Inventories COST FLOW ASSUMPTIONS BY JUDITH PAQUETTE Objectives

Inventories COST FLOW ASSUMPTIONS… BY JUDITH PAQUETTE

Objectives 1. Understand physical inventory. 2. Explain and calculate inventory and cost of goods sold, using the different cost flow assumptions. 3. Explain the impact of the inventory cost flow assumptions on the Income Statement and Balance Sheet. 4. Explain the lower-of-cost-or-market basis of accounting for inventories. 5. Indicate the effects of inventory errors on the financial statements. 6. Compute and interpret the inventory turnover ratio.

How to Classify INVENTORY IS A CURRENT ASSET MERCHANDISE COMPANY MANUFACTURING COMPANY One Classification Three Classifications • Merchandise Inventory • Raw Material • Work in Process • Finished Goods

TAKING A PHYSICAL INVENTORY Physical Inventory taken for two reasons: Perpetual System 1. Check accuracy of inventory records. 2. Determine amount of inventory lost (wasted raw materials, shoplifting, or employee theft). Periodic System 1. Determine the inventory on hand 2. Determine the cost of goods sold for the period.

TAKING A PHYSICAL INVENTORY Determining Ownership of Goods AFFECTS WHICH INVENTORY IS COUNTED Goods in Transit Purchased goods not yet received. Sold goods not yet delivered. Goods in transit should be included in the inventory of the company that has legal title to the goods. Legal title is determined by the terms of sale.

REMEMBER… Freight Costs – Terms of Sale—who pays the freight bill? Depends. Read the terms to see WHICH PARTY owns the Inventory during Read the terms to see transport. FOB SHIPPING POINT: Title Transfer to Buyer at the Shipping point. Therefore BUYER PAYS THE FREIGHT BILL. Most common. Buyer owns during transport Seller ================ Buyer FOB DESTINATION: Title Transfer to Buyer at the Destination (at the Buyer’s store/warehouse/etc. ) Therefore SELLER PAYS THE FREIGHT BILL Seller owns during transport Seller ================ Buyer Interesting note: I have driven a Kenworth truck….

TAKING A PHYSICAL INVENTORY Determining Ownership of Goods AFFECTS WHICH INVENTORY IS COUNTED Consigned Goods In some lines of business, it is common to hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownership of goods. These are called consigned goods.

Consigned goods belong to the Inventory of the Consignor The Consignee (The Red Chair or Gail’s Consignment) doesn’t OWN the goods; they are just selling the goods.

How Much Inventory Should a Company Have? Only enough for sales needs § Excess inventory costs: § storage costs § interest costs § obsolescence - technology, fashion § 58

How do we assign cost to Inventory? We know all the inventory costs (purchase, freight, purchase returns/allowances, purchase discounts)… But once we put all the inventory together, how do we know which inventory and at what cost sold? We have to make Cost Flow Assumptions.

Why is it necessary to have Cost Flow Assumptions? Changing Prices 45

How do we assign cost to Inventory? There are Various Cost Flow Methods: Specific Identification First-in, first-out (FIFO) Last-in, last-out (LIFO) Average Cost

SPECIFIC IDENTIFICATION § Inventory is identified as coming from specific purchases. Each purchase is individually tracked. (usually limited to high priced inventory; does not make sense for high volume inventory) 58

SPECIFIC IDENTIFICATION Impractical for most inventory § Most cost flow methods make assumptions about which inventory was sold. § 58

SPECIFIC IDENTIFICATION - example Nov 1: $50, 000 Nov 25: $53, 000 Dec 5: $55, 000 Let’s assume the Bellevue Square Tesla dealership purchased three cars from Tesla (to re-sell) at three different times with slightly increasing costs. § When the B-square dealership sells one of these cars, it will track the exact car sold easily, by its VIN (vehicle identification number) and easily identify the COGS for the item sold. § Each Tesla car is tracked by a unique VIN. The Nov 25 th car is SOLD FOR $90, 000 COGS = $53, 000 Gross Profit = $37, 000 58

COST FLOW ASSUMPTIONS Do NOT have to match the Physical movement of goods. § You can use an earlier (older) cost first if you choose. § Just be consistent. § 58

Imagine…. a BIKE SHOP With ONLY one model of bike That you buy in large quantities… At different times What do you use for cost?

