Chapter 7: Inventory and Cost of Goods Sold

Objective 7.1: Describe the issues in managing different types of inventory

Types of Inventory

• Merchandise inventory consists of products that are @@already made@@. Merchandisers then sell these finished goods to their customers.
• Manufacturers have @@three types of inventory@@: raw materials, work in process, and finished goods.
• These three types of inventory represent the manufacturing process.
  • Raw materials are materials that are waiting to be processed, such as plastic, steel, and fabric.
  • Work in Process goods are not up for sale yet, but are in the process of getting to that stage.
  • Finished goods are the inventory that are completed and ready to be sold to customers.
• Raw materials are used to create the goods that are in the process of being manufactured, which results in the completed products
• Consignment inventory are any products being held by a company so they do not claim ownership over the owners’ product. In the case the inventory is difficult to sell, the ownership is not under them.
• Goods in transit are goods being transported to the location of the buyer, whether this is someones front door or a store getting ready to sell those items (Walmart).

Inventory Management Decisions

• Inventory managers must:
  • Ensure there is enough inventory to meet demand.
  • Ensure the quality of the product is satisfactory.
  • Minimize costs of acquiring, transporting, and storing inventory.

Objective 7.2: Explain how to report inventory and cost of goods sold.

Balance Sheet and Income Statement Reporting

• Inventory is reported on the Balance Sheet as a current asset because it will be sold to generate cash within a year.
• When inventory is sold, the cost moves from the Inventory account (balance sheet) and becomes Cost of Goods Sold expense (income statement).
• ==Equation to calculate gross profit:==
  • Net Sales - Cost of Goods Sold = Gross Profit

Cost of Goods Sold Equation

• The Cost of Goods Sold equation changes depending if it’s for periodic or perpetual updating of inventory.

• Periodic Updating is used for small businesses (mom and pop shops).

  • ==It uses the Cost of Goods Equation, which is:==
  • Beginning Inventory + Purchases - Ending Inventory = Cost of Goods Sold

• Perpetual Updating is used for bigger companies (Walmart).

  • ==It uses the Ending Inventory equation, which is:==
  • Beginning Inventory + Purchases - Cost of Goods Sold = Ending Inventory

• Example (periodic): A company has 10 units in their beginning inventory that each cost $15. The company then purchases 25 units that cost $15 each. Its has 15 units in ending inventory. (COGAS = Cost of Goods Available for Sale)

  

• Periodic Steps

  • Step 1: Multiply number of units and cost per unit to find the total cost of beginning inventory and purchases.
  • 10 x $15 = $150
  • 25 x $15 = $375
  • Step 2: Add the number of units for beginning inventory and purchases to find COGAS units and total cost.
  • 10 + 25 = 35 units
  • $150 + $375 = $525
  • Step 3: We are told that ending inventory is 15.
  • Step 4: Multiply ending inventory units by cost per unit to find total cost.
  • 15 x $15 = $225
  • Step 5: Subtract total cost of ending inventory from COGAS to find the total cost of Cost of Goods Sold.
  • $525 - $225
  • Cost of Goods Sold = $300

• Example (perpetual): A company has 10 units in their beginning inventory that each cost $15. The company then purchases 25 units that cost $15 each. It then sells 20 units.

  

• Step 1: Multiply number of units and cost per unit to find the total cost of beginning inventory and purchases.

  • 10 x $15 = $150
  • 25 x $15 = $375

• Step 2: Add the number of units for beginning inventory and purchases to find COGAS units and total cost.

  • 10 + 25 = 35 units
  • $150 + $375 = $525

• Step 3: We are told that cost of goods sold is 20

• Step 4: Multiply cost of goods sold units by cost per unit to find total cost.

  • 20 x $15 = $300

• Step 5: Subtract total cost of cost of goods sold from COGAS to find the total cost of ending inventory.

  • $525 - $300
  • Ending inventory = $225

Objective 7.3: Compute costs using four inventory costing methods.

