CHAPTER 3

INVENTORIES

TOPIC OVERVIEW:
This chapter explains inventory, its characteristics, components and valuation, initial and
subsequent measurement as well as the periodic and perpetual inventory systems.

LEARNING OBJECTIVES:
After studying this chapter, the students should be able to:
1. Describe inventories of manufacturing and merchandising companies.
2. Explain the initial recognition, initial measurement, subsequent measurement, derecognition,
and financial statement presentation of inventories.
3. Identify the situations in which periodic or perpetual system is appropriate.
4. Compare and contrast perpetual and periodic inventory system.
5. Account properly changes in inventory method and inventory error.
6. Calculate the correct balance of inventory and related accounts.

INVENTORIES

Inventories (PAS 2) are assets:

1. held for sale in the ordinary course of business
2. in the process of production for such sale
3. in the form of materials or supplies to be consumed in the production process or in the rendering
of services

Initial Recognition
An entity should recognize an inventory when:
a. the entity controls the asset as a result of past events, and
b. it is probable that future economic benefits will flow to the entity

Initial Measurement: Cost of Inventories

The cost of inventories shall comprise all cost of purchase, costs of conversion and other costs
incurred in bringing the inventories to their present location and condition.

Cost of Purchase
The standard lists the following as comprising the costs of purchase of inventories:
1. Purchase price plus
2. Import duties and other irrevocable taxes plus transport, handling and any other cost directly
attributable to the acquisition of finished goods, services and materials less trade discounts,
rebates, and other similar amounts

Costs of Conversion
Costs of conversion of inventories consist of two main parts:
1. Costs directly related to the units of production
2. Fixed and variable production overheads that are incurred in converting materials into finished
goods, allocated on a systematic basis.

Fixed production overheads are those indirect costs of production that remain relatively constant
regardless of the volume of production, (e.g. the cost of factory management and administration)
Variable production overheads are those indirect costs of production that vary directly, or nearly
directly, with the volume of production. (e.g., indirect materials and labor)

Other Costs
Other costs are included in the cost of inventories only to the extent that they are incurred in
bringing the inventories to their present location and condition. Examples of other costs are as
follows:
a. Borrowing costs – PAS 23 requires capitalizing interest on inventories which take a substantial
amount of time to create. However, an entity should not capitalize borrowing costs for inventories
that are manufactured in large quantities on a repetitive basis.
b. Storage Costs – this can be included for products that require a maturation process or substantial
amount of time to create.
c. Non-production overheads or costs of designing products for specific customer – this can be
included in cost if they contribute in bringing the inventories to their present condition and
location.

Excluded from Cost of Inventories

The standard lists types of cost which would not be included in cost of inventories. Instead, they
should be recognized as an expense in the period they are incurred.
1. Abnormal amounts of wasted materials, labor or other production costs.
2. Storage costs (except costs which are necessary in the production process before a further
production stage.)
3. Administrative overheads not incurred to bring inventories to their location and condition
4. Selling Costs
5. Foreign exchange differences arising directly on the recent acquisition of inventories invoiced
in a foreign currency
6. Interest cost when inventories are purchased with deferred settlement terms

ILLUSTRATION: Cost of Inventories

The costs set out below are those typically incurred by manufacturing businesses.
ITEMS
1 Supplier’s gross price for raw materials, P 150,000
2 Materials purchased from another supplier on extended credit amounting to P 570,000.
The price to be paid under normal credit term is P 550,000.
3 Invoice price of raw materials purchased amounting to P 180,000, quantity discounts of
10, 5 are followed by supplier.
4 Materials purchased from a supplier amounting to P616,000, inclusive of 12% VAT. The
company is VAT registered and can claim this as an input VAT.
5 Materials purchased from a supplier amounting to P515,000, inclusive of nonrecoverable
purchase tax of P15,000
6 Costs of transporting raw materials to the business premises, P5,000
7 Import duties paid to authorities on import of raw materials to be used in the
manufacturing process, P25,000
8 Labor costs directly incurred in the processing of raw materials, P420,000
9 Normal amount of wasted labor, P57,000
10 Abnormal amount of wasted labor, P69,000
11 Variable costs incurred in the processing of raw materials, P10,000

