7: Reporting and Interpreting Cost of Goods Sold and Inventory

Learning Objectives

• 7-1: Apply the cost principle to identify amounts included in inventory and cost of goods sold for various businesses (retailers, wholesalers, manufacturers).

• 7-2: Report inventory and cost of goods sold using four inventory costing methods.

• 7-3: Decide on beneficial inventory costing methods for companies.

• 7-4: Report inventory at the lower of cost or net realizable value.

• 7-5: Understand methods for controlling inventory and analyze inventory error effects on financial statements.

• 7-6: Evaluate inventory management using the inventory turnover ratio and analyze effects on cash flows.

Understanding Inventory Management

• Goals:

• Keep sufficient high-quality inventory for customer needs.

• Minimize inventory carrying costs (production, storage, obsolescence, financing).

Items Included in Inventory

• Types of Inventory:

  Manufacturing:

  • Raw Materials Inventory: Basic materials used in production.

• Work in Process Inventory: Incomplete goods in production.

• Finished Goods Inventory: Completed goods ready for sale.

  Merchandise:

• Merchandise Inventory: Inventory held for resale by merchants.

Costs Included in Inventory Purchases

• Initial Cost Recording:

• Recorded at cost, including all expenses to prepare the inventory for sale:

  • + Invoice price

  • +Freight-in

  • +Inspection and preparation costs

• - Deduct returns and discounts to determine

• = total inventory cost.

• Materiality Constraint: Minor costs like inspection may not need to be assigned to inventory.

Inventory Costing Methods

• Four Methods:

1. Specific Identification

2. First-In, First-Out (FIFO)

3. Last-In, First-Out (LIFO)

4. Average Cost

• *****Cost Flow Assumptions: The chosen method for accounting does not necessarily reflect the physical movement of goods but is a financial reporting necessity.**************

• FIFO: Oldest inventory costs are used first for cost of goods sold.

• LIFO: Newest inventory costs are used first.

• Average Cost: Cost of goods sold and inventory are recorded at a weighted average.

Cost of Goods Sold Calculation

• Formula:

  CGS = Beginning Inventory + Purchases - Ending Inventory

• Example: For Harley-Davidson:

• Beginning Inventory: $40,000

• Purchases: $55,000

• Ending Inventory: $35,000

• Cost of Goods Sold = $40,000 + $55,000 - $35,000 = $60,000

  

Inventory Systems

• Perpetual System: Inventory updated with every transaction.

• Periodic System: Inventory updated at the end of a period, calculates cost of goods sold based on periodic counts.

Evaluating Inventory Management

• Inventory Turnover Ratio:

• Formula: Cost of Goods Sold / Average Inventory

• Indicates efficiency of inventory management; higher ratios suggest more efficient management.

• Average Days to Sell Inventory:

• Formula: 365 / Inventory Turnover Ratio

External Reporting Considerations

• LIFO Conformity Rule: If LIFO is used for tax purposes, it must also be used for financial reporting.

• Valuation at Lower of Cost or Net Realizable Value:

• Required under conservatism principle to prevent overstating assets or income.

• Write-downs are necessary when the net realizable value drops below cost.

Ethical Considerations in Inventory Accounting

• Managers may choose inventory methods to report higher earnings, creating potential conflicts with owners' interests.

• A well-designed compensation structure can align managers' actions with owners' goals.

Conclusion

• Effective inventory management practices are essential for optimizing financial performance, supporting customer service, and maintaining accurate financial reporting.

• Companies must navigate the complexities of cost accounting methods while adhering to regulatory standards and ethical considerations.