Chapter 8: Inventories – Measurement

Inventory Overview

  • Inventory represents assets a company:

    • Intends to sell in the normal course of business

    • Is in production for future sale (work in process, WIP)

    • Is currently used in production of goods to be sold (raw materials)

  • Cost of goods sold (COGS) is an expense on the income statement that represents the cost of the inventory sold during the year.

Types of Inventory

  • Merchandising inventory

    • Goods purchased primarily in finished form from wholesalers/retailers

    • Cost includes: purchase price plus any other costs necessary to get goods in condition and location for sale

  • Manufacturing inventory

    • Consists of: raw materials, work-in-process (WIP), finished goods

    • Raw materials: cost of materials to be used in production

    • WIP: costs of components that have started production but are not yet complete

    • Finished goods: goods completed in production but not yet sold

    • Cost components in manufacturing: direct materials, direct labor, manufacturing overhead

Inventory for a Manufacturer (Component Costs)

  • Raw materials: materials purchased that will be used in production

  • Direct labor: labor directly traceable to production

  • Manufacturing overhead: indirect costs allocated to production

  • Work in process (WIP): costs of partially completed goods

  • Finished goods: completed goods awaiting sale

  • Flow: Raw materials purchased → Direct labor and overhead applied → Work in Process transferred to Finished Goods → Finished Goods sold -> Cost of Goods Sold is applied when goods are sold

Inventory Disclosure (Examples: Intel and Best Buy)

  • Manufacturing companies disclose dollar amount of each inventory category (in notes or balance sheet)

  • Merchandising companies typically disclose a single inventory category

  • Intel (example, $ in millions):

    • Raw materials: $1,517

    • Work in process: $7,565

    • Finished goods: $4,142

    • Merchandise inventory: —

    • Total inventories: $13,224

  • Best Buy (example, $ in millions):

    • Raw materials: —

    • Work in process: —

    • Finished goods: —

    • Merchandise inventory: $5,140

    • Total inventories: $5,140

Inventory Components and Cost Flow (Manufacturing Company)

  • Raw materials purchased

  • Raw materials used

  • Direct labor incurred

  • Manufacturing overhead incurred

  • Work in process transferred to finished goods

  • Finished goods sold

  • Direct labor applied

  • Manufacturing overhead applied

  • Cost of Goods Sold (COGS)

Inventory Systems

Perpetual Inventory System

  • Continuously adjust the inventory account for purchases, sales, and returns

  • Continuously adjust COGS for goods sold or returned by customers

  • Provides up-to-date view of goods on hand on any date

Perpetual Inventory System (illustrative example: Lothridge Wholesale Beverage)

  • Beginning inventory: $120,000 on hand

  • Purchases on account: $600,000

  • Sales for the year: $820,000

  • COGS for inventory sold: $540,000

  • Ending inventory: $180,000

  • Journal entries illustrate recording purchases, sales, and COGS under a perpetual system

Periodic Inventory System

  • Adjusts inventory and records COGS only at end of period

  • Merchandises purchases, returns, discounts, and freight-in are recorded in temporary accounts

  • COGS for the period: Beginning inventory + Net purchases - Ending inventory

  • For Lothridge example under periodic system:

    • Beginning inventory: $120,000

    • Purchases: $600,000

    • Ending inventory (physical count): $180,000

    • COGS: $540,000

    • Net purchases = Beginning inventory + Purchases - Ending inventory; COGS computed at period end

Cost of Goods Sold (COGS) and Periodic vs Perpetual

  • COGS formula (Periodic):
    extCOGS=extBeginningInventory+extNetPurchases−extEndingInventoryext{COGS} = ext{Beginning Inventory} + ext{Net Purchases} - ext{Ending Inventory}

  • Ending inventory and COGS are determined at period-end physical count or adjustment

  • Perpetual system provides more timely information; periodic system reduces ongoing recordkeeping but requires physical counts

Comparison: Perpetual vs Periodic (LO8-1)

  • Perpetual: limited recordkeeping during period; higher ongoing costs but more timely data

  • Periodic: higher recordkeeping complexity during period; requires physical count for end-of-period values

  • Financial statement effects: generally not significant; timing and accuracy differ

Physical Units Included in Inventory (LO8-2)

  • Items in possession of the company

  • Goods in transit

  • Goods on consignment

  • Anticipated sales returns

Goods in Transit (LO8-2)

  • Inventory items being shipped from seller to buyer

  • Ownership at year-end determines which entity reports the inventory in its balance sheet

  • Shipping terms (e.g., FOB shipping point vs FOB destination) determine who bears risk and title during transit

Goods in Transit (continued): FOB Terms (LO8-2)