Required: Identify the cost as either inventoriable or not and determine the amount to be included
as part of inventory.
Solution:
Inventoriable? Amount Explanations
1 YES P 150,000
2 YES 550,000 The amount to be recorded is based on the price under
normal credit term. The difference between the price
under normal credit and extended credit term is recorded
as interest expense over the credit term.
3 YES 180,000 Invoice price means the quantity or trade discount was
already deducted.
4 YES 550,000 This is an example of recoverable purchase tax.
5 YES 515,000
6 YES 5,000
7 YES 25,000
8 YES 420,000
9 YES 57,000
10 NO - Abnormal waste is not inventoriable.
11 YES 10,000

Items to be included in inventory

Goods in transit from supplier
a. FOB Shipping Point Buyer
b. FOB Destination Seller
Consigned goods Consignor (Seller)
Sales out on approval Seller
Sales with buyback agreement Seller
Sales with right of return Buyer
Sales on installments Buyer
Segregated goods in the warehouse
a. Special-order goods Buyer upon completion
b. Hold for shipping instructions Seller

Accounting for Inventories

Two systems are offered in accounting for inventories, namely periodic system and perpetual
system.
The periodic system calls for the physical counting of goods on hand at the end of the accounting
period to determine quantities. It is generally used when the individual inventory items have small
peso investment, such as groceries, hardware and auto parts.
On the other hand, perpetual inventory system requires the maintenance of records called stock
cards that usually offer a running summary of the inventory inflow and outflow. It is commonly
used when the inventory items treated individually represent a relatively large peso investment
such as jewelry and cars.
ILLUSTRATION:
At the beginning of January 1, CV Company has 2,000 inventories costing P20 per unit. The
following transactions transpired during the year:
1. Purchased on account 3,000 units of inventory at P20 per unit
2. Sold on account 2,500 units of inventory for P50 per unit
3. Purchased on account 4,000 units of inventory at P20 per unit
4. Sold on account 3,000 units of inventory for P50 per unit
5. On December 31, physical count revealed that 3,500 units were on hand

Required: Prepare all the necessary journal entries using:

a. Periodic inventory system
b. Perpetual inventory system

Periodic Inventory System Perpetual Inventory System

Purchases 60,000 Inventory 60,000
Accounts Payable 60,000 Accounts Payable 60,000

Accounts Receivable 125,000 Accounts Receivable 125,000

Sales 125,000 Sales 125,000

Cost of goods sold 50,000

Inventory 50,000

Purchases 80,000 Inventory 80,000

Accounts Payable 80,000 Accounts Payable 80,000

Accounts Receivable 150,000 Accounts Receivable 150,000

Sales 150,000 Sales 150,000

Cost of goods sold 60,000

Inventory 60,000

Inventory, end 70,000

Cost of goods sold 110,000
Purchases 140,000 No closing entry
Inventory, beg 40,000

Trade discount/volume discount/quantity discount

Trade discounts are given to encourage orders in large quantities. These discounts are deducted
from the list price to arrive at the invoice price and are never recognized in the accounting record
since the journal entry is based on the amount on the sales invoice.

Cash discount/Settlement discount

Cash discounts are reductions from invoice price as an inducement for prompt payment of an
account within the discount period (e.g. 2/10, n/30). This is also called sales discount from the
point of view of the seller, while it is termed as purchase discount from the point of view of the
buyer.

1. Gross method – purchases are recorded at the gross amount. Purchase discounts taken are
recorded under Purchase Discount account which is reported as a reduction of purchases.

2. Net method – purchases are recorded at the net amount. Purchase discounts not taken are
recorded to the Purchase Discount Lost account.
ILLUSTRATION:
Prepare the necessary journal entries for the following transactions:
a. Purchases on account, P200,000, 2/10, n/30.
b. Assume payment is made within the discount period
c. Assume payment is made beyond the discount period

GROSS METHOD NET METHOD

Account Title Debit Credit Account Title Debit Credit
Purchases 200,000 Purchases 196,000
Accounts Payable 200,000 Accounts Payable 196,000

Accounts Payable 200,000 Accounts Payable 196,000

Cash 196,000 Cash 196,000
Purchase Discount 4,000

Accounts Payable 200,000 Accounts Payable 196,000

Cash 200,000 Purchase Discount 4,000
Lost
Cash 200,000

SUBSEQUENT MEASUREMENT OF INVENTORIES

Inventories are required to be stated at the lower of cost and net realizable value (NRV).
Inventories are usually written down to net realizable value item by item. In some circumstances,
however, it may be appropriate to group similar or related items.

