Transcript Inventories Generally, 2 types of inventories: Merchandise (for sale) inventory Processing Inventory • Raw Materials Inventory • Work In Process Inventory Inventories When to Include Items? Include items.

Inventories
Generally, 2 types of inventories:
Merchandise (for sale) inventory
Processing Inventory
• Raw Materials Inventory
• Work In Process Inventory
Inventories
When to Include Items?
Include items in inventory when ownership transfers.
FOB (Free-on-Board):
• Specifies where ownership transfers.
• Shipping Point: when delivered to carrier.
• Destination: when delivered from carrier to recipient.
Inventories
When to Include Items?
Consignment:
• Provide product to marketing agent (shopkeeper) to sell.
• Marketing agent receives commission for sale.
• Marketing agent does not take ownership.
• Original owner retains ownership.
Inventories
Generally, 2 ways to keep track of inventory:
Perpetual (real-time) tracking
• Updates as items leave and arrive
• e.g. Supermarket Scanners
Periodic tracking or counting
• Inventory counted at regular intervals
• Usually involves a hand-count
• Inventory sold is “backed-into” by looking
at changes in inventory balance
Inventories
Periodic Inventory System
We take end of period count of inventory and compare
to beginning inventory + newly purchased inventory to
compute Cost of Goods Sold.
Information needed:
• Beginning Inventory
• Purchases
• Ending Inventory
Inventories
Periodic Inventory System
$5
$5
$5
Beginning Inventory = $15
$5
$5
Purchases = $10
Cost of Goods
Available for Sale
= BI + Purchases
= $25
Inventories
Periodic Inventory System
$5
Ending Inventory = $5
Cost of Goods Sold
= Cost of Goods Available for Sale – EI
= $25 - $5
= $20
Inventories
Periodic Inventory System
$5
$5
$5
Available for Sale
$25
$5
$5
Let’s take another look…
Inventories
Periodic Inventory System
$5
$5
$5
Available for Sale
$25
Ending Inv $5
$5
$5
Inventories
Periodic Inventory System
$5
Available for Sale
Ending Inv
COGS
$25
($5)
$20
Sold
$20
(or stolen)
Inventories
Periodic Inventory System—Inventory Errors
• Inventory Errors in a Periodic System directly hit Net Income.
• These errors affect 2 periods.
• The error in the first period is reversed in the second period.
- i.e., if Net Income is overstated in period 1, it will be
understated in period 2.
Inventories
Periodic Inventory System—Inventory Errors
Period 1
Period 2
Beg Inventory
+ Purchases
= CoG Avail for Sale
- Ending Inventory
= Cost of Goods Sold
Beg Inventory
+ Purchases
= CoG Avail for Sale
- Ending Inventory
= Cost of Goods Sold
Sales Revenue
- Cost of Goods Sold
= Net Income
Sales Revenue
- Cost of Goods Sold
= Net Income
Inventories
Periodic Inventory System—Inventory Errors
Period 1
Period 2
Beg Inventory
+ Purchases
= CoG Avail for Sale
- Ending Inventory
= Cost of Goods Sold
Beg Inventory
+ Purchases
= CoG Avail for Sale
- Ending Inventory
= Cost of Goods Sold
Sales Revenue
- Cost of Goods Sold
= Net Income
Sales Revenue
- Cost of Goods Sold
= Net Income
Assume we accidentally OVERCOUNT (overstate) 1st pd Ending Inv.
Inventories
Periodic Inventory System—Inventory Errors
Period 1
Period 2
Beg Inventory
+ Purchases
= CoG Avail for Sale
- Ending Inventory (Too big)
= Cost of Goods Sold (Too small)
Beg Inventory
+ Purchases
= CoG Avail for Sale
- Ending Inventory
= Cost of Goods Sold
Sales Revenue
- Cost of Goods Sold
= Net Income
Sales Revenue
- Cost of Goods Sold
= Net Income
Inventories
Periodic Inventory System—Inventory Errors
Period 1
Period 2
Beg Inventory
+ Purchases
= CoG Avail for Sale
- Ending Inventory (Too big)
= Cost of Goods Sold (Too small)
Beg Inventory
+ Purchases
= CoG Avail for Sale
- Ending Inventory
= Cost of Goods Sold
Sales Revenue
- Cost of Goods Sold (Too small)
= Net Income
(Too big)
Sales Revenue
- Cost of Goods Sold
= Net Income
Inventories
Periodic Inventory System—Inventory Errors
Period 1
Period 2
Beg Inventory
+ Purchases
= CoG Avail for Sale
- Ending Inventory (Too big)
= Cost of Goods Sold
Beg Inventory
(Too big)
+ Purchases
= CoG Avail for Sale
