Chapter 8
Inventory and
Costs of Sales
Assoc. Prof. Dr. Thamrongsak Svetalekth
CHAPTER
Inventory and the Cost of Sales
8
LO1 LO2 LO3
Counting
Accounting for
Inventory and Cost Inventory Inventory and
of Goods Sold Calculating
Purchases and
Cost of Goods
Sales
Sold
LO4 LO5
Valuing and
Cost Formulas Reporting
Inventory at the
for Inventory
Lower of Cost or
Net Realizable
Value
Type of Companies
1. Service Company
2. Merchandise Company
3. Manufacturing Company
3
Merchandising Operations
Merchandising Companies
Buy and Sell Goods
Wholesaler Retailer Consumer
The primary source of revenues is referred to as sales revenue or sales.
Inventory and Cost of Goods Sold
LO1 What is Inventory?
Inventory
► Goods held for resale.
Cost of Goods Sold
► The costs incurred to purchase or manufacture the
merchandise sold during a period.
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LO1 What is Inventory?
Activity: Buying/Making and Selling Inventory
Exhibit 8.2 Timeline of Business Issues Involved with Inventory
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LO1 What is Inventory?
Inventory
Three different types of inventory in a manufacturing
company
► Raw materials: materials purchased for use in
manufacturing process.
► Work in process: partially completed units in
production.
► Finished goods: manufactured products ready for sale.
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LO1 What is Inventory?
What Costs Included in Inventory Cost
Inventory cost consists of all costs involved in buying the
inventory and preparing it for sale.
► Raw materials
► Labor costs
► Manufacturing overhead: The indirect manufacturing
costs associated with producing inventory.
► Freight-in costs
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LO1 What is Inventory?
What Costs are not Included in Inventory Cost
The following costs are not included in inventory cost, but
should be reported as operating expenses.
► Maintaining the merchandise warehouse
► Maintaining the retail showroom
► Salespersons’ salaries.
► Advertising costs
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Classifying Inventory
Merchandising Manufacturing
Company Company
One Classification: Three Classifications:
Merchandise Inventory Raw Materials
Work in Process
Finished Goods
Regardless of the classification, companies report all inventories under
Current Assets on the balance sheet.
Merchandising Operations
Income Measurement
Not used in a Service
Sales Less
business.
Revenue
Cost of Equals Gross Less
Goods Sold Profit
Operating Equals Net
Cost of goods sold is the total cost of
Expenses Income
merchandise sold during the period.
(Loss)
Operating Cycles
The operating
cycle of a
merchandising
company
ordinarily is
longer than that
of a service
company.
LO1 Who Owns the Inventory?
Goods Being Shipped
► FOB (free-on-board) destination
► FOB (free-on-board) shipping point
Exhibit 8.3 Ownership Transfer for Goods in Transit
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Freight Cost
• FOB Shipping Point – Purchaser pays the
freight costs.
• FOB Destination Point – Seller pays the
freight costs.
Recording Purchases of Merchandise
Freight Costs – Terms of Sale
Seller places goods Free
On Board the carrier, and
buyer pays freight costs.
Seller places goods Free
On Board to the buyer’s
place of business, and
seller pays freight costs.
Freight costs incurred by the seller are an operating expense.
LO1 Who Owns the Inventory?
Goods on Consignment
► The consignors provide inventory to consignee for
resale while retain ownership of the inventory until it
is sold.
consignor consignee
Keeping ownership
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LO1 Ending Inventory and Cost of Goods Sold
Cost of Goods Available for Sale
Beginning Inventory Cost of Goods
+ =
inventory purchased Available for Sale
The Cost Allocation Process
Ending
inventory
Cost of Goods
Available for Sale
Cost of
Goods sold
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Inventory Cost Methods
• Specific identification
• Matches each unit of inventory with its actual cost
• First-in, first-out (FIFO)
• Assumes first units purchased are first ones sold
• Last-in, first-out (LIFO) (Cancelled)
• Assumes last units purchased are first ones sold
• Weighted-average cost
• Assumes units sold come from random mixture
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Cost Formulas for Inventory
LO4 Cost Formulas for Inventory
◆ FIFO (first in, first out) IFRS does not allow
the use of LIFO.
► The first good purchased are the first goods sold
► Ending inventory consists of the most purchased goods.
◆ LIFO (last in, first out)
► The last good purchased are the first goods sold.
► Ending inventory consists of the first goods purchased.
◆ Weighted Average Cost
► Using weighted average cost of all merchandise for the cost of goods
sold and the cost of ending inventory.
◆ Specific Identification
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LO4 Specific Identification Cost Formula
Illustration
► Assume that the periodic system is adopted, consider
the September 2022 records of Nephi Company, which
sells one type of bicycle.
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LO4 Specific Identification Cost Formula
◆ Each item is specifically identified.
◆ Usually used for large or expensive items.
Illustration
► Suppose that of the 28 bicycles sold by Nephi on
September 20, 8 came from the beginning inventory,
4 came from the September 3 purchase, and 16 came
from the September 18 purchase.
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LO4 Specific Identification Cost Formula
Illustration
► The cost of ending inventory is the total of the individual
costs of the bicycles still on hand at the end of the
month.
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LO4 Specific Identification Cost Formula
Illustration
► The cost of goods sold is the total of the costs of the
specific bicycles sold.
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LO4 FIFO Cost Formula
◆ It is assumed that the oldest units are sold and the newest
units remain in inventory.
Illustration
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LO4 FIFO Cost Formula
Illustration
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LO4 Weighted Average Cost Formula
◆ With weighted average cost formula, a weighted average
cost must be computed for all the inventory available for
sale during the period.
