Chapter 5: Inventory & Cost of Goods Sold
Perpetual & Periodic Inventory Systems, Inventory Costing Method, Accounting Standards & Inventory, Gross Profit, Inventory Turnover, Inventory Errors
What is ‘Costs of Goods Sold’?
Cost of Goods Sold (COGS), also known as cost of sales, is the expense of products sold. Basically, how much it cost to make the product. It doesn’t include inventory that hasn’t yet been sold. And only merchandising businesses (companies that sell physical merchandise) have this expense.
Perpetual & Periodic Inventory Systems
Accounting for Inventory
The value of inventory affects 2 accounts: inventory (current asset) on the balance sheet; & cost of goods sold, shown as an expense on the income statement.
Sales Price vs. Cost of Inventory
- Sales Revenue: Based on the sale price of the inventory sold.
- Cost of Goods Sold: Based on the cost of the inventory sold.
- Inventory: Based on the cost of the inventory still on hand.
What is Gross Profit?
Gross Profit, also known as Gross Margin, is sales revenue minus cost of goods sold. Operating expenses have not yet been subtracted from it.
Number of Units of Inventory
Represents the number of units of inventory a business has on hand at a certain point.
The manager must also account for inventory that has been shipped, depending on who owns it by having legal title. If inventory is shipped FOB (free on board) shipping point, the buyer has legal title as soon as it leaves the shipper’s dock. If the goods are shipped FOB destination, the seller has legal title until it’s delivered to the buyer.
What Goes Into Inventory Cost?
IFRS & ASPE state the following:
The cost of inventories shall comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition.
Inventory’s cost includes its basic purchase price, plus freight-in, insurance while in transit, & any costs paid to get the inventory ready to sell, less returns, allowances & discounts. Once at the showroom, all other costs (advertising, delivery) become their own expenses.
What are the Perpetual & Periodic Inventory Systems?
- Periodic Inventory System: Inventory is counted at least once a year, or after a certain period. Generally used for inexpensive goods (e.g. dollar store) & does not keep a running record of all good bought, sold & on hand.
- Perpetual Inventory System: Uses software to keep a running record of inventory on hand. Most businesses use the perpetual inventory system. However, they still count inventory on hand every year to check accuracy.
Accounting for Inventory in the Perpetual & Periodical Systems
How does the Perpetual System work?
A clerk scans the bar code of the product a customer wishes to purchase. A computer records the sale & updates the inventory records.
How to Record Transactions in the Perpetual System?
- Buying Inventory: Debit Inventory & Credit Cash or Accounts Payable.
- Selling Inventory:
- Record the Sale: Debit Cash or Accounts Receivable & Credit Sales Revenue.
- Record the Cost of Inventory Sold: Debit Costs of Goods Sold & Credit Inventory.
How to Record Transactions in the Periodical System?
The business keeps no running record of merchandise. Instead, at the end of the period the business counts inventory on hand & applies the unit costs to determine the cost of ending inventory. This inventory figure appears on the balance sheet & is used to compute cost of goods sold.
The Inventory account carries the beginning balance left over from the preceding period. Businesses records purchases of inventory in the Purchases account (expense). Then, at the end of the period, the Inventory account must be updated for the financial statements. A journal entry removes the beginning balance by crediting Inventory & debiting Cost of Goods Sold. A 2nd journal entry sets up the ending Inventory balance, based on the physical count. Final entry transfers the amount of Purchase related accounts to Cost of Goods Sold. These end-of-period entries can be made during the closing process.
How is Net Purchases of Inventory Calculated?
Net Purchases is often referred to as purchases.
- Freight-In: Transportation cost paid by the buyer to move goods from the seller to the buyer.
- Purchase Return: Decrease in cost of inventory because the buyer returned the goods to the seller.
- Purchase Allowance: Decrease in cost because buyer got a deduction—often due to merchandise defects.
- Purchase Discount: Decrease in cost of inventory that is earned by paying quickly.
- A common arrangement states payment terms of 2/10 n/30. This means buyer gets a 2% discount for payment within 10 days, or pay full amount within 30 days.
- Another common credit term is ‘net 30’ which directs the customer to pay the full amount within 30 days.
Reporting in the Financial Statements
Example of Recording Transactions
Sales Returns & Allowances
Retailers/consumers can return unsatisfactory or damaged merchandise for a refund/exchange. This is called sales returns & allowances. Returned merchandise means lost profits.
Retailers, wholesalers & manufacturers typically disclose sales revenue at the net amount, which means after the sales discounts and sales returns and allowances have been subtracted.
Sometimes businesses offer customers sales discounts for early payment. A typical sales discount incentive might be 2/10, n/30. This means the seller is willing to give a discount of 2% if the buyer pays the invoice within 10 days, or the buyer must pay full price within 30 days.
3 Inventory Costing Methods
Inventory Costing Methods
The cost of inventory is complicated to calculate because unit cost changes over time. To compute COGS & cost of ending inventory still on hand, we must assign a unit cost to the items.
Methods can have different effects on reported inventory balances, COGS, income taxes & cash flows.
Specific Identification Cost
Each specific unit has a different cost. For example, a car dealer can have 2 cars with different features that each have a specific cost.