  • If shipped FOB shipping point, title transfers to the buyer at shipment; buyer records inventory earlier; seller may have no entry at shipment date

  • If shipped FOB destination, title transfers to the buyer only upon arrival; seller retains ownership until delivery

Goods in Transit (Illustration: Lothridge example) (LO8-2)

  • Sale on Dec 29, 2027; goods arrive Jan 3, 2028

  • Depending on terms (FOB shipping point vs destination), balance sheet reporting may differ for year-end

Goods on Consignment (LO8-2)

  • Transferor (consignor) retains legal title until sold by consignee

  • Consignee (buyer) holds physical possession and is responsible for selling

  • Inventory remains on consignor’s books until sale occurs; sale is recorded by consignor when title passes to third party

  • Example: Premier Clothing (consignor) ships inventory to Regal Outlets (consignee) with a 10% commission; any unsold items after six months are returned to consignor

Sales Returns (LO8-2)

  • When customers return merchandise:
    1) Debit Sales Returns; credit Refund Liability
    2) Reduce COGS
    3) Increase Inventory

  • At period-end, estimate future returns and adjust ending inventory accordingly to include costs of inventory expected to be returned

Net Purchases and Inventory Costs (LO8-3)

  • Inventory costs include expenditures to acquire inventory and bring it to desired condition and location for sale or use in manufacturing

  • Product costs include:

    • Purchase price

    • Freight-in (incoming) borne by buyer

    • Insurance during transit (if shipped f.o.b. shipping point)

    • Costs of unloading, unpacking, preparing inventory for sale, or raw materials for use

Freight-in on Purchases

  • In perpetual system: freight-in is added to the inventory account

  • In periodic system: freight-in is added to a temporary account (freight-in or transportation-in) and included in net purchases for COGS calculation

  • Freight-out (outgoing shipping) is not included in inventory cost; charged to COGS or operating expense

Purchase Returns

  • A buyer views a purchase return as a reduction of purchases

  • Perpetual system: return reduces inventory

  • Periodic system: use Purchase Returns to accumulate returns and subtract from total purchases to compute net purchases

Purchase Discounts (LO8-3)

  • Represents reductions if payment is made within a designated period (e.g., 2/10, n/30)

  • Recorded by either gross method ornet method

  • Gross method example: purchase for $20,000 with terms 2/10, n/30; if paid within discount period, cash and accounts payable are reduced by the discounted amount; inventory unaffected under gross method at purchase date

  • Net method example: record payable net of discount; cash paid equals discounted amount; inventory recorded at discounted price

  • Lothridge example illustrates both methods and the effect on entries

Inventory Transactions — Perpetual and Periodic Systems (LO8-3)

  • Provided example shows: purchases, freight-in, returns, discounts, cash payments, sales, and COGS under both systems

  • End-of-period adjustments differ depending on the chosen system

Illustration—Inventory Cost Flow (LO8-4): Converse Company

  • Beginning inventory and purchases during the year:

    • Beg. Inv: 4,000 units @ $5.50 = $22,000

    • Jan 17 purchase: 1,000 @ $6.00 = $6,000

    • Mar 22 purchase: 3,000 @ $7.00 = $21,000

    • Oct 15 purchase: 3,000 @ $7.50 = $22,500

  • Goods available for sale: 11,000 units, total cost $71,500

  • Sales: 6,500 units

  • Question: What is the cost of the 6,500 units sold? (LO8-4)

  • Using weighted-average cost (Periodic):

    • Weighted-average unit cost = rac71,50011,000=6.50rac{71{,}500}{11{,}000} = 6.50

    • COGS for 6,500 units = 6,500imes6.50=42,2506{,}500 imes 6.50 = 42,250

    • Ending inventory (4,500 units) = 4,500imes6.50=29,2504{,}500 imes 6.50 = 29,250

Allocation of Units Available for Sale (LO8-4)

  • Beginning inventory: 4,000 units @ cost; Purchases: 7,000 units total

  • Ending inventory: 4,500 units; Units sold: 6,500

  • Goods available for sale: 11,000 units

  • Ending inventory + COGS must equal cost of goods available for sale ($71,500)

Specific Identification Method (LO8-4)

  • Tracks actual units sold

  • Used for unique, expensive items with low volume (e.g., automobiles with serial numbers)

  • Each item’s actual cost is matched to its sale

Cost Flow Assumptions (LO8-4)

  • Average cost: cost of inventory is a weighted average of all goods available for sale

  • FIFO (First-In, First-Out): units acquired first are sold first; ending inventory consists of most recently acquired units

  • LIFO (Last-In, First-Out): units acquired last are sold first; ending inventory consists of oldest units