Illustration
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LO4 Weighted Average Cost Formula
Illustration
Weighted Average Cost of Goods Sold: 28 units x $272.73 per unit=$7,636 (rounded)
Weighted Average Ending Inventory: 16 units x $272.73 per unit=$4,364 (rounded)
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LO4 FIFO vs. Weighted Average Cost Formula
Comparison
► When prices are increasing, companies tend to prefer FIFO
because the performance looks better.
► From the perspective of financial position, FIFO measures
inventory value better because it approximates current cost.
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LO4 Quiz Yourself
◆ Zielesch Company reports the following activity during
March related to its inventory of watches:
Mar. 1 Beginning inventory consisted of 6 watches costing $40 each.
5 Purchased 10 watches costing $ 45 each.
11 Purchased 7 watches costing $48 each.
22 Purchased 11 watches costing $50 each.
27 Sold 27 watches for $150 each.
◆ Determine (a) the cost of goods sold for the month and (b)
the ending inventory balance for March 31 using
1. FIFO cost formula
2. Weighted average cost formula
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Valuing and Reporting Inventory at the Lower of Cost or Net Realizable Value
LO5 Inventory Valued at Net Realizable Value
Lower of Cost or Net Realizable Value
► Compare the inventory cost to its net realizable value,
and report the lower of cost or net realizable value on
the balance sheet.
Net Realizable Value
► The selling price of an item less reasonable selling
costs.
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Lower of Cost and Net Realisable Value
During the year
Record inventory purchases at cost
At the end of the year
Net Realisable
Cost Which is lower for
unsold inventory? value
(specific identification, (estimated selling price
FIFO, or weighted-average) less cost to sell)
No year-end Reduce inventory from cost
adjustment needed to net realisable value
(Report ending inventory at (and report an expense for the
purchase cost) reduction)
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LO5 Inventory Valued at Net Realizable Value
Illustration
◆ An automobile dealer has a demonstrator car that
originally cost $18,000 and now can be sold for only
$16,000. A commission of $500 must be paid to sell the car,
the net realizable value is $15,500, or $2,500 less than
cost. This loss is calculated as follows:
Cost of Goods Sold 2,500
Allowance for Inventory Write-down 2,500
a contra account to
To write down inventory to its net realizable value.
Inventory (a deduction from
inventory)
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LO5 Quiz Yourself
◆ For each of the following, identify the appropriate inventory
value to be reported on the balance sheet by comparing
with historical cost with the net realizable value.
Solution
Item A—$31 Item B—$17
Item C—$22 Item D—$45
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Calculating the Lower of Cost
and Net Realisable Value
Cost NRV
Inventory Lower of Year-end
Items Quantity Per unit Total Per unit Total Cost and NRV Adjustment*
FunStation 2 15 $300 $4,500 $200 $3,000 = $ 3,000 $1,500
FunStation 3 20 400 8,000 450 9,000 = 8,000 0
$12,500 $11,000 $1,500
Recorded Cost Ending Inventory
*The year-end adjustment is recorded when NRV is below cost. The adjustment equals the
difference between cost and net realizable value times the quantity of inventory
Reduce 15 FunStation 2s from their original cost of $4,500 (= 15 units × $300) to
their lower net realisable value of $3,000 (= 15 units × $200) with the following
year-end adjustment.
December 31 Debit Credit
Cost of Goods Sold (expense) .................................... 1,500
Inventory ............................................................... 1,500
(Adjust inventory down to net realizable value)
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Calculating the Lower of Cost
and Net Realisable Value
At the end of the year, a company reports the following
inventory amounts ($ per unit):
Item # of Units Cost Net Realisable Value
A 100 $4 $8
B 150 $8 $6
The amount to report for ending inventory using the
lower of cost and net realisable value is:
a. $1,600
b. $1,700
c. $2,000
d. $1,300
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Calculating the Lower of Cost
and Net Realisable Value
At the end of the year, a company reports the following
inventory amounts ($ per unit):
Item # of Units Cost Net Realisable Value
A 100 $4 $8
B 150 $8 $6
The year-end adjustment using the lower of cost and net
realisable value would include:
a. A credit to Inventory for $300
b. A debit to Cost of Goods Sold for $400
c. A debit to Inventory for $500
d. A credit to Cost of Goods Sold for $700
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Assessing How Well Companies Manage Their Inventories
LO6 Evaluating the Level of Inventory
Inventory Turnover
► Provides a measure of how many times a company
turns over, or replenishes, its inventory during a year.
Cost of Goods Sold
Inventory Turnover =
Average Inventory
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LO6 Evaluating the Level of Inventory
Number of Days’ Sales in Inventory
► Provides a measure of how many days’ worth of sales
does the company have in inventory.
Number of Days’ 365
Sales in Inventory = Inventory Turnover
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LO6 Evaluating the Level of Inventory
Illustration : During 2019
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LO6 Number of Days’ Purchases in Accounts Payable
Caterpillar’s operating cycle in 2019
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LO6 Number of Days’ Purchases in Accounts Payable
► Provides a measure of how many days’ worth of
inventory does the company have in accounts payable.
Number of Days’ Purchases = 365
in Accounts Payable Purchases / Average Accounts Payable
Caterpillar’s number of days’ purchased in 2019
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LO6 Number of Days’ Purchases in Accounts Payable
Caterpillar’s net operating cycle in 2019
• Caterpillar must pay its suppliers in 65 days but must wait for 173 days
before receiving the cash from its customers.
• Caterpillar must finance the remaining 108 days of its operating cycle with
bank loans or additional stockholder investment.
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LO6 Quiz Yourself
◆ Skiba Company reported the following information for
the year:
Ending inventory $3,000
Cost of goods sold 4,200
Beginning inventory 2,600
◆ Compute (1) inventory turnover and (2) number of
days’ sales in inventory.
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Q&A