Weighted-Average Cost (for the Perpetual System)
The weighted-average cost method, sometimes called the average cost method, is based on the average cost of inventory during the period. Since the inventory records are updated each time merchandise is sold, a new average cost per unit is computed every time a purchase is made.
- Calculate the weighted-average cost per unit: *Cost of goods available = Beginning Inventory + Purchases
2. Determine the value for COGS:
3. Calculate the cost of ending inventory: The cost of ending inventory is determined by taking the 5 units left over from Purchase #2, plus the 15 units bought from Purchase #3. The new weighted-average cost per unit = $340/20 units = $17 per unit.
Weighted-Average Cost (for the Periodic System)
Under the periodic inventory system, the cost of inventory is based on the average cost of the inventory for the entire period.
- Calculate the weighted-average cost per unit:
- Determine the value for COGS:
- Calculate the cost of ending inventory:
First-In, First-Out (FIFO) Cost (for the Periodic System)
Like the perpetual inventory system, the first costs into inventory are assigned to the first units sold.
First-In, First-Out (FIFO) Cost (for the Perpetual System)
Under this method, the first costs into inventory are the first costs assigned to cost of goods sold.
Notice how the amounts for COGS & ending inventory are the same under both perpetual & periodic inventory methods!
Inventory Costing Methods & COGS, Gross Profit, and Ending Inventory
The various inventory methods produce different COGS figures. Here’s an example summary:
Comparison of the Inventory Methods
- How well does each method measure income by allocating COGS against revenue?
- Weighted-average results in the most realistic net income figure, it’s an average that combines all costs (old costs & recent costs). In contrast, FIFO uses old inventory costs against revenue & less realistic.
2. Which method reports the most up-to-date inventory cost on the balance sheet?
- FIFO reports the most current inventory cost on the balance sheet. Weighted-average can value inventory at very old costs because weighted-average leaves the oldest prices in ending inventory.
3. What effects do the methods have on income taxes?
- In a period of rising costs, FIFO uses old inventory costs against revenue, resulting in higher income taxes. Weighted-average is an average that combines all costs, which leads to lower profits & lower income taxes.
Decision Guidelines for Managing Inventory
How Accounting Standards Apply to Inventory
Comparability is one of the enhancing qualitative characteristics of accounting information. For accounting information to be comparable, it must be reported in a way that makes it possible to compare it to other companies & with its own financial statements from one period to the next. It must also be reported in a way that is consistent with how it was reported in previous periods. This is called the consistency principle.
This does not mean that a company is not permitted to change its accounting methods. Both IFRS & ASPE allow a change, if it “results in the financial statements providing reliable & more relevant information”. The change should normally be applied retrospectively, which means that prior years’ financial statements should be restated to reflect the change. In addition, the effect of the change on the current financial statements should be disclosed, & would be found in the notes.
What is the ‘Lower of Cost & Net Realizable Value’ Rule?
The lower-of-cost-and-net-realizable-value (LCNRV) rule is based on the premise that inventory can become obsolete or damaged or its selling price can decline. Both IFRS & ASPE require inventory be reported at whichever is lower—the inventory’s cost or its net realizable value (NRV), that is, the amount the business could get if it sold the inventory, less any costs incurred to sell it. If the net realizable value of inventory falls below its historical cost, the business must write down the value of its goods to net realizable value. On the balance sheet, the business reports ending inventory at its LCNRV.
An LCNRV write-down decreases Inventory and increases Cost of Goods Sold, as follows:
Inventory that has been written down to net realizable value should be reassessed each period. If the net realizable value has increased, the previous write-down should be reversed up to the new net realizable value, as follows:
Companies disclose how they apply LCNRV in a note to their financial statements.
Compute/Evaluate Gross Profit & Inventory Turnover
What is the Gross Profit Percentage?
Merchandisers strive to increase gross profit percentage, also called the gross margin percentage. Gross profit—sales minus cost of goods sold—is a key indicator of a company’s ability to sell inventory at a profit.
A 43.4% gross profit means that each dollar of sales generates 43.4 cents of gross profit.
What is Inventory Turnover?
The faster the sales, the higher the company’s income; the slower the sales, the lower the company’s income. Inventory turnover, the ratio of cost of goods sold to average inventory, indicates how rapidly inventory is sold, and it varies industry to industry.
Inventory turnover shows how many times a company sold its average inventory during a year. To calculate how long it takes to sell inventory, take 365 days and divide by the inventory turnover.
Decision Guidelines for Gross Profit Percentage & Inventory Turnover
Analyze the Effects of Inventory Errors
Ending/Beginning Inventory, COGS & Gross Profit Relationships
Beginning inventory (BI) & ending inventory (EI) have opposite effects on COGS (beginning inventory is added; ending inventory is subtracted); therefore, after two periods, an inventory accounting error “washes out” (counterbalances).
There’s a direct relationship between EI & gross profit (GP), but an inverse relationship between BI & GP. An understatement of EI results in an understatement of GP, but an understatement of BI results in an overstatement of GP.
Inventory errors cannot be ignored simply because they counterbalance.
Reporting on the Statement of Cash Flows
Inventories are current assets. Since inventory transactions affect cash, their effects are reported on the statement of cash flows. Inventory transactions are operating activities.
2 Most Common Ways to Cook the Books with Inventory
- Inserting fictitious inventory, thus overstating quantities.
- Deliberately overstating unit prices used in the computation of ending inventory amounts.