Chapter 6

Inventories

Skyline College
Lecture Notes
 What Is Inventory?

Inventory is a current asset

Items normally sold within a year or a
company’s operating cycle

Manufacturing Businesses Merchandising Businesses

(Cisco or Hewlett Packard) (Walgreens or Costco)
Inventory consists of: Inventory consists of goods held for
 Raw materials or goods used in sale in regular course of business
production of products
 Work in process or partially
completed products
 Finished goods ready for sale

Copyright © Houghton Mifflin Company. All rights reserved. 6–2

 Accounting for Inventories

Copyright © Houghton Mifflin Company. All rights reserved. 6–3

 Inventory Decisions

Inventory processing systems

Costing methods
Valuation methods

Result in different amounts of reported

net income, taxes paid, and cash flows

Impact external Impact internal

evaluation of evaluations like
company by investors performance reviews
and bonuses

Copyright © Houghton Mifflin Company. All rights reserved. 6–4

 Determining Inventory Levels

Keep large quantities

and selections of
Keep low quantities
inventory?
of inventory?

 Costs of handling and  Lower storage costs

storage are high  May result in lost sales
 Customers will be or dissatisfied
satisfied with quick customers
order fulfillment and
large selections
Copyright © Houghton Mifflin Company. All rights reserved. 6–5
 Inventory Turnover
Measurement of the number of times a company’s average
inventory is sold during an accounting period

Cost of Goods Sold

Inventory Turnover =
Average Inventory

Cisco’s Inventory $5,766 m

Turnover =
($1,207 m + $873 m) ÷ 2

= 5.5 times

Copyright © Houghton Mifflin Company. All rights reserved. 6–6

 Inventory Turnover for Selected
Industries

Copyright © Houghton Mifflin Company. All rights reserved. 6–7

 Days’ Inventory On Hand

Indicates the average number of days required

to sell the inventory on hand

Number of Days in a Year

Days’ Inventory on Hand =
Inventory Turnover

Cisco’s Days’ Inventory 365 days

on Hand =
5.5 times

= 66.4 days

Copyright © Houghton Mifflin Company. All rights reserved. 6–8

 Days’ Inventory on Hand for Selected
Industries

Copyright © Houghton Mifflin Company. All rights reserved. 6–9

 Supply Chain Management

Computerized system that a company uses to

order and track inventory
A just-in-time (JIT) operating environment
helps reduce inventory levels by coordinating
orders and shipments of products so that they
arrive “just in time” for customer orders

Using these procedures and processes mean

that less money is tied up in carrying
inventory
Copyright © Houghton Mifflin Company. All rights reserved. 6–10
 How Do Inventory Mistakes Affect
Income?
If ending Cost of goods Income before
inventory is sold is income taxes is
overstated… understated overstated

If ending Cost of goods Income before

inventory is sold is income taxes is
understated… overstated understated

Important: Errors not only affect the current year, but also the following year.
(An overstatement of ending inventory in year 1 will cause an overstatement in
beginning inventory in year 2, resulting in an understatement of income in year
2.)
Copyright © Houghton Mifflin Company. All rights reserved. 6–11
 Inventory Errors: Examples

Column 1 Column 2 Column 3

Ending Inventory Ending Inventory Ending Inventory
Correctly Stated Overstated Understated
Net Sales $100,000 $100,000 $100,000
Beg. Inv. $12,000 $12,000 $12,000
Net cost of 58,000 58,000 58,000
purchases
Cost of goods $70,000 $70,000 $70,000
available for sale

End. Inv. 10,000 16,000 4,000

Cost of Goods Sold 60,000 54,000 66,000
Gross margin $ 40,000 $ 46,000 $ 34,000
Operating expenses 32,000 32,000 32,000
Income before $ 8,000 $ 14,000 $ 2,000
income taxes
Copyright © Houghton Mifflin Company. All rights reserved. 6–12
 Inventory Cost

Inventory cost includes:

 Invoice price less purchases discounts
 Freight-in, including insurance in transit
 Applicable taxes and tariffs

Inventory costing and Goods flow—movement of

valuation methods goods in operations
really depend on the versus
flow of costs rather Cost flow—association of cost
than the flow of with its assumed flow in
physical inventory operations

Copyright © Houghton Mifflin Company. All rights reserved. 6–13

 Merchandise in Transit

Copyright © Houghton Mifflin Company. All rights reserved. 6–14

 Lower-of-Cost-or-Market Rule

Cost is usually the most appropriate basis for

the valuation of inventory.
BUT
The lower-of-cost-or-market (LCM) rule
requires that when the replacement cost of
inventory falls below historical cost, the
inventory is written down to the lower value
and a loss is recorded.

Copyright © Houghton Mifflin Company. All rights reserved. 6–15

 Disclosure of Inventory Methods

Cisco Annual Report

Inventories Inventories are stated at the lower of cost or

market. Cost is computed…on a first-in, first-out basis. The
company provides allowances on excess and obsolete
inventories.

