Inventory

Inventory consists of products acquired for resale to customers.

Cost of Goods Sold

It is often the largest current asset of a firm. As inventory is sold, it becomes an EXPENSE, called Cost of goods sold.

Beginning Inventory

=
Total Cost of Goods Available for Sale

Cost of Goods Sold

Purchases

Ending Inventory

Cost of Goods Sold

Calculating Cost of goods sold: Umbrella example?

Cost of Goods Sold

Cost of goods sold can be calculated as follows (Note how you can flow units OR dollars):
units 0 100 100 30 70

You bought 100 umbrellas for $6 each and sold 70 of them for $10 each. How would you prepare the COGS statement?

COGS = 70 x $6 = 420 Inventory = 30 x $6 = 180

Beg. Inv. Purchases Goods available for sale End Inv. Cost of Goods sold

$ $ $ $ $

600 600 180 420

Cost of Goods Sold

Now assume you buy 50 more umbrellas, only this time they cost you $8 each. You sell 60 umbrellas. What is your cost of goods sold?

Cost Flow Assumptions

Which ones were sold? Follow a general rule- use a cost flow assumption.

Beg. Inv. Purchases Goods available for sale End Inv. Cost of Goods sold

$ $ $

180 400 580 ? ?

units 30 50 80 20 60

The cost flow assumption does not have to match the physical flow of the inventory!!!

Physical Flow
The physical flow of most types of goods is that the oldest goods are sold first.
Consider

Cost Flow Assumptions

A company assumes a cost flow for accounting purposes.

a grocery store's produce department. The same is true of staple goods even though they have longer shelf lives.

But consider a gravel pile for an example of a situation where the newest inventory is sold first.

FIFO Weighted Average

LIFO Specific Identification

Example
Our friend Noah sells umbrellas on street corners. Its been very dry, but believes LOTS of rain is on the way. He hires some buddies to sell umbrellas, tooand waits...

Assume the following history of purchases. In late July, it finally RAINS! 330 umbrellas are sold for $10 each.
Date BI (black) Purchases: 7/3-blue 7/10-green 7/17-red GAS EI Goods sold Umbrella Inventory Units $/Unit Total 60 $ 5.00 $ 300.00 100 150 100 410 330 5.50 6.00 7.00 550.00 900.00 700.00 $ 2,450.00

How many units are in ending inventory? Lets assign costs to EI and COGS under each of the 4 assumptions.
Date BI (black) Purchases: 7/3-blue 7/10-green 7/17-red GAS EI Goods sold

80!

Umbrella Inventory Units $/Unit Total 60 $ 5.00 $ 300.00 100 150 100 410 330 5.50 6.00 7.00 550.00 900.00 700.00 $ 2,450.00

Preparing this inventory reconciliation is the first step in inventory costing problems. GAS stands for goods available for sale. Note that the format is very similar to the cost of goods sold model. Your task is to assign total cost of goods available for sale to units sold (COGS) and End. Inv.
Date BI (black) Purchases: 7/3-blue 7/10-green 7/17-red GAS EI Goods sold Umbrella Inventory Units $/Unit Total 60 $ 5.00 $ 300.00 100 150 100 410 80 330 5.50 6.00 7.00 550.00 900.00 700.00 $ 2,450.00

Specific ID
This one is not really an assumption. Specific identification is generally used when a firm sells low-volume, high-cost items.

Specific Identification
We can track our umbrellas by color. Assume there are 10 black, 20 blue, 10 green, and 40 red ones left in inventory at the end of the year. Lets compute the cost of ending inventory first.

The firm maintains accounting records showing the cost of each inventory item, making it easy to determine what has been sold and what is still left on hand at the end of the accounting period.

Specific Identification

Specific Identification

Specific Identification
Ending Inventory Units $/Unit Total 10 5.00 $ 50 20 5.50 $ 110 10 6.00 $ 60 40 7.00 $ 280 $ 500
Cost of Goods Sold Units $/Unit Total 50 5.00 $ 250

Date BI

Ending Inventory Units $/Unit Total 10 5.00 $ 50.00

Cost of Goods Sold Date Units $/Unit Total

Date BI 7/3 7/10 7/17

Date BI 7/3 7/10 7/17 Sold

End. Inv.

