Chapter 7: Inventory and Cost of Goods Sold

Understand the Business

Types of Inventory

The generic term inventory means goods that are held for sale in the normal course of business or are used to produce other goods for sale. Merchandisers hold merchandise inventory, which consists of products acquired in a finished condition, ready for sale without further processing. Manufacturers often hold three types of inventory, with each representing a different stage in the manufacturing process. They start with raw materials inventory such as plastic, steel, or fabrics. When these raw materials enter the production process, they become part of work in process inventory, which includes goods that are in the process of being manufactured. When completed, work in process inventory becomes finished goods inventory, which is ready for sale just like merchandise inventory. For purposes of this chapter, we’ll docs on merchandise inventory, but the concerts we cover apply equally to manufacturers inventory.

Two other accounting terms may be used to describe inventory. Consignment inventory refers to goods a company is holding on behalf of the goods for the owner (for a fee) but does not want to take ownership of the goods in the event the goods are difficult to sell. Consignment inventory is reported on the balance sheet of the owner, not the company holding the inventory. Goods in transit are inventory items being transported. This type of inventory is reported on the balance sheet of the owner, not the company transporting it. As you may remember from Exhibit 6.4 in Chapter 6, ownership of inventory is determined by the terms of the inventory sale agreement. If a sale is made FOB destination, goods in transit belong to the seller until they reach their destination (the customer). If a sale is made FOB shipping point, goods in transit belong to the customer at the point of shipping (from the seller’s premises).

Inventory Management Decisions

The primary goals of inventory managers are to

Maintain a sufficient quantity of investors to meet customers needs.
Ensure inventory quality meets customers’ expectations and company standards.
Minimize the cost of acquiring and carrying inventory (including costs related to purchasing, production, storage, spoilage, theft, obsolescence, and financing).

These factors are tricky to manage because as one of them changes (e.g., quality), so, too, do the others (e.g., cost). Ultimately, inventory management often comes down to purchasing goods that can be sold soon after they are acquired. As the following Spotlight indicates, big data analytics can help with inventory management decisions.

Study the Accounting Methods

Balance Sheet and Income Statement Reporting

Because inventory will be used or converted into cash within one year, it is reported on the balance sheet as a current asset. Goods are initially recorded in inventory at cost, which is the amount paid to acquire the asset and prepare it for sale. See American Eagle reports inventory.

When a company sells goods, it removes their cost from the Inventory account and reports the cost on the income statement as the expense Cost of Goods Sold. As Exhibit 7.2 shows, Cost of Goods Sold (CGS) is subtracted from Net Sales to yield the income statement subtotal called Gross Profit.

Cost of Goods Sold Equation

☑ Chapter 6 explained that the balance sheet account Inventory is related to the income statement account Cost of Goods Sold through the cost of goods sold equation. The cost of goods sold equation can take one of two forms, depending on whether the inventory costs are updated periodically at year-end (or month-end) when inventory is counted, or perpetually each time inventory is bought or sold:

Exhibit 7.3 illustrates how to use these equations with a simple case where a company has beginning inventory of 5 units that each costs $10, then purchases 20 units with a cost of $10 each, sells 15 units, and is left with 10 units in ending inventory. Exhibit 7.3 shows that, in a periodic inventory system, you must calculate the cost of Ending Inventory and then use the cost of goods sold equation to "force out" the Cost of Goods Sold (left table). In a perpetual inventory system, the Cost of Goods Sold is updated with each inventory transaction, which "forces out" the cost of Ending Inventory (right table). With a perpetual inventory system, you can "prove" the cost of Ending Inventory by calculating it directly using the number of units on hand (10 units on hand at $10 per unit = $100). Be sure you understand all of the calculations in Exhibit 7.3 before moving on because we use it as a basis for more calculations later in this chapter.

Inventory Costing Methods

In the example presented in the previous section, the cost of all units of the item was the same-$10. If inventory costs normally remained constant, we'd be done right now. But just as you notice every time you fill up your car with gas, the cost of goods does not always stay the same. In recent years, the costs of many items have risen moderately. In other cases, such as electronic products, costs have dropped dramatically. When the costs of inventory change over time, it is not obvious how to determine the cost of goods sold (and the cost of ending inventory). To see why, think about the following simple example:

The sale on May 8 of two units, at a selling price of $125 each, would generate sales revenue of $250 ($125 × 2), but what amount would be considered the cost of goods sold? The answer depends on which goods are reported as sold.