Net Realizable Value

NRV is the estimated selling price in the ordinary course of business, less the estimated cost of
completion and the estimated costs necessary to make the sale.

Two Methods of Accounting for the Lower of Cost or Net Realizable Value
1. Direct Method.
Merchandise inventory, beg (at LCNRV) xxx
Add: Net purchases xxx
Total goods available for sale xxx
Less: Merchandise inventory, end (at LCNRV) xxx
Cost of Goods Sold after Inventory Write-down xxx

2. Allowance Method.
Merchandise inventory, beg (at cost) xxx
Add: Net purchases xxx
Total goods available for sale xxx
Less: Merchandise inventory, end (at cost) xxx
Cost of Goods Sold before Inventory Write-down xxx
Add: Loss on inventory write-down xxx
Less: Gain on inventory write-down xxx
Cost of Goods Sold after Inventory Write-down xxx

Gain or loss may be computed as follows:

Merchandise inventory, end (at cost) xxx
Less: Merchandise inventory, end (at LCNRV) xxx
Required allowance xxx
Less: Allowance for inventory write-down, beg xxx
Loss (gain) on inventory write-down xxx
To illustrate how this valuation technique is applied, assume the following data for 2017, the first
year of operations and 2018:
December 31, 2017 December 31, 2018
Inventory at Cost, per Materials Ledger Card P360,000 P420,000
Inventory at Net Realizable Value 348,000 416,000

On December 31, 2017, an adjusting entry is made to set up the valuation account for P12,000, the
difference between the inventory cost and NRV as follows:
Loss on Inventory Write-down 12,000
Allowance for Inventory Write-down 12,000

NOTE: The Loss on Inventory Write-down is treated as an addition to Cost of Goods Sold in the
Income Statement while the Allowance for Inventory Write-down is a deduction from the
Inventory account in the Balance Sheet.
At the end of the later periods, the allowance account will again be adjusted to reflect the inventory
value at that time. Continuing our illustration, at the end of 2017, the allowance account of P
12,000 should be reduced to P4,000, which is the difference between the cost of P420,000 and the
NRV of P416,000. To reduce the balance of the allowance account from P 12,000 to P4,000, the
allowance account is debited by P8,000, the difference between these amounts. This adjustment is
recorded as follows:
Allowance for Inventory Write-down 8,000
Recovery from Inventory Write-down 8,000

NOTE: The Recovery from Inventory Write-down is a deduction from Cost of Goods Sold.
The allowance account balance of P4,000 at the end of 2018 will again be treated as a deduction
from the inventory at cost on the balance sheet.
If the net realizable value exceed the cost of the inventory, the valuation account is no longer
necessary. An entry would be made to close the Allowance for Inventory Write-down by debiting
the account for its current balance and crediting Recovery from Inventory Write-down. The
inventory would be shown in the statement of financial position at cost.

COST FORMULA
To determine the amount of cost to be compared to the net realizable value (NRV), the following
may be used:
1. Specific identification of cost. When the inventory items are few and are not ordinarily
interchangeable, specification identification technique may be used. It involves tracing an item
sold, or an item remaining in inventory to the specific item that was purchased. It is inappropriate
to use this method when there are large number of items in inventory that are ordinarily
interchangeable because selecting those items that remain in inventory could be used to obtain
predetermined effects on profit or loss. In this case, PAS 2 allows either FIFO or Weighted
Average.
2. FIFO. The first-in-first-out (FIFO) technique states that the first materials purchased (the oldest
or earliest) are the first materials to be used. The materials on hand are therefore assumed to be the
last one purchased.

3. Weighted average. It allows you to mingle the costs of similar items purchased and use weighted
averages to measure inventories held, either on a periodic basis or as each shipment is received.

ILLUSTRATION: Cost Formula

RR Company sells blankets for P30 each. The following was taken from the inventory records
during July:
Date Product Units Cost
July 3 Purchase 500 P15
July 10 Sale 300
July 17 Purchase 1,000 P17
July 20 Sale 600
July 23 Sale 300
July 30 Purchase 1,000 P20

Required: Determine the cost of sales and cost of ending inventory under each of the following
independent assumptions:
1. FIFO (periodic)
2. FIFO (perpetual)
3. Weighted average method
4. Moving average method

Solution:
1. First-In-First-Out Method (periodic)
Units sold = 1,200

Date Quantity Unit Cost Total Cost

July 10 Sale (from July 3) 300 P15 P 4,500
July 20 Sale (from July 3) 200 15 3,000
July 20 Sale (from July 17) 400 17 6,800
July 23 Sale (from July 17) 300 17 5,100
Total Cost of Sales 1,200 P 19,400

