c. 2014 Cengage Learning.   All Rights Reserved.  May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

InventoriesInventories

Chapter 7Chapter 7Chapter 7Chapter 7

Learning ObjectivesLearning Objectives

1.1. Describe the importance of control over Describe the importance of control over inventory.inventory.

2.2. Describe three inventory cost flow Describe three inventory cost flow assumptions and how they impact the assumptions and how they impact the income statement and balance sheet.income statement and balance sheet.

3.3. Determine the cost of inventory under the Determine the cost of inventory under the perpetual inventory system, using the FIFO, perpetual inventory system, using the FIFO, LIFO, and weighted average cost methods.LIFO, and weighted average cost methods.

4.4. Determine the cost of inventory under the Determine the cost of inventory under the periodic inventory system, using the FIFO, periodic inventory system, using the FIFO, LIFO, and weighted average cost methods.LIFO, and weighted average cost methods.

Learning ObjectivesLearning Objectives

5.5. Compare and contrast the use of the Compare and contrast the use of the three inventory costing method.three inventory costing method.

6.6. Describe and illustrate the reporting of Describe and illustrate the reporting of merchandise inventory in the financial merchandise inventory in the financial statements.statements.

7.7. Describe and illustrate the inventory Describe and illustrate the inventory turnover and the number of days’ sales in turnover and the number of days’ sales in inventory in analyzing the efficiency and inventory in analyzing the efficiency and effectiveness of inventory management.effectiveness of inventory management.

c. 2014 Cengage Learning.   All Rights Reserved.  May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Learning Learning Objective

ObjectiveDescribe the importance of

Describe the importance of

control over inventory.

control over inventory.

11

Control of InventoryControl of Inventory

o Two primary objectives of control over Two primary objectives of control over inventory are:inventory are: Safeguarding the inventory from damage or Safeguarding the inventory from damage or

theft.theft.

Reporting inventory in the financial statements.Reporting inventory in the financial statements.

Safeguarding InventorySafeguarding Inventory

o The The purchase orderpurchase order authorizes the authorizes the purchase of the inventory from an purchase of the inventory from an approved vendor.approved vendor.

Safeguarding InventorySafeguarding Inventory

o The The receiving report receiving report establishes an initial establishes an initial record of the receipt of the inventory. record of the receipt of the inventory.

Safeguarding InventorySafeguarding Inventory

o Recording inventory using a perpetual Recording inventory using a perpetual inventory system is also an effective inventory system is also an effective means of control. The amount of inventory means of control. The amount of inventory is always available in the is always available in the subsidiary subsidiary inventory ledgerinventory ledger..

Safeguarding InventorySafeguarding Inventory

o Controls for safeguarding inventory should Controls for safeguarding inventory should include security measures to prevent include security measures to prevent damage and customer or employee theft. damage and customer or employee theft. Some examples of security measures Some examples of security measures include the following:include the following: Storing inventory in areas that are restricted to Storing inventory in areas that are restricted to

only authorized employees.only authorized employees.

Locking high-priced inventory in cabinets.Locking high-priced inventory in cabinets.

Using two-way mirrors, cameras, security tags, Using two-way mirrors, cameras, security tags, and guards.and guards.

Reporting InventoryReporting Inventory

o A A physical inventoryphysical inventory or count of inventory or count of inventory should be taken near year-end to make should be taken near year-end to make sure that the quantity of inventory sure that the quantity of inventory reported in the financial statements is reported in the financial statements is accurate.accurate.

c. 2014 Cengage Learning.   All Rights Reserved.  May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Learning Learning Objective

ObjectiveDescribe three inventory cost

Describe three inventory cost

flow assumptions and how they

flow assumptions and how they

impact the income statement

impact the income statement and balance sheet.

and balance sheet.

22

INVENTORY INVENTORY COST FLOW COST FLOW

ASSUMPTIONSASSUMPTIONS

Inventory Cost Flow AssumptionsInventory Cost Flow Assumptions

Inventory Cost Flow AssumptionsInventory Cost Flow Assumptions

o Assume that one unit is sold on May 30 for Assume that one unit is sold on May 30 for $20. Depending upon which unit was sold, $20. Depending upon which unit was sold, the gross profit varies from $11 to $6 as the gross profit varies from $11 to $6 as shown below:shown below:

Inventory Cost Flow AssumptionsInventory Cost Flow Assumptions

o Under the specific identification inventory Under the specific identification inventory cost flow method, the unit sold is cost flow method, the unit sold is identified with a specific purchase.identified with a specific purchase.

