Chapter 6

Cost of Sales
and Inventory

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Types of Companies
• Merchandising company
– Sells goods in same form as acquired.
• Manufacturing company
– Converts raw material into finished goods.
• Service company
– Provides intangible services.

6-2
 Inventory Issues
• What is inventory?
• What costs are included in inventory?
• How do we separate COGS from Ending
Inventory?

6-3
 Inventories Definition
 Asset items held for sale in the ordinary
course of business or goods that will be
used or consumed in the production of
goods to be sold.

6-4
 Methods of determining
amounts in inventory
 Periodic inventory method or
 Perpetual inventory method.

 Measurement of inventories and cost of

sales are related.

6-5
 Cost flow assumptions
 Specific identification.
 Average cost.
 First-in, first-out (FIFO).
 Last-in, last-out (LIFO).

6-6
 Merchandising Inventories
• Merchandising
– Sells goods in same form in which they are
acquired.
 Inventory costs (and costs of goods sold) =
acquisition costs.

6-7
 Manufacturing Inventories
 Manufacturing company converts raw
materials and purchased parts into
finished goods.
 3 types of inventories;
 Materials.
 Work-in-process.
 Finished goods.

6-8
 Service Inventories
 Service organizations (hotels, beauty
parlors, plumbers)
 May have materials inventories.

6-9
 Professional Service
Inventories
 Professional service firms (accounting
firms, legal firms)
 Intangible inventory costs are costs incurred
for client but not yet billed called jobs-in-
progress or unbilled costs.

6-10
 Supplies
 Tangible items that will be consumed in
the course of normal operations.
 e.g. office and janitorial supplies, lubricants,
repair parts.
 Not sold and not accounted for as part of
cost of goods sold.

6-11
 Merchandise companies
 Inventories accounted for at cost.
 Cost includes cost of
 Acquiring merchandise (invoice cost of goods,
freight-in).
 Making goods ready for sale (unpacking and
marking).
 Adjust for:
 Returns and allowances
 Cash discounts from supplier.

6-12
 Methods of accounting for
purchase (or cash) discounts
 Net of discount
 Charge discounts not taken when paid.
 Record at invoice price
 Record discount when taken.

6-13
 Terminology
• Purchase = receipt of merchandise not
placing of a purchase order (PO).
 Usually title transfers when goods are shipped
(FOB shipping point).

6-14
 Relationship of Inventory and
Cost of Goods Sold
 Beginning inventory + net purchases =
goods available for sale
 Goods available for sale = cost of goods
sold + ending inventory.
 Equivalently: Beg. inventory + net
purchases -ending inventory = cost of
goods sold.
 Net purchases = gross purchases -purchase
returns and allowances + freight-in
6-15
 Measurement Issue

• Dividing goods available for sale between

COGS and End. Inventory.
• 2 approaches:
– Periodic inventory method.
– Perpetual inventory method.

6-16
 Periodic inventory method
 Determine amount of ending inventory and
deduce costs of goods sold.
 Count inventory (i.e., a physical inventory is
taken) at the end of the period.
 Multiply count times cost for each item to
determine total amount of inventory.
 Beginning inventory of current period = ending
inventory of preceding period.
 COGS = COGA - End. Inventory

6-17
 Perpetual Inventory Method
 Measure amount actually delivered to
customers; deduce ending inventory.
 Perpetual inventory record is kept for each
item in inventory.
 Advantages of perpetual inventory method:
 Detailed record is useful.
 Built in check.
 Identifies shrinkage by item.
 Income statement can be prepared without taking
a physical inventory.
6-18
 Retail Method

• Variation of perpetual method.

 Record purchases at cost and at retail.
 Calculate gross margin percent and its
complement (the cost of goods sold as
a percent of retail).
 Cost of goods sold = Retail sales for the
period * cost of goods sold percent.
 Ending inventory = Beginning inventory +
purchases -cost of goods sold.
6-19
 Gross Profit Method
• Similar to retail method except uses an
average or normal gross profit percentage
in the calculation.

6-20
 Manufacturing Companies
 Product costs or cost of goods sold =
materials and parts used + conversion
costs
 Conversion costs = production labor +
overhead (other costs incurred in
manufacturing).