Cost of ending inventory

Units in ending inventory = 1,300
Date Quantity Unit Cost Total Cost
July 17 300 P17 P 5,100
July 30 1,000 20 20,000
Total Cost of Ending Inventory 1,300 P 25,100

2. First-In-First-Out Method (Perpetual)

Cost of Merchandise
Purchases Inventory
Sold
Unit Total Unit Total Unit Total
Date Qty Qty Qty
Cost Cost Cost Cost Cost Cost
July 3 500 P15 P7,500 500 P15 P7,500
July 10 300 P15 P4,500 (300) 15 (4,500)
Balance 200 15 3,000
July 17 1,000 17 P17,000 1,000 17 17,000
Balance 1,200 20,000
July 20 200 15 3,000 (200) 15 (3,000)
 400 17 6,800 (400) 17 (6,800)
July 23 300 17 5,100 (300) 17 (5,100)
Balance 300 17 P5,100
July 30 1,000 20 P20,000 1,000 20 20,000
Total 2,500 P44,500 1,200 P19,400 1,300 P25,100

3. Weighted Average Method

Quantity Unit Cost Total Cost
Beginning inventory -
Purchases
July 3 500 P15 P 7,500
July 17 1,000 17 17,000
July 30 1,000 20 20,000
Total Goods Available for Sale 2,500 P 17.80 P 44,500

Cost of Sale = P17.80 x 1,200

P21,360

4. Moving Average Method

Cost of Merchandise
Purchases Inventory
Sold
Unit Total Unit Total Unit Total
Date Qty Qty Qty
Cost Cost Cost Cost Cost Cost
July 3 500 P15 P7,500 500 P15 P7,500
July 10 300 P15 P4,500 (300) 15 (4,500)
Balance 200 15 3,000
July 17 1,000 17 P17,000 1,000 17 17,000
Balance 1,200 16.67 20,000
July 20 600 16.67 10,000 (600) 16.67 (10,000)
Balance 600 16.67 10,000
July 23 300 16.67 5,000 (300) 16.67 (5,000)
Balance 300 16.67 P5,000
July 30 1,000 20 P20,000 1,000 20 20,000
Total 1,200 P19,500 1,300 P25,000

INVENTORY ESTIMATION
Use of Estimate in Inventory Estimation
1. The inventory is destroyed by fire and another catastrophe, or theft of the merchandise has
occurred and the amount of inventory is required for insurance purposes.
2. A physical count of the goods on hand is made and it is necessary to prove the correctness or
reasonableness of such count by making an estimate.
3. Interim financial statements are prepared and a physical count of the goods on hand is not
necessary either because it may take time to do the same or because only an estimate thereof is
required to fairly present the financial position and performance of the entity.

Two Approaches in Estimating the Value of Inventory

1. Gross Profit Method
2. Retail Inventory Method

GROSS METHOD
Based on the entity’s past experience, the average gross profit rate may be used to estimate the
cost of goods sold as well as the ending inventory to be reported in the interim financial statements.

Gross profit method is useful when:

1. A periodic system is in use and inventories are required for interim statements.
2. Inventories have been destroyed or lost by fire, theft, or other casualty, and the specific data
required for inventory valuation are not available.
3. The relationship between gross profit and sales remains stable over time.

However, the gross profit method would not be useful when:

1. There is a significant change in the mix of products being sold and the gross margin percentage
changes significantly during the year.
2. Estimating inventories to be reported in the annual financial statements

Formulas:
Gross Profit based on Sales
Sales xxx 100%
Less: Cost of Goods Sold (xxx) 75%
Gross Profit xxx 25%

Gross Profit based on Cost

Sales xxx 125%
Less: Cost of Goods Sold (xxx) 100%
Gross Profit xxx 25%

Note: In the determination of sales for the purpose of using both the gross profit method and the
retail method, sales discounts and allowances are ignored since although these items reduce sales,
they do not reduce the physical quantity of inventory sold; the cost of goods sold includes the total
cost of items sold for which discounts were availed or for which allowances were set up. Only
sales returns are deducted to arrive at the amount of sales for the purpose of determining the gross
profit ratio.

