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Chapter 8 Inventories and
Cost of Goods Sold
Financial Accounting 4e by Porter and Norton
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Inventory of Wholesalers and Retailers
Purchased in finished form Resold without transformation Classified as “Merchandise Inventory”
on balance sheet
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CURRENT ASSETS:
Cash and cash equivalents $1,251,532 $ 446,131
Net accounts and notes receivable 726,541 585,761
Merchandise inventory 1,633,327 1,757,664
Prepaid expenses and other current assets 41,311 57,623
TOTAL CURRENT ASSETS 3,652,711 2,847,179
Property, plant and equipment, net 853,778 988,947
Other assets 32,897 35,207
TOTAL ASSETS $4,539,386 $3,871,333
CIRCUIT CITYConsolidated Balance Sheets [Partial]
February 28,2002 2001ASSETS (in thousands)
More than 1/3
of totalassets
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Inventory of Manufacturers
ManufacturingOverhead
Direct Materials
Direct Labor
Costs Included in Inventory
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Inventory of Manufacturers
ManufacturingOverhead
Direct Materials
Direct Labor Manufacture
Products
Work in Process
FinishedGoods
Raw Materials
Costs Includedin Inventory
Balance SheetClassifications
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Current assets:Cash and cash equivalents $ 304.0 $ 254.3Accounts receivable less allowance for
doubtful accounts of $72.1 and $65.4 1,621.4 1,569.4Inventories:
Finished goods 1,399.4 1,416.6Work in progress 15.1 17.3Raw materials 9.6 12.1
1,424.1 1,446.0Deferred income taxes 113.3 111.5Prepaid expenses 162.5 215.2
Total current assets 3,625.3 3,596.4
Property, plant and equipment, net 1,618.8 1,583.4Identifiable intangible assets and goodwill 397.3 410.9Deferred income taxes and other assets 178.2 266.2TOTAL ASSETS $ 5,819.6 $ 5,856.9
NIKE, INC.Consolidated Balance Sheets [Partial]
May 31,2001 2000ASSETS (in millions)
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Inventory Valuation and Income Measurement
Value Assigned toInventory
on BalanceSheet
ValueExpensedas Cost of Goods Soldon IncomeStatement
When Sold =
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Beginning inventory $ 500
+ Purchases 1,200
= Cost of goods available for sale 1,700
Calculating Cost of Goods Sold
Internal calculation
- Ending inventory (600)
= Cost of goods sold $ 1,100
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Inventory costs include
Any freight costs incurred by buyer Cost of insurance for inventory in transit Cost of storing inventory before selling Excise and sales taxes
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Inventory Costing MethodsFour costing methods available:
SpecificIdentification
WeightedAverage
First-in, First-out(FIFO)
Last-in, First-out(LIFO)
Beginning inventory, Jan. 1: 500 units (unit cost $10)
Inventory purchases:Date Units Unit Cost1/20 300 $ 114/8 400 129/5 200 1312/12 100 14Total purchases 1,000
Ending inventory, Dec. 31: 600 units
Detailed Costing Method Example
Calculate the cost of goods sold and ending inventory under each method using the data below:
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Specific Identification Method
Step 1: Identify the specific units in inventory at the end of the year and their costs.
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Specific Identification Method
Units in ending inventory:
Date purchased Units Cost Total cost
1/20 100 $11 $1,100
4/8 300 12 3,600
9/5 200 13 2,600
Ending inventory 600 $7,300
Units x Cost = Total cost
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Specific Identification Method
Step 2: Identify the units sold and calculate the cost of goods sold.
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Specific Identification Method
Date purchased Units Cost Total cost
Beg. Inventory 500 $10 $5,000
1/20 200 11 2,200
4/8 100 12 1,200
12/12 100 14 1,400
Cost of goods sold 900 $9,800
Units x Cost = Total cost
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Weighted Average Method
Step 1: Calculate the cost of goods available for sale.
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Weighted Average Method
Date purchased Units Cost Total cost
Beg. inventory 500 $10 $ 5,000
1/20 300 11 3,300
4/8 400 12 4,800
9/5 200 13 2,600
12/12 100 14 1,400
Cost of goods available for sale 1,500 $17,100
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Weighted Average Method
Step 2: Divide the cost of goods availablefor sale by the total units todetermine the weighted averagecost per unit.
:
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Weighted Average Method
Cost of Goods Available Units Available
$17,100 1,500
= $ 11.40/unit
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Weighted Average Method
Step 3: Calculate ending inventory and COGS by multiplying the weighted average cost per unit by the # of units in ending inventory and the # of units sold.
