Chapter 6 Inventories

Control of Inventory (Learning Objective 1)

  • Two primary objectives of inventory control:
    • Safeguarding inventory from damage or theft.
    • Reporting inventory accurately in financial statements.

Safeguarding Inventory

  • Controls begin when inventory is ordered.
  • Key documents for inventory control:
    • Purchase order: Authorizes purchase from approved vendor.
    • Receiving report: Establishes initial record of inventory receipt.
    • Vendor’s invoice
    • Subsidiary inventory ledger: Tracks inventory amount and helps maintain proper levels.
  • Security measures should prevent damage and theft (customer or employee).

Reporting Inventory

  • Physical inventory count at year-end ensures accuracy in financial statements.
  • Cost is assigned to inventory for financial reporting.

Discussion Activity 1

  • Personal experiences with physical inventory counts in retail settings.
  • Additional measures companies use to safeguard inventory (cameras, RFID tags, locked displays, security personnel).
  • Physical inventory is necessary even with perpetual inventory systems (bar codes) to identify shrinkage or errors.

Inventory Cost Flow Assumptions (Learning Objective 2)

  • Issue: Identical units acquired at different costs during a period.
  • Solution: Use a cost flow assumption and related inventory costing method to determine the cost of goods sold.

Inventory Cost Flow Assumptions Example

  • Three identical units purchased at different costs:
    • May 10: 1 unit at $9
    • May 18: 1 unit at $13
    • May 24: 1 unit at $14
    • Total: 3 units for $36
  • Average cost per unit: 36 ÷ 3 = $12
  • If one unit is sold on May 30 for $20, the gross profit varies depending on which unit is sold:

Gross Profit Calculation Based on Unit Sold

  • May 10 Unit Sold:
    • Sales: $20
    • Cost of Goods Sold: $(9)
    • Gross Profit: $11
    • Ending Inventory: $27 ($13 + $14)
  • May 18 Unit Sold:
    • Sales: $20
    • Cost of Goods Sold: $(13)
    • Gross Profit: $7
    • Ending Inventory: $23 ($9 + $14)
  • May 24 Unit Sold:
    • Sales: $20
    • Cost of Goods Sold: $(14)
    • Gross Profit: $6
    • Ending Inventory: $22 ($9 + $13)

Inventory Cost Flow Methods

  • Specific Identification: Unit sold is identified with a specific purchase; ending inventory consists of remaining units.
  • First-In, First-Out (FIFO): First units purchased are assumed to be sold; ending inventory consists of most recent purchases.
  • Last-In, First-Out (LIFO): Last units purchased are assumed to be sold; ending inventory consists of the first purchases.
  • Weighted Average: Cost of units sold and ending inventory is a weighted average of purchase costs.
    • Purchase costs are weighted by quantities purchased at each cost.

Inventory Costing Methods Under a Perpetual Inventory System (Learning Objective 3)

  • FIFO, LIFO, and weighted average cost methods illustration under a perpetual inventory system.
  • Data for Item 127B:
    • Jan. 1: Inventory of 1,000 units at $20.00
    • Jan. 4: Sale of 700 units at $30 per unit
    • Jan. 10: Purchase of 500 units at $22.40
    • Jan. 22: Sale of 360 units at $30 per unit
    • Jan. 28: Sale of 240 units at $30 per unit
    • Jan. 30: Purchase of 600 units at $23.30

Perpetual Inventory System: First-In, First-Out (FIFO) Method

  • Costs included in cost of goods sold in the order they were purchased, matching physical flow of goods.
  • FIFO provides similar results to specific identification method.

Perpetual Inventory System: FIFO Example Ending Balance

  • Ending balance on January 31: $18,460
  • Made up of two inventory layers:
    • Layer 1 (Jan. 10): 200 units at $22.40 = $4,480
    • Layer 2 (Jan. 30): 600 units at $23.30 = $13,980
    • Total: 800 units = $18,460

Perpetual Inventory System: Last-In, First-Out (LIFO) Method

  • Cost of units sold is the cost of the most recent purchases.
  • Originally used when units sold were from most recent purchases.
  • For tax purposes, LIFO is widely used even when it doesn't represent physical flow.
  • Subsidiary inventory ledger can be maintained in units only; converted to dollars for financial statements.

Perpetual Inventory System: LIFO Example Ending Balance

  • Ending balance on January 31: $17,980
  • Made up of two inventory layers:
    • Layer 1 (Beginning Inventory, Jan. 1): 200 units at $20.00 = $4,000
    • Layer 2 (Jan. 30): 600 units at $23.30 = $13,980
    • Total: 800 units = $17,980

Perpetual Inventory System: Weighted Average Cost Method

  • Weighted average unit cost computed each time a purchase is made.
  • Unit cost used to determine cost of each sale until another purchase occurs (moving average).

