Chapter 7

Inventory

Albrecht, Stice, Stice, Swain

COPYRIGHT 2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Types of Inventory
Raw materials
Materials purchased for use in manufacturing process.

Work in process
Partially completed units in production.

Finished goods
Manufactured products ready for sale.

Cost of goods sold

Costs incurred to purchase or manufacture the merchandise sold during the period.
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Costs Included in Inventory

What costs are included in inventory?
Raw materials Labor costs Manufacturing overhead
The indirect manufacturing costs associated with producing inventory.

Freight in costs

Who Owns the Inventory?

When goods are in transit?
Q: Who owns inventory on a truck or railroad car? A: The party who is paying the shipping costs.

When goods are on consignment?

Q: Who owns inventory stocked in a warehouse? A: The supplier until the inventory is sold. The warehouse owner stocks and sells the inventory and receives a commission on sales as payment for services rendered.
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Perpetual vs. Periodic Systems

Perpetual inventory system
Detailed records of the number of units and the cost of each purchase and sale are prepared THROUGHOUT the period.

Periodic inventory system

System of accounting where cost of goods sold is determined and inventory is adjusted at the END of the accounting period, not when merchandise is purchased or sold.
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Perpetual vs. Periodic Method

Inventory is purchased: Inventory 500 Accounts Payable 500 Transportation costs: Inventory 10 Cash 10 Purchase returns: Accounts Payable 50 Inventory 50 Purchase discounts: Account Payable 450 Inventory 9 Cash 441 Inventory is purchased: Purchases 500 Accounts Payable 500 Transportation costs: Freight In 10 Cash 10 Purchase returns: Accounts Payable 50 Purchase Returns 50 Purchase discounts: Accounts Payable 450 Purchase Discounts 9 Cash 441
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Perpetual vs. Periodic Method

When inventory is sold: Accounts Receivable 50 Sales 50 Cost of Goods Sold 30 Inventory 30
Closing Entry: None

When inventory is sold: Accounts Receivable 50 Sales 50 No inventory entry at time of sale Closing Entries: Inventory 451 Purchase Returns 50 Purchase Discounts 9 Freight In 10 Purchases 500 Cost of Goods Sold 30 Inventory 30 7

Inventory Counts
Inventory counts
Necessary under both the periodic and the perpetual method. With a periodic system, a physical count is the only way to get the information necessary to compute cost of goods sold. Under perpetual method, physical counts allow companies to determine inventory shrinkage.
Shrinkage equals the difference between what ending inventory should be what the count reveals it is.
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Cost of Goods Sold Computations

Periodic Method
Beginning Inventory + Net Purchases = Cost of Goods Available for Sale Ending Inventory = Cost of Good Sold

Perpetual Method
Ending Inventory (from inventory system) Ending Inventory (from inventory count) = Inventory Shrinkage + Cost of Goods Sold (from inventory system) = Total Cost of Goods Sold

Inventory Cost Flow Assumptions

FIFO (first in, first out)
Oldest units sold first.

LIFO (last in, last out)

Newest units sold first.

Average Cost
Average cost per unit is calculated by taking the average cost of goods available for sale.

Specific Identification
Each item is specifically identified. Usually used for large or expensive items (cars).
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Inventory Cost Flow

Rice King buys and sells rice and had the following transactions for the year:
June 10 Purchased 10 tons at $6 per ton. July 28 Purchased 10 tons at $9 per ton. October 10 Sold 10 tons at $11 per ton.

How much did Rice King make during the year?

FIFO
Sold Old Rice
LIFO Sold New Rice Avg. Cost Sold Mixed Rice

Sales ($11 x 10 tons) COGS (10 tons) Gross margin

$110 60 $ 50

$110 90 $ 20

$110 75 $ 35
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LIFO vs. FIFO

LIFO gives a better FIFO gives a better reflection of COGS on measure of inventory the income statement. on the balance sheet.
Therefore, LIFO is a better measure of net income. Therefore, FIFO is a better measure of inventory value.