- Ending Inventory
= Cost of Goods Sold
Sales Revenue
- Cost of Goods Sold
= Net Income
Sales Revenue
- Cost of Goods Sold
= Net Income
Inventories
Periodic Inventory System—Inventory Errors
Period 1
Period 2
Beg Inventory
+ Purchases
= CoG Avail for Sale
- Ending Inventory
= Cost of Goods Sold
Beg Inventory
(Too big)
+ Purchases
= CoG Avail for Sale (Too big)
- Ending Inventory
= Cost of Goods Sold(Too big)
Sales Revenue
- Cost of Goods Sold
= Net Income
Sales Revenue
- Cost of Goods Sold
= Net Income
Inventories
Periodic Inventory System—Inventory Errors
Period 1
Period 2
Beg Inventory
+ Purchases
= CoG Avail for Sale
- Ending Inventory
= Cost of Goods Sold
Beg Inventory
+ Purchases
= CoG Avail for Sale
- Ending Inventory
= Cost of Goods Sold(Too big)
Sales Revenue
- Cost of Goods Sold
= Net Income
Sales Revenue
- Cost of Goods Sold (Too big)
= Net Income (Too small)
Inventories
Periodic Inventory System—Inventory Errors
Period 1
Period 2
Beg Inventory
+ Purchases
= CoG Avail for Sale
- Ending Inventory (Too big)
= Cost of Goods Sold
Beg Inventory
+ Purchases
= CoG Avail for Sale
- Ending Inventory
= Cost of Goods Sold
Sales Revenue
- Cost of Goods Sold
= Net Income (Too big)
Sales Revenue
- Cost of Goods Sold
= Net Income (Too small)
Note the reversal in the 2nd period.
Inventories
Valuing inventory stock (determining COGS)
A common problem is that inventory is often brought in with
different cost layers.
Different methods to value inventory:
• Specific Identification: each item tracked at actual value
• Average Cost Method: use weighted average cost of items
• First-in-First-Out
• Last-in-First-Out
Inventories
Average Cost Method
Amount
Unit Cost
Value
100
$5
$500
200
$6
$1,200
200
$7
$1,400
500
$3,100
Sell 300 units:
Average cost = $3,100 / 500 = $6.20 per unit
Cost of Goods Sold = $6.20 x 300 units = $1,860
Inventories
Average Cost Method
Amount
Unit Cost
Value
100
$5
$500
200
$6
$1,200
200
$7
$1,400
500
200
$6.20
$1,240 $3,100
Sell 300 units:
Average cost = $3,100 / 500 = $6.20 per unit
After Sale, 200 units left. Unit cost now adjusted to $6.20.
Inventories
Average Cost Method
Amount
Unit Cost
Value
200
$6.20
$1,240
(new purchase)
100
300
$6.50
$650
$1,890
Any new purchases create new layers and a new average will
be computed.
$1,890 / 300 = $6.30 per unit
Inventories
FIFO Method
Amount
Unit Cost
Value
100
$5
$500
200
$6
$1,200
200
$7
$1,400
Sell 250 units:
100 x $5 = $500
150 x $6 = $900
COGS = $1,400
These layers are
depleted first. (Top
down).
Inventories
LIFO Method
Amount
Unit Cost
Value
100
$5
$500
200
$6
$1,200
200
$7
$1,400
Sell 250 units:
200 x $7 = $1,400
50 x $6 = $300
COGS = $1,700
These layers are
depleted first.
(Bottom up.)
Inventories
Differences in Methods
• Weighted Average has least potential for manipulation
• LIFO has highest COGS (lowest Net Income) during
rising inflation
• FIFO has the lowest COGS (highest Net Income) during
rising inflation
• Specific Identification may be the most accurate
Inventories
Problems with LIFO
• LIFO Liquidation is an issue when, due to high demand,
a firm using LIFO has to dip deep into its inventory.
• When this happens, many of the earlier (cheaper) layers
get liquidated.
• This forces the firm to match revenues against cheaper,
and likely less accurate costs.
• One potential remedy is the Dollar Value LIFO Method
Inventories
Dollar Value LIFO
• To use Dollar Value LIFO, you only need to know two things:
• Ending Value of Total Inventory
• The rate of inflation
• From these, you “back out” the layers of inventory
Inventories
Dollar Value LIFO
1999 Ending Inventory
Value
2000 Ending Inventory
Value
$200,000
$299,000
$99,000 increase in value
Is this increase in value due to purchases of new
inventory or due to inflation?
Both!
Inventories
Dollar Value LIFO
1999 Ending Inventory
Value
2000 Ending Inventory
Value
$200,000
$299,000
To find out actual inventory purchases, we need to deflate
(discount) the 2000 Ending Inventory back to 1999 price
levels.
This effectively wipes away the inflation effect to give us
the true purchases effect.