Determining the Gross Profit Rate

1. Look for possible trend.
2. If the problem states that “Average Gross Profit” would be used, then
Gross Profit Rate Year 1 +Year 2 +Year n
Average Gross Profit =
Number of years

3. If the problem states that “The overall gross profit ratio for the past years was in effect during
the year of fire or theft”, then
Gross Profit Year 1 +Year 2 +Year n
Overall Gross Profit =
Sales Year 1 + Sales Year 2 + Sales Year n

Note: Use this when there is no trend on the gross profit ratios and the problem is silent as to
what gross profit will be used.

ILLUSTRATION: Gross Profit Method

On December 31, 2018, BE Company had a fire which completely destroyed the finished goods.
After the fire, a physical inventory was taken. The inventories consisted the following:
01/01/18 12/31/18
Finished goods 200,000 ?
Work in Process 300,000 280,000
Direct Materials 400,000 320,000
Data for 2018 were:
Sales P 4,500,000
Purchases 1,900,000
Freight in 200,000
Direct Labor 900,000
 Manufacturing overhead – 75% of direct labor ?

Case No. 1: Assume the following data and trend continues:

2015 2016 2017
Sales P 1,500,000 P 2,300,000 P 3,000,000
Less: Cost of Sales 1,230,000 1,840,000 2,340,000
Gross Profit P 270,000 P 460,000 P 660,000

Required:
1. How much is the cost of goods sold for the year ended December 31, 2018?
2. How much is the estimated cost of finished goods on December 31, 2018 that was completely
destroyed by fire?

Case No. 2: Assume the following data and average gross profit to be used in 2018:
2015 2016 2017
Sales P 1,500,000 P 2,300,000 P 3,000,000
Less: Cost of Sales 1,230,000 1,840,000 2,340,000
Gross Profit P 270,000 P 460,000 P 660,000

Required:
1. How much is the cost of goods sold for the year ended December 31, 2018?
2. How much is the estimated cost of finished goods on December 31, 2018 that was completely
destroyed by fire?

Case No. 3: Assume the following data and the insurance company agreed that the fire loss claim
should be based on the assumption that the overall gross profit ratio for the past two years was in
effect during the current year.
2016 2017
Sales P 2,300,000 P 3,000,000
Less: Cost of Sales 1,840,000 2,340,000
Gross Profit P 460,000 P 660,000

Required:
1. How much is the cost of goods sold for the year ended December 31, 2018?
2. How much is the estimated cost of finished goods on December 31, 2018 that was completely
destroyed by fire?

Solution:
Case No. 1
Direct Materials, beg P 400,000
Add: Purchases 1,900,000
Freight in 200,000
Less: Direct Materials, end (320,000)
Direct Materials Used 2,180,000
Direct Labor 900,000
Manufacturing Overhead 675,000
Total Manufacturing Costs 3,755,000
Add: Work in process, beg 300,000
Cost of Goods Placed in Process 4,055,000
Less: Work in process, end (280,000)
Cost of Goods Manufactured 3,775,000
Add: Finished Goods, beg 200,000
Cost of Goods Available for Sale P 3,975,000
 2015 2016 2017 2018
Gross Profit P 270,000 P 460,000 P 660,000
Divided by: Sales 1,500,000 2,300,000 3,000,000
Gross Profit Rate 18% 20% 22% 24%

Sales P 4,500,000 100%

Less: Cost of Goods Sold 1.) 3,420,000 76%
Gross Profit P 1,080,000 24%

2.)
Cost of Goods Manufactured 3,775,000
Add: Finished Goods, beg 200,000
Cost of Goods Available for Sale P 3,975,000
Less: Finished Goods, end 555,000
Cost of Goods Sold P 3,420,000

Case No. 2:
2015 2016 2017 2018
Gross Profit P 270,000 P 460,000 P 660,000
Divided by: Sales 1,500,000 2,300,000 3,000,000
Gross Profit Rate 18% 20% 22% 20%

Gross Profit Rate Year 1 +Year 2 +Year 3

Average Gross Profit =
Number of years

18% + 20% + 22%

20% =
3

Sales P 4,500,000 100%

Less: Cost of Goods Sold 1.) 3,600,000 80%
Gross Profit P 900,000 20%

2.)
Cost of Goods Manufactured 3,775,000
Add: Finished Goods, beg 200,000
Cost of Goods Available for Sale P 3,975,000
Less: Finished Goods, end 375,000
Cost of Goods Sold P 3,600,000