Four generally accepted inventory costing methods are available for determining the cost of goods sold and the cost of goods remaining in ending inventory, regardless of whether a company uses a perpetual or periodic inventory system. The method chosen does not have to correspond to the physical flow of goods, so any one of these four methods is acceptable under GAAP in the United States.

The specific identification method individually identifies and records the cost of each item sold as Cost of Goods Sold. This method requires accountants to keep track of the purchase cost of each item. In the example just given, if the items sold were identified as one of the two received on May 3 and the one received on May 6, which cost $70 and $95, the total cost of those items ($70 + $95 = $165) would be reported as Cost of Goods Sold. The cost of the remaining items ($70 + $85 = $155) would be reported as Inventory on the balance sheet at the end of the period. Companies tend to use the specific identification method when accounting for individually expensive and unique items. CarMax, a national auto dealership, uses specific identification.

The units within each American Eagle product line are identical, so the company does not use the specific identification method. Like most companies, American Eagle uses one of the three other cost flow methods to account for inventory items. These three other inventory costing methods are not based on the physical flow of goods on and off the shelves. Instead, these methods are based on assumptions accountants make about the flow of inventory costs. These three cost flow assumptions are applied to our simple four-unit example in Exhibit 7.4.

First-in, first-out (FIFO) assumes the inventory costs flow out in the order the goods are received. As in Exhibit 7.4, the earliest items received, the two $70 units received on May 3, become the $140 Cost of Goods Sold on the income statement, and the remaining $85 and $95 units received on May 5 and 6 become ending Inventory on the balance sheet.
Last-in, first-out (LIFO) assumes the inventory costs flow out in the opposite of the order the goods are received. As in Exhibit 7.4, the latest items received, the $95 and $85 units received on May 6 and 5, become the $180 Cost of Goods Sold on the income statement, and the two remaining $70 units received on May 3 become ending Inventory on the balance sheet.
Weighted average cost uses the weighted average of the costs of goods available for sale for both the cost of each item sold and those remaining in inventory. As in Exhibit 7.4, the weighted average of the costs ([(2× $70) + (1x $85) + (1 x $95)] / 4 = $80) is assigned to the two items sold, resulting in $160 as Cost of Goods Sold on the income statement. The same $80 weighted average cost is assigned to the two items in ending Inventory reported on the balance sheet.

As Exhibit 7.4 illustrates, the choice of cost flow assumption can have a major effect on Gross Profit on the income statement and Inventory on the balance sheet. Walgreens, for example, would report $3.3 billion more in inventory cost if it used FIFO rather than LIFO. But doing so would also increase the company's income taxes, so it stays with LIFO.

Notice that although they're called "inventory" costing methods, their names actually describe how to calculate the cost of goods sold. That is, the "first-out" part of FIFO and LIFO refers to the goods that are sold (i.e., first out), not the goods that are still in ending inventory. Also notice that the cost flows assumed for LIFO are the opposite of FIFO, and weighted average is a middle-of-the-road method.

Inventory Cost Flow Computations

Now that you've seen how these cost flow assumptions work and that they actually make a difference in a company's balance sheet and income statement, you're ready for a more realistic example. So, let's assume that during the first week of October American Eagle entered into the following transactions for its Henley T-shirt product line. All sales were made at a selling price of $15 per unit. These sales occurred after American Eagle made two batches of T-shirt purchases, which were added to inventory purchased the previous month.

FIFO (First-in, first-out) The first-in, first-out (FIFO) method assumes the oldest goods (the first in to inventory) are the first ones sold (the first out of inventory). So to calculate the cost of the 35 units sold, use the costs of the first-in (oldest) goods (10 units at $7 plus 25 of the 30 units at $8 = a total of $270). The costs of the newer goods are included in the cost of the ending inventory (10 units at $10 plus 5 units remaining from the 30 units at $8 = a total of $140). These calculations are summarized in the following table.

As the table above shows, the Cost of Goods Sold can be calculated directly (10× $7 plus 25 x $8 = a total of $270) or it can be "forced out" by subtracting the cost of ending inventory from the cost of goods available for sale ($410-$140 = $270). This latter approach is helpful if the number of units sold is not known, which is always the case when a company uses a periodic inventory system. 1

LIFO (Last-in, first-out) The last-in, first-out (LIFO) method assumes the newest goods (the last in to inventory) are the first ones sold (the first out of inventory). So to calculate the cost of the 35 units sold, use the costs of the last-in (newest) goods (10 units at $10 plus 25 of the 30 units at $8 = total of $300). The costs of the older goods, including those in beginning inventory, are included in the cost of the ending inventory (10 units at $7 plus 5 units remaining from the 30 units at $8 = a total of $110). These calculations are summarized in the table below.