XAvg.Cost
# Units
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Weighted Average Method
ALLOCATE TO Ending Cost of Inventory Goods
SoldUnits on hand 600 Units sold 900Weighted average cost X $11.40 $ 11.40
Total cost of goods available of $17,100 allocated: $6,840 $10,260
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First-in, First-out (FIFO) Method
Step 1: Assign the cost of the beginning inventory to cost of goods sold.
1stin
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First-in, First-out (FIFO) Method
ALLOCATE TOEnding Cost ofUnits Cost Inventory Goods Sold
1/1 500 $10 $5,000
1/20 300 $11
4/8 400 $12
9/5 200 $13
12/12 100 $14
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First-in, First-out (FIFO) Method
Step 2: Continue to work forward until you assign the total # of units sold during the period to cost of goods sold. Allocate the remaining units to ending inventory.
2nd3rd etc.
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First-in, First-out (FIFO) Method
ALLOCATE TOEnding Cost ofUnits Cost Inventory Goods Sold
1/1 500 $10 $5,000
1/20 300 $11 3,300
4/8 300 / 100 $12 $3,600 1,200
9/5 200 $13 2,600
12/12 100 $14 1,400
TOTALS $7,600 $9,500
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Last-in, First-out (LIFO) Method
Step 1: Assign the cost of the last units purchased to cost of goods sold.
1stin
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Last-in, First-out (LIFO) Method
ALLOCATE TOEnding Cost ofUnits Cost Inventory Goods Sold
1/1 500 $10
1/20 300 $11
4/8 400 $12
9/5 200 $13
12/12 100 $14 $1,400
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1stin
Step 2: Work backward until you assign the total # of units sold during the period to cost of goods sold (allocate the remaining units to ending inventory).
Last-in, First-out (LIFO) Method
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Last-in, First-out (LIFO) Method
ALLOCATE TOEnding Cost ofUnits Cost Inventory Goods Sold
1/1 500 $10 $5,000
1/20 100 / 200 $11 1,100 $2,200
4/8 400 $12 4,800
9/5 200 $13 2,600
12/12 100 $14 1,400
TOTALS $6,100 $11,000
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Comparison of Costing Methods
Cost of GoodsSold
Ending Inventory
11,000
6,840
7,600
10,260
9,500
17,100
17,000
17,100
WeightedAverage
FIFO
LIFO
Goods Available for Sale
6,100
Specific Identification $7,300 9,800 $17,100
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Comparison of Costing Methods
X XX
XX
Weighted Avg. FIFO LIFO
In periods of rising prices:
highest COGS? lowest COGS?highest gross margin?lowest net income?lowest income taxes?
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LIFO Issues
LIFO Liquidation liquidation can result in high gross margin
(and large tax bill) LIFO Conformity Rule
if used for tax, LIFO must also be used for books
LIFO Reserve difference between inventory value stated at
FIFO and value stated at LIFO
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Reasons for Inventory Errors
Mathematical mistakes Physical inventory counting errors Cut-off problems - in-transit Goods on consignment
Lower of Cost or Market
Before After
Price PriceChange Change
Cost 150 120
Report loss in year
market falls below cost…
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Before After
Price PriceChange Change
Selling price $200 $160
Cost 150 120
Gross margin $ 50 $ 40
Lower of Cost or Market
Gross margin % 25% 25%
…to maintain
normal G.M.%
when sold
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Market = replacement cost (not retail value) Cost determined under one of four methods Justified on basis of conservatism Can be applied to:
entire inventory individual items groups of items
Lower of Cost or Market
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Estimating Inventory Values
Sometimes impossible or impractical to measure inventory at cost– Estimation is necessary
Two methods used to estimate ending inventory values:– gross profit method– retail inventory method
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Gross Profit Method
1 Beginning inventory
2 + Purchases
3 = Cost of goods available for sale
4 - Ending inventory
5 = Cost of goods sold
Use income statement model butreverse steps 4 and 5
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Gross Profit Method
Beginning inventory $ 100,000
+ Purchases 30,000
= Cost of goods available for sale 130,000
- Cost of goods sold (estimated) * 90,000
= Ending inventory (estimated) $ 40,000
* Cost of goods sold is estimated as a percentage of sales
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Cost of Goods SoldAverage Inventory
Inventory Turnover Ratio
The number of times per period inventory is turned over (i.e., sold)
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Circuit City 5.9 times per yearSafeway 9.3 times per year
Inventory Turnover Ratios
Example:
Can you compare the two ratios?
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Days’ Sales in Inventory
The average # of days inventory is on handbefore its sold.
# of Days in PeriodInventory Turnover
Ratio
1 2 3
4 5 6 7 8 9 10
11 12 13 14 15 16 17
18 19 20 21 22 23 24
25 26 28 29 30 3127
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Days’ Sales in Inventory
Circuit City 365 = 61 days5.9
Safeway 365 = 39 days9.3
Do these averages seem reasonable?