Users should pay attention to the inventory disclosures in

the notes to the financial statements. If Cisco holds
inventory too long, the items can become out of date and
lose value.

Copyright © Houghton Mifflin Company. All rights reserved. 6–16

 Inventory Costing Methods

Inventory cost is determined using one of the

following generally accepted methods, each based on a
different assumption of cost flow:

1. Specific identification method

2. Average-cost method
3. First-in, first-out (FIFO) method
4. Last-in, first-out (LIFO) method

Copyright © Houghton Mifflin Company. All rights reserved. 6–17

 Specific Identification Method
Units in the ending inventory are identified as coming from specific purchases
Inventory Data
June 1 Inventory 80 units @ $10.00 $ 800
June 6 Purchase 220 units @ $12.50 2,750
June 25 Purchase 200 units @ $14.00 2,800
Goods available for sale 500 units $6,350
Sales 280 units
On hand June 30 220 units

Specific Identification Method

50 units @ $10.00 $ 500 Cost of goods avail. for sale $6,350
100 units @ $12.50 1,250 Less June 30 inventory 2,730
70 units @ $14.00 980 Cost of goods sold $3,620
220 units at cost of $2,730

Copyright © Houghton Mifflin Company. All rights reserved. 6–18

 Periodic Average-Cost Method

Inventory Data
Inventory is priced June 1 Inventory 80 units @ $10.00 $ 800
at the average cost June 6 Purchase 220 units @ $12.50 2,750
of the goods June 25 Purchase 200 units @ $14.00 2,800
available for sale Goods available for sale 500 units $6,350
during the period Sales 280 units
On hand June 30 220 units

Cost of Goods Available for Sale ÷ Units Available for Sale = Average Unit Cost
$6,350 ÷ 500 units = $12.70
Ending Inventory = 220 units @ $12.70 = $2,794
Cost of goods avail. for sale $6,350
Less June 30 inventory 2,794
Cost of goods sold $3,556

Copyright © Houghton Mifflin Company. All rights reserved. 6–19

 Periodic First-In, First-Out (FIFO)

Assumes that the Inventory Data

first units June 1 Inventory 80 units @ $10.00 $ 800
purchased will be June 6 Purchase 220 units @ $12.50 2,750
the first units sold; June 25 Purchase 200 units @ $14.00 2,800
Ending inventory Goods available for sale 500 units $6,350
is priced using the Sales 280 units
most recent On hand June 30 220 units
purchases
First-In, First-Out (FIFO) Method
200 units @ $14.00 from purchase of June 25 $2,800
20 units @ $12.50 from purchase of June 20 250
220 units at a cost of $3,050
Cost of goods avail. for sale $6,350
Less June 30 inventory 3,050
Cost of goods sold $3,300

Copyright © Houghton Mifflin Company. All rights reserved. 6–20

 Periodic Last-In, First-Out (LIFO)

Inventory Data
Ending inventory
June 1 Inventory 80 units @ $10.00 $ 800
is priced using the
June 6 Purchase 220 units @ $12.50 2,750
earliest purchases
June 25 Purchase 200 units @ $14.00 2,800
Goods available for sale 500 units $6,350
Sales 280 units
On hand June 30 220 units

Last-In, First-Out (LIFO) Method

80 units @ $10.00 from June 1 inventory $ 800
140 units @ $12.50 from purchase of June 6 1,750
220 units at a cost of $2,550
Cost of goods avail. for sale $6,350
Less June 30 inventory 2,550
Cost of goods sold $3,800

Copyright © Houghton Mifflin Company. All rights reserved. 6–21

 Impact of Inventory Methods

Copyright © Houghton Mifflin Company. All rights reserved. 6–22

 Discussion: Ethics on the Job

Rite Aid Corporation, a large drugstore

chain, falsified income by manipulating its
computerized inventory system to cover
losses from shoplifting, employee theft, and
spoilage.
Q. To increase income, what manipulation of
inventory amounts would have been
necessary?

Copyright © Houghton Mifflin Company. All rights reserved. 6–23

 Impact to Gross Margin
June Example: Period of Rising Inventory Purchase Prices
Specific Average-Cost First-In, First-Out Last-In, First-Out
Identification Method (FIFO) Method (LIFO) Method
Method

Sales $5,000 $5,000 $5,000 $5,000

Cost of goods sold
Beg. inventory $800 $800 $800 $800
Purchases 5,550 5,550 5,550 5,550
Cost of goods
avail. for sale $6,350 $6,350 $6,350 $6,350
Less end. inv. 2,730 2,794 3,050 2,550
COGS $3,620 $3,556 $3,300 $3,800
Gross margin $1,380 $1,444 $1,700 $1,200

Highest Lowest
In times of declining prices: FIFO results in lowest gross gross
gross margin, LIFO results in highest gross margin. margin margin
Copyright © Houghton Mifflin Company. All rights reserved. 6–24
 Which Costing Methods Are Used
Most Frequently?