Case No. 3:
Gross Profit Year 1 +Year 2
Overall Gross Profit =
Sales Year 1 + Sales Year 2

460,000 + 660,000
Overall Gross Profit =
2,300,000 + 3,000,000

1,120,000
21% =
5,300,000

Sales P 4,500,000 100%

Less: Cost of Goods Sold 1.) 3,555,000 79%
Gross Profit P 945,000 21%
2.)
Cost of Goods Manufactured 3,775,000
Add: Finished Goods, beg 200,000
Cost of Goods Available for Sale P 3,975,000
Less: Finished Goods, end 420,000
Cost of Goods Sold P 3,555,000

RETAIL INVENTORY METHOD

The retail method is simply a pragmatic way of determining cost by starting with the selling price
and deducting a suitable estimate of the profit margin. The retail method is often used in the retail
industry for measuring inventories of large numbers of rapidly changing items with similar
margins for which it is impracticable to use other costing methods, for example, supermarkets,
department stores and other retail concerns where there is a wide variety of goods.

Since the inventories are recorded at retail price, the cost of inventory is determined by reducing
the sales value of the inventory by the appropriate percentage gross margin. The percentage used
takes into consideration inventory that has been marked down to below its original selling price.
An average percentage for each retail department is often used.

The ratio exploited using this method is not the gross profit ratio but rather the cost ratio.
Basic Formula
Goods available for sale at retail xxx
Less: Net Sales
Sales xxx
Less: sales return only (xxx) xxx
Ending inventory at retail xxx
Multiply: Cost ratio xxx
Ending inventory at cost xxx

Methods in Computing Cost Ratio

For the purpose of computing cost ratio, there are three methods that can be used by an entity:
Methods Beginning Markups Markdown
Inventory
Conservative/Conventional Include Include Exclude
Average Include Include Include
First-in, First-out Exclude Include Include

Note: PAS 2, paragraph 22 requires either average cost approach or the FIFO approach (but more
particularly the average cost approach). The standard requires that the percentage to be used in the
application of the retail method should be the percentage that has been marked down below its
original selling price, meaning net markdowns should be included in the determination of the cost
ratio. The conservative or lower of cost or market is not an acceptable approach under PFRS but
is used under US GAAP.

Definition of Terms:
 Initial markup – the original markup on the cost of goods or the amount added to the
original cost to get the original retail price
 Original retail – the sales price at which the goods are first offered for sale
 Additional markup – increase in the sales price above the original sales price or the
amount added to the original retail price
 Markup cancellation – a decrease in the sales price that does not reduce the sales price
below the original sales price
  Net markup – additional markup minus markup cancellation
 Markdown – a decrease in the sales price below the original price
 Markdown cancellation – an increase in sales price that does not raise the sales price
above the original sales price
 Net markdown – markdown minus markdown cancellation
 Maintained markup (mark on) – difference between cost and sales price after adjustment
for all of the above items

GAS at cost minus beginning inventory at cost

FIFO =
GAS at retail minus beginning inventory at retail

GAS at cost
Average =
GAS at retail

GAS at cost
Conservative =
GAS at retail excluding net markdowns

COST RETAIL
At cost only:
Freight in xx
Purchase allowance (xx)
Purchase discount (xx)
At retail only:
Mark-up xx
Mark-up cancellation (xx)
Markdown (xx)
Markdown cancellation xx
Normal shrinkage, wastage, etc. (see note 1) (xx)
Employee discounts (see note 1) (xx)
At cost and retail
Beginning inventory xx xx
Purchase xx xx
Purchase return (xx) (xx)
Departmental transfer in xx xx
Departmental transfer out (xx) (xx)
Abnormal losses (see note 2) (xx) (xx)

Notes:
1. This is deducted after computing the cost ratio. Alternatively, these items can be added to sales
before computing the goods available for sale at retail.
2. This is deducted in arriving at the amounts to be used in computing the cost ratio.