Inventory Cost Flow AssumptionsInventory Cost Flow Assumptions

o Under the Under the first-in, first out (FIFO) first-in, first out (FIFO) inventoryinventory cost flow methodcost flow method, the first units , the first units purchased are assumed to be sold first purchased are assumed to be sold first and the ending inventory is made up of and the ending inventory is made up of the most recent purchases.the most recent purchases.

Inventory Cost Flow AssumptionsInventory Cost Flow Assumptions

o Under the Under the last-in, first out (LIFO) inventorylast-in, first out (LIFO) inventory cost flow methodcost flow method, the last units purchased , the last units purchased are assumed to be sold first and the are assumed to be sold first and the ending inventory is made up of the first ending inventory is made up of the first units purchased.units purchased.

Inventory Cost Flow AssumptionsInventory Cost Flow Assumptions

o Under the Under the weighted average inventory weighted average inventory cost flowcost flow methodmethod, the cost of the units , the cost of the units sold and in ending inventory is a weighted sold and in ending inventory is a weighted average of the purchase costs.average of the purchase costs.

INVENTORY INVENTORY COST FLOW COST FLOW

ASSUMPTIONSASSUMPTIONS

(continued)

INVENTORY INVENTORY COST FLOW COST FLOW

ASSUMPTIONSASSUMPTIONS

(continued)

INVENTORY INVENTORY COST FLOW COST FLOW

ASSUMPTIONSASSUMPTIONS

(concluded)

EXAMPLE EXAMPLE EXERCISEEXERCISE

c. 2014 Cengage Learning.   All Rights Reserved.  May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Learning Learning Objective

ObjectiveDetermine the cost of inventory

Determine the cost of inventory

under the perpetual inventory

under the perpetual inventory

system, using the FIFO, LIFO, and

system, using the FIFO, LIFO, and

weighted average cost methods.

weighted average cost methods.

33

Inventory Costing MethodsInventory Costing Methods

o For purposes of illustration, the data for For purposes of illustration, the data for Item 127B are used, as shown below. We Item 127B are used, as shown below. We will examine the will examine the perpetual inventory perpetual inventory system system first.first.

FIRST-IN, FIRST-IN, FIRST-OUT FIRST-OUT METHODMETHOD

(continued)

FIRST-IN, FIRST-IN, FIRST-OUT FIRST-OUT METHODMETHOD

(continued)

FIRST-IN, FIRST-IN, FIRST-OUT FIRST-OUT METHODMETHOD

(continued)

FIRST-IN, FIRST-IN, FIRST-OUT FIRST-OUT METHODMETHOD

(continued)

FIRST-IN, FIRST-IN, FIRST-OUT FIRST-OUT METHODMETHOD

(continued)

FIRST-IN, FIRST-IN, FIRST-OUT FIRST-OUT METHODMETHOD

(continued)

FIRST-IN, FIRST-IN, FIRST-OUT FIRST-OUT METHODMETHOD

(continued)

LAST-IN, FIRST-LAST-IN, FIRST-OUT METHODOUT METHOD

(continued)

LAST-IN, FIRST-LAST-IN, FIRST-OUT METHODOUT METHOD

(continued)

LAST-IN, FIRST-LAST-IN, FIRST-OUT METHODOUT METHOD

(continued)

LAST-IN, FIRST-LAST-IN, FIRST-OUT METHODOUT METHOD

(continued)

LAST-IN, FIRST-LAST-IN, FIRST-OUT METHODOUT METHOD

(continued)

LAST-IN, FIRST-LAST-IN, FIRST-OUT METHODOUT METHOD

LAST-IN, FIRST-LAST-IN, FIRST-OUT METHODOUT METHOD

(continued)

Weighted Average Cost MethodWeighted Average Cost Method

o When the weighted average cost method When the weighted average cost method is used in a perpetual system, an average is used in a perpetual system, an average unit cost for each item is computed each unit cost for each item is computed each time a purchase is made. time a purchase is made.

o This unit cost is then used to determine This unit cost is then used to determine the cost of each sale until another the cost of each sale until another purchase is made and a new average is purchase is made and a new average is computed. This averaging technique is computed. This averaging technique is called a called a moving averagemoving average..