Copyright © Houghton Mifflin Company. All rights reserved. 6–25

 LIFO Method

Best suited for the income statement because

it matches revenues and cost of goods sold
Not the best measure of the current balance
sheet value of inventory, particularly during a
prolonged period of price increases and
decreases
Used for durable goods in times of rising
prices—pay less income tax

Copyright © Houghton Mifflin Company. All rights reserved. 6–26

 Average Cost

Used for low-cost durable goods

Blends old prices with new prices so levels
out the effects of cost increases and decreases

Copyright © Houghton Mifflin Company. All rights reserved. 6–27

 FIFO Method

Best suited to the balance sheet

because the ending inventory is closest
to current values
Does not provide as good a matching
of current costs and revenues for
income statement purposes
Used for perishable goods and durable
goods in times of declining prices

Copyright © Houghton Mifflin Company. All rights reserved. 6–28

 Inventory and Income Taxes

Method chosen must be used consistently

from year to year (may change with IRS
approval if there is a good reason,
exception—a change from LIFO)
If a company uses LIFO for tax purposes,
the IRS requires the same method for
financial reporting
IRS will not allow lower-of-cost-or-market
(LCM) inventory valuation if LIFO is used
Copyright © Houghton Mifflin Company. All rights reserved. 6–29
 Perpetual versus Periodic Systems
Perpetual Periodic
 Continuous record of quantities  Only ending inventory is
& costs is maintained as counted and priced
purchases and sales are made  Cost of goods sold is
 Cost of goods sold is determined by deducting the
accumulated as sales are made; cost of the ending inventory
costs are transferred from the from the cost of goods
Merchandise Inventory account available for sale
to the Cost of Goods Sold
account
 Cost of ending inventory is the
balance of the Merchandise
Inventory account

Copyright © Houghton Mifflin Company. All rights reserved. 6–30

 FIFO Under the
Perpetual Inventory System: Example
Keep track of inventory costs and amounts in date order

Inventory Data
June 1 Inventory 80 units @ $10.00 $ 800
June 6 Purchase 220 units @ $12.50 2,750
June 10 Sale 80 units @ $10.00 ($ 800)
200 units @ $12.50 (2,500) (3,300)
June 10 Balance 20 units @ $12.50 $ 250
June 25 Purchase 200 units @ $14.00 2,800
June 25 Inventory 20 units @ $12.50 $250
200 units @ $14.00 2,800 $3,050
Cost of goods sold $3,300

Cost of goods sold is the total of sales on June 10

Copyright © Houghton Mifflin Company. All rights reserved. 6–31

 LIFO Under the
Perpetual Inventory System: Example
Keep track of inventory costs and amounts in date order

Inventory Data
June 1 Inventory 80 units @ $10.00 $ 800
June 6 Purchase 220 units @ $12.50 2,750
June 10 Sale 220 units @ $12.50 ($2,750)
60 units @ $10.00 (600) (3,350)
June 10 Balance 20 units @ $10.00 $ 200
June 25 Purchase 200 units @ $14.00 2,800
June 25 Inventory 20 units @ $10.00 $200
200 units @ $14.00 $2,800 $3,000
Cost of goods sold $3,350

Cost of goods sold is the total of sales on June 10

Copyright © Houghton Mifflin Company. All rights reserved. 6–32

 Impact of Cost Flow Assumptions
Under a Perpetual Inventory System

Copyright © Houghton Mifflin Company. All rights reserved. 6–33

 Retail Method for Estimating
Ending Inventory
Uses the ratio of cost to retail price to estimate
ending inventory
Can be used instead of actually determining the
cost of items in inventory
Retail products can be scanned at their retail
price and cost calculated through the use of ratios

Copyright © Houghton Mifflin Company. All rights reserved. 6–34

 Retail Method
Records must show:
 Beginning inventory at cost and at retail
 Amount of goods purchased during period at cost and at retail
Net purchases for the period (excluding freight-in) 107,000 145,000
Freight-in 3,000
Goods available for sale $150,000 $200,000
Ratio of cost to retail price: $150,000 = 75%
$200,000
Net sales during the period 160,000
Estimated ending inventory at retail $40,000
Ratio of cost to retail 75%
Estimated cost of ending inventory $30,000

Copyright © Houghton Mifflin Company. All rights reserved. 6–35

 Gross Profit Method for Estimating
Ending Inventory

It is a useful way of estimating the amount of

inventory lost or destroyed (ie theft, fire, etc)
Step 1 Figure the cost of goods available for sale add
purchases to beginning inventory

Step 2 Estimate the cost of goods sold by deducting the

estimated gross margin from sales

Step 3 Deduct the estimated cost of goods sold from

the cost of goods available for sale to arrive at
the estimated cost of ending inventory
Copyright © Houghton Mifflin Company. All rights reserved. 6–36