Libby Libby Short

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Chapter 7
Reporting and Interpreting Cost of Goods Sold and
Inventory
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HARLEY-DAVIDSON

• Business Strategy? Differentiation
• Problem? Demand exceeds their ability to
  produce.
• Solutions?
• Expand Manufacturing new plants
• Inventory management growing twice as fast as
  sales, needs control
• Reduce cost of goods sold material, labor and
  overhead to maintain margins

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Nature of Inventory and Cost of Goods Sold
BeginningInventory
Purchasesfor the Period
Work in ProcessInventory
Ending Inventory(Balance Sheet)
Cost of Goods Sold(Income Statement)
Beginning inventory Purchases Ending
inventory Cost of goods sold
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Flow of Inventory Costs
Merchandiser
MerchandisePurchases
Cost ofGoods Sold
MerchandiseInventory
Manufacturer
RawMaterials
Raw MaterialsInventory
Work in ProcessInventory
Finished GoodsInventory
DirectLabor
Cost ofGoods Sold
FactoryOverhead
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Inventory Cost

• The cost principle requires that inventory be
  recorded at the price paid or the consideration
• given up.

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Inventory Cost

• Include all costs incurred to bring the
  product to useable or saleable condition, such
  as
• Invoice price
• Freight charges
• Inspection costs
• Preparation costs.

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CORRECTING INVENTORY ERRORS

• Use basic inventory formula
• Beginning Inventory
• Purchases of the period
• - Ending Inventory
• Cost of Goods Sold

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Question

• If the 2000 ending inventory is understated by
  3,000, which of the following is true for 2000?
• a. Beginning Inventory was understated.
• b. Cost of Goods Sold will be understated.
• c. Gross Profit will be overstated.
• d. Net Income will be understated.

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Question

• If the 2000 ending inventory is understated by
  3,000, which of the following is true for 2000?
• a. Beginning Inventory was understated.
• b. Cost of Goods Sold will be understated.
• c. Gross Profit will be overstated.
• d. Net Income will be understated.

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Question

• If the 2000 ending inventory is understated by
  3,000, which of the following is true for 2001?
• a. Beginning Inventory was understated.
• b. Cost of Goods Sold will be understated.
• c. Gross Profit will be overstated.
• d. All of the above.

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Question
Remember The ending inventory for 2000 becomes
the beginning inventory for 2001.

• If the 2000 ending inventory is understated by
  3,000, which of the following is true for 2001?
• a. Beginning Inventory was understated.
• b. Cost of Goods Sold will be understated.
• c. Gross Profit will be overstated.
• d. All of the above.

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Inventory Costing Methods
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All Four Methods objective is to apply Goods
Available for sale to ending inventory and COGS
Total Dollar Amount of Goods Available for Sale
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First-In, First-Out
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First-In, First-Out
The schedule on the next screen shows the mouse
pad inventory for Computers, Inc. The physical
inventory count shows 1,200 mouse pads in ending
inventory. Use the FIFO inventory method to
determine (1) Ending inventory cost. (2)
Cost of goods sold.
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First-In, First-Out
Remember The costs of most recent purchases are
in ending inventory. Start with 11/29 and add
units purchased until you reach the number in
ending inventory.
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First-In, First-Out
Now, we have allocated the cost to all 1,200
units in ending inventory.
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First-In, First-Out
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(No Transcript)
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Last-In, First-Out
Ending Inventory
Oldest Costs
Cost of Goods Sold
Recent Costs
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Last-In, First-Out
Remember The costs of the oldest purchases are
in ending inventory. Start with beginning
inventory and add units purchased until you reach
the number in ending inventory.
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Last-In, First-Out
Now, we have allocated the cost to all 1,200
units in ending inventory.
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Last-In, First-Out
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Weighted-Average

• Weighted-average cost (WAC) per unit
• Cost of goods available for sale
• Number of units available for sale
• Ending Inventory
• Units in Ending Inventory WAC per Unit
• Cost of Good Sold
• Units Sold WAC per Unit

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Weighted-Average
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Weighted-Average
Weighted-Average Cost per Unit
9,725 1,800 Ending
Inventory 1,200 Units 5.40278
6,483 Cost of Goods Sold 600 Units
5.40278 3,242 Rounded
5.40278
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Specific Identification

• Specific cost of each inventory item is known.
• Used with small volume, high dollar inventory.

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Comparison of Methods
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Comparison of Methods
In periods of rising prices, FIFO results in the
highest ending inventory, gross profit, tax
expense, and net income, and the lowest cost of
goods sold.
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Comparison of Methods
In periods of rising prices, LIFO results in the
lowest ending inventory, gross profit, tax
expense, and net income, and the highest cost of
goods sold.
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Choosing Inventory Costing Methods
If . . .
Then . . .
LIFO Conformity Rule
LIFO for taxes
LIFO for books
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LIFO/FIFO COMPARABILITY?

• If you use LIFO, you must report FIFO in the
  footnotes if material
• The difference between LIFO and FIFO inventory
  balances is called the LIFO reserve
• The impact of LIFO on the current year COGS is
  the difference between beginning and ending LIFO
  reserve
• In a period of rising prices, the reserve will
  increase

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LIFO/FIFO Example

• Beginning LIFO reserve 20,722
• Ending LIFO reserve 22,613
• Difference in COGS ( 1,891)
• Note Since the reserve increased, the impact is
  a decrease on COGS from a LIFO basis to a FIFO
  basis, and higher FIFO earnings.

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Key Ratio Analysis

• Inventory Turnover

Cost of Goods Sold

Average Inventory
Inventory Turnover
Average Inventory is . . . (Beginning Inventory
Ending Inventory) 2
This ratio is often used to measure the
efficiency of inventory management, potential
obsolescence or sales declines
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Key Ratio Analysis(Compare to competitors p. 380)
Inventory Turnover
Cost of Goods Sold

Average Inventory
Inventory Turnover
The 1998 inventory turnover ratio for
Harley-Davidson
1,373,286 (117,475
155,616) 2
10.1
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Lower of Cost or Market(Principle of
Conservatism)
Ending inventory is reported at the lower of cost
or market (LCM).
Market is either . . .
Net Realizable ValueThe expected sales
priceless selling costs.
Replacement CostThe current purchase price of
identical goods.
or
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Lower of Cost or Market

• Recognition of gain on increases in inventory
  value is not allowed by GAAP
• Once you write the inventory down, you do not
  write it up again, even if the market value
  increases back up

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Perpetual and Periodic Inventory Systems
Provides up-to-date inventory records.
Perpetual System
Provides up-to-date CGS records.
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Comparison of Perpetual and Periodic Systems
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Inventory Carrying Costs

• Required rate of return on investment/opportunity
  cost
• Warehouse or storage costs
• Wages, etc. for warehouse personnel
• Inventory shrinkage/obsolescence
• Can be from 25 to 35 of inventory value! Per
  year!

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The End of Chapter 7