Inventory Costing Methods

• The four inventory costing methods tell us the @@value of what was sold and what should be in Cost of Goods expense@@.
• All methods are accepted by the Generally Accepted Accounting Principles (GAAP).
• Specific identification
  • Individually identifies and records the cost of each item sold as Cost of Goods Sold.
  • The cost of each item must be tracked.
  • This method is best used for luxury items (Cars, Jewelry)
• The last three are not based on physical flow of goods, but based on Cost Flows Assumptions, which are assumptions accountants make about the flow of inventory costs.
• First in, first out (FIFO) - Inventory goes out (sold) in the order the goods are received.
• Last in, last out (LIFO) - The last goods received are the first to be sold.
• Weighted average - The average for Cost of Goods Available for Sale is used for each good sold and for the goods that are still in inventory.
  • Equation to calculate weighted average cost:
  • Cost of Goods Available for Sale/Number of Units Available for Sale = Cost per unit
• Apply the average to what was sold and what was not sold (sales and ending inventory).
• ==Equation to calculate total cost:==
  • Number of units x Cost per units = Total cost
• After sales are made, calculate ending inventory by subtracting sales from beginning inventory.
• Example: Using the following table of information, we will apply it using the specific identification method, FIFO method, LIFO method, and weighted average.

Specific Identification

• The cost of each item sold is recorded as part of Cost of Goods Sold.
• Example: Units from from November 1 and November 7 are sold.
  • $60 + $85 = $145
  • $145 is reported as Cost of Goods Sold
  • The unit from November 5th that was not sold remains in Inventory ($65).

FIFO (First in, first out)

• We are selling 2 units.
• The first unit purchased was on November 1st, so we sell that first.
• The second unit we would sell would be from November 5th.
• Add those units together: $60 + $65 = $125 (Cost of Goods Sold)

LIFO (Last in, first out)

• We are selling 2 units.
• The last unit purchased was on November 7th, so we selling that first.
• The second unit we would sell would be from November 5th.
• Add those units together: $85 + $65 = $125

Weighted Average

• We use the equation (total cost/total units) = Cost per unit.

• Add the cost of each unit together to find total cost: $85 + $65 + $60 = $210

• We have a total of 3 units.

• Divide total cost by total units: 210/3 = $70 per unit

  

Financial Statement Effects

• The inventory costing methods split cost of goods available for sale between ending Inventory and Cost of Goods Sold differently.
• Cost that goes into Inventory will not go into Cost of Goods Sold.
• The method that results in the highest cost in Inventory will have the lowest cost in Cost of Goods Sold.
• The method that results in the highest cost in Cost of Goods Sold will have the lowest cost in Inventory.
• @@Costs rising and falling have different financial effects@@
  • Rising costs = larger inventory and smaller cost of goods sold.
  • Falling costs = smaller inventory and larger costs of goods.

Tax Implications and Cash Flows Effects

• Using a method that results in lower inventory and higher cost of goods sold is beneficial because of lower income tax.
• A company may only switch from one method to another if it improves the accuracy of the company’s financial results.
• Methods can also be used for specific types of inventory, but must be consistent with how the method is used.
• The LIFO conformity rule says the method used for the company’s income tax return must also be used for the financial statement.

Objective 7.4: Report inventory at the lower of cost or market/net realizable value.

Lower of Cost or Market/Net Realizable Value

• The value of inventory may be lower than the cost of the inventory because…
  • It is replaced by similar goods and a lower cost
  • The goods are outdated or damaged.
• As required by the GAAP, @@there is a rule for reporting inventory at the lower cost or market (LCM)/net realizable value (NRV)@@.
• If the inventory value has fallen below its cost, it must be marked down to the lower value.
• Market value is a replacement cost.
• Net realizable value is the inventory value to be realized when sold.

Objective 7.5: Evaluate inventory management by computing and interpreting the inventory turnover ratio.

Inventory Turnover

• Inventory balance can be good or bad. When you have a lot of inventory for sale, you will make good profit. When inventory builds up because of lack of sales, thats bad.
• Inventory turnover is the cycle of an increasing balance when a company buys goods and a decreasing balance when a company sells goods.
• To evaluate change in inventory, we use inventory turnover analysis.
• An inventory turnover ratio shows how many times inventory is bought and sold. A higher ratio indicates inventory is bought and sold quickly.
• ==Equation to calculate the inventory turnover ratio:==
  • Cost of Goods Sold/Average Inventory
  • The higher the better.

Days to Sell

• “Days to Sell” focuses on the length of time it takes to sell inventory.
• ==Equation to calculate days to sell:==
  • 365/Inventory Turnover Ratio
  • A higher number represents a longer amount of time to sell goods.

Example of Inventory Turnover and Days to Sell

• The chart shows the Cost of Goods Sold (COGS) and Inventory of a company from two different years.
• Using this information, it is plugged into the inventory turnover equation.
• The inventory turnover ratio is then plugged into the days to sell equation to get the final answer.

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