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Managing Inventory
Its a balance! Avoid tying up resources in inventory.
Vs.

Maintaining sufficient inventory for smooth business operations.

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Measuring the Management of Inventory

Inventory Turnover
How many times during the year a company sells all of its inventory.
Cost of Goods Sold Average Inventory

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Measuring the Management of Inventory

Number of Days Sales in Inventory
How many days worth of sales the company has in inventory.
365 Inventory Turnover
Calculated as cost of goods sold divided by average inventory. (Shown in 15 previous slide).

Managing the Operating Cycle

Number of Days Purchases in Accounts Payable
How many days worth of inventory the company has in accounts payable. 365 Purchases / Average Account Payable
38 Days Days Sales in Inventory 72 Days Average Collection Period

30 Days
Days Purchases in Accounts Payable

80 Days
External Financing
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Inventory Errors
Inventory errors
Beginning inventory Purchases Ending inventory

Affects
Cost of goods sold Gross margin Net income
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Inventory Errors
Understate Ending Inventory Sales OK
Understate Purchases

Understate Beginning Inventory OK

LOW OK LOW OK LOW

Understate Sales

OK
OK LOW LOW OK LOW

LOW
OK OK OK OK OK

Beginning inventory OK Net purchases OK Goods available OK Ending inventory LOW Cost of goods sold HIGH

Gross margin Expenses Net income

LOW OK LOW

HIGH OK HIGH

HIGH OK HIGH

LOW OK LOW
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Perpetual LIFO and Average Cost

Complications arise because the last in and average cost change with every new purchase.
The cost of goods sold for each sale needs to be recomputed after a new purchase is made. This means a lot more work.

These complications do not occur with FIFO because the first in will always be the same.
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Net Realizable Value

Net Realizable Value
Selling price less selling costs. Used to value inventory when it is damaged, used, or obsolete.
When inventory needs to be written down:

Loss on Write-down of Inventory . . . . . . Inventory . . . . . . . . . . . . . . . . . . . . . . .

200
200

To write down of inventory to its net realizable value.

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Lower of Cost or Market

Lower of cost or market
A basis for valuing inventory at the lower of original cost or current market value.

Determining market value

Ceiling
Maximum amount (net realizable value).

Replacement Cost
What inventory could currently be purchased for.

Floor
Minimum amount (net realizable value minus a normal profit).

Market value is the middle of these three values.

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Example: LCM
Inventory NRV Item Cost Floor Ceiling A 34 20 30 B 42 32 46 C 52 44 62 D 38 50 68 Define market value as: Replacement cost, if it falls between the ceiling and the floor. The floor, if the replacement cost is less than the floor. The ceiling, if the replacement cost is higher than the ceiling. When replacement cost, ceiling, and floor are compared, market is always the middle value. Market Replacement Cost 32 36 42 32

Compare the defined market value with the original cost and choose the lower amount.

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Using LCM
LCM can be applied in three ways.
By computing cost and market figures for each item of inventory and using the lower of the two figures in EACH case. By computing cost and market figures for the total inventory and then applying the LCM rule to that TOTAL. By applying the LCM rule to categories of inventory.
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Gross Margin Method

Gross Margin Method
Used when a physical count of inventory is impossible or impractical. Cost of goods sold and ending inventory are estimated using available information:
Beginning inventory. Purchases. Historical gross margin percentage.

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Gross Margin Method Example

Orem Industries has net sales for January 1 to March 31 of $100,000 and net purchases of $65,000. Inventory on January 1 was $15,000 and the company has a historic gross profit percentage of 40%.
Net sales revenue Cost of goods sold: Beginning inventory Purchases Total available for sale Ending Inventory (3) Cost of goods sold (2) Gross margin (1) (1) $100,000 X .40

Dollars $100,000
$15,000 65,000 $80,000 20,000 60,000 $ 40,000

% of sales 100%

60% 40%

(2) $100,000 - $40,000

25 (3) $80,000 - $40,000