Periodic Average Cost (LO8-4)

  • Beginning inventory balance: 4,000 units @ $5.50

  • Additions: purchases at various costs

  • Cost of goods available for sale: 11,000 units; Weighted-average cost per unit = rac71,50011,000=6.50rac{71{,}500}{11{,}000} = 6.50

  • COGS (6,500 units) = 6,500imes6.50=42,2506{,}500 imes 6.50 = 42,250

  • Ending inventory (4,500 units) = 4,500imes6.50=29,2504{,}500 imes 6.50 = 29,250

  • Note: The weighted-average cost is calculated at the end of the period in periodic systems

Perpetual Average Cost (LO8-4)

  • Moving-average cost is updated after each purchase

  • New average = (cost of existing inventory balance + cost of new purchase) / (units on hand after purchase)

  • Example shows sequential updates of average cost after each transaction

  • Resulting COGS and ending inventory reflect moving-average costs

FIFO — Periodic (LO8-4)

  • Under periodic FIFO, oldest units are sold first, regardless of timing of purchases within the period

  • Ending inventory consists of the most recently acquired units

  • Example results: COGS and ending inventory differ from other methods (FIFO vs average vs LIFO) depending on cost changes during the period

LIFO — Periodic (LO8-4)

  • Under periodic LIFO, last units purchased are assumed sold first; ending inventory consists of oldest units

  • Example results illustrate higher COGS and lower ending inventory for rising costs

Comparison of Cost Flow Methods (LO8-4)

  • Periodic methods: Average, FIFO, LIFO

  • Example comparison (goods available for sale $71,500):

    • Average: COGS = $42,250; Ending inventory = $29,250

    • FIFO: COGS = $38,500; Ending inventory = $33,000

    • LIFO: COGS = $46,500; Ending inventory = $25,000

  • The choice of method affects COGS and ending inventory values

  • The overall goods available for sale remains the same across methods

Inventory Cost Flow Under GAAP vs IFRS (LO8-9)

  • GAAP: LIFO is permissible in the U.S. for financial reporting

  • IFRS: LIFO is generally not permitted; FIFO and other methods are common

  • Some firms disclose a mix of methods, and note differences in inventories between GAAP and IFRS (e.g., General Mills example comparing inventories under LIFO vs FIFO/NRV)

Factors Influencing Method Choice (LO8-5)

  • Choices reflect a combination of objectives and incentives:

    • Inventory cost flow method

    • Depreciation method

    • Pension assumptions

    • Other strategic choices to meet objectives

  • Managers may pursue methods that maximize personal or organizational benefits

Practical Considerations: Method Choice and Physical Flow (LO8-5)

  • FIFO is often suited to situations where oldest goods are sold first (physical flow)

  • Average cost can approximate actual flow for inventories with a mix of items purchased at different times

  • LIFO is less commonly used because of recordkeeping and potential liquidation risks

Tax and Reporting Considerations (LO8-5)

  • Rising costs: LIFO often yields lower reported profits for tax purposes (tax advantages)

  • IRS LIFO conformity rule: If LIFO is used to measure taxable income, it must also be used for external financial reporting

LIFO Reserves (LO8-6)

  • LIFO Reserves = Inventory balance under LIFO (external reporting) minus Inventory balance under FIFO or average (internal records)

  • LIFO reserve is reported as a contra account to adjust the internal method to the external LIFO method for reporting

  • Reasons to avoid maintaining LIFO internal records:
    1) High recordkeeping costs
    2) Bonus/profit-sharing plans tied to non-LIFO measures
    3) Using FIFO/average for pricing decisions
    4) Maximizing tax deductions

LIFO Reserves: Illustrative Adjusting Entries (LO8-6)

  • Doubletree Corporation example (internal FIFO, external LIFO):

    • 2027 (first year): LIFO ending inventory = $110,000; FIFO ending = $120,000; LIFO reserve = $10,000

    • End-of-year adjusting entry (to convert to LIFO):

    • Debit Cost of Goods Sold $10,000; Credit LIFO Reserve $10,000

    • 2028: LIFO reserve increases to $30,000 (FIFO $160,000 vs LIFO $130,000)

    • Debit Cost of Goods Sold $20,000; Credit LIFO Reserve $20,000

    • 2029: LIFO reserve decreases to $25,000 (FIFO $175,000 vs LIFO $150,000)

    • Debit LIFO Reserve $5,000; Credit Cost of Goods Sold $5,000

  • Result on financial statements: LIFO reserve adjustments affect reported COGS and ending inventory

LIFO Reserve Disclosure (Caterpillar, Inc.)