Knowledge Check Activity 1

  • Question: Which inventory costing method results in the highest cost of goods sold during rising costs?
  • Answer: c. LIFO (last-in, first-out)
  • Explanation: Rising costs mean latest inventory items are most expensive, leading to higher cost of goods sold under LIFO. Older, cheaper items remain in inventory.

Inventory Costing Methods Under a Periodic Inventory System (Learning Objective 4)

  • Revenue recorded at each sale, but no cost of goods sold entry.
  • Physical inventory taken at period-end to determine inventory cost and cost of goods sold.
  • Cost flow assumption (FIFO, LIFO, or weighted average) required when identical units have different costs.

Periodic Inventory System: First-In, First-Out (FIFO) Method

  • Using same data as perpetual inventory example for Item 127B.
  • Beginning inventory and purchases:
    • Jan. 1: 1,000 units at $20.00 = $20,000
    • Jan. 10: 500 units at $22.40 = $11,200
    • Jan. 30: 600 units at $23.30 = $13,980
    • Total available for sale = 2,100 units for $45,180

Periodic Inventory System: FIFO Method - Cost of Ending Inventory

  • Physical count on January 31 shows 800 units on hand.
  • Using FIFO, ending inventory consists of most recent costs:
    • January 30 purchase: 600 units at $23.30 = $13,980
    • January 10 purchase: 200 units at $22.40 = $4,480
    • Inventory, January 31: 800 units = $18,460

Periodic Inventory System: FIFO Method - Cost of Goods Sold

  • Cost of goods sold calculated as:
    • Beginning inventory: $20,000
    • Purchases: $25,180 ($11,200 + $13,980)
    • Cost of goods available for sale: $45,180
    • Ending inventory: $(18,460)
    • Cost of goods sold: $26,720

Periodic Inventory System: Last-In, First-Out (LIFO) Method

  • Ending inventory consists of the earliest costs.
  • Based on same data as FIFO example, 800 units in ending inventory cost $16,000 (800 units from beginning inventory at $20.00 per unit).

Periodic Inventory System: LIFO Method - Cost of Goods Sold

  • Cost of goods sold calculated as:
    • Beginning inventory: $20,000
    • Purchases: $25,180 ($11,200 + $13,980)
    • Cost of goods available for sale: $45,180
    • Ending inventory: $(16,000)
    • Cost of goods sold: $29,180

Periodic Inventory System: Weighted Average Cost Method

  • Weighted average unit cost determines the cost of goods sold and ending inventory.
  • If purchases are uniform, results are similar to physical flow.
  • Weighted Average Unit Cost = \frac{Total Cost of Units Available for Sale}{Units Available for Sale}

Periodic Inventory System: Weighted Average Cost Method - Example Calculation

  • Using Item 127B data:
    • Total cost of units available for sale: $45,180
    • Units available for sale: 2,100 units
    • Weighted average unit cost = \frac{$45,180}{2,100} = $21.51 per unit (rounded)
  • Cost of January 31 ending inventory: $17,208 (800 units × $21.51)

Periodic Inventory System: Weighted Average Cost Method - Cost of Goods Sold

  • Cost of goods sold calculated as:
    • Beginning inventory: $20,000
    • Purchases: $25,180 ($11,200 + $13,980)
    • Cost of goods available for sale: $45,180
    • Ending inventory: $(17,208)
    • Cost of goods sold: $27,972

Knowledge Check Activity 2

  • Question: Which statement about inventory costing under the periodic inventory system is correct?
  • Answer: a. At the time of sale, no entry is made to cost of goods sold.
  • Explanation: Periodic system only records revenue at the time of sale; cost of goods sold is determined at the end of the accounting period after a physical inventory.

Comparing Inventory Costing Methods (Learning Objective 5)

  • Different cost flow assumptions for FIFO, LIFO, and weighted average methods.
  • Normally yield different amounts for:
    • Cost of goods sold
    • Gross profit
    • Net income
    • Ending inventory

Comparing Inventory Costing Methods - Example

  • Perpetual inventory system with sales of $39,000 (1,300 units × $30):
    • First-In, First-Out:
      • Sales: $39,000
      • Cost of goods sold: $(26,720)
      • Gross profit: $12,280
      • Inventory, Jan. 31: $18,460
    • Weighted Average Cost:
      • Sales: $39,000
      • Cost of goods sold: $(26,900)
      • Gross profit: $12,100
      • Inventory, Jan. 31: $18,280
    • Last-In, First-Out:
      • Sales: $39,000
      • Cost of goods sold: $(27,200)
      • Gross profit: $11,800
      • Inventory, Jan. 31: $17,980
  • Differences occur due to increasing costs (prices). If costs remain the same, all methods yield the same results.