Cost Flow Assumptions – A Bike Shop Assume they bought a LOT of bikes! Date Explanation Bikes Unit Cost Total Cost 2 -Jun Beg. Inv 500 $ 100 $ 50, 000 8 -Jun Purchase 400 $ 125 $ 50, 000 25 -Jun Purchase 350 $ 130 $ 45, 500 Total Available for Sale 1, 250 $ 145, 500 Ending Inventory 250 Units Sold 1, 000 ? ? ?

Inventory Costing – Cost Flow Assumptions Date Explanation 2 -Jun Beg. Inv 8 -Jun Purchase 25 -Jun Purchase Total Available for Sale Ending Inventory Units Sold Bikes 500 400 350 1, 000 ? ? ? Unit Cost Total Cost $ 100 $ 50, 000 $ 125 $ 50, 000 $ 130 $ 45, 500 1, 250 $ 145, 500 250 Unit costs can be assigned to costs on hand using one of the three methods: • FIFO • LIFO • Average Cost.

FIFO – First In First Out FIFO assumes that the earliest units purchased are the first units sold – FIFO is how you calculate COGS, with the oldest units purchased FIFO leaves the most recently purchased items in ending inventory. Inventory is valued at the most current cost, Replacement Value FIFO most closely resembles how one moves inventory that might spoil (produce, milk, meat, etc. ) AND IS A GOOD BUSINESS PRACTICE (rotate the inventory)

Stores try to sell the oldest milk first but customer want to buy the youngest milk!

FIFO – FIRST IN FIRST OUT - Cost Flow Assumptions Date Explanation 2 -Jun Beg. Inv 8 -Jun Purchase 25 -Jun Purchase Total Ending Inventory Units Sold FIFO calculating COGS 2 -Jun 8 -Jun 25 -Jun COGS Ending Inventory Bikes 500 400 350 1, 250 1, 000 500 $ 100 400 $ 125 100 $ 130 Unit Cost $ 100 $ 125 $ 130 $ 50, 000 $ 13, 000 1, 000 $ 113, 000 250 $ 32, 500 Total Cost $ 50, 000 $ 45, 500 $ 145, 500 ? ? ?

(Weighted) Average Cost calculates a weighted average unit cost based on the Total Cost of the Goods Available for Sale divided by the Total Units Available for Sale. This would include beginning inventory (units and cost), if there is any. COGS is Calculated: by taking the Unit Average Cost times the number of units sold Ending Inventory is Calculated: by taking the Unit Average Cost times the number of units left in inventory (“units on hand”). Assume a situation in which a company had 620 items (same product) of Inventory which cost $6, 200 Total cost = $6, 200 Total Units = 620 Average Unit cost = $10/unit. Now assume that 500 units were sold and there are 120 units in Ending Inventory. Cost of INVENTORY = $1, 200 Cost of COGS = $5, 000

(Weighted) Average Cost - Cost Flow Assumptions Date Explanation 2 -Jun Beg. Inv 8 -Jun Purchase 25 -Jun Purchase Total Ending Inventory Units Sold Bikes Unit Cost 500 $ 100 400 $ 125 350 $ 130 1, 250 1, 000 Average Cost - calculating COGS Total Cost Units Available Avg Cost/bike COGS Ending Inventory 1, 000 250 Total Cost $ 50, 000 $ 45, 500 $ 145, 500 ? ? ? $ 145, 500 1, 250 bikes $116. 40 $ 116, 400 $116. 40 $ 29, 100

LIFO – Last In First Out LIFO assumes that the LAST units purchased are the FIRST units sold – LIFO is how you calculate COGS, with the MOST RECENTLY PURCHASED units; COGS is valued at Replacement Value LIFO leaves the oldest purchased units in Ending Inventory LIFO COSTING rarely coincides with the actual flow of goods. Exceptions: • Piles of goods (wood/hay/coal), where drawing from the oldest makes no sense.