WEIGHTED WEIGHTED AVERAGE COST AVERAGE COST

METHODMETHOD

c. 2014 Cengage Learning.   All Rights Reserved.  May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Learning Learning Objective

ObjectiveDetermine the cost of inventory

Determine the cost of inventory

under the periodic inventory

under the periodic inventory

system, using the FIFO, LIFO, and

system, using the FIFO, LIFO, and

weighted average cost methods.

weighted average cost methods.

44

First-In, First-Out MethodFirst-In, First-Out Method

o Using FIFO, the earliest batch purchased Using FIFO, the earliest batch purchased is considered the first batch of is considered the first batch of merchandise sold. The physical flow does merchandise sold. The physical flow does not have to match the accounting method not have to match the accounting method chosen. This time we will be examining chosen. This time we will be examining the the periodic inventory systemperiodic inventory system..

Cost of merchandise Cost of merchandise available for saleavailable for sale

First-In, First-Out MethodFirst-In, First-Out Method

o Beginning inventory and purchases of Item Beginning inventory and purchases of Item 127B in January are as follows:127B in January are as follows:

First-In, First-Out MethodFirst-In, First-Out Method

o The physical count on January 31 shows The physical count on January 31 shows that 800 units are on hand. (Conclusion: that 800 units are on hand. (Conclusion: 1,300 units were sold.) What is the cost of 1,300 units were sold.) What is the cost of the ending inventory?the ending inventory?

First-In, First-Out MethodFirst-In, First-Out Method

o Now we can calculate the cost of Now we can calculate the cost of merchandise sold as follows:merchandise sold as follows:

FIRST-IN, FIRST-IN, FIRST-OUT FIRST-OUT METHODMETHOD

Last-In, First-Out MethodLast-In, First-Out Method

o Using LIFO, the most recent batch Using LIFO, the most recent batch purchased is considered the first batch of purchased is considered the first batch of merchandise sold. The actual flow of merchandise sold. The actual flow of goods does not have to be LIFO. For goods does not have to be LIFO. For example, a store selling fresh fish would example, a store selling fresh fish would want to sell the oldest fish first (which is want to sell the oldest fish first (which is FIFO), even though LIFO is used for FIFO), even though LIFO is used for accounting purposes.accounting purposes.

Last-In, First-Out MethodLast-In, First-Out Method

o Assume again that the physical count on Assume again that the physical count on January 31 is 800 units (and that 1,300 January 31 is 800 units (and that 1,300 units were sold). What is the cost of the units were sold). What is the cost of the merchandise sold?merchandise sold?

LAST-IN, FIRST-LAST-IN, FIRST-OUT METHODOUT METHOD

Weighted Average Cost MethodWeighted Average Cost Method

o The The weighted average cost methodweighted average cost method uses uses the weighted average unit cost for the weighted average unit cost for determining cost of merchandise sold and determining cost of merchandise sold and the ending merchandise inventory.the ending merchandise inventory.

Average cost Average cost per unitper unit

Ending Ending InventoryInventory

Weighted Average Cost MethodWeighted Average Cost Method

Weighted Average Cost MethodWeighted Average Cost Method

c. 2014 Cengage Learning.   All Rights Reserved.  May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Learning Learning Objective

ObjectiveCompare and contrast the use of

Compare and contrast the use of

the three inventory costing

the three inventory costing methods.methods.

55

Comparing Inventory Cost MethodsComparing Inventory Cost Methods

o Using the perpetual inventory system Using the perpetual inventory system illustration with sales of $39,000 (1,300 illustration with sales of $39,000 (1,300 units x $30), the differences in ending units x $30), the differences in ending inventory, cost of merchandise sold, and inventory, cost of merchandise sold, and gross profit are illustrated in the next gross profit are illustrated in the next three slides.three slides.

PARTIAL PARTIAL INCOME INCOME

STATEMENTS STATEMENTS (FIFO)(FIFO)

PARTIAL INCOME PARTIAL INCOME STATEMENTS STATEMENTS

(WEIGHTED AVERAGE (WEIGHTED AVERAGE COST)COST)

PARTIAL PARTIAL INCOME INCOME

STATEMENTS STATEMENTS (LIFO)(LIFO)

COMPARING COMPARING INVENTORY INVENTORY

COST COST METHODSMETHODS

Comparing Inventory Cost MethodsComparing Inventory Cost Methods

o When the FIFO method is used during a When the FIFO method is used during a period of inflation or rising prices, FIFO will period of inflation or rising prices, FIFO will show a larger profit than the other two show a larger profit than the other two inventory costing methods.inventory costing methods.

