Inventory & Cost of Goods Sold

Chapter Overview

This chapter focuses on the accounting for inventory, the application and comparison of inventory costing methods, the computation and evaluation of gross profit percentage and inventory turnover, and the use of the Cost of Goods Sold (COGS) model for decision-making.

• How to account for inventory

• Apply and compare various inventory costing methods

• Compute and evaluate gross profit (margin) percentage and inventory turnover

• Use the Cost of Goods Sold (COGS) model to make decisions

How to Account for Inventory

Service vs. Merchandising Companies

Merchandising companies differ from service companies in their financial statements by including inventory-related accounts.

• Cost of Goods Sold appears on the income statement for merchandisers.

• Inventory appears as a current asset on the balance sheet for merchandisers.

Inventory and Cost of Goods Sold When Inventory Cost is Constant

When inventory cost is constant, the calculation of inventory and cost of goods sold is straightforward.

• Inventory (Balance Sheet): Number of units on hand × Cost per unit

• Cost of Goods Sold (Income Statement): Number of units sold × Cost per unit

Asset vs. Expense: Inventory Flow

The cost of inventory shifts from asset to expense when goods are delivered to the buyer.

• Inventory (Asset): Cost of inventory on hand (Balance Sheet)

• Cost of Goods Sold (Expense): Cost of inventory sold (Income Statement)

Sale Price vs. Cost of Inventory

• Sales Revenue: Based on sales price of inventory sold

• Cost of Goods Sold: Based on cost of inventory sold

• Inventory: Based on cost of inventory on hand

Formulas:

Accounting for Inventory Systems

Perpetual vs. Periodic Inventory Systems

How the Perpetual System Works

• Optical scanner reads bar code, records sale, and updates inventory records.

• Two entries for each sale:

  • Record revenue and asset received

  • Record cost of goods sold and reduction of inventory

Recording Transactions (Perpetual System)

• Purchase of Inventory:

  Account	Debit	Credit
  Inventory	1,000
  Accounts Payable		1,000

• Purchase Return:

  Account	Debit	Credit
  Accounts Payable	500
  Inventory		500

• Payment within Discount Period (2/10, n/30):

  Account	Debit	Credit
  Accounts Payable	1,000
  Inventory	20
  Cash		980

  Discount = $1,000 × 2% = $20

Inventory Costing Methods

Overview of Methods

Accounting uses four generally accepted inventory costing methods:

1. Specific unit cost (specific identification)

2. Average cost (weighted-average method)

3. First-in, first-out (FIFO) cost

4. Last-in, first-out (LIFO) cost

Each method can affect reported profits, income taxes, and cash flow differently.

Specific Unit Cost

• Used for unique inventory items (e.g., automobiles, antiques, jewels, real estate)

• Inventory is valued at the specific cost of each unit

• Too expensive for inventories with common characteristics

• Also called the specific identification method

Average Cost Method

• Sometimes called the weighted-average method

• Based on the average cost of inventory during the period

Formula:

First-in, First-out (FIFO) Method

• First costs into inventory are first costs assigned to cost of goods sold (oldest items sold first)

• Ending inventory is based on latest costs incurred

Last-in, First-out (LIFO) Method

• Opposite of FIFO: last costs into inventory go to cost of goods sold (most recent items sold first)

• Oldest costs remain in ending inventory

Illustrative Example

Suppose a company begins with 10 units at $10 each, purchases 25 units at $14, and 25 units at $18. It sells 40 units and ends with 20 units.

• Goods available: 60 units, $900 total cost

• Average cost per unit: $900 / 60 = $15

• Cost of goods sold: 40 × $15 = $600

• Ending inventory: 20 × $15 = $300

FIFO and LIFO Example

Effects of FIFO, LIFO, and Average Cost

Gross profit is highest under FIFO when costs are rising, and lowest under LIFO.

Lower-of-Cost-or-Market Rule (LCM)

Definition and Application

The LCM rule requires inventory to be reported at the lower of its historical cost or market value (current replacement cost).

• If replacement cost is below historical cost, inventory is written down to market value.

• Ending inventory is reported at LCM value on the balance sheet.

• LCM write-down increases cost of goods sold and decreases inventory.

Journal Entry Example:

• Debit: Cost of Goods Sold

• Credit: Inventory

• To write inventory down to market value

GAAP vs. IFRS: Under U.S. GAAP, LCM write-downs cannot be reversed. Under IFRS, some write-downs may be reversed if market value recovers, but not above original cost.

Gross Profit Percentage and Inventory Turnover

Gross Profit Percentage

• Gross profit is sales minus cost of goods sold.

• Gross profit percentage is a key indicator of a company's ability to sell inventory at a profit.

Formula:

Example: If sales are $35,376 million and COGS is $15,437 million, gross profit percentage is:

Inventory Turnover

• Ratio of cost of goods sold to average inventory.

• Indicates how rapidly inventory is sold.

• Varies by industry.

Formula:

Example: If COGS is $15,437 million, beginning inventory is $1,672 million, and ending inventory is $1,908 million:

• million

• times

• Days to sell inventory: days

Cost of Goods Sold (COGS) Model for Decision Making

COGS Model Formula

This model is used by all companies, regardless of their accounting system, to determine the cost of goods sold for a period.

Summary Table: Inventory Costing Methods Comparison

Key Takeaways

• Inventory accounting affects both the balance sheet and income statement.

• Choice of inventory costing method impacts financial results and tax liability.

• Gross profit percentage and inventory turnover are critical performance metrics.

• LCM rule ensures inventory is not overstated on the balance sheet.