Understanding Inventory and Cost of Goods Sold in Manufacturing and Merchandising Companies

1. Chapter 6 Inventory and Cost of Goods Sold

2. Inventory • Includes items a company intends for sale to customers clothes at The Limited, shoes at Payless ShoeSource, building supplies at Home Depot, and so on. • Also includes items that are not yet finished products. For instance, lumber at a cabinet manufacturer and rubber at a tire manufacturer are part of inventory because the firm will use them to make a finished product for sale to customers

3. Part A Understanding Inventory and Cost of Goods Sold

4. LOB1 Trace the flow of inventory costs from manufacturing companies to merchandising companies Inventory Merchandise company Manufacturing company Wholesaler Retailer Raw material Work in progress Finished goods

5. Merchandising Companies

6. Manufacturing Companies • Companies manufacture the inventories they sell, rather than buying them from suppliers in finished form. • We classify inventory into three categories • Raw materials inventory: Includes the cost of components that will become part of the finished product but have not yet been used in production. • Work-in-process inventory: Refers to the products that have started the production process but are not yet complete at the end of the period. • Finished goods inventory: Once the manufacturing process is complete, transfer these costs to finished goods inventory.

7. Raw material Types of Companies and Flow of Inventory Costs Flow of Inventory Costs Direct labor Overhead Raw material Manufacturing Companies Work in process Finished goods Merchandising Companies Products End users ServiceCompanies Services

8. LO2 Calculate cost of goods sold

9. Relationship between Inventory and Cost of Goods Sold

10. LO3 Determine the cost of goods sold and ending inventory using different inventory cost methods Inventory cost method Specific Identification First in, First out (FIFO) Last in, First out (LIFO) Average Cost Specific Identification Method

11. Inventory Transactions for Mario’s Game Shop • It has 100 units of inventory at the beginning of the year and then makes two purchases during the year—one on April 25 and one on October 19. • There are 1,000 game cartridges available for sale. • During the year, it sells 800 video game cartridges for $10 each. This means that 200 cartridges remain in ending inventory at the end of the year.

12. First-In, First-Out (FIFO) • First units purchased are the first ones sold. Beginning inventory sells first, followed by the inventory from the first purchase during the year, followed by the inventory from the second purchase during the year, and so on. • Mario’s Game Shop, which 800 units were sold? • They were the first 800 units purchased, and that all other units remain in ending inventory.

13. Last-In, First-Out (LIFO) • Last units purchased are the first ones sold. • Mario’s, If 800 units were sold, all the 600 units purchased on October 19 were sold, along with 200 units from the April 25 purchase. That leaves 100 of the units from the April 25 purchase and all 100 units from beginning inventory assumed to remain in ending inventory .

14. Average Cost Method • Both cost of goods sold and ending inventory consist of a random mixture of all the goods available for sale. • Each unit of inventory has a cost equal to the weighted-average cost of all inventory items.

15. Comparison of Cost of Goods Sold Under The Three Inventory Cost Flow Assumptions A company purchases three units of inventory and sells two. • FIFO: Inventory is sold in the order purchased. • LIFO: Inventory is sold in the opposite order that we purchased it. • Weighted average cost: Inventory is sold using an average of all inventory purchased.

16. LO4 Explain the financial statement effects and tax effects of inventory cost flow assumptions Effects of Managers’ Choice of Inventory Reporting Methods • Why Choose FIFO? • Matches physical flow • for most companies. • Results in higher assets • and net income when • inventory costs are rising. • Has a balance sheet • focus. • Why Choose LIFO? • Results in tax savings. • Has an income statement • focus.

17. Comparison of Inventory Cost Flow Assumptions When Prices Are Rising A comparison of FIFO, LIFO, and average cost for Mario’s Game Shop is provided below.

18. LIFO Reserve • Choice between FIFO and LIFO results in different amounts for ending inventory and cost of goods sold. • It complicates the investment decisions of stockholders. • Due to financial statement effects of different inventory methods, companies that choose LIFO must report what’s called their LIFO reserve. • It is the additional amount of inventory a company would report if it used FIFO instead of LIFO. • Companies that have been using LIFO for a long time or that have seen dramatic increases in inventory costs, the LIFO reserve can be substantial. • The effect of the LIFO reserve for Lone Star Technologies, which uses LIFO to account for most of its inventory follows.

19. Part B Recording Inventory Transactions

20. LO5 Explain the differences between a perpetual inventory system and a periodic inventory system

21. Inventory Information for Incredible Electronics for 2010 To record inventory transactions under the perpetual system and periodic system. We keep the amount of inventory small to make the calculations easy, but both systems can be applied to inventory of any size. Consider the given information below during 2010:

22. Perpetual inventory system Debit inventory when we purchase inventory . Credit cash if the purchase was paid in cash or, credit accounts payable if the purchase was on account, increasing total liabilities. Periodic Inventory system Debit purchases account instead of inventory. We use the purchases account to temporarily track increases in inventory. We close this account to cost of goods sold at the end of the period. Inventory Purchases • FOB shipping point • Title passes when the seller ships the inventory, not when the buyer receives it. • FOB destination • Title would not transfer to the buyer and the purchase transaction would not be recorded until the shipped inventory reached its destination.

23. Freight Charges • Under the perpetual system, we add the cost of freight-in to inventory. • Under the periodic system, it also eventually becomes part of the cost of inventory, but we initially record it in a separate freight-in account. Like purchases, the freight-in account is closed to cost of goods sold at the end of the period.