6-21
 3 Types of Manufacturing
Inventory Accounts
 Materials inventory or raw materials.
 Not yet used in production.
 Adjusted for returns and freight-in.
 Work-in-process.
 Goods started but not yet finished.
 Materials + conversion costs.
 Finished goods
 Manufactured but not yet shipped.
 Materials + conversion costs.
6-22
 Flow Through Accounts
• Pattern:
– Tfrd Out = beg inv + tfrd in - end inv

6-23
 Raw Materials Inventory
• Tfrd Out = beg inv + tfrd in - end inv
• Materials used = beg inv + purchases -end
inv

6-24
 Work in process
• Tfrd Out = beg inv + tfrd in - end inv
• Cost of goods manufactured = beg inv +
(materials used + labor + overhead) - end
inv

6-25
 Finished Goods
• Tfrd Out = beg inv + tfrd in - end inv
• Cost of goods sold = beg inv + Cost of
goods manufactured - end inv

6-26
 Product costing systems
• Perpetual inventory system for
manufacturing companies.
• (Chapters 17-19)

6-27
 Product Costs
 = inventory costs = inventoriable costs.
 Expensed (COGS) in period when FG
sold.
 GAAP requires full production costing.
 Materials cost.
 Labor costs incurred directly in producing the
product.
 Other production or indirect production or
production overhead costs.
6-28
 Period Costs
 Costs that are expensed in the period
incurred.
 Much of SG&A (Selling, General &
Administrative) Expenses on IS.

6-29
 Professional service firms
 E.g. law and accounting firms.
 Labor , overhead, and incidental product
costs but no materials cost.
 Expensed in period billed (i.e., when revenues
are recognized).

6-30
 Inventory Costing Methods
(Cost Flow Assumptions)
• Specific identification.
• Average cost.
• FIFO
• LIFO

6-31
 Specific identification
 Big ticket items.
 Uniquely identified items.
 May offer opportunity to manipulate costs.

6-32
 Average Cost
 (Beginning inventory amount + purchases)
/ units available for sale = per unit
inventory costs = per unit cost of goods
sold
 Periodic method.
 Computed for the entire period.
 Perpetual method.
 A new unit cost can be calculated after each
purchase.

6-33
 First-in, first-out (FIFO).
 Expenses costs of oldest purchases first.
 Most recently purchased goods are in
inventory.
 Likely but not necessary to follow actual flow
of goods.
 Ending inventory approximates current cost of
goods.

6-34
 Last-in, last-out (LIFO).
 Assumes most recently purchased goods
are sold first
 Inventory based on costs of oldest
purchases.
 Cost of goods sold usually does not reflect
physical flow.
 Ending inventory may be costed at amounts
of years ago.
 Inventory may be well below current costs.
6-35
 LIFO Reserve
 FIFO (or average for cost) for internal
reporting purposes.
 LIFO financial reporting.
 LIFO reserve = FIFO inventory amount - LIFO
inventory amount.

6-36
 Arguments for FIFO
 Usually follows physical flow of goods.
 If prices are based on oldest cost, results
in best matching.
 More accurate balance sheet valuation.
 Non-theoretical/practical argument:
 Results in highest income during periods of
rising prices.

6-37
 Arguments for LIFO
 If prices are based on current costs,
results in best matching of revenues and
costs and therefore most useful income
statement.
 Closest to reflecting current or
replacement costs of goods sold.
 However, it is still historical costs and could
differ from current costs.

6-38
 Arguments for LIFO
(continued)
 During periods of price increases:
 Higher costs of goods sold.
 Lower taxable income.
 Lower income taxes.
 Higher cash flows.
 If LIFO for tax purposes than also financial
reporting.

6-39
 Why not more LIFO?
 Most countries do not permit.
 Would require a double set of books.
 Prices of some items are not increasing.
 Because of IRS LIFO conformity
requirement, lower earnings reported to
shareholders.

6-40
 Lower of Cost or Market
(LCM)
 Market price may be below cost due to:
 Physical deterioration.
 Change in consumer tastes.
 Technological obsolescence.
 LCM is a reflection of conservatism
concept.
 Market is defined as replacement cost.

6-41
 Upper and lower bounds
 Ceiling or upper bound:
 Net realizable value (NRV).
 NRV = estimated selling price - estimated costs of
selling.
 So inventory not above cash that will be received.
 Floor or lower bound:
 NRV - normal profit margin.
 So inventory not written down artificially low; thus,
not understating, then overstating income.

6-42
 Steps in Applying LCM
 Compute market, floor and ceiling
amounts.
 Select the middle amount as market.
 Select lower of cost or market.

6-43
 Analysis of inventory
 Inventory turnover = Cost of goods sold /
Inventory
 Average for period or ending inventory.
 Measures efficiency of asset usage.
 Days’ inventory = Inventory / (Cost of
goods sold  365)
• Gross margin as % of sales.
 Ratios differ by industry.
6-44
 Chapter 6

End of
Chapter 6

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.