INVENTORY COSTINGINVENTORY COSTING

CHAPTERCHAPTER

66

• Needs to happen at least once a year• This is done to verify or correct what you

have on paper for your inventory value• Actually count, weigh, or measure what you

have in inventory• Easiest to do when business is closed or

sales are very low, so there isn’t a lot of activity to cause confusion

TAKING PHYSICAL TAKING PHYSICAL INVENTORYINVENTORY

TAKING PHYSICAL TAKING PHYSICAL INVENTORYINVENTORY

There are a couple of situations where people get confused about what to include in inventory

1. Goods in Transit

2. Consigned Goods

TO COUNT OR NOT TO COUNTTO COUNT OR NOT TO COUNTTO COUNT OR NOT TO COUNTTO COUNT OR NOT TO COUNT

Who do goods belong to when they are in the process of being shipped from the seller to the buyer?

The answer is it depends on the terms of the transaction

Whoever is paying for the shipping is the owner of the good during shipment

FOB shipping point buyer is owner and should count as inventory

FOB destination seller is owner and should count as inventory

GOODS IN TRANSITGOODS IN TRANSITGOODS IN TRANSITGOODS IN TRANSIT

When a company agrees to sell another company’s goods for a fee without taking ownership of the item

The holder of the goods (consignee) does not count these items in their inventory

The shipper of the goods (consignor) does count them, as they still own the item(s) in question

CONSIGNED GOODSCONSIGNED GOODSCONSIGNED GOODSCONSIGNED GOODS

SPECIFIC IDENTIFICATIONSPECIFIC IDENTIFICATIONSPECIFIC IDENTIFICATIONSPECIFIC IDENTIFICATIONThis is the best method for determining costEach item is tagged with it`s cost, that

follows the item as long as it is in the company

With this method you could look at the remaining inventory and know the value

This method is expensive and usually automated

INVENTORY COSTINGINVENTORY COSTINGINVENTORY COSTINGINVENTORY COSTING

Once the inventory is counted a value needs to be attached to it

When all inventory for 1 specific item was purchased for the same price this is easy

When inventory costs vary attaching a value becomes more difficult

BE 2, PAGE 317BE 2, PAGE 317BE 2, PAGE 317BE 2, PAGE 317

Mary Ann’s Hat Shop counted the entire inventory in the store on August 31 and arrived at a total inventory cost of $65 000. The count included $5000 of inventory held on consignment for a local designer; $500 of inventory that was being held for customers who were deciding if they actually wanted to purchase the merchandise; and $750 of inventory that had been sold to customers but was being held for alterations. There were two shipments of inventory received on September 1. The first shipment cost $6000. It had been shipped on August 29, terms FOB destination, and the freight charges were $240. The second shipment cost$3750. It had been shipped on August 28, terms FOB shipping point, and the freight charges were $150. Neither of these shipments were included in the August 31 count. Calculate the correct cost of the inventory on August 31.

BRIEF EXERCISE 6-2 The correct cost of inventory is: Total cost per inventory count $65,000 Less: Inventory on consignment (5,000) Inventory held for alterations (750)

Add: Goods shipped FOB shipping point prior to Aug. 31 3,750 Freight on inventory purchases 150

Correct inventory cost at August 31 $63,150

ANSWERANSWERANSWERANSWER

BE6-3, BE6-4, E6-1, E6-2, E6-3 (a,b,c), E6-4

PRACTICEPRACTICEPRACTICEPRACTICE

USING ACTUAL PHYSICAL USING ACTUAL PHYSICAL FLOW COSTINGFLOW COSTING

USING ACTUAL PHYSICAL USING ACTUAL PHYSICAL FLOW COSTINGFLOW COSTING

The specific identification method tracks the actual physical flow of the goods.

Each item of inventory is marked, tagged, or coded with its specific unit cost.

It is most frequently used when the company sells a limited variety of high unit-cost items.

USING ASSUMED COST USING ASSUMED COST FLOW METHODSFLOW METHODS

USING ASSUMED COST USING ASSUMED COST FLOW METHODSFLOW METHODS

Other cost flow methods are allowed since specific identification is often impractical.

These methods assume flows of costs that may be unrelated to the physical flow of goods.

Cost flow assumptions:1. First-in, first-out (FIFO).2. Average cost.3. Last-in, first-out (LIFO).

Fraser Valley Electronics Assume that Fraser Valley Electronics has the following information for one of its

products, a Z202 Astro Condenser:

The company had a total of 1,000 units available for sale during the year. The total cost of the 1,000 units available for sale was $12,000. A physical inventory count at the end of the year determined that 450 units remained on hand. Consequently, it can be calculated that 550 (1,000 − 450) units were sold during the year.

FIFOFIFOFIFOFIFO

The FIFO method assumes that the earliest goods purchased are the first to be sold.

Often reflects the actual physical flow of merchandise.

Under FIFO, the costs of the earliest goods purchased are the first to be recognized as cost of goods sold. The costs of the most recent goods purchased are recognized as the ending inventory.

FIFO method assumes earliest goods purchased are the first to be sold

AVERAGE COSTAVERAGE COSTAVERAGE COSTAVERAGE COST

The average cost method assumes that the goods available for sale are homogeneous.

The allocation of the cost of goods available for sale is made on the basis of the weighted average unit cost incurred.

The weighted average unit cost is then applied to the units sold to determine the cost of goods sold and to the units on hand to determine the ending inventory.

Average Cost Method

Average Cost Method

Average cost method assumes that goods available for sale are homogeneous

LIFOLIFO

The LIFO method assumes that the latest goods purchased are the first to be sold and that the earliest goods purchased remain in ending inventory.

Seldom coincides with the actual physical flow of inventory.

