Chapter 7 – Inventory & Cost of Goods Sold Study Notes

Types of Inventory

• Merchandisers
  • Buy finished goods; sell finished goods.
  • Inventory category: Merchandise inventory (completed products awaiting sale).
• Manufacturers
  • Buy raw materials → convert to finished goods → sell.
  • Inventory sub-categories
  • Raw Materials: materials waiting for processing.
  • Work in Process (WIP): partially completed products.
  • Finished Goods: completed products awaiting sale.

Inventory Management Goals

• Maintain sufficient quantity to meet customer demand.
• Ensure quality meets customer expectations and internal standards.
• Minimize the cost of acquiring and carrying inventory (ordering, storage, insurance, obsolescence).

Balance-Sheet & Income-Statement Presentation

• Inventory reported as a current asset.
• Cost of Goods Sold (CGS) reported on the income statement and subtracted from Net Sales to derive Gross Profit.

Cost of Goods Sold Equation

• Periodic system (inventory counted at period-end)
  $\text{CGS}=\text{BI}+P-\text{EI}$
• Perpetual system (inventory records updated continuously)
  $\text{EI}=\text{BI}+P-\text{CGS}$

Example (periodic):

• BI = 5 units @ $10
• Purchases = 20 units @ $10
• Units sold = 15
• EI = 10 units
  $\text{CGS}=5(10)+20(10)-10(10)=150$

Inventory Costing Methods

• Specific Identification
  • Trace actual cost of each specific item sold.
  • Appropriate for unique, high-value items (e.g., cars, jewels).
• First-in, First-out (FIFO)
  • Earliest (oldest) costs → CGS; latest (newest) costs → EI.
• Last-in, First-out (LIFO)
  • Latest costs → CGS; earliest costs → EI.
• Weighted Average Cost (WAC)
  • All costs averaged; same cost assigned to CGS and EI.

Illustrative three-unit example (Periodic)

• Purchases: May 3 @$70, May 5 @$75, May 6 @$95; Sales: 2 units on May 8 @ $125.
  • Specific Identification (items @$70 & @$95 sold)
  • CGS = $70+95=165$; EI = $75$.
  • FIFO
  • CGS = $70+75=145$; EI = $95$.
  • Gross Profit = $250-145=105$.
  • LIFO
  • CGS = $75+95=170$; EI = $70$.
  • Gross Profit = $80$.
  • WAC
  • Avg cost = $(70+75+95)/3=80$.
  • CGS = $2\times80=160$; EI = $80$; Gross Profit = $90$.

Detailed FIFO / LIFO / WAC Computations (50-unit example)

Inputs:

• Oct 1 BI: 10 @ $7
• Oct 3 Purchase: 30 @ $8
• Oct 5 Purchase: 10 @ $10
• Oct 6 Sale: 35 units
  Cost of goods available: $10(7)+30(8)+10(10)=410$

FIFO

• CGS = $(10@7)+(25@8)=70+200=270$
• EI = $(10@10)+(5@8)=140$

LIFO

• CGS = $(10@10)+(25@8)=100+200=300$
• EI = $(10@7)+(5@8)=70+40=110$

WAC

• Avg cost = $410/50=8.20$
• CGS = $35\times8.20=287$
• EI = $15\times8.20=123$

Financial-Statement Effects of Costing Choice (sample data)

• Sales constant @ $525$.
• Gross Profit & Net Income vary:
  • FIFO Net Income $105$; Inventory $140$.
  • LIFO Net Income $84$; Inventory $110$.
  • WAC Net Income $93$; Inventory $123$.
• Tax implications (30% rate): higher CGS (LIFO) → lower taxable income → cash-flow benefit when prices rise.

Lower of Cost or Market / Net Realizable Value (LCM/NRV)

• Required when replacement cost or NRV < recorded cost because of:
  1. Decline in replacement price.
  2. Obsolescence, damage, or spoilage.
• Write-down entry:
  • Debit CGS, credit Inventory.

