Inventory & COGS

Understanding Inventory and Cost of Goods Sold

• Inventory Definition:

  • Items a company intends to sell to customers in normal business operations.

  • Includes unfinished goods (work in process).

  • Typically classified as a current asset on the balance sheet.

• Flow of Inventory:

  • Inventory flows from manufacturing to merchandising companies and is reported as an asset in the balance sheet.

  • Inventory types based on company:

  • Manufacturing Companies:

    • Raw materials

    • Work in Process

    • Finished Goods

  • Merchandising Companies:

    • Merchandise Inventory

• Inventory Examples:

  • Manufacturing Company (e.g., Intel) Inventory:

  • Raw Materials: $840M

  • Work in Process: $6,225M

  • Finished Goods: $1,679M

  • Total: $8,744M

  • Merchandising Company (e.g., Best Buy):

  • Merchandise Inventory: $5,174M

Key Concepts

• Cost of Goods Sold (COGS):

  • Reported in the income statement and represents the cost of inventory sold during the period.

  • Ending inventory is reported as an asset, while COGS is recorded as an expense.

• Inventory Account Principles:

  • Cost of Inventory Calculation Example:

  • Beginning Inventory: $20,000

  • Purchases During the Year: $90,000

  • Total Inventory Available for Sale: $110,000

    • Ending Inventory (reported): $30,000

    • COGS (expense): $80,000

• Inventory Cost Methods:

  • Specific Identification: Matches each unit with its exact cost.

    • Is for inventory items that are sold at their purchase price which may vary based on the purchasing time and the quantity purchased of inventory.

  • FIFO (First In, First Out): First units purchased are the first ones sold.

  • LIFO (Last In, First Out): Last units purchased are the first ones sold.

  • Weighted-Average Cost: Each unit has a cost equal to the average of all inventory items.

Financial Statement Effects

• Multiple-Step Income Statement:

  • Reports multiple levels of profitability:

  • Gross Profit = Net Revenues - COGS

  • Operating Income = Gross Profit - Operating Expenses

  • Income Before Taxes = Operating Income + Nonoperating Revenues - Nonoperating Expenses

  • Net Income = Total Revenues - Total Expenses

• Implications of Inventory Accounting Choices:

  • FIFO vs LIFO:

  • FIFO usually reflects physical flow better, leading to higher assets and profits in rising cost periods.

  • LIFO leads to lower profits, beneficial for tax reduction during inflation.

Inventory Management Metrics

• Inventory Turnover Ratio:

  • Indicates how many times inventory is sold during a period.

  • Formula:
    ext{Inventory Turnover Ratio} = rac{ ext{Cost of Goods Sold}}{ ext{Average Inventory}}

• Gross Profit Ratio: Measures how much profit exceeds inventory costs for each dollar of sales.

  • Formula:
    ext{Gross Profit Ratio} = rac{ ext{Gross Profit}}{ ext{Net Sales}}

Applying the Lower of Cost and Net Realizable Value

• Lower of Cost and Net Realizable Value Rule:

  • Inventory should be reported at whichever is lower: cost or net realizable value (estimated selling price minus costs to sell).

  • Adjust downward when net realizable value falls below cost.

Inventory Error Implications

• Inventory Errors:

  • Errors in inventory affect both the balance sheet and income statement.

  • Overstated ending inventory leads to understated COGS and overstated profits in the current year, while the opposite occurs in the following year.

Types of Inventory Systems

• Perpetual Inventory System:

  • Continuously updates inventory records after every transaction.

• Periodic Inventory System:

  • Updates inventory balance at set intervals through physical counts.