Inventories
Dollar Value LIFO
1999 Ending Inventory
Value
$200,000
If price index is 15%,
the discount multiplier
is:
1 = 0.8696
1.15
2000 Ending Inventory
Value
$299,000
x 0.8696
$260,000
Inventories
Dollar Value LIFO
1999 Ending Inventory
Value
$200,000
2000 Ending Inventory
Value
$299,000
x 0.8696
$260,000
$60,000 of actual inventory
increase (stated at year 1999 price levels)
Inventories
Dollar Value LIFO
Year
[a]
Ending
Value
[b]
Disc.
Multiplier
[1/Price
Index]
1999
(Base)
200,000
---
2000
2001
[c] = [a] x [b]
[d]
Ending Value Real Increase
(Base Year $) in Inventory
(Base Year $)
200,000
---
[e]
New
Layer at
inflated
cost
200,000
Inventories
Dollar Value LIFO
Year
[a]
Ending
Value
[b]
Disc.
Multiplier
[1/Price
Index]
1999
(Base)
200,000
---
2000
299,000
2001
[c] = [a] x [b]
[d]
Ending Value Real Increase
(Base Year $) in Inventory
(Base Year $)
200,000
---
[e]
New
Layer at
inflated
cost
200,000
Inventories
Dollar Value LIFO
Year
[a]
Ending
Value
[b]
Disc.
Multiplier
[1/Price
Index]
1999
(Base)
200,000
---
2000
299,000
1/1.15
2001
[c] = [a] x [b]
[d]
Ending Value Real Increase
(Base Year $) in Inventory
(Base Year $)
200,000
---
[e]
New
Layer at
inflated
cost
200,000
Inventories
Dollar Value LIFO
Year
[a]
Ending
Value
[b]
Disc.
Multiplier
[1/Price
Index]
1999
(Base)
200,000
---
200,000
2000
299,000
0.8696
260,000
2001
[c] = [a] x [b]
[d]
Ending Value Real Increase
(Base Year $) in Inventory
(Base Year $)
---
[e]
New
Layer at
inflated
cost
200,000
Inventories
Dollar Value LIFO
Year
[a]
Ending
Value
[b]
Disc.
Multiplier
[1/Price
Index]
[c] = [a] x [b]
[d]
Ending Value Real Increase
(Base Year $) in Inventory
(Base Year $)
1999
(Base)
200,000
---
200,000
---
2000
299,000
0.8696
260,000
60,000
2001
This is the real increase reinflated
= 60,000 x 1.15
= 69,000
[e]
New
Layer at
inflated
cost
200,000
Inventories
Dollar Value LIFO
Year
[a]
Ending
Value
[b]
Disc.
Multiplier
[1/Price
Index]
1999
(Base)
200,000
---
200,000
---
200,000
2000
299,000
0.8696
260,000
60,000
69,000
2001
[c] = [a] x [b]
[d]
Ending Value Real Increase
(Base Year $) in Inventory
(Base Year $)
[e]
New
Layer at
inflated
cost
Inventories
Dollar Value LIFO
Year
[a]
Ending
Value
[b]
Disc.
Multiplier
[1/Price
Index]
[c] = [a] x [b]
[d]
Ending Value Real Increase
(Base Year $) in Inventory
(Base Year $)
1999
(Base)
200,000
---
200,000
---
200,000
2000
299,000
0.8696
260,000
60,000
69,000
2001
360,000
1/1.20
Assume a price index of 120 percent in this year.
[e]
New
Layer at
inflated
cost
Inventories
Dollar Value LIFO
Year
[a]
Ending
Value
[b]
Disc.
Multiplier
[1/Price
Index]
[c] = [a] x [b]
[d]
Ending Value Real Increase
(Base Year $) in Inventory
(Base Year $)
[e]
New
Layer at
inflated
cost
1999
(Base)
200,000
---
200,000
---
200,000
2000
299,000
0.8696
260,000
60,000
69,000
2001
360,000
0.8333
300,000
Inventories
Dollar Value LIFO
Year
[a]
Ending
Value
[b]
Disc.
Multiplier
[1/Price
Index]
[c] = [a] x [b]
[d]
Ending Value Real Increase
(Base Year $) in Inventory
(Base Year $)
[e]
New
Layer at
inflated
cost
1999
(Base)
200,000
---
200,000
---
200,000
2000
299,000
0.8696
260,000
60,000
69,000
2001
360,000
0.8333
300,000
40,000
Inventories
Dollar Value LIFO
Year
[a]
Ending
Value
[b]
Disc.
Multiplier
[1/Price
Index]
[c] = [a] x [b]
[d]
Ending Value Real Increase
(Base Year $) in Inventory
(Base Year $)
1999
(Base)
200,000
---
200,000
---
200,000
2000
299,000
0.8696
260,000
60,000
69,000
2001
360,000
0.8333
300,000
40,000
48,000
This is the real increase reinflated
= 40,000 x 1.20
= 48,000
[e]
New
Layer at
inflated
cost
Inventories
Dollar Value LIFO
Year
[e]
New Layer at inflated cost
1999
(Base)
200,000
2000
69,000
2001
48,000
This is how the inventory would be layered on the books.