ACCT 2101 Principles of Accounting I
Chapter 6: Inventory and COGS
Inventory
Inventories are assets consisting of goods owned by the business and held for resale or for future
use in the manufacturing of goods for sale.
The fundamental issue for financial reporting purposes is determining the value of items in
inventory vs. the amount in COGS.
COGS = Beginning Inventory + Purchases – Ending Inventory
What costs should be included in inventory purchases (and eventually in ending inventory)?
Purchases should include the costs of the goods plus all costs required to obtain physical
possession and to put the merchandise in saleable condition.
Two types of inventory:
• Merchandising Inventories: physical form of the goods is not altered prior to the sale.
Cost = purchase price + [taxes, duties, freight, storage, insurance during transit, etc.]
– [discounts & allowances, purchase returns, purchase discounts]
• Manufacturing Inventories: physical form of the goods is altered prior to the sale.
Typically include three categories:
o Raw Material Inventory
o Work-in-Process Inventory
o Finished Goods Inventory
Cost = raw materials + direct labor cost + indirect factory costs (e.g., electricity, depreciation of
equipment & building, supervisory salaries, suppliers, etc.)
Keeping track of inventories
Two Methods:
• Perpetual Inventory System: Keeps a running record of the amount in inventory – BOTH
in physical units (quantity) and dollars (costs). For each sale, cost of goods sold (COGS)
and inventory is determined.
• Periodic Inventory system: does not keep a running record of inventory on hand.
Inventory is physically counted at the end of the accounting period, and cost of goods
sold (COGS) is residual value:
Beginning Inventory + Inventory Purchased – Ending Inventory = Cost of goods sold
Inventory Control
• All companies need periodic verification of the inventory records
• Companies should take the physical inventory near the end of their fiscal year
• Inventory Over and Short adjusts Cost of Goods Sold
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ACCT 2101 Principles of Accounting I
Inventory Cost Flow Assumptions
Firms purchase or manufacture products at different times and different costs
• Which units were sold, and which units are still in inventory?
• How should dollar amounts be assigned?
The choice of method for making the allocation between Ending Inventory and COGS is the
major issue in inventory accounting.
Beginning+ + Inventory
= = Goods Available
Inventory Purchase for Sale
Ending Cost of
Inventory Goods Sold
Inventory Costing Methods
• Specific Identification
• First-In. First-Out (FIFO). This method assumes that the first units purchased are the first
units sold.
• Last-In, First-Out (LIFO). The LIFO inventory costing method assumes that the last units
purchased are the first to be sold.
• Average cost. The average cost method assumes that the units are sold without regard to
the order in which they are purchased. Instead, it computes COGS and ending inventories
as a simple weighted average.
Cost of Goods Available for Sale
Weighted-Average Unit Cost =
Units (quantity) available for sale
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ACCT 2101 Principles of Accounting I
Example: Cost Flow Assumptions
Year 1 (First year of operations, so beginning inventory = 0)
Purchases of inventory (P1 is the first purchase, P2 is the second, etc.):
Units X $/Unit Total $
Purchase 1 6,000 3 18,000
Purchase 2 4,000 4 16,000
Purchase 3 5,000 5 25,000
Total Purchases 15,000 59,000
Sales 8,000 $10/unit
Year 2
Units X $/Unit Total $
Purchase 25,000 6 150,000
Sale 25,000 $10/unit
For each year, calculate Cost of Goods Sold and Ending Inventory under the assumption that the
firm uses (1) FIFO; (2) LIFO; (3) weighted average method to account for their inventory.
Assuming periodic inventory system
Year 1 Year 2
FIFO
LIFO
Weighted
average
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ACCT 2101 Principles of Accounting I
Important points about inventory methods:
• The accounting cost method does not have to represent the physical flow of merchandise
from the warehouse.
• LIFO conformity rule – tax codes require that if you use LIFO for tax purposes, you must
use it for financial accounting purposes.
• LIFO generates lower net income in times of rising prices and non-decreasing inventory
quantity.
• LIFO is only used in the US
• Factors that affect company’s decision to choose LIFO:
o Many companies choose LIFO to reduce income taxes in periods when they
expect prices to rise and quantities not to fall. However, because of the LIFO
conformity rule, lowering taxes also means lowering profits.
o LIFO records are more complicated and costly to maintain.
LIFO Liquidation
LIFO liquidation occurs when ending inventory is less than beginning inventory.
• LIFO can generate some very old “layers” of costs.
• Dipping into these layers can generate very high income.
Questions:
Why would you want to avoid LIFO liquidation?
How can you avoid LIFO liquidation?
Why would you NOT take actions to avoid LIFO liquidation?
Lower of Cost or Net Realizable Value:
• Inventories are reported at the lower of cost or NRV
• Recognize loss when NRV < cost
• Recognizes losses when value declines instead of when the inventory is sold
• The basic rationale for the rule is accounting conservatism
Definition of “Net Realizable Value”: The estimated selling price of the product in the ordinary
course of business less normal selling costs
• Normal selling costs include: sales commissions, shipping costs, installation, etc.
If Cost < NRV: do nothing
If Cost > NRV: Dr: Loss or COGS
Cr:Inventory
Applying the rule: you can apply the rule
(1) on an item-by-item basis
(2) on a group basis
(3) on a total-inventory basis
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ACCT 2101 Principles of Accounting I
Example: Ted Company uses the lower of cost or NRV method in valuing its inventory items.
The inventory at December 31, 2014, consists of products A, B and C, each having 1,000 units.
Relevant unit data for these products appear below:
Item A Item B Item C
Cost $ 80 $80 $80
Estimated selling price 180 100 90
Estimated selling cost 30 30 30
Required:
Using the lower of cost or net realizable value rule, determine the proper value of inventory for
balance sheet reporting purposes at December 31, 2014. Prepare any necessary journal entry.
Apply the lower of cost or NRV method:
• on an individual inventory basis;
• on a group basis (group 1 includes items A and B, group 2 includes item C);
• on a total inventory basis.
Solution Worksheet:
Inventory (On an individual basis): Inventory Value
Item NRV Cost LC-NRV___
Item A
Item B
Item C
Total
Inventory (On a group basis): Inventory Value
Item NRV Cost LC-NRV___
Group 1
Group 2
Total
Inventory (On an aggregate inventory basis): Inventory Value
Item NRV Cost LC-NRV____
Total INV