  • Inventory reported at FIFO (internal) less the LIFO reserve to arrive at LIFO amount on the balance sheet

  • Inventories and LIFO reserve (illustrative figures in dollars, e.g., 2022 and 2021):

    • Inventories at FIFO: $19,591 (2022) / $16,637 (2021)

    • Less: LIFO reserve: $(3,321)$ (2022) / $(2,599)$ (2021)

    • Inventories at LIFO: $16,270$ (2022) / $14,038$ (2021)

LIFO Liquidations (LO8-6, LO8-5)

  • LIFO liquidation: when the number of units sold exceeds the number purchased in a period, causing old layers to be liquidated

  • Consequence: old, lower-cost layers may be matched with current selling prices, affecting net income depending on cost changes

  • Example (National Distributors):

    • Beginning inventory: 20,000 units @ $16

    • Purchases: 30,000 units @ $20

    • Goods available for sale: 50,000 units

    • Sold: 45,000 units

    • If no liquidation, COGS would be 45,000 × $20 = $900,000

    • LIFO liquidation effect (before tax) reduces COGS to $840,000, increasing gross profit by $60,000

Decision Makers’ Perspective—Inventory Management (LO8-7)

  • Objectives: maintain sufficient inventories to sustain operations while minimizing ordering and carrying costs

  • Conflicts: too much inventory raises costs; too little inventory can cause stockouts

  • Tools to balance: computerized inventory control systems, outsourcing, Just-in-Time (JIT)

Just-in-Time (JIT) System (LO8-7)

  • Raw materials and components arrive when needed to meet exact demand, minimizing high inventory balances

  • Example: Harley-Davidson uses JIT to coordinate production and minimize inventory while meeting custom-order demands

Key Ratios Used to Monitor Inventories (LO8-7)

  • Gross profit ratio (gross margin): extGrossprofitratio=racextGrossprofitextNetsalesext{Gross profit ratio} = rac{ ext{Gross profit}}{ ext{Net sales}}

    • Gross profit = Net sales − COGS

  • Inventory turnover ratio: measures how many times inventory is sold during a period
    extInventoryturnover=racextCostofgoodssoldextAverageinventoryext{Inventory turnover} = rac{ ext{Cost of goods sold}}{ ext{Average inventory}}

  • Higher ratios indicate more efficient inventory management; declining ratios may signal obsolescence or weak marketing/sales

Methods of Simplifying LIFO (LO8-8)

  • Limitations of LIFO: high recordkeeping costs when many distinct units or frequent cost changes

  • Techniques to simplify LIFO:

    • LIFO inventory pools

    • Dollar-value LIFO (DVL) method

LIFO Inventory Pools (LO8-8)

  • Group inventory units into pools based on physical similarities

  • Within pools, purchases are treated as if made at the same time and cost; unit costs within the pool are averaged

  • If ending inventory in a pool increases, ending inventory and beginning inventory adjust with a single layer added at the pool’s average cost

LIFO Inventory Pools: Diamond Lumber (LO8-8 to LO8-8)

  • Beginning inventory pool: Pine, Oak, Maple with quantities and costs

  • Beginning average cost for the pool = total cost / total units

  • Example result: average cost per board foot = $2.54; ending inventory computed by pool cost and ending quantity

Dollar-Value LIFO (DVL) (LO8-8)

  • Pools are defined by dollar value, not by physical units

  • Cost indexes track changes in inventory values over time

  • Cost flow is analyzed by layers created in different years

DVL Components and Process (LO8-8)

  • Cost indexes adjust ending inventory layers to current year costs

  • Steps:
    1) Convert ending inventory to base-year costs
    2) Identify layers of ending inventory created each year
    3) Restate each layer using the cost index in the year acquired

The DVL Inventory Estimation Technique (LO8-8)

  • Step 1: Ending inventory in base-year costs

    • Example: ending inventory base-year cost = $462,000; base-year cost index 1.05; ending inventory at DVL cost ≈ $462,000 ÷ 1.05 = $440,000

  • Step 2: Identify layers created each year (e.g., beginning layer, new layers from increases in quantity)

  • Step 3: Restate each layer using the year-specific cost index to produce ending inventory at DVL cost

  • Example result: layers restated to produce ending inventory at DVL cost; cumulative adjustments shown

LIFO Matters: Advantages of DVL and LIFO Pools

  • Dollar-value LIFO advantages:

    • Simplifies recordkeeping

    • Minimizes liquidation risk of LIFO layers

    • Replacements of old items are viewed as maintaining the dollar value of inventory

End of Chapter 8

  • Inventory measurement, cost flow assumptions, and reporting affect financial statements and tax considerations

  • The choice of method interacts with practical flow, reporting needs, and strategic objectives