24. Purchase Returns • Under the perpetual system, the company records the purchase returns as a reduction in both inventory and accounts payable. • Under the periodic system, the company credits an account called purchase returns, a contra purchases account, instead of inventory. Purchase returns is a temporary account that will be closed to (and become part of) cost of goods sold at the end of the period.

25. Purchase Discounts Digital Wholesale, offers terms 2/10, n/30 for purchases on account, and Incredible Electronics takes advantage of the discount. Incredibles’ purchases on account were $55,000, purchases returns were $5,000, the balance of account payable is $50,000. Subtracting the 2% purchase discount, Incredible owes only $49,000. • Incredible Electronics reduces its inventory balance by the amount of the discount. The true cash price for inventory is $49,000, not $50,000. • The company will record the discount in purchase discounts. • Purchase discounts, like returns, is a temporary account that will be closed to cost of goods sold at the end of the period.

26. Inventory Sales • Incredible sales $80,000. What is the cost of this inventory? • Cost of goods sold = $53,000 ($61,000 - $8000). • Record cost of goods sold of $53,000 only when using perpetual system. • Periodic system we record the reduction in inventory and increase in cost of goods sold only periodically, as part of the period-end adjustment.

27. Period End Adjustment • It is needed only under the periodic system. • The entry serves the following purposes: • Adjusts the balance of inventory to its proper ending balance. • Records the cost of goods sold for the period to match inventory costs with the related revenues. • Closes (or zeros out) the temporary purchases accounts (purchases, freight-in, returns, and discounts).

28. LO6 Prepare a multiple-step income statement • Sales and purchases of inventory are most important set of transactions , companies report revenues and expenses from these separately from other revenues and expenses. • It makes easier for investors and other financial statement users to determine the profitability of a company’s inventory transactions. • Use the information for Incredible to calculate gross profit on the sale and purchase of inventory.

29. Multiple-step Income Statement

30. Part C Other Inventory Reporting Issues

31. LO7 Apply the lower-of-cost-or-market rule for inventories • When the value of inventory falls below its cost, companies are required to report inventory at the lower market value. And it is considered to be the replacement cost . • Once it has determined both the cost and market value of inventory, Inventory is reported at the lower of the two amounts

32. Calculating the Lower of Cost or Market • Mario’s reports the FunStation 2 in ending inventory at market value. • The 15 FunStation 2s were originally reported in inventory at their cost of $4,500. • To reduce the inventory from that original cost of $4,500 to its lower market value of $3,000, Mario records the following year-end adjustment.

33. LO8 Analyze management of inventory using the inventory turnover ratio and gross profit ratio • If managers purchase too much inventory, the company runs the risk of the inventory becoming obsolete and market value falling below cost. • Analysts as well as managers often use the inventory turnover ratio to evaluate a company’s effectiveness in managing its investment in inventory. • Investors often rely on the gross profit ratio to determine the core profitability of a company’s operations. Inventory turnover ratio is cost of goods sold divided by average inventory. It shows the number of times the firm sells its average inventory balance during a reporting period.

34. Analyze the inventory of Best Buy and Sharper Image Corporation • We can analyze the inventory of Best Buy and Sharper Image Corporation by calculating these ratios for both companies. • Best Buy sells a large volume of commonly purchased products. • Sharper Image sells a variety of high-end specialty products, including electronics, toys and other home and personal care products that typically are not carried by most other retailers. • Below are relevant amounts for each company.

35. Computation of the Inventory Turnover Ratio The turnover ratio is more than twice as high for Best Buy. On average, it takes Sharper Image an additional 73 days to sell its inventory.

36. LO8 Analyze management of inventory using the inventory turnover ratio and gross profit ratio Gross profit ratio: Important indicator of the company’s successful management of inventory. • Measures the amount by which the sale price of inventory exceeds its cost per dollar of sales. • Higher the ratio, higher is the “markup” a company is able to achieve on its inventories.

37. Calculation of Gross Profit Ratio for Best buy and Sharper Image For Best Buy, the gross profit ratio is 25% This means that for every $1 of sales revenue, the company spends $0.75 on inventory, resulting in a gross profit of $0.25. For Sharper Image gross profit ratio is 49%

38. LO9 Calculate inventory amounts using FIFO and LIFO under a perpetual inventory system • We can calculate the amount of ending inventory by one of several methods. • We saw in Part B, the periodic and perpetual inventory systems determine when to report inventory transactions • Mario’s Game Shop. It sold 800 games to customers. Modify it by giving exact dates for the sale of the 800 games—250 on July 17 and 550 on December 15. The chronological order of inventory transactions follows.

39. FIFO with Perpetual System FIFO AND LIFO WITH PERIODIC SYSTEM FIFO, the first 800 units purchased for the period are those we assume were sold first. LIFO the last 800 units purchased for the period are those we assume were sold first. FIFO WITH PERPETUAL SYSTEM First units sold at the time of the sale, consistent with the perpetual systems approach to continually recording transactions.

40. LIFO with Perpetual System • Last units purchased at the time of the sale are the ones were sold first. • What are the last 250 units purchased at the time of the July 17 sale? • What are the last 550 units purchased at the time of the December 15 sale?

41. LO10 Determine the financial statement effects of inventory errors • Inventory Errors • Errors can unknowingly occur in inventory amounts if there are mistakes in a physical count of inventory or in the pricing of inventory quantities. • The formula for cost of goods sold, follows

42. Determine the financial statement effects of inventory errors Summary of Effects of Inventory Error in the Current Year. Relationship between Cost of Goods Sold in the Current Year and the Following Year

43. Inventory Amounts Correct Inventory Amounts Incorrect Inventory Amounts

44. End of chapter 6