Under the periodic method, all goods purchased during the year are assumed to be available for the first sale, regardless of date of purchase.

Rarely used in Canada.

LIFO method assumes latest goods purchased are the first to be sold

BE6-5, BE6-6, BE6-7, BE6-8, E6-7, E6-8

PRACTICEPRACTICEPRACTICEPRACTICE

INCOME STATEMENT EFFECTSINCOME STATEMENT EFFECTSINCOME STATEMENT EFFECTSINCOME STATEMENT EFFECTS

In periods of rising prices, FIFO reports the highest net income, LIFO the lowest and average cost falls in the middle.

The reverse is true when prices are falling.

When prices are constant, all cost flow methods will yield the same results.

FIFO produces the best balance sheet

valuation since the inventory costs are closer

to their current, or replacement, costs.

BALANCE SHEET EFFECTSBALANCE SHEET EFFECTSBALANCE SHEET EFFECTSBALANCE SHEET EFFECTS

USING INVENTORY COST FLOW USING INVENTORY COST FLOW METHODS CONSISTENTLYMETHODS CONSISTENTLY

USING INVENTORY COST FLOW USING INVENTORY COST FLOW METHODS CONSISTENTLYMETHODS CONSISTENTLY

A company needs to use its chosen cost flow method consistently from one accounting period to another.

Such consistent application enhances the comparability of financial statements over successive time periods.

When a company adopts a different cost flow method, the change and its effects on net income should be disclosed in the financial statements.

Both beginning and ending inventories appear on the income statement.

The ending inventory of one period automatically becomes the beginning inventory of the next period.

Inventory errors affect the determination of cost of goods sold and net income.

INVENTORY ERRORS - INVENTORY ERRORS - INCOME STATEMENT EFFECTSINCOME STATEMENT EFFECTS

INVENTORY ERRORS - INVENTORY ERRORS - INCOME STATEMENT EFFECTSINCOME STATEMENT EFFECTS

FORMULA FOR FORMULA FOR COST OF GOODS SOLDCOST OF GOODS SOLD

FORMULA FOR FORMULA FOR COST OF GOODS SOLDCOST OF GOODS SOLD

+ =BeginningInventory

Cost of Goods

Purchased

EndingInventory

Cost of GoodsSold

_

The effects on cost of goods sold can be determined by entering the incorrect data in the above formula and then substituting the correct data.

The effects on cost of goods sold can be determined by entering the incorrect data in the above formula and then substituting the correct data.

EFFECTS OF INVENTORY EFFECTS OF INVENTORY ERRORS ON CURRENT YEAR’S ERRORS ON CURRENT YEAR’S

INCOME STATEMENT INCOME STATEMENT

EFFECTS OF INVENTORY EFFECTS OF INVENTORY ERRORS ON CURRENT YEAR’S ERRORS ON CURRENT YEAR’S

INCOME STATEMENT INCOME STATEMENT

An error in ending inventory of the current periodwill have a reverse effect on net income of the next

accounting period.

An error in ending inventory of the current periodwill have a reverse effect on net income of the next

accounting period.

Understate beginning inventory Understated Overstated

Overstate beginning inventory Overstated Understated

Understate ending inventory Overstated Understated

Overstate ending inventory Understated Overstated

The effect of ending inventory errors on the balance sheet can be determined by using the basic accounting equation:

Assets = Liabilities + Owner’s Equity

ENDING INVENTORY ERROR – ENDING INVENTORY ERROR – BALANCE SHEET EFFECTSBALANCE SHEET EFFECTS

ENDING INVENTORY ERROR – ENDING INVENTORY ERROR – BALANCE SHEET EFFECTSBALANCE SHEET EFFECTS

Overstated Overstated None Overstated Understated Understated None Understated

When the value of inventory is lower than the cost, the inventory is written down to its market value.

This is known as the lower of cost and market (LCM) method.

Market is defined as replacement cost or net realizable value.

VALUING INVENTORY AT THE VALUING INVENTORY AT THE LOWER OF COST AND MARKETLOWER OF COST AND MARKETVALUING INVENTORY AT THE VALUING INVENTORY AT THE

LOWER OF COST AND MARKETLOWER OF COST AND MARKET

ILLUSTRATION ILLUSTRATION 6-206-20 ALTERNATIVE LOWER OF COST ALTERNATIVE LOWER OF COST AND MARKET (LCM) RESULTSAND MARKET (LCM) RESULTS

Cost Market LCMTelevision setsConsoles 60,000$ 55,000$ Portables 45,000 52,000 Total 105,000 107,000 Video equipmentRecorders 48,000 45,000 Movies 15,000 14,000 Total 63,000 59,000 Total inventory 168,000$ 166,000$ $ 166,000

The common practice is to use total inventory rather than individual items or major

categories in determining the LCM valuation.

INVENTORY TURNOVERINVENTORY TURNOVERINVENTORY TURNOVERINVENTORY TURNOVER

Shows how many time inventory is sold, or turns over in a period

The higher the turns the less money is tied up in inventory

The higher the inventory turns the better

COGS Average Inventory

Inventory Turnover

DAYS SALES IN INVENTORYDAYS SALES IN INVENTORYDAYS SALES IN INVENTORYDAYS SALES IN INVENTORY

Takes inventory turnover and puts into terms of how long inventory is on hand before it sells

Holding inventory costs moneyThe lower the better

Days SalesIn Inventory

Inventory Turnover

Days in Year

PRACTICEPRACTICEPRACTICEPRACTICE

BE6-9, BE6-10, BE6-11,

BE6-15, BE6-16, E6-9, E6-10, E6-11(a)

REVIEWREVIEWREVIEWREVIEW

P6-7A, P6-8A