80

Sold

330

The items in ending inventory are specifically identified by color in this example. Now- compute cost of goods sold Ive started. There were 60 umbrellas in Beg. Inv. If 10 are left- 50 were sold. You can finish the chart from there.

Specific Identification
Date BI 7/3 7/10 7/17 End. Inv. Ending Inventory Units $/Unit Total 10 5.00 $ 50 20 5.50 $ 110 10 6.00 $ 60 40 7.00 $ 280 80 $ 500
Date BI 7/3 7/10 7/17 Sold Cost of Goods Sold Units $/Unit Total 50 5.00 $ 250 80 5.50 $ 440 140 6.00 $ 840 60 7.00 $ 420 $ 330 $ 1,950

Average Cost
Another cost flow assumption is average cost (or weighted average).

An average cost of items is computed by dividing the number of units available for sale into the cost of goods available for sale. A simple average does not consider the volume of items at each cost level- the approach above does.

Note that EI + COGS = Cost of goods available for sale. After computing one (EI or COGS), a short cut is to subtract from Cost of GAS to get the other!

Weighted Average

Average Cost
Step 1: Compute the weighted average cost of one unit Step 2: Multiply that cost by the number of units in ending inventory or the number of units sold The schedule we built earlier is all set up to provide this information.

Average Cost
Step 1: $2,450/ 410 = $5.98/unit (rounded)
Date BI (black) Purchases: 7/3-blue 7/10-green 7/17-red GAS EI Goods sold Umbrella Inventory Units $/Unit Total 60 $ 5.00 $ 300.00 100 150 100 410 330 5.50 6.00 7.00 550.00 900.00 700.00 $ 2,450.00

Average Cost
Step 2: Multiply the average unit cost by the number of units!
Ending Inventory Units $/Unit Total

FIFO
Another cost flow assumption is first-in, firstout (or FIFO).

Date

Cost of Goods Sold Date Units $/Unit Total

It follows a common physical flow of goods in that it assumes that oldest goods on hand are the first sold. The beginning inventory and the earliest purchases are assumed to be sold first, thus being part of cost of goods sold, while the cost of the most recent purchases will be assigned to ending inventory.

End. Inv.

80

5.98 $ 478.40

Sold

330

5.98 $ 1,973.40

Round to $478...and $1,972

FIFO

FIFO

FIFO

Ending Inventory Units $/Unit Total $ $ $ $ End. Inv. 80 $ Date

Date

Cost of Goods Sold Units $/Unit Total $ -

Date 7/17

Ending Inventory Units $/Unit Total 80 7.00 $ 560 $ $ $ 80 $ 560

Date

Cost of Goods Sold Units $/Unit Total $ -

$ Sold

End. Inv.

Sold

330

Lets start with EI. How many units are you costing? 80 Are they the oldest or the newest? You ASSUME you sold the old ones- so the new ones are left. The 80 newest items are the $7 ones.

Now calculate cost of goods sold. How many units are you costing? Are they the oldest or the newest? (the 330 oldest items)

FIFO

LIFO
A final cost flow assumption is last-in, first-out (or LIFO).

Date 7/17

Ending Inventory Units $/Unit Total 80 7.00 $ 560 $ $ $ 80 $ 560

Date BI 7/3 7/10 7/17 Sold

End. Inv.

Cost of Goods Sold Units $/Unit Total 60 5.00 $ 300 100 5.50 $ 550 150 6.00 $ 900 20 7.00 $ 140 $ 330 $ 1,890

The most recent purchases are assumed to have been sold, thus being part of cost of goods sold, while the cost of the beginning inventory and the oldest purchases will be assigned to ending inventory.

Do the 2 totals add up to $2,450?

LIFO

LIFO

LIFO
Ending Inventory Units $/Unit Total 60 5.00 $ 300 20 5.50 $ 110 $ $ 80 $ 410
Cost of Goods Sold Units $/Unit Total $ -

Ending Inventory Date Units $/Unit Total $ $ $ $ End. Inv. 80 $

Date

Cost of Goods Sold Units $/Unit Total $ -

Date BI 7/3

Date

$ $ Sold -

End. Inv.

