Chapter 7

1. Chapter 7 Reporting and Interpreting Cost of Goods Sold and Inventory

2. HARLEY-DAVIDSON • Business Strategy? Differentiation • Problem? Demand exceeds their ability to produce. • Solutions? • Expand Manufacturing – new plants • Inventory management – growing twice as fast as sales, needs control • Reduce cost of goods sold – material, labor and overhead to maintain margins

3. Nature of Inventory and Cost of Goods Sold BeginningInventory Purchasesfor the Period Work in ProcessInventory Ending Inventory(Balance Sheet) Cost of Goods Sold(Income Statement) Beginning inventory + Purchases – Ending inventory = Cost of goods sold

4. Flow of Inventory Costs Merchandiser MerchandisePurchases MerchandiseInventory Cost ofGoods Sold Manufacturer RawMaterials Raw MaterialsInventory Work in ProcessInventory Finished GoodsInventory DirectLabor Cost ofGoods Sold FactoryOverhead

5. Inventory Cost The cost principle requires that inventory be recorded at the price paid or the consideration given up.

6. Inventory Cost Include all costs incurred to bring the product to useable or saleable condition, such as: Invoice price Freight charges Inspection costs Preparation costs.

7. CORRECTING INVENTORY ERRORS • Use basic inventory formula: Beginning Inventory + Purchases of the period - Ending Inventory = Cost of Goods Sold

8. Question If the 2000 ending inventory is understated by $3,000, which of the following is true for 2000? a. Beginning Inventory was understated. b. Cost of Goods Sold will be understated. c. Gross Profit will be overstated. d. Net Income will be understated.

9. Question If the 2000 ending inventory is understated by $3,000, which of the following is true for 2000? a. Beginning Inventory was understated. b. Cost of Goods Sold will be understated. c. Gross Profit will be overstated. d. Net Income will be understated.

10. Question If the 2000 ending inventory is understated by $3,000, which of the following is true for 2001? a. Beginning Inventory was understated. b. Cost of Goods Sold will be understated. c. Gross Profit will be overstated. d. All of the above.

11. Question Remember:The ending inventory for 2000 becomes the beginning inventory for 2001. If the 2000 ending inventory is understated by $3,000, which of the following is true for 2001? a. Beginning Inventory was understated. b. Cost of Goods Sold will be understated. c. Gross Profit will be overstated. d. All of the above.

12. FIFO LIFO Weighted Average Specific Identification Inventory Costing Methods

13. Ending Inventory Cost of Goods Sold All Four Methods – objective is to apply Goods Available for sale to ending inventory and COGS Total Dollar Amount of Goods Available for Sale

14. Costs of Goods Sold Oldest Costs Ending Inventory Recent Costs First-In, First-Out

15. First-In, First-Out The schedule on the next screen shows the mouse pad inventory for Computers, Inc. The physical inventory count shows 1,200 mouse pads in ending inventory. Use the FIFOinventorymethod to determine: (1) Ending inventory cost. (2) Cost of goods sold.

16. First-In, First-Out Remember: The costs of most recent purchases are in ending inventory. Start with 11/29 and add units purchased until you reach the number in ending inventory.

17. First-In, First-Out Now, we have allocated the cost to all 1,200 units in ending inventory.

18. First-In, First-Out

19. ANY QUESTIONS BEFORE WE DISCUSS LIFO?

20. Last-In, First-Out Ending Inventory Oldest Costs Cost of Goods Sold Recent Costs

21. Last-In, First-Out Remember: The costs of the oldest purchases are in ending inventory. Start with beginning inventory and add units purchased until you reach the number in ending inventory.

22. Last-In, First-Out Now, we have allocated the cost to all 1,200 units in ending inventory.

23. Last-In, First-Out

24. Weighted-Average Weighted-average cost (WAC) per unit Cost of goods available for sale Number of units available for sale Ending Inventory Units in Ending Inventory ´ WAC per Unit Cost of Good Sold Units Sold ´ WAC per Unit

25. Weighted-Average

26. Weighted-Average Weighted-Average Cost per Unit: $9,725 1,800 Ending Inventory: 1,200 Units × $5.40278 = $6,483* Cost of Goods Sold: 600 Units × $5.40278 = $3,242* *Rounded = $5.40278

27. Specific Identification • Specific cost of each inventory item is known. • Used with small volume, high dollar inventory.

28. Comparison of Methods

29. Comparison of Methods In periods of rising prices, FIFO results in the highest ending inventory, gross profit, tax expense, and net income, and the lowest cost of goods sold.

30. Comparison of Methods In periods of rising prices, LIFO results in the lowest ending inventory, gross profit, tax expense, and net income, and the highest cost of goods sold.

31. Choosing Inventory Costing Methods If . . . Then . . . LIFO Conformity Rule LIFO for taxes LIFO for books

32. LIFO/FIFO COMPARABILITY? • If you use LIFO, you must report FIFO in the footnotes if material • The difference between LIFO and FIFO inventory balances is called the LIFO reserve • The impact of LIFO on the current year COGS is the difference between beginning and ending LIFO reserve • In a period of rising prices, the reserve will increase

33. LIFO/FIFO Example • Beginning LIFO reserve 20,722 • Ending LIFO reserve 22,613 • Difference in COGS ( 1,891) • Note: Since the reserve increased, the impact is a decrease on COGS from a LIFO basis to a FIFO basis, and higher FIFO earnings.

34. Key Ratio Analysis Inventory Turnover Cost of Goods Sold = Average Inventory Inventory Turnover Average Inventory is . . . (Beginning Inventory + Ending Inventory) ÷ 2 This ratio is often used to measure the efficiency of inventory management, potential obsolescence or sales declines

35. Key Ratio Analysis(Compare to competitors p. 380) Inventory Turnover Cost of Goods Sold = Average Inventory Inventory Turnover The 1998 inventory turnover ratio for Harley-Davidson: $1,373,286 ($117,475 + $155,616) ÷ 2 = 10.1

36. Lower of Cost or Market(Principle of Conservatism) Ending inventory is reported at the lower of cost or market (LCM). Market is either . . . Net Realizable ValueThe expected sales priceless selling costs. Replacement CostThe current purchase price of identical goods. or

37. Lower of Cost or Market • Recognition of gain on increases in inventory value is not allowed by GAAP • Once you write the inventory down, you do not write it up again, even if the market value increases back up

38. Perpetual and Periodic Inventory Systems Provides up-to-date inventory records. Perpetual System Provides up-to-date CGS records.

39. Comparison of Perpetual and Periodic Systems

40. Inventory Carrying Costs • Required rate of return on investment/opportunity cost • Warehouse or storage costs • Wages, etc. for warehouse personnel • Inventory shrinkage/obsolescence • Can be from 25 to 35% of inventory value! Per year!

41. The End of Chapter 7