As in the table, Cost of Goods Sold can be calculated directly (10 × $10 plus 25 x $8 = a total of $300) or it can be "forced out" by subtracting the cost of ending inventory from the cost of goods available for sale ($410-$110 = $300). We recommend you do both, as a way to double- check your calculations.

Weighted Average Cost The weighted average cost method is applied in two steps. The first step is to calculate the total cost of the goods available for sale. You multiply the number of units at each cost by the cost per unit and then sum these amounts to get the total cost:

Then you calculate the weighted average cost per unit using the following formula:

Cost of goods sold and ending inventory are both calculated using the same weighted average cost per unit, as in the following table.

Financial Statement Effects Exhibit 7.5 summarizes the financial statement effects of the FIFO, LIFO, and weighted average cost methods. Remember these methods differ only in the way they split the cost of goods available for sale between ending Inventory and Cost of Goods Sold. If a cost goes into Inventory, it doesn't go into Cost of Goods Sold. Thus, the method that assigns the highest cost to ending Inventory will assign the lowest cost to Cost of Goods Sold (and vice versa). As you can see in Exhibit 7.5, the effect on Cost of Goods Sold affects many other items on the income statement including Gross Profit, Income from Operations, Income before Income Tax Expense, Income Tax Expense, and Net Income.

Depending on whether costs are rising or falling, different methods have different effects on the financial statements. When costs are rising, as they were in our example, FIFO produces a larger inventory value (making the balance sheet appear to be stronger) and a smaller cost of goods sold (resulting in a larger gross profit, which makes the company look more profitable). When costs are falling, these effects are reversed; FIFO produces a smaller ending inventory value and a larger cost of goods sold-a double whammy. These are not "real" economic effects, however, because the inventory cost flow assumption does not affect the number of units sold or held in ending inventory. The following graphic summarizes the relative amounts reported:

Tax Implications and Cash Flow Effects Given the financial statement effects, you might wonder why a company would ever use a method that produces a smaller inventory amount and a larger cost of goods sold. The answer is suggested in Exhibit 7.5, in the line called Income Tax Expense. When faced with increasing costs per unit, as in our example, a company that uses FIFO will have a higher income tax expense. This income tax effect is a real cost, in the sense that the company will actually have to pay more income taxes in the current year, thereby reducing the company's cash.

Consistency in Reporting A common question is whether managers are free to choose LIFO one period, FIFO the next, and then go back to LIFO, depending on whether unit costs are rising or declining during the period. Because this switching would make it difficult to compare financial results across periods, accounting rules discourage it. A change in method is allowed only if it improves the accuracy of the company's financial results. A company can, however, use different methods for different types of inventory that differ in nature or use, provided the methods are used consistently over time. Tax rules also limit the methods that can be used. In the United States, the LIFO Conformity Rule requires that if LIFO is used on the income tax return, it also must be used in financial statement reporting.

Lower of Cost or Market/Net Realizable

The value of inventory can fall below its recorded cost for two reasons: (1) it's easily replaced by identical goods at a lower cost or (2) it's become outdated or damaged. The first case is common for high-tech electronics. As companies become more efficient at making these cutting-edge products, they become cheaper to make. The second case commonly occurs with fad items or seasonal goods such as American Eagle's winter coats, which tend to drop in value at the end of the season.

When inventory value falls below its cost, GAAP requires the inventory to be written down to its lower value. This rule is known as reporting inventory at the lower of cost or market/net realizable value (LCM/NRV). "Market value" focuses on how much the inventory would cost to replace in current market conditions (replacement cost). "Net realizable value" focuses on the inventory value likely to be realized when sold (selling price minus selling costs such as delivery). Technically, accounting rules require companies using FIFO and weighted average cost to compare inventory cost to net realizable value, and companies using LIFO to compare cost to market value. Either way, the main point of the LCM/NRV rule is to ensure inventory is reported at no more than it is worth. Also, by recording the write-down in the period in which a loss in value occurs, companies better match their revenues and expenses of that period.