Comparing Inventory Cost Comparing Inventory Cost MethodsMethodso When the LIFO method is used during a When the LIFO method is used during a

period of inflation or rising prices, LIFO will period of inflation or rising prices, LIFO will show a lower profit than the other two show a lower profit than the other two inventory costing methods.inventory costing methods.

o During a period of rising prices, using LIFO During a period of rising prices, using LIFO offers an income tax savings compared to offers an income tax savings compared to the other two inventory costing methods.the other two inventory costing methods.

Comparing Inventory Cost Comparing Inventory Cost MethodsMethodso The weighted average cost method of The weighted average cost method of

inventory costing is a compromise inventory costing is a compromise between FIFO and LIFO. Net income for the between FIFO and LIFO. Net income for the weighted average cost method is weighted average cost method is somewhere between the net incomes of somewhere between the net incomes of LIFO and FIFO.LIFO and FIFO.

c. 2014 Cengage Learning.   All Rights Reserved.  May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Learning Learning Objective

ObjectiveDescribe and illustrate the

Describe and illustrate the

reporting of merchandise

reporting of merchandise

inventory in the financial

inventory in the financial statements.

statements.

66

Reporting Merchandise InventoryReporting Merchandise Inventory

o Cost is the primary basis for valuing and Cost is the primary basis for valuing and reporting inventories in the financial reporting inventories in the financial statements. However, inventory may be statements. However, inventory may be valued at other than cost in the following valued at other than cost in the following cases:cases: The cost of replacing items in inventory is The cost of replacing items in inventory is

below the recorded cost.below the recorded cost.

The inventory cannot be sold at normal prices The inventory cannot be sold at normal prices due to imperfections, style changes, or other due to imperfections, style changes, or other causes.causes.

Valuation at Lower of Cost or Valuation at Lower of Cost or MarketMarketo MarketMarket, as used in , as used in lower-of-cost-or-market lower-of-cost-or-market

methodmethod, is the cost to replace the , is the cost to replace the merchandise on the inventory date.merchandise on the inventory date.

Valuation at Lower of Cost or MarketValuation at Lower of Cost or Market

o Cost and replacement cost can be Cost and replacement cost can be determined for the following:determined for the following: Each item in the inventory.Each item in the inventory.

Each major class or category of inventory.Each major class or category of inventory.

Total inventory as a whole.Total inventory as a whole.

VALUATION AT VALUATION AT LOWER OF LOWER OF COST OR COST OR MARKETMARKET

Valuation at Net Realizable ValueValuation at Net Realizable Value

o Merchandise that is out of date, spoiled, Merchandise that is out of date, spoiled, or damaged should be written down to its or damaged should be written down to its net realizable valuenet realizable value. This is the estimated . This is the estimated selling price less any direct costs of selling price less any direct costs of disposal, such as sales commissions or disposal, such as sales commissions or special advertising.special advertising.

Original costOriginal cost $1,000$1,000Estimated selling priceEstimated selling price 800800Selling expensesSelling expenses 150150

Valuation at Net Realizable ValueValuation at Net Realizable Value

o Assume the following data about an item Assume the following data about an item of damaged merchandise:of damaged merchandise:

o The merchandise should be valued at its The merchandise should be valued at its net realizable value of $650 ($800 – $150).net realizable value of $650 ($800 – $150).

Merchandise Inventory on the Balance Merchandise Inventory on the Balance SheetSheet

o Merchandise inventory is usually Merchandise inventory is usually presented in the Current Assets section of presented in the Current Assets section of the balance sheet, following receivables.the balance sheet, following receivables.

Merchandise Inventory on the Balance Merchandise Inventory on the Balance SheetSheet

o The method of determining the cost of the The method of determining the cost of the inventory (FIFO, LIFO, or weighted inventory (FIFO, LIFO, or weighted average) and the method of valuing the average) and the method of valuing the inventory (cost or the lower of cost or inventory (cost or the lower of cost or market) should be shown.market) should be shown.