ILLUSTRATION:
Presented below are the date taken from XX Company for the three months ended March 31:
COST RETAIL
Inventory, Jan 1 P 179,600 P 200,000
Purchases 475,400 800,000
Purchase returns 50,000 80,000
Purchase discounts 23,000
Purchase allowance 10,000
Freight in 5,000
Markups 200,000
 Markup cancellation 40,000
Departmental transfer in 70,000 100,000
Departmental transfer out 60,000 90,000
Abnormal loss 20,000 40,000
Markdown 115,000
Markdown cancellations 10,000
Sales 800,000
Sales returns 80,000
Sales allowance and discounts 120,000
Normal shrinkage 100,000

Required: Compute for the ending inventory at cost and cost of sales using:
1. Conservative Method
2. First-in, First-out Method
3. Average Method

Solution:
COST RETAIL
Inventory, Jan 1 P 179,600 P 200,000
Purchases 475,400 800,000
Less: Purchase returns 50,000 80,000
Less: Purchase discounts 23,000
Less: Purchase allowance 10,000
Add: Freight in 5,000
Add: Markups 200,000
Less: Markup cancellation 40,000
Add: Departmental transfer in 70,000 100,000
Less: Departmental transfer out 60,000 90,000
Less: Abnormal loss 20,000 40,000
Goods available for sale - conservative P 567,000 P 1,050,000
Less: Markdown 115,000
Add: Markdown cancellations 10,000
Goods available for sale - Average P 567,000 P 945,000
Less: Net Sales
Sales 800,000
Sales returns (80,000)
Normal shrinkage 100,000
Ending inventory at retail P 125,000

1. Computation of cost ratio

567,000 – 179,600 52%
FIFO =
945,000 – 200,000

567,000 60%
Average =
945,000

567,000 54%
Conservative =
1,050,000

Conservative
Ending inventory at retail P 125,000
Multiply by: Cost Ratio 0.54
Ending inventory at cost P 67,500
 GAS at cost P 567,000
Less: Ending inventory at cost 67,500
Cost of Sales P 499,500
FIFO
Ending inventory at retail P 125,000
Multiply by: Cost Ratio 0.52
Ending inventory at cost P 65,000
GAS at cost P 567,000
Less: Ending inventory at cost 65,000
Cost of Sales P 502,000
Average
Ending inventory at retail P 125,000
Multiply by: Cost Ratio 0.60
Ending inventory at cost P 75,000
GAS at cost P 567,000
Less: Ending inventory at cost 75,000
Cost of Sales P 492,000

References:

Asuncion, et. al. (2018). Applied Auditing Book 1 of 2, Baguio City: Real Excellence Publishing
Guerrero, P. (2018) Cost Accounting Principles and Procedural Application, Manila,
Philippines: GIC Enterprises and Co., Inc.
Valix, et. al. (2016). Financial Accounting Volume 1, Manila Philippines

Assessments:
1. MA Company sells blankets for P40 each. The following was taken from the inventory records
during August:
Date Product Units Cost
August
1 Beginning 600 P 20
4 Purchase 400 24
12 Sale 200
15 Purchase 1,100 25
17 Purchase Return 100 25
22 Sale 600
23 Sale 400
25 Sales return 100
31 Purchase 1,000 30

Required: Determine the cost of sales and cost of ending inventory under each of the following
independent assumptions:
1. FIFO (perpetual)
2. Moving average method
2. At year-end, a fire completely destroyed the goods in process inventory of EE Company. A
physical inventory was taken after the fire. The raw materials were valued at P600,000, the finished
goods at P1,000,000 and factory supplies at P100,000. The beginning inventories consisted of the
following:
Finished goods 1,400,000
Goods in process 1,000,000
Raw materials 300,000
Factory supplies 400,000

Data for current year

Sales 3,000,000
Purchases 1,000,000
Freight in 100,000
Direct Labor 800,000
Manufacturing overhead – 50% of direct labor ?
Average gross profit rate on sales 30%

Required: Calculate the following:

1. Cost of goods sold
2. Cost of goods manufactured
3. Goods in process, ending

3. AA Company used the retail inventory method to approximate the ending inventory.
COST RETAIL
Inventory, Jan 1 650,000 1,200,000
Purchases 9,000,000 14,700,000
Purchase returns 300,000 500,000
Purchase allowance 150,000
Freight in 200,000
Markups
Markup cancellation
Departmental transfer in 200,000 300,000
Markup 400,000
Markup cancellation 100,000
Markdown 1,200,000
Markdown cancellations 200,000
Sales 9,500,000
Sales discounts 100,000
Employee discounts 500,000
Estimated normal shoplifting loss 600,000
Estimated normal shrinkage 400,000

Required: Compute for the following:

1. Goods available for sale – conservative
2. Goods available for sale – average
3. Cost ratio – FIFO
4. Cost ratio – conservative
5. Cost ratio – average
6. Ending inventory at cost and cost of sales using
 Conservative
 FIFO
 Average