Let's look at how an inventory write-down is determined and recorded. Included in American Eagle's ending inventory are two items whose values have recently changed: vintage jeans and leather coats.2 The vintage jeans are recorded in Inventory at their average cost of $20 per item. These jeans are expected to sell for $25 each, so they do not need to be written down because they already are reported at the lower amount (i.e., their $20 cost). However, the leather coats are estimated to have a lower value ($150) than their recorded cost ($165 each). Thus, the inventory of leather coats needs to be written down by $15 per leather coat or, in total, $15,000 ($15 × 1,000 units).

The effect of a $15,000 write down on the accounting equation and the journal entry to record it are

Most companies report the expense of an inventory write- down as Cost of Goods Sold, even though the written-down goods may not have been sold. This reporting is appropriate because writing down goods that haven't yet sold is a necessary cost of carrying the goods that did sell. By recording the write-down in the period in which a loss in value occurs, companies better match their revenues and expenses of that period.

However, some managers are reluctant to fairly apply the LCM/NRV rules. Inventory write-downs can have a large effect on net income (as you learned in the Spotlight on Business Decisions). Not only that, but investors and analysts also view an inventory write-down as a sign of inventory management problems. The failure to follow inventory LCM/NRV rules is one of the most common types of financial statement misstatements.

Evaluate Inventory Management

Inventory Turnover Analysis

How can you tell whether an increase in a company's inventory balance is good news or bad news? If the increase occurs because management is building up stock in anticipation of higher sales, it could be good news. But if it results from an accumulation of old inventory items that nobody wants, it is probably bad news. Those who work inside the company can determine whether the change is good or bad news by talking with the sales managers. But if you are looking at the company's financial statements from the outside, how can you tell?

The method most analysts use to evaluate such changes is called inventory turnover analysis. Exhibit 7.6 illustrates the idea behind inventory turnover analysis. As a company buys goods, its inventory balance goes up; as it sells goods, its inventory balance goes down. This process of buying and selling, which is called inventory turnover, is repeated over and over during each accounting period for each line of products

Analysts can assess how many times, on average, inventory has been bought and sold during the period by calculating the inventory turnover ratio. A higher ratio indicates that inventory moves more quickly from purchase to sale, reducing storage and obsolescence costs. Because less money is tied up in inventory, the excess can be invested to earn interest or reduce borrowing, which reduces interest expense. More efficient purchasing and production techniques as well as high product demand will boost this ratio. A sudden decline in the inventory turnover ratio may signal an unexpected drop in demand for the company's products or sloppy inventory management.

Rather than evaluate the number of times inventory turns over during the year, some analysts prefer to think in terms of the length of time (in days) required to sell inventory. Converting the inventory turnover ratio to the number of days needed to sell the inventory is easy. You simply divide 365 days by the year's inventory turnover ratio to get the days to sell. This measure provides the same basic information, but it is a little easier to interpret than the inventory turnover ratio. In terms of Exhibit 7.6, the inventory turnover ratio indicates the number of loops in a given period; days to sell indicates the average number of days between loops.

Comparison to Benchmarks

Inventory turnover ratios and the number of days to sell can be helpful in comparing different companies' inventory management practices. But use them cautiously because these measures can vary significantly between industries. For merchandisers, inventory turnover refers to buying and selling goods, whereas for manufacturers, it refers to producing inventory and delivering it to customers. Industry differences are reflected in Exhibit 7.7, which shows that McDonald's has a turnover ratio of 59.0, which means it takes almost a week (6.2 days to be precise) to sell its entire food inventory (including the stuff in its freezers). The motorcycles at Harley-Davidson hog more time, as indicated by its inventory turnover ratio of 5.2, which equates to over two months (70.2 days) to produce and sell. American Eagle's inventory turned over only 6.3 times during the year, which is just once every 57.9 days.

Inventory turnover also can vary significantly between companies within the same industry, particularly if they take different approaches to pricing their inventory. In Chapter 6, we saw that Walmart follows a low-cost pricing policy, which means setting its sales prices only slightly above cost. This policy led Walmart to earn about 24.4 cents of gross profit on each dollar of sales, whereas Nordstrom earned 35.1 cents of gross profit. But when you consider the inventory turnover measures, you can see the full implications of this pricing policy. Walmart turns its inventory over about 8.5 times a year (42.9 days), whereas Nordstrom turns its inventory over 4.5 times a year (81.1 days). Often, the company with a lower gross profit percentage has a faster inventory turnover.

With inventory turnover ratios varying between industries and companies, it's most useful to compare a company's turnover with its own results from prior periods. For practice at computing and comparing to prior periods, try the following Self-Study Practice.