CHAPTER 6

INVENTORY AND COST OF GOODS SOLD

UNDERSTANDING INVENTORY AND COST OF GOODS SOLD

Inventory: Items a company intends for sale to customers

Inventory is reported as a current asset on the balance sheet because it

is a valuable resource that the company expects to convert to cash in
less than one year.

Ending Inventory: The amount a company reports as inventory on the balance

sheet at the end of a period, which represents the cost of the
inventory the company has not yet sold often the largest asset on the balance sheet

Cost of Goods Sold: The amount a company reports on the income statement as
the cost of inventory sold during a period often the largest expense on the income
statement.

Merchandising Companies vs. Manufacturing Companies

Merchandising Companies: purchase inventories that are primarily in finished

form for resale to customers
 These companies may assemble, sort, repackage, redistribute, store, refrigerate,
deliver, or install the inventory, but they do not manufacture it.

Typically Wholesalers or Retailers

Wholesalers – resell inventory to retail companies or to professional users

Retailers – purchase inventory from manufacturers or wholesalers and then sell

this inventory to end users

Manufacturing Companies: manufacture the inventories they sell, rather than

buying them in finished form from suppliers

- Manufacturing companies buy the inputs for the products they manufacture.

- Thus, inventory is classified into 3 categories:

1. Raw materials – the cost of components that will become part of the finished
product but have not yet been used in production

2. Work-in-process – products that have been started in the production process but
are not yet complete at the end of the period

3. Finished goods – items for which the manufacturing process is complete

MULTI-STEP INCOME STATEMENT

A muli-step income statement reports multiple levels of income (or profit).

- Shows revenues and expenses that arise from different types of activities

- Investors and creditors are better able to determine the source of a company’s
profitability; this often enables a better prediction of future profitability
Gross Profit

- Inventory transactions are typically the most important activities of a

merchandising company, and therefore the revenues and expenses related to those
inventory transactions are reported in the top section of the multi-step income
statement

 Gross Profit = Net Revenues - Cost of Goods Sold

- Gross Profit provides a key measure of profitability for the company’s primary
business activities

Operating Income After gross profit, the next item reported on a multi-step
income statement are Selling, General, and Administrative Expenses (often
referred to as Operating Expenses)
- Examples include advertising, salaries, rent, utilities, supplies, and depreciation

Operating Income = Gross Profit - operating Expenses

Operating Income measures profitability from normal operations, a key

performance measure for predicting the future profit-generating ability of the
company.

Income before Income Taxes

After operating income, a company reports non-operating income and expenses

(often referred to as Other Income and Expenses)

- Non-operating income and expenses arise from activities that are not part of the
company’s primary operations

- Examples of non-operating income include gains on sale of long-term assets

(such as investments, land, equipment, and buildings), dividend income, and
interest income

- Examples of non-operating expenses include losses on sale of long-term assets

and interest expense

- Investors focus less on non-operating income and expenses because non-

operating activities often do not have long-term implications on the company’s
profitability

Income Before Income Taxes = operating Income + Other Income - Other

Expense

Net Income

- Next, a company subtracts income tax expense to end its bottom-line net income

- Income tax expense is reported separately because it represents a significant

expense

- Net Income = Income before Income Taxes - Income Tax Expense

INVENTORY COST METHODS

Four Methods of Inventory Costing:

1. Specific Identification

2. First-In, First-Out (FIFO)

3. Last-In, First-Out (LIFO) called cost flow Assumptions

4. Weighted-Average Cost

1. Specific Identification – identifies each unit of inventory with its actual cost

- Used primarily by companies with unique, expensive products with low sales
volume (due to cost-benefit constraints)

- Examples include automobiles, airplanes, large ships, fine jewelry

2. First-In, First-Out (FIFO) – assumes that the first units purchased (first in) are
the first ones sold (first out)

- Assumes that beginning inventory is sold first, followed by the inventory from
the first purchase during the year, followed by the inventory from the second
purchase of the year, and so on

- Companies are allowed to report inventory costs by assuming which units of

inventory are sold and not sold, even if this does not match the actual low.

3. Last-In, First-Out (LIFO) – assumes that the last units purchased (last in) are
the first ones sold (first out)

- Nearly all companies sell their actual inventory in a FIFO manner, but they are
allowed to report it as if they sold it in a LIFO manner

4. Weighted-Average Cost – assumes that both cost of goods sold and ending
inventory consist of a random mixture of all the goods available for sale.

- Weighted-Average Cost = Cost of Goods Available for Sale / # of Units

Available for Sale
 Example: Use the following information to calculate the value of inventory on
hand on Mar 31 and cost of goods sold during March in FIFO periodic inventory
system and under FIFO perpetual inventory system.