MERCHANDISE MERCHANDISE INVENTORY ON INVENTORY ON THE BALANCE THE BALANCE

SHEETSHEET

Inventory ErrorsInventory Errors

o Some reasons that inventory errors may Some reasons that inventory errors may occur include the following:occur include the following: Physical inventory on hand was miscounted.Physical inventory on hand was miscounted.

Costs were incorrectly assigned to inventory.Costs were incorrectly assigned to inventory.

Inventory in transit was incorrectly included or Inventory in transit was incorrectly included or excluded from inventory.excluded from inventory.

Consigned inventory was incorrectly included Consigned inventory was incorrectly included or excluded from inventory.or excluded from inventory.

Inventory ErrorsInventory Errors

o Inventory errors often arise from Inventory errors often arise from consignedconsigned inventoryinventory. Manufacturers . Manufacturers sometimes ship merchandise to retailers sometimes ship merchandise to retailers who act as the manufacturer’s agent. who act as the manufacturer’s agent.

Inventory ErrorsInventory Errors

o The manufacturer, called the The manufacturer, called the consignorconsignor, , retains title until the goods are sold. Such retains title until the goods are sold. Such merchandise is said to be shipped on merchandise is said to be shipped on consignment to the retailer, called the consignment to the retailer, called the consigneeconsignee..

INVENTORY INVENTORY ERRORSERRORS

LO 6LO 6

BALANCE BALANCE SHEET EFFECTSSHEET EFFECTS

c. 2014 Cengage Learning.   All Rights Reserved.  May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Learning Learning Objective

ObjectiveDescribe and illustrate the inventory

Describe and illustrate the inventory

turnover and the number of days’

turnover and the number of days’

sales in inventory in analyzing the

sales in inventory in analyzing the

efficiency and effectiveness of

efficiency and effectiveness of

inventory management.

inventory management.

77

Inventory TurnoverInventory Turnover

o Inventory turnoverInventory turnover measures the measures the relationship between cost of merchandise relationship between cost of merchandise sold and the amount of inventory carried sold and the amount of inventory carried during the period. It is calculated as during the period. It is calculated as follows:follows:

Inventory Turnover =Cost of Merchandise Sold

Average Inventory

Inventory TurnoverInventory Turnover

o Inventory turnover for Best Buy is shown Inventory turnover for Best Buy is shown below (in millions).below (in millions).

Number of Days’ Sales in Inventory

Average Inventory

Average Daily Cost of Merchandise Sold

=

Inventory TurnoverInventory Turnover

o The number of days’ sales in inventory The number of days’ sales in inventory measures the length of time it takes to measures the length of time it takes to acquire, sell, and replace the inventory. It acquire, sell, and replace the inventory. It is computed as follows:is computed as follows:

Inventory TurnoverInventory Turnover

o The number of days’ sales in inventory for The number of days’ sales in inventory for Best Buy is computed below (in millions).Best Buy is computed below (in millions).

c. 2014 Cengage Learning.   All Rights Reserved.  May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

AppendixAppendix

Estimating Estimating

Inventory Cost

Inventory CostEstimating Estimating

Inventory Cost

Inventory Cost

Retail Method of Inventory CostingRetail Method of Inventory Costing

o The The retail inventory methodretail inventory method of estimating of estimating inventory cost requires costs and retail inventory cost requires costs and retail prices to be maintained for the prices to be maintained for the merchandise available for sale.merchandise available for sale.

o A ratio of cost to retail price is then used A ratio of cost to retail price is then used to convert ending inventory at retail to to convert ending inventory at retail to estimate the ending inventory cost.estimate the ending inventory cost.

RETAIL RETAIL METHOD OF METHOD OF INVENTORY INVENTORY

COSTINGCOSTING

Gross Profit Method of Inventory Gross Profit Method of Inventory CostingCostingo The The gross profit method gross profit method uses the uses the

estimated gross profit for the period to estimated gross profit for the period to estimate the inventory at the end of the estimate the inventory at the end of the period.period.

GROSS PROFIT GROSS PROFIT METHOD OF METHOD OF INVENTORY INVENTORY

COSTINGCOSTING

c. 2014 Cengage Learning.   All Rights Reserved.  May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

InventoriesInventories

The EndThe EndThe EndThe End