What Is Inventory?
Chapter 6
¾Inventory is a current asset
¾Items normally sold within a year or a
company’s operating cycle
Inventories
Manufacturing Businesses
(Cisco or Hewlett Packard)
Inventory consists of:
9 Raw materials or goods used in
production of products
9 Work in process or partially
completed products
9 Finished goods ready for sale
Skyline College
Lecture Notes
Merchandising Businesses
(Walgreens or Costco)
Inventory consists of goods held for
sale in regular course of business
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Accounting for Inventories
6–2
Inventory Decisions
9Inventory processing systems
9Costing methods
9Valuation methods
Result in different amounts of reported
net income, taxes paid, and cash flows
Impact internal
evaluations like
performance reviews
and bonuses
Impact external
evaluation of
company by investors
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6–3
Determining Inventory Levels
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6–4
Inventory Turnover
Measurement of the number of times a company’s average
inventory is sold during an accounting period
Keep large quantities
and selections of
inventory?
9 Costs of handling and
storage are high
9 Customers will be
satisfied with quick
order fulfillment and
large selections
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Keep low quantities
of inventory?
Cost of Goods Sold
Inventory Turnover =
9 Lower storage costs
9 May result in lost sales
or dissatisfied
customers
Average Inventory
Cisco’s Inventory
Turnover
=
$5,766 m
($1,207 m + $873 m) ÷ 2
=
6–5
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5.5 times
6–6
1
Inventory Turnover for Selected
Industries
Days’ Inventory On Hand
Indicates the average number of days required
to sell the inventory on hand
Number of Days in a Year
Days’ Inventory on Hand =
Inventory Turnover
Cisco’s Days’ Inventory
on Hand
=
=
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6–7
Days’ Inventory on Hand for Selected
Industries
365 days
5.5 times
66.4 days
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6–8
Supply Chain Management
9Computerized system that a company uses to
order and track inventory
9A just-in-time (JIT) operating environment
helps reduce inventory levels by coordinating
orders
d andd shipments
hi
t off products
d t so that
th t they
th
arrive “just in time” for customer orders
Using these procedures and processes mean
that less money is tied up in carrying
inventory
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6–9
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How Do Inventory Mistakes Affect
Income?
If ending
inventory is
overstated…
Cost of goods
sold is
understated
Income before
income taxes is
overstated
If ending
inventory is
understated…
Cost of goods
sold is
overstated
Income before
income taxes is
understated
Inventory Errors: Examples
Column 1
Ending Inventory
Correctly Stated
Net Sales
Beg. Inv.
Net cost of
purchases
h
Cost of goods
available for sale
End. Inv.
Cost of Goods Sold
Important: Errors not only affect the current year, but also the following year.
(An overstatement of ending inventory in year 1 will cause an overstatement in
beginning inventory in year 2, resulting in an understatement of income in year
2.)
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6–10
6–11
Gross margin
Operating expenses
Income before
income taxes
Column 2
Ending Inventory
Overstated
$100,000
Column 3
Ending Inventory
Understated
$100,000
$100,000
58,000
$12,000
58,000
$12,000
58,000
$70,000
$70,000
$70,000
$12,000
16,000
10,000
4,000
60,000
54,000
66,000
$ 40,000
$ 46,000
$ 34,000
32,000
32,000
32,000
$ 8,000
$ 14,000
$ 2,000
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6–12
2
Inventory Cost
Merchandise in Transit
Inventory cost includes:
9 Invoice price less purchases discounts
9 Freight-in, including insurance in transit
9 Applicable taxes and tariffs
Inventory costing and
valuation methods
really depend on the
flow of costs rather
than the flow of
physical inventory
Goods flow—movement of
goods in operations
versus
Cost flow—association of cost
with its assumed flow in
operations
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6–13
Lower-of-Cost-or-Market Rule
6–14
Disclosure of Inventory Methods
9Cost is usually the most appropriate basis for
the valuation of inventory.
BUT
9The lower-of-cost-or-market (LCM) rule
requires that when the replacement cost of
inventory falls below historical cost, the
inventory is written down to the lower value
and a loss is recorded.
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6–15
Inventory Costing Methods
Cisco Annual Report
Inventories Inventories are stated at the lower of cost or
market. Cost is computed…on a first-in, first-out basis. The
company provides allowances on excess and obsolete
inventories.