Discussion Activity 2

  • Researching inventory valuation methods used by companies (e.g., NIKE) via the SEC website (www.sec.gov).
  • NIKE uses lower of cost or net realizable value, an average method, or the specific identification method.
  • Larger companies may use multiple inventory valuation methods.

Reporting Inventory in the Financial Statements (Learning Objective 6)

  • Cost is the primary basis for valuing and reporting inventories.
  • Inventory may be valued at other than cost if:
    • Replacement cost is below recorded cost.
    • Inventory cannot be sold at normal prices (imperfections, obsolescence, damage, etc.)

Valuation at Lower of Cost or Market (LCM)

  • If market value (net realizable value) is lower than cost, LCM is used.
  • Net Realizable Value = Estimated Selling Price – Direct Costs of Disposal

Valuation at Lower of Cost or Market (LCM) - Example

  • Damaged inventory item:
    • Original cost: $1,000
    • Estimated selling price: $800
    • Estimated selling expenses: $150
  • Market Value (Net Realizable Value) = $800 – $150 = $650
  • Inventory valued at $650 (lower of $1,000 cost and $650 market value).

Applying the Lower-of-Cost-or-Market (LCM) Method

  • LCM can be applied to:
    1. Each item in inventory
    2. Each major class or category of inventory
    3. Total inventory as a whole
  • Price decline included in the cost of goods sold, reducing gross profit and net income.
  • Matching price declines to the period in which they occur is a primary advantage of LCM.
  • Example: 400 units of Item A
    • Cost per unit: $10.25
    • Market value (net realizable value) per unit: $9.50

Inventory on the Balance Sheet

  • Inventory is reported in the “Current assets” section.
  • Method of determining cost (FIFO, LIFO, weighted average) and valuing inventory (cost or LCM) are disclosed on the balance sheet or in accompanying notes.

Effects of Inventory Errors on the Financial Statements

  • Inventory errors affect the balance sheet and income statement.
  • Reasons for inventory errors:
    • Miscounted physical inventory
    • Incorrect cost assignment due to incorrect application of inventory costing method
    • Inventory in transit incorrectly included or excluded
    • Consigned inventory incorrectly included or excluded

Common Inventory Errors

  • Errors often arise during year-end physical inventory.
  • Merchandise ordered FOB shipping point in transit at year-end should be included in physical inventory, even if not yet received.
  • Consigned inventory (goods shipped to a retailer but still owned by the manufacturer) should be included in the manufacturer's inventory.

Knowledge Check Activity 3

  • Lakeview Forest Products sells an item costing $1,500. Due to obsolescence, the estimated selling price is now $1,200 with $200 selling expenses. What is the adjusted value using LCM?
  • Answer: d. $1,000
  • Explanation: Market Value (net realizable value) = $1,200 – $200 = $1,000. The inventory is valued at $1,000 because it's lower than the cost of $1,500.

Analysis for Decision Making: Inventory Turnover and Days’ Sales in Inventory (Learning Objective 7)

  • Retail businesses must maintain adequate inventory to meet customer needs.
  • Two key measures:
    • Inventory turnover
    • Days’ sales in inventory
  • Inventory Turnover = \frac{Cost of Goods Sold}{Average Inventory}
  • Measures how many times inventory is sold during the year.

Inventory Turnover and Days’ Sales in Inventory

  • Generally, a larger inventory turnover indicates more efficient inventory management.

  • Days’ Sales in Inventory = \frac{Average Inventory}{Average Daily Cost of Goods Sold}

  • Measures the time it takes to acquire, sell, and replace inventory.

  • Average Daily Cost of Goods Sold = \frac{Cost of Goods Sold}{365}

Differences Among Industries (Inventory Turnover and Days Sales)

  • Inventory turnover and days sales in inventory differ among industries.
  • Supermarkets have faster turnover than electronics stores. Best Buy Inventory turnover 6.9 Days’ sales in inventory 52.7 days compared to Kroger Inventory turnover 12.8 Days’ sales in inventory 28.5 days because food is perishable and sells more rapidly than electronics. Thus, Kroger’s inventory management should be significantly more efficient than Best Buy’s.