11CHAPTER 9CHAPTER 9COST OF GOODS SOLD COST OF GOODS SOLD AND INVENTORYAND INVENTORY2WHAT IS REPORTED AS WHAT IS REPORTED AS INVENTORY?INVENTORY?• Inventory represents goods that are either manufactured or purchased for resale in the normal course of business• Inventory is classified as an asset on the balance sheet3WHAT IS INVENTORY?WHAT IS INVENTORY?• There are three types of inventory for a manufacturing firm:– Raw materials• Goods acquired in a raw state that will eventually be finished products– Work in process• Partially finished products– Finished goods• Completed products waiting for sale24Raw MaterialsWork in ProcessFinished GoodsCost of Goods SoldINVENTORY COST FLOW FOR INVENTORY COST FLOW FOR A MANUFACTURING FIRMA MANUFACTURING FIRMBalance SheetBalance SheetIncome StatementIncome StatementManufacturing OverheadLabor5INVENTORY OWNERSHIPINVENTORY OWNERSHIP• Legal title rule– Goods should be reported in the balance sheet of the business holding legal title to the goods• Goods in transit– Legal title depends upon the shipping terms6GOODS IN TRANSITGOODS IN TRANSIT• Shipping terms:– FOB (free-on-board) destination• The seller is paying the shipping cost• The seller owns the inventoryuntil it is delivered– FOB shipping point• The buyer is paying the shipping cost• The buyer owns the inventoryduring transit37GOODS ON CONSIGNMENTGOODS ON CONSIGNMENT• The dealer does not pay for the inventory unless it is sold • Although the dealer has possession of the inventory, the supplier still owns the inventory at the balance sheet date 8THE COST OF INVENTORYTHE COST OF INVENTORY• The cost of inventory includes all costs of acquisition and preparation for sale– Purchase price– Freight– Receiving and storage costs9THE COST OF INVENTORYTHE COST OF INVENTORY• The cost of work in process and finished goods inventory includes– Raw materials– Production labor– Some allocation of factory overhead• Activity-based cost (ABC) systemsallocate overhead based on some clearly identified cost drivers410Beginning InventoryBeginning InventoryAdd: Inventory PurchasesAdd: Inventory Purchases= Goods Available for Sale = Goods Available for Sale Less: Ending Inventory Less: Ending Inventory = Cost of Goods Sold= Cost of Goods SoldCOST OF GOODS SOLDCOST OF GOODS SOLD11OVERVIEW OF PERPETUAL OVERVIEW OF PERPETUAL AND PERIODIC SYSTEMSAND PERIODIC SYSTEMS• Perpetual system– Inventory records are updated whenever a purchase or a sale is made– Advances in information technology have made the cost of using this system practical• Periodic system– Inventory records are not updated when a sale is made12TAKING A PHYSICAL TAKING A PHYSICAL COUNT OF INVENTORYCOUNT OF INVENTORY• The actual quantity on hand is determined by taking a physical count• A cost is attached to the quantity counted• With a perpetual system, a physical count can reveal inventory shrinkage513ENDING INVENTORY ERRORSENDING INVENTORY ERRORS• When inventory is overstated– Cost of good sold is understated– Net income is overstated• When inventory is understated– Cost of good sold is overstated– Net income is understated14INVENTORY VALUATION INVENTORY VALUATION METHODSMETHODS• Where specific identification is not possible, an assumption must be made about which cost is associated with the units remaining• Three assumptions are generally accepted:– FIFO (first-in, first-out)– LIFO (last-in, first-out)– Average cost15SPECIFIC IDENTIFICATIONSPECIFIC IDENTIFICATION• Requires no assumption about the flow of inventory units• Inventory items are specifically identified and valued• The actual cost of goods sold can be computed as inventory is sold616INVENTORY VALUATION INVENTORY VALUATION METHODSMETHODSAssume the following data:Unit TotalUnitsCost CostJanuary 1 200 $10 $2,000March 23 300 $12 3,600July 15 500 $11 5,500November 6 100$13 1,3001,100 $12,400Sales: 700 units @ $1517AVERAGE COST METHODAVERAGE COST METHODCost of Goods Available for SaleUnits Available for Sale$12,4001,100 unitsEnding Inventory = 400 Units x $11.27Ending Inventory = 400 Units x $11.27Cost of Goods Sold = 700 Units x $11.27Cost of Goods Available for Sale= Average Cost/Unit= $11.27 Average Cost/Unit= $4,510= $4,510= 7,890$12,40018Goods Available Goods Available for Salefor Sale1,100 units1,100 units==Ending InventoryEnding Inventory400 units400 units++Goods SoldGoods Sold700 units700 units$12,400$12,400=$2,000$2,000200 units @ $10/unit$3,600$3,600300 units @ $12/unit$2,200$2,200SOLD200 units @ $11/unit$4,600$4,600$7,800$7,800SOLDSOLD$3,300$3,300300units @ $11/unit100 units @ $13/unit$1,300$1,300+PurchasePurchaseJan. 1200 units @ $10/unitPurchasePurchaseMarch 23300 units @ $12/unitPurchasePurchaseJuly 15500 units @ $11/unitPurchasePurchaseNov. 6100 units @ $13/unitFIFOFIFO719$12,400$12,400=$1,200$1,200100 units @ $12/unit$5,500$5,500500 units @ $11/unit$1,300$1,300SOLD100 units @ $13/unit$4,400$4,400$8,000$8,000SOLDSOLD$2,000$2,000200units @ $10/unit200 units @ $12/unit$2,400$2,400+PurchasePurchaseJan. 1200 units @ $10/unitPurchasePurchaseMarch 23300 units @ $12/unitPurchasePurchaseJuly 15500 units @ $11/unitPurchasePurchaseNov. 6100 units @ $13/unitGoods Available Goods Available for Salefor Sale1,100 units1,100 units==Ending InventoryEnding Inventory400 units400 units++Goods SoldGoods Sold700 units700 unitsLIFOLIFO20• FIFO– Advantages:• Inventories are reported on the balance sheet near current costs• Cost flow often matches the physical flow of goods in a business– Disadvantages:• Current costs are not matched with current revenues• Choosing FIFO for financial reporting prohibits the use of LIFO on the tax return (LIFO conformity rule)COMPARISON OF METHODSCOMPARISON OF METHODS21• LIFO– Advantages:• Current costs are matched with current revenues (matching principle)• Income taxes are minimized during periods of rising prices– Disadvantages:• Inventory is valued at old prices• Cost flow may not match the physical flow of goods in the businessCOMPARISON OF METHODSCOMPARISON OF METHODS822MORE LIFO ISSUESMORE LIFO ISSUES• Any year in which the number of units purchased exceeds the number of units sold, a new LIFO layer is created in ending inventory• The creation of LIFO layers results in ending inventory at very old prices23INVENTORY ESTIMATION INVENTORY ESTIMATION AND VALUATIONAND VALUATION• The gross profit method is used