Users should pay attention to the inventory disclosures in
the notes to the financial statements. If Cisco holds
inventory too long, the items can become out of date and
lose value.
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6–16
Specific Identification Method
Units in the ending inventory are identified as coming from specific purchases
Inventory cost is determined using one of the
following generally accepted methods, each based on a
different assumption of cost flow:
Inventory Data
June 1
Inventory
June 6
Purchase
June 25 Purchase
Goods available for sale
Sales
On hand June 30
1. Specific identification method
2. Average-cost method
Specific Identification Method
50 units @ $10.00
$ 500 Cost of goods avail. for sale
1,250 Less June 30 inventory
100 units @ $12.50
980 Cost of goods sold
70 units @ $14.00
220 units at cost of
$2,730
3. First-in, first-out (FIFO) method
4. Last-in, first-out (LIFO) method
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80 units @ $10.00 $ 800
220 units @ $12.50 2,750
200 units @ $14.00 2,800
500 units
$6,350
280 units
220 units
6–17
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$6,350
2,730
$3,620
6–18
3
Periodic Average-Cost Method
Periodic First-In, First-Out (FIFO)
Inventory Data
Inventory is priced
at the average cost
of the goods
available for sale
during the period
June 1
Inventory
June 6
Purchase
June 25 Purchase
Goods available for sale
Sales
On hand June 30
80 units @ $10.00
220 units @ $12.50
200 units @ $14.00
500 units
280 units
220 units
$ 800
2,750
2,800
$6,350
Cost of Goods Available for Sale ÷ Units Available for Sale = Average Unit Cost
$6,350 ÷ 500 units
Ending Inventory = 220 units @ $12.70
Cost of goods avail. for sale
Less June 30 inventory
Cost of goods sold
Inventory Data
June 1
Inventory
June 6
Purchase
June 25 Purchase
Goods available for sale
Sales
On hand June 30
80 units @ $10.00
220 units @ $12.50
200 units @ $14.00
500 units
280 units
220 units
First-In, First-Out (FIFO) Method
200 units @ $14.00 from purchase of June 25
20 units @ $12.50 from purchase of June 20
220 units at a cost of
= $12.70
= $2,794
$6,350
2,794
$3,556
Cost of goods avail. for sale
Less June 30 inventory
Cost of goods sold
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6–19
Periodic Last-In, First-Out (LIFO)
Ending inventory
is priced using the
earliest purchases
Assumes that the
first units
purchased will be
the first units sold;
Ending inventory
is priced using the
most recent
purchases
$ 800
2,750
2,800
$6,350
$2,800
250
$3,050
$6,350
3,050
$3,300
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6–20
Impact of Inventory Methods
Inventory Data
June 1
Inventory
June 6
Purchase
June 25 Purchase
Goods available for sale
Sales
On hand June 30
80 units @ $10.00
220 units @ $12.50
200 units @ $14.00
500 units
280 units
220 units
Last-In, First-Out (LIFO) Method
80 units @ $10.00 from June 1 inventory
140 units @ $12.50 from purchase of June 6
220 units at a cost of
Cost of goods avail. for sale
Less June 30 inventory
Cost of goods sold
$ 800
2,750
2,800
$6,350
$ 800
1,750
$2,550
$6,350
2,550
$3,800
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6–21
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6–22
Discussion: Ethics on the Job
Impact to Gross Margin
Rite Aid Corporation, a large drugstore
chain, falsified income by manipulating its
computerized inventory system to cover
losses from shoplifting, employee theft, and
spoilage.
il
June Example: Period of Rising Inventory Purchase Prices
Specific
Identification
Method
Sales
Cost of goods sold
Beg. inventory
Q. To increase income, what manipulation of
inventory amounts would have been
necessary?
Purchases
Cost of goods
avail. for sale
Less end. inv.
COGS
Gross margin
Average-Cost
Method
First-In, First-Out Last-In, First-Out
(FIFO) Method
(LIFO) Method
$5,000
$5,000
$5,000
$5,000
$800
5,550
$800
5,550
$800
5,550
$800
5,550
$6,350
2,730
$6,350
2,794
$6,350
3,050
$6,350
2,550
$3,620
$3,556
$3,300
$3,800
$1,380
$1,444
$1,700
$1,200
In times of declining prices: FIFO results in lowest
gross margin, LIFO results in highest gross margin.
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6–23
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Highest
gross
margin
Lowest
gross
margin
6–24
4
Which Costing Methods Are Used
Most Frequently?