Sold

330

Lets start with EI. How many units are you costing? 80 Are they the oldest or the newest? Lifo assumes you sell the new ones- so the OLD ones are left in ending inventory.

The oldest ones are the $5 one. But there are only 60- so you need 20 of the next oldest items.

Now calculate COGS How many units are you costing? 330 Are they the oldest or the newest? Newest

LIFO

Heres a summary of the income statements.

Assume the 330 Umbrellas sell For $10 each
For Month ended July 31 Specific Weighted Ident. Average Noah Moe $ 3,300 $ 3,300 $ $ $ $ $ $ 300 2,150 2,450 500 1,950 1,350 120 1,230 369 861 $ $ $ $ $ $ 300 2,150 2,450 478 1,972 1,328 120 1,208 362 846

Date BI 7/3

Ending Inventory Units $/Unit Total 60 5.00 $ 300 20 5.50 $ 110 $ $ 80 $ 410

Date 7/17 7/10 7/3

Cost of Goods Sold Units $/Unit Total 100 7.00 $ 700 150 6.00 $ 900 80 5.50 $ 440 $ $ 2,040

End. Inv.

Sold

330

Do the 2 totals add up to $2,450?

Net sales Cost of goods sold: BI Net purchases Goods available for sale EI Cost of goods sold Gross margin Operating expenses: Income before taxes Taxes expense (30%) Net income

FIFO Larry $ 3,300 $ $ $ $ $ $ 300 2,150 2,450 560 1,890 1,410 120 1,290 387 903

LIFO Curly $ 3,300 $ $ $ $ $ $ 300 2,150 2,450 410 2,040 1,260 120 1,140 342 798

Heres a summary of the income statements.

For Month ended July 31 Specific Weighted Ident. Average Noah Moe $ 3,300 $ 3,300 300 2,150 2,450 500 1,950 1,350 120 1,230 369 861 $ $ $ $ $ $ 300 2,150 2,450 478 1,972 1,328 120 1,208 362 846

Heres a summary of the income statements.

For Month ended July 31 Specific Weighted Ident. Average Noah Moe $ 3,300 $ 3,300 $ $ $ $ $ $ 300 2,150 2,450 500 1,950 1,350 120 1,230 369 861 $ $ $ $ $ $ 300 2,150 2,450 478 1,972 1,328 120 1,208 362 846

Net sales Cost of goods sold: BI $ Assume they each Net purchases Pay $120 for a license Goods available for sale $ And have a 30% EI Tax rate. Cost of goods sold $ Gross margin $ Operating expenses: Income before taxes $ Taxes expense (30%) Net income $

FIFO Larry $ 3,300 $ $ $ $ $ $ 300 2,150 2,450 560 1,890 1,410 120 1,290 387 903

LIFO Curly $ 3,300 $ $ $ $ $ $ 300 2,150 2,450 410 2,040 1,260 120 1,140 342 798

Net sales Cost of goods sold: BI Net purchases Goods available for sale EI Cost of goods sold Gross margin Operating expenses: EI and COGS Income before taxes come from Taxes expense (30%) schedules Netthe income

FIFO Larry $ 3,300 $ $ $ $ $ $ 300 2,150 2,450 560 1,890 1,410 120 1,290 387 903

LIFO Curly $ 3,300 $ $ $ $ $ $ 300 2,150 2,450 410 2,040 1,260 120 1,140 342 798

we built earlier

Heres a summary of the income statements.

For Month ended July 31 Specific Weighted Ident. Average Noah Moe $ 3,300 $ 3,300 $ $ $ $ $ $ 300 2,150 2,450 500 1,950 1,350 120 1,230 369 861 $ $ $ $ $ $ 300 2,150 2,450 478 1,972 1,328 120 1,208 362 846

Heres a summary of the income statements.