LIFO – LAST IN FIRST OUT - Cost Flow Assumptions Date Explanation 2 -Jun Beg. Inv 8 -Jun Purchase 25 -Jun Purchase Total Ending Inventory Units Sold LIFO calculating COGS 25 -Jun 8 -Jun 2 -Jun COGS Ending Inventory Bikes Unit Cost 500 $ 100 400 $ 125 350 $ 130 1, 250 1, 000 350 $ 130 400 $ 125 250 $ 100 Total Cost $ 50, 000 $ 45, 500 $ 145, 500 ? ? ? $ 45, 500 $ 50, 000 $ 25, 000 1, 000 $ 120, 500 250 $ 25, 000

Comparing the Cost Flow Methods – INCOME STATEMENT EFFECTS – Rising Prices George's Bike Shop - using periodic inventory FIFO Average Cost LIFO Sales $ 240, 000 Beginning Inv 50, 000 Purchases 95, 500 Cost of Good Avail. 145, 500 Ending Inv 32, 500 29, 100 25, 000 COGS 113, 000 116, 400 120, 500 Gross Profit 127, 000 123, 600 119, 500 Operating Exp. 52, 800 Income before Tax 74, 200 70, 800 66, 700 Tax Exp (30%) 22, 260 21, 240 20, 010 Net Income $ 51, 940 $ 49, 560 $ 46, 690 Which Cost Flow method a company chooses will affect Net Income, Taxes, and Ending Inventory costs!

BALANCE SHEET EFFECTS – FIFO is more accurate Ø A major advantage of the FIFO method is the costs allocated to Ending Inventory will approximate current cost. (REPLACEMENT COST) Thus, with FIFO, the Balance Sheet is more accurate ; it reflects current inventory prices. Ø A major disadvantage of the LIFO method is that the costs allocated to ending inventory are not current, and may be: Ø Significantly understated in times of inflation. Ø Significantly overstated in times of deflation.

INCOME STATEMENT EFFECTS – LIFO is more accurate Ø A major advantage of the LIFO method is the costs allocated to COGS will approximate current cost. (REPLACEMENT COST) Thus, with LIFO, the Income Statement is more accurate ; it reflects current prices. Ø A major disadvantage of the FIFO method is that the costs allocated to COGS are not current, and may be: Ø Significantly understated in times of inflation. Ø Significantly overstated in times of deflation.

An Examples – rising prices RISING COSTS. . . 15 -Feb. Purchased 30 -May. Purchased 28 -Nov. Purchased Sold You can calculate: Units Unit Cost 100 $4. 00 400 $5. 00 500 $7. 60 600? ? ? Units Sold COGS and Ending Inventory Using the three methods: FIFO, LIFO, AND AVERAGE COST

First…. calculate total costs, Goods available for sale, and average unit cost RISING COSTS. . . 15 -Feb. Purchased 30 -May. Purchased 28 -Nov. Purchased Sold Goods Available End Inv Average cost 100 $4. 00 400 $5. 00 500 $7. 60 600? ? ? $400 $2, 000 $3, 800 $6, 200 400 $ 6. 20

Then, do the calculations for FIFO, Avg. Cost, and LIFO Assume that costs are increasing Costing Calculate: Indicate: Lower or Higher costs Method Indicate: Current or Older costs FIFO Income Balance Statement: Sheet: COGS End. Inv COGS Ending Inventory Lower Higher $3, 160 $3, 040 Older Current Average $3, 720 LIFO $4, 300 $2, 480 Middle Higher $1, 900 Current Middle NOTE: 1) The relative values for COGS and Ending Income Taxes: Inventory. Net Income 2) And the affect on Net Income Higher Middle Lower Older. Lower

An Examples – decreasing prices You can calculate: DECREASING COSTS 15 -Feb 30 -May 28 -Nov Units Unit Cost Purchased 100 $7. 00 Purchased 400 $6. 00 Purchased 500 $5. 00 Sold 600? ? ? Units Sold COGS and Ending Inventory Using the three methods: FIFO, LIFO, AND AVERAGE COST