LIFO Method
9Best suited for the income statement because
it matches revenues and cost of goods sold
9Not the best measure of the current balance
sheet value of inventory,
y, particularly
p
y during
ga
prolonged period of price increases and
decreases
9Used for durable goods in times of rising
prices—pay less income tax
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6–25
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Average Cost
6–26
FIFO Method
9Used for low-cost durable goods
9Blends old prices with new prices so levels
out the effects of cost increases and decreases
9Best suited to the balance sheet
because the ending inventory is closest
to current values
9Does not p
provide as ggood a matching
g
of current costs and revenues for
income statement purposes
9Used for perishable goods and durable
goods in times of declining prices
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6–27
Inventory and Income Taxes
6–28
Perpetual versus Periodic Systems
Perpetual
9Method chosen must be used consistently
from year to year (may change with IRS
approval if there is a good reason,
exception—a change from LIFO)
Periodic
9 Continuous record of quantities 9 Only ending inventory is
counted and priced
& costs is maintained as
9 Cost of goods sold is
purchases and sales are made
determined by deducting the
9 Cost of goods sold is
cost of the ending inventory
accumulated as sales are made;
f
from
the
th costt off goods
d
costs are transferred from the
available for sale
Merchandise Inventory account
to the Cost of Goods Sold
account
9 Cost of ending inventory is the
balance of the Merchandise
Inventory account
9If a company uses LIFO for tax purposes,
the IRS requires the same method for
financial reporting
9IRS will not allow lower-of-cost-or-market
(LCM) inventory valuation if LIFO is used
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6–29
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6–30
5
FIFO Under the
Perpetual Inventory System: Example
LIFO Under the
Perpetual Inventory System: Example
Keep track of inventory costs and amounts in date order
Keep track of inventory costs and amounts in date order
Inventory Data
June 1
Inventory
June 6
Purchase
June 10
Sale
June 10
June 25
June 25
Balance
Purchase
Inventory
80 units
220 units
80 units
200 units
20 units
200 units
20 units
200 units
@ $10.00
@ $12.50
@ $10.00
@ $12.50
@ $12.50
@ $14.00
@ $12.50
@ $14.00
$ 800
2,750
($ 800)
(2,500)
$250
2,800
Cost of goods sold
Inventory Data
June 1
Inventory
June 6
Purchase
June 10
Sale
(3,300)
$ 250
2,800
June 10
June 25
June 25
$3,050
$3,300
Cost of goods sold
Cost of goods sold is the total of sales on June 10
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Balance
Purchase
Inventory
80 units
220 units
220 units
60 units
20 units
200 units
20 units
200 units
@ $10.00
@ $12.50
@ $12.50
$12 50
@ $10.00
@ $10.00
@ $14.00
@ $10.00
@ $14.00
$ 800
2,750
($2,750)
($2
750)
(600)
$200
$2,800
(3,350)
$ 200
2,800
$3,000
$3,350
Cost of goods sold is the total of sales on June 10
6–31
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Impact of Cost Flow Assumptions
Under a Perpetual Inventory System
6–32
Retail Method for Estimating
Ending Inventory
9Uses the ratio of cost to retail price to estimate
ending inventory
9Can be used instead of actually determining the
cost of items in inventory
9Retail products can be scanned at their retail
price and cost calculated through the use of ratios
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6–33
Records must show:
9 Beginning inventory at cost and at retail
9 Amount of goods purchased during period at cost and at retail
Freight-in
Goods available for sale
Ratio of cost to retail price: $150,000 = 75%
$200,000
Net sales during the period
Estimated ending inventory at retail
Ratio of cost to retail
Estimated cost of ending inventory
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6–34
Gross Profit Method for Estimating
Ending Inventory
Retail Method
Net purchases for the period (excluding freight-in)
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107,000
It is a useful way of estimating the amount of
inventory lost or destroyed (ie theft, fire, etc)
145,000
3,000
$150 000 $200,000
$150,000
$200 000
160,000
$40,000
75%
$30,000
6–35
Step 1
Figure the cost of goods available for sale add
h
tto beginning
b i i inventory
i
t
purchases
Step 2
Estimate the cost of goods sold by deducting the
estimated gross margin from sales
Step 3
Deduct the estimated cost of goods sold from
the cost of goods available for sale to arrive at
the estimated cost of ending inventory
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6–36
6