For Month ended July 31 Specific Weighted Ident. Average Noah Moe $ 3,300 $ 3,300 $ $ $ $ $ $ 300 2,150 2,450 500 1,950 1,350 120 1,230 369 861 $ $ $ $ $ $ 300 2,150 2,450 478 1,972 1,328 120 1,208 362 846

Net sales FIFO yields Cost of goods sold: The highest BI Net incomeNet purchases Why? Goods available for sale EI Cost of goods sold Gross margin Operating expenses: Income before taxes Taxes expense (30%) Net income

FIFO Larry $ 3,300 $ $ $ $ $ $ 300 2,150 2,450 560 1,890 1,410 120 1,290 387 903

LIFO Curly $ 3,300 $ $ $ $ $ $ 300 2,150 2,450 410 2,040 1,260 120 1,140 342 798

Net sales LIFO yields Cost ofThe goods sold: lowest BI Net incomeNet purchases Why? Goods available for sale EI Cost of goods sold Gross margin Operating expenses: Income before taxes Taxes expense (30%) Net income

FIFO Larry $ 3,300 $ $ $ $ $ $ 300 2,150 2,450 560 1,890 1,410 120 1,290 387 903

LIFO Curly $ 3,300 $ $ $ $ $ $ 300 2,150 2,450 410 2,040 1,260 120 1,140 342 798

Choice of Inventory Method

Which brother has the most cash?

Cash Flow
For Month ended July 31 Specific Weighted Ident. Average Noah Moe 1,000 1,000 Cash (assumed at 7/1) (2,150) (2,150) Cash paid for purchases 3,300 3,300 Collections from sales (120) (120) Other (payment for license 2,030 2,030 Cash before taxes (369) (362) Taxes 1,661 1,668 Cash at 7/31

FIFO Larry 1,000 (2,150) 3,300 (120) 2,030 (387) 1,643

LIFO Curly 1,000 (2,150) 3,300 (120) 2,030 (342) 1,688

Choice of Inventory Method

Taxes

Perpetual versus periodic

The periodic method makes an assumption that all sales occur at the end of the period- so only one calculation of Cost of good sold is necessary. The perpetual method requires that you do an inventory costing schedule and calculation every time there is a sale. It is much more calculation intensive. In the Noah example, all of the umbrellas were sold at the end of the accounting period. So you would get the same result under periodic or perpetual method. Our examples will all have all of the sales at the end of the accounting period as a simplification.

With respect to taxes, LIFO gives the lowest taxable income, thus increasing a firm's cash flow. FIFO will give the highest taxable income, and because of taxes, the lowest cash flow.

LIFO conformity rule.

If a company chooses to use LIFO for tax purposes, it must also use LIFO for financial reporting purposes.

Choice of Inventory Method

Taxes

Quality of Financial Statement Information

There is usually a trade-off in the quality of financial statement information between the income statement and the balance sheet.

With respect to taxes, LIFO gives the lowest taxable income, thus increasing a firm's cash flow. If a firm uses LIFO for tax purposes, then it must be used for financial reporting. FIFO will give the highest taxable income, and because of taxes, the lowest cash flow.

LIFO has a more accurate COGS (IS) FIFO has a more accurate cost of inventory (BS)

A company provides detail on its inventory method in the footnotes to the statements.

Lower of Cost or Market

An application of the conservatism principle

Lower of Cost or Market

Assume your business has 30 widgets in ending inventory with a cost of $7 30 x $7 = $210. Assume at 1/31, widgets could be purchased for $6. What adjustment is needed?
Assets Inventory Bal. B4 Adj. Adj. Bal. After Adj. 210 (30) 180 (30) Loss = Liabilities + Equity

Inventory is valued using a cost flow assumption as above Then if necessary, it is written down to market Market is defined as replacement cost Replacement cost is subject to lower and upper bounds in U.S. GAAP, but we will simplify and just use replacement cost in our examples.

Lower of Cost or Market

Assume your business has 30 widgets in ending inventory with a cost of $7 30 x $7 = $210. Assume at 1/31, widgets could be purchased for $8. What adjustment is needed? Market is $240, Cost is $210
Assets Inventory Bal. B4 Adj. Adj. Bal. After Adj. 210 0 210 0 = Liabilities + Equity