Example

• Vintage jeans: cost $20, market $25 → no loss.
• Leather coats: cost $165, market $150 (↓$15)
  • Quantity 1,000 → total write-down $15,000$.
  • Entry:
    Dr Cost of Goods Sold $15,000$
    Cr Inventory $15,000$

Inventory Turnover & Days to Sell

• Inventory Turnover
  $\text{Turnover}=\dfrac{\text{CGS}}{\text{Average Inventory}}$
• Days to Sell
  $\text{Days}=\dfrac{365}{\text{Turnover}}$

Polaris example (millions)

• 2018: CGS $4,580$; Avg Inv $880$ → Turnover $5.2$; Days $70.2$.
• 2017: Turnover $5.4$; Days $67.6$.
• Slight decline in 2018.
• Gross Profit % 2018 = $\dfrac{6,080-4,580}{6,080}=24.7\%$.
• Arctic Cat: turnover 2.9, GP% 3.5 → lower GP and slower sales → more likely LCM/NRV write-down.

Perpetual System Supplement (7A)

• Same cost flow assumptions (FIFO, LIFO, WAC) applied at each sale date rather than period-end.
• Weighted Average cost recalculated after each purchase (moving-average).
• Sample perpetual WAC: $\frac{310}{40}=7.75$ per unit after final purchase.

Effects of Inventory Errors (Supplement 7B)

• CGS equation: $BI+P-EI=CGS$.
• Year 1 EI overstated $10,000:
  • Year 1 CGS understated $10,000 → Net Income overstated.
  • Year 2 BI overstated $10,000 → Year 2 CGS overstated $10,000 → Net Income understated.
• Over two years the error self-corrects on total income but affects individual periods and ratios.

Selected Solved Exercises (Periodic System)

M7-7 FIFO (units: 50 BI @10; 250 purchased @13; 100 sold @15)

• Goods available $3,750$.
• EI (200 @13) $2,600$.
• CGS $1,150$.
• Sales $1,500$.
• Gross Profit $350$.

M7-8 LIFO same data

• EI $2,450$ (50 @10 + 150 @13).
• CGS $1,300$.
• Gross Profit $200$.

M7-9 WAC

• Avg cost $12.50$.
• EI $2,500$.
• CGS $1,250$.
• Gross Profit $250$.

M7-10 Aircard (16,000 units)

• Goods available $744,000$.
  • FIFO EI $350,000$; CGS $394,000$.
  • LIFO EI $300,000$; CGS $444,000$.
  • WAC cost $46.50$; EI $325,500$; CGS $418,500$.

E7-7 Oahu Kiki (700 units, 240 sold)

• FIFO EI $45,400$; CGS $20,400$.
• LIFO EI $40,200$; CGS $25,600$.
• WAC avg $94$ → EI $43,240$; CGS $22,560$.

E7-13 LCM/NRV (Peterson Furniture)

• Total write-down $1,500$.
• Entry: Dr CGS 1,500 / Cr Inventory 1,500.

Ethical & Practical Implications

• Choice of cost flow assumption affects reported profit, taxes, and management bonuses, raising ethical considerations.
• LCM/NRV prevents overstating assets and income; conservative accounting principle.
• Turnover ratio informs efficiency and potential obsolescence; poor turnover may signal need for write-downs.

Key Formulas Recap

• CGS (Periodic): $CGS=BI+P-EI$
• Inventory Turnover: $\dfrac{CGS}{\text{Average Inventory}}$
• Days to Sell: $\dfrac{365}{\text{Turnover}}$
• Gross Profit %: $\dfrac{\text{Net Sales}-CGS}{\text{Net Sales}}\times100$
• Weighted Average Cost (Periodic): $\dfrac{\text{Cost of Goods Available}}{\text{Units Available}}$
• Moving Average (Perpetual): recalc after each purchase.
• LCM/NRV write-down: debit Expense (CGS or Loss), credit Inventory for excess of cost over market/NRV.