Cost of Sales and Inventory

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Accounting For Managers Professor ZHOU Ning SCHOOL OF ECONOMICS AND MANAGEMENT BEIHANG UNIVERSITY

[email protected]

Chapter 6 Cost of Sales and Inventory

The objectives of chapter 6   

Inventory costing methods Lower of cost or market Analysis of inventory

6-3

Inventory Issues 

What is inventory?



What costs are included in inventory?



How do we separate COGS from Ending

Inventory?

6-4

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.

6-5

Merchandising Inventories 

Merchandising 

Sells goods in same form in which they are acquired.



Inventory costs (and costs of goods sold) = acquisition costs.

6-6

Merchandising Inventories

6-7

Relationship of Inventory and Cost of Goods Sold Ending inventory Purchase AFS COGS

Beginning inventory

Beginning inventory + net purchases = Goods available for sale

cost of goods sold + ending inventory=Goods available for sale Cost of goods sold =Beg. inventory + net purchases -ending inventory Net purchases = gross purchases-purchase returns and allowances + freight-in

6-8

Discussion problem 6-1 W

X

Y

Z

$2,250

$1,800

$1,350

$2,100

Beginning inventory

300

225

500 ??

300

Plus: Purchases

975

975 ??

850

1,200

Less: Ending inventory

225

300

300

?? 150

1,050 ??

900

1,050 ??

1,350 ??

1,200 ??

900 ??

300 ??

750

300

400

150

?? 800

$ ?? 900

$ ?? 500

$ 150

Sales Cost of goods sold:

Cost of good sold Gross margin Period expenses Net income (Loss)

Ending inventory = Beginning Inventory + Purchase – Shipments (COGS)

$ (50)

6-9

Manufacturing Inventories 

Manufacturing company converts raw materials and purchased parts into finished goods. 

3 types of inventories; 

Materials.



Work-in-process.



Finished goods. 6-10

3 Types of Manufacturing Inventory Accounts 

Materials inventory or raw materials.  



Work-in-process.  



Not yet used in production. Adjusted for returns and freight-in.

Goods started but not yet finished. Materials + conversion costs.

Finished goods  

Manufactured but not yet shipped. Materials + conversion costs. 6-11

Manufacturing Inventories

6-12

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).

6-13

Product costing systems 

Perpetual inventory system for manufacturing companies.

6-14

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. 6-15

Period Costs 

Costs that are expensed in the period incurred. 

Much of SG&A (Selling, General & Administrative) Expenses on IS.

6-16

Manufacturing Inventories

6-17

Service Inventories 

Service organizations (hotels, beauty parlors, plumbers) 

May have materials inventories.

6-18

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.

6-19

Inventory Costing Methods (Cost Flow Assumptions)    

Specific identification. Average cost. First-in, first-out (FIFO) Last-in, first-out (LIFO)

6-20

Specific identification  

Big ticket items: e.g. automobiles, paintings. Uniquely identified items.



8.333 9.467

1,250 1,420

9.889 8

890 720

May offer opportunity to manipulate costs.

6-21

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. 6-22

Average Cost

6-23

First-in, first-out (FIFO)  

Expenses costs of oldest purchases first. Most recently purchased goods are in the ending inventory. 



Likely but not necessary to follow actual flow of goods. Ending inventory approximates current cost of goods.

6-24

First-in, first-out (FIFO)

6-25

Last-in, first-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 cost at amounts of years ago. 

Inventory may be well below current costs. 6-26

Last-in, first-out (LIFO)

6-27

LIFO Reserve 



FIFO (or average for cost) for internal reporting purposes. LIFO financial reporting. 

LIFO reserve = FIFO inventory amount LIFO inventory amount.

6-28

Comparison of Methods

Cost of goods sold

Ending inventory

Total

FIFO

$1,250

$890

$2,140

Average cost

1,338

802

2,140

LIFO

1,420

720

2,140

6-29

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. 6-30

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. 6-31

Arguments for LIFO (con.) 

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.

6-32

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.

6-33

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. 6-34

Analysis of inventory 



 

Inventory turnover  Average for period or ending inventory.  Measures efficiency of asset usage.

Days’ inventory

Gross margin as % of sales. Ratios differ by industry. 6-35

Summary of Chapter 6   

Inventory costing methods Lower of cost or market Analysis of inventory

6-36

Assignments of Chapter 6    

Problem 6-3 Problem 6-5 Problem 6-6 Case 6-1

6-37

Thank you

6-38

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Cost of Sales and Inventory

Accounting For Managers Professor ZHOU Ning SCHOOL OF ECONOMICS AND MANAGEMENT BEIHANG UNIVERSITY [email protected] Chapter 6 Cost of Sales and I...

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