First…. calculate total costs, Goods available for sale, and average unit cost – Decreasing Costs DECREASING COSTS 15 -Feb. Purchased 100 $7. 00 $700 30 -May. Purchased 400 $6. 00 $2, 400 28 -Nov. Purchased 500 $5. 00 $2, 500 Sold Goods Available End Inv Average cost 600? ? ? $5, 600 400 $ 5. 60

Then, do the calculations for FIFO, Avg. Cost, and LIFO Assume that costs are decreasing. Costing Calculate: Method Indicate: Lower or Higher costs Indicate: Current or Older costs Income Balance Sheet: Income Statement: Ending Taxes: COGS Inventory Net Income COGS End Inv FIFO $3, 600 $2, 000 $3, 360 $2, 240 $3, 100 $2, 500 Average LIFO Higher Older Lower Current. Lower Middle Lower Current Higher Older Higher Middle NOTE: 1) The relative values for COGS and Ending Inventory. 2) And the affect on Net Income

No Matter whether costs are rising or costs are declining: Ending Inventory is more current with FIFO COGS is more current with LIFO COGS is older/less accurate with FIFO Ending Inventory is older/less accurate with LIFO During Times of Inflation, using LIFO, Income Taxes will be LOWER

TAX DECISIONS – WHICH METHOD? LIFO or FIFO? Many companies have selected LIFO. Why? The reason is that LIFO results in the lowest income taxes (because of lower net income) during times of rising prices.

Inventory Costing – be consistent! Method should be used consistently, to improve comparability. Although consistency is preferred, a company may change its inventory costing method, but must disclose it.

Lower of Cost or Market When the market value of inventory is lower than its cost Companies are permitted to write down the inventory to its market value in the period in which the price decline occurs. Market value = Replacement Cost Example of conservatism. Note: this is an EXCEPTION TO THE HISTORIC COST PRINCIPLE! Can be done: At the item level (product) Or at the item category level

Lower of Cost or Market – an example – item level Item Quantity A B C Total Cost $ 10052 $ 5075 $ 35105 Market Lower of Cost or Market $ 62 $ 5, 200 $ 60 $ 3, 000 $ 74 $ 2, 573 $ 10, 773 The Company will write down the inventory to reflect the current Market Value. A journal entry will be made to reduce (credit) the Inventory Account and record the loss (debit an expense account e. g. , Loss on Inventory Valuation)

Inventory Errors Common Cause: Counting error or pricing error. Ownership issues (who has title to the goods? ) Errors affect both the income statement and balance sheet. One error in ending inventory will affect two year’s of Financial Statements.

One Error in calculating Ending Inventory will affect TWO YEARs. YEAR ONE - ERROR IN ENDING INVENTORY Situation NET INCOME Ending Inventory 1 Year 1: Overstated 2 Year 1: Understated COGS Year 1: Understated Year 1: Overstated Year 1: Overstated Year 1: Understated YEAR TWO Carry Forward of ERROR IN Year 1 ENDING INVENTORY Situation Beginning Inventory COGS NET INCOME 1 Year 2: Overstated Year 2: Understated 2 Year 1: Understated Year 2: Overstated

The accuracy of the Income Statement is dependent upon the accuracy of the Physical Inventory

Analyzing Inventory How Much Inventory should a Company have on hand? 1. Too MUCH Inventory – RISKS: high carrying costs (e. g. , investment, storage, insurance, obsolescence, and damage). 2. Too LITTLE Inventory– may lead to stockouts and lost sales. (Do YOU return to stores that consistently run LOW of products? )

Statement Presentation and Analysis Inventory management has both pros and cons 1. High Inventory Levels - may incur high carrying costs (e. g. , investment, storage, insurance, obsolescence, and damage). 2. Low Inventory Levels – may lead to stockouts and lost sales.

INVENTORY RATIOS Inventory turnover measures the number of times on average the inventory is sold during the period. = Cost of Goods Sold Note: Average Inventory = (This Year’s Inventory + Last Year’s Inventory)/2 Average Inventory Days in inventory measures the average number of days inventory is held. Days in Year (365) Days in Inventory = Inventory Turnover

End Part X of INVENTORIES Next VIDEO: - New topic: Internal Control & Fraud