Mar 1 Beginning Inventory 68 units @ $15.00 per unit

5 Purchase 140 units @ $15.50 per unit
9 Sale 94 units @ $19.00 per unit
11 Purchase 40 units @ $16.00 per unit
16 Purchase 78 units @ $16.50 per unit
20 Sale 116 units @ $19.50 per unit
29 Sale 62 units @ $21.00 per unit
Solution

FIFO Periodic

Units Available for Sale = 68 + 140 + 40 + 78 = 326

Units Sold = 94 + 116 + 62 = 272
Units in Ending Inventory = 326 − 272 = 54

Cost of Goods Sold Units Unit Cost Total

Sales From Mar 1 Inventory 68 $15.00 $1,020
Sales From Mar 5 Purchase 140 $15.50 $2,170
Sales From Mar 11 Purchase 40 $16.00 $640
Sales From Mar 16 Purchase 24 $16.50 $396
272 $4,226

Ending Inventory Units Unit Cost Total

Inventory From Mar 16 Purchase 54 $16.50 $891

FIFO Perpetual

Purchases Sales Balance

Date Unit Unit Unit
Units Total Units Total Units Total
Cost Cost Cost
Mar 1 68 $15.00 $1,020
5 140 $15.50 $2,170 68 $15.00 $1,020
140 $15.50 $2,170
9 68 $15.00 $1,020 114 $15.50 $1,767
 26 $15.50 $403
11 40 $16.00 $640 114 $15.50 $1,767
40 $16.00 $640
16 78 $16.50 $1,287 114 $15.50 $1,767
40 $16.00 $640
78 $16.50 $1,287
20 114 $15.50 $1,767 38 $16.00 $608
2 $16.00 $32 78 $16.50 $1,287
29 38 $16.00 $608 54 $16.50 $891
Ending
24 $16.50 $396
Inventory

Example

Use LIFO on the following information to calculate the value of ending inventory
and the cost of goods sold of March.

Mar 1 Beginning Inventory 60 units @ $15.00

5 Purchase 140 units @ $15.50
14 Sale 190 units @ $19.00
27 Purchase 70 units @ $16.00
29 Sale 30 units @ $19.50
Solution

LIFO Periodic

Units Available for Sale = 60 + 140 + 70 = 270

Units Sold = 190 + 30 = 220
Units in Ending Inventory = 270 − 220 = 50

Cost of Goods Sold Units Unit Cost Total

Sales From Mar 27 Inventory 70 $16.00 $1,120
Sales From Mar 5 Purchase 140 $15.50 $2,170
Sales From Mar 1 Purchase 10 $15.00 $150
220 $3440

Ending Inventory Units Unit Cost Total

Inventory From Mar 27 Purchase 50 $15.00 $750

LIFO Perpetual

Purchases Sales Balance

Date Unit Unit Unit Unit Unit Unit
Total Total Total
s Cost s Cost s Cost
Ma $15.0
60 $900
r1 0
$15.5 $2,17 $15.0
5 140 60 $900
0 0 0
$15.5 $2,17
140
0 0
$15.5 $2,17 $15.0
14 140 10 $150
0 0 0
$15.0
50 $750
0
$16.0 $1,19 $15.0
27 70 10 $150
0 0 0
$16.0 $1,12
70
0 0
$16.0 $15.0
29 30 $480 10 $150
0 0
$16.0
40 $640
0
$15.0
31 10 $150
0
$16.0
40 $640
0

Average Cost Inventory Method

Average cost method (AVCO) calculates the cost of ending inventory and cost of
goods sold for a period on the basis of weighted average cost per unit of inventory.
Weighted average cost per unit is calculated using the following formula:

Weighted Average Total Cost of Inventory

=
Unit Cost Total Units in Inventory
Like FIFO and LIFO methods, AVCO is also applied differently in periodic
inventory system and perpetual inventory system. In periodic inventory system,
weighted average cost per unit is calculated for the entire class of inventory. It is
then multiplied with number of units sold and number of units in ending inventory
to arrive at cost of goods sold and value of ending inventory respectively.
In perpetual inventory system, we have to calculate the weighted average cost per
unit before each sale transaction.

The calculation of inventory value under average cost method is explained with the
help of the following example:

Example

Apply AVCO method of inventory valuation on the following information, first in

periodic inventory system and then in perpetual inventory system to determine the
value of inventory on hand on Mar 31 and cost of goods sold during March.

Mar 1 Beginning Inventory 60 units @ $15.00 per unit

5 Purchase 140 units @ $15.50 per unit
14 Sale 190 units @ $19.00 per unit
27 Purchase 70 units @ $16.00 per unit
29 Sale 30 units @ $19.50 per unit
Solution

AVCO Periodic

Units Available for Sale = 60 + 140 + 70 = 270

Units Sold = 190 + 30 = 220
Units in Ending Inventory = 270 − 220 = 50

Weighted Average Unit Cost Units Unit Cost Total

Mar 1 Inventory 60 $15.00 $900
Mar 5 Purchase 140 $15.50 $2,170
27 Purchase 70 $16.00 $1,120
270 * $15.52 $4,190
* $4,190 ÷ 270

Cost of Goods Sold 220 $15.52 $3,414

Ending Inventory 50 $15.52 $776
AVCO Perpetual

Purchases Sales Balance

Date Unit Unit Unit
Units Total Units Total Units Total
Cost Cost Cost
Mar
60 $15.00 $900
1
5 140 $15.50 $2,170 60 $15.00 $900
140 $15.50 $2,170
200 $15.35 $3,070
14 190 $15.35 $2,916 10 $15.35 $154
27 70 $16.00 $1,120 10 $15.35 $154
70 $16.00 $1,120
80 $15.92 $1,274
29 30 $15.92 $478 50 $15.92 $796
31 50 $15.92 $796