Chapter

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Cost of Sales and Inventory

6

6-2

Inventory Issues

• What is inventory?

• What costs are included in inventory?

• How do we separate COGS from Ending Inventory?

6-3

Inventories Definition

Asset items held for sale in the ordinary course of business or goods that will be used or consumed in the production of goods to be sold

6-4

Supplies

Tangible items that will be consumed in the course of normal operations: e.g. office and janitorial supplies, lubricants,

repair parts

Not sold and not accounted for as part of cost of goods sold

6-5

Types of Companies

• Merchandising company:– Sells goods in same form as acquired

• Manufacturing company:– Converts raw material into finished goods

• Service company:– Provides intangible services

6-6

Merchandising Inventories

• Merchandising: Inventory costs (and COGS) = acquisition costs

6-7

Manufacturing Inventories

Manufacturing company converts raw materials and purchased parts into finished goods: 3 types of inventories:

Materials Work-in-process Finished goods

6-8

Service Inventories

Service organizations (hotels, beauty parlors, plumbers): May have materials inventories

6-9

Professional Service Inventories

Professional service firms (accounting firms, legal firms): Intangible inventory costs are costs incurred

for client but not yet billed called jobs-in-progress or unbilled costs

6-10

Merchandise companies

Inventories accounted for at cost: Cost includes cost of:

Acquiring merchandise (invoice cost of goods, freight-in)

Making goods ready for sale (unpacking and marking)

Adjust for: Returns and allowances Cash discounts from supplier

6-11

Methods of accounting for purchase discounts

Net of discount: Charge discounts not taken when paid

Record at invoice price: Record discount when taken

6-12

Relationship of Inventory and COGS

Beginning inventory + net purchases = goods available for sale

Goods available for sale = cost of goods sold + ending inventory

Equivalently: Beg. inventory + net purchases -ending inventory = cost of goods sold: Net purchases = gross purchases -purchase

returns and allowances + freight-in

6-13

Measurement Issue

• Dividing goods available for sale between COGS and End. Inventory

• Measurement of inventories and cost of sales are related:– Periodic inventory method– Perpetual inventory method

6-14

Periodic inventory method

Determine amount of ending inventory and deduce costs of goods sold: Count inventory (i.e., a physical inventory is

taken) at the end of the period Multiply count times cost for each item to

determine total amount of inventory: Beginning inventory of current period = ending

inventory of preceding period

6-15

Perpetual Inventory Method

Measure amount actually delivered to customers; deduce ending inventory

Perpetual inventory record is kept for each item in inventory Advantages of perpetual inventory method:

Detailed record is useful Built in check Identifies shrinkage by item Income statement can be prepared without taking a

physical inventory

6-16

Manufacturing Companies

Product costs or cost of goods sold = materials and parts used + conversion costs: Conversion costs = production labor +

overhead (other costs incurred in manufacturing)

6-17

3 Types of Manufacturing Inventory Accounts

Materials inventory or raw materials: Not yet used in production Adjusted for returns and freight-in

Work-in-process: Goods started but not yet finished Materials + conversion costs

Finished goods: Manufactured but not yet shipped. Materials + conversion costs

6-18

Professional service firms

E.g. law and accounting firms: Labor , overhead, and incidental product

costs but no materials cost Expensed in period billed (i.e., when revenues

are recognized)

6-19

Inventory Costing Methods

• Specific identification

• Average cost

• FIFO

• LIFO

6-20

Specific identification

Big ticket items Uniquely identified items:

May offer opportunity to manipulate costs

6-21

Average Cost

(Beginning inventory amount + purchases) / units available for sale = per unit inventory costs = per unit cost of goods sold: Periodic method:

Computed for the entire period

Perpetual method: A new unit cost can be calculated after each

purchase

6-22

First-in, first-out (FIFO)

Expenses costs of oldest purchases first Most recently purchased goods are in

inventory: Likely but not necessary to follow actual flow

of goods Ending inventory approximates current cost of

goods

6-23

Last-in, last-out (LIFO)

Assumes most recently purchased goods are sold first

Inventory based on costs of oldest purchases: Cost of goods sold usually does not reflect

physical flow Ending inventory may be costed at amounts

of years ago: Inventory may be well below current costs

6-24

Arguments for FIFO

Usually follows physical flow of goods If prices are based on oldest cost, results

in best matching More accurate balance sheet valuation Non-theoretical/practical argument:

Results in highest income during periods of rising prices

6-25

Arguments for LIFO

If prices are based on current costs, results in best matching of revenues and costs and therefore most useful income statement

Closest to reflecting current or replacement costs of goods sold: However, it is still historical costs and could

differ from current costs

6-26

Arguments for LIFO(continued)

During periods of price increases: Higher costs of goods sold Lower taxable income Lower income taxes Higher cash flows:

If LIFO for tax purposes than also financial reporting

6-27

Lower of Cost or Market (LCM)

Market price may be below cost due to: Physical deterioration Change in consumer tastes Technological obsolescence

LCM is a reflection of conservatism concept

Market is defined as replacement cost

6-28

Analysis of inventory

Inventory turnover = Cost of goods sold / Inventory: Average for period or ending inventory Measures efficiency of asset usage

Days’ inventory = Inventory / (Cost of goods sold 365)

Gross margin as % of sales Ratios differ by industry

Chapter

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

End of Chapter 6

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