6
Reporting CHAPTER and Interpreting
COGS & Inventory
I.
II.
Understanding Inventory
Three Inventory Methods
III.
2012Ying Li
First-In, First-Out Method
Last-In, First-Out Method
Average Cost Method
Other Issues
6-1
Inventory Concepts
Inventory is property held for sale (or converted into
products for sale) in the normal course of business
Manufacturing firms have:
Raw Materials Inventory
Work In Process Inventory
Finished Goods Inventory
Different industries have different types of inventory
e.g., Disney has film costs
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Inventory Concepts
Firms try to optimize level of inventory
Reasons to hold inventory:
Meet expected demand
Speculative (e.g., price increase)
Production smoothing
Overproduction to lower per-unit cost basis
Costs of holding inventory
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Risk of obsolescence
Risk of theft or damage
Holding costs
Inventory Concepts
Cost principle
Acquired assets and services should be recorded at their
actual (historical) cost.
That cost and should maintain that historical cost for as long
as they are owned.
Inventory costs include:
Purchase price
Shipping cost (freight-in)
Insurance in transit
If manufacture yourself, include material, labor and overhead
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An example
On Sept. 1, 2010, OIC company had 2 units of telephones
(each cost $10) on hand. In Sept., it purchased 10 more
phones at a $10 each on account. Record the purchase of
the 10 telephone sets.
Inventory
$100
Accounts Payable
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$100
6-5
Example continued
During September, the company sold 9 telephone (which
were purchased at $10 each) at $20 each for cash. Record
the sale of the telephone sets.
Cash
$180
Sales Revenue
Cost of Goods Sold
Inventory
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$180
$90
$90
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What is the ending balance of Inventory?
Inventory
Cost of Goods
Available
for Sale
= 120
BB
100
EB
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20
90
30
6-7
The Inventory T-account
Inventory
Cost of Goods
Available
for Sale
=
Beginning Bal.
$ of Purchase
COGS
Ending Bal.
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6-8
From the last slide, we have:
Beginning Inv. + Purchase COGS = Ending Inv.
Cost of Goods
Available for Sale
Note
Inventory is increased by purchases of additional
inventory, and reduced by sales.
The above model does not work for service
companies, which do not have inventory.
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6-9
TRICKY POINTS
In accounting, whenever we talk about beginning
inventory, purchase, COGS, and ending inventory, they
are ALWAYS in $ terms;
If you want to talk about units, you should say:
- units in beginning / ending inventory
- units purchased
- units sold
Purchase is NOT a new account, it is only the increased
amount in inventory due to purchases.
2012Ying Li
6-
Example
At the end of 2008, Allen companys inventory was
$1,200. In 2009, the companys COGS was $6,000, and
the ending balance of inventory was $1,500. How much
inventory did the company purchase in 2009?
Beg. Inv. + Purchase COGS = End Inv.
$1,200 +
? - $6,000 = $1,500
Purchase = ($1,500 $1,200) + $6,000
= $6,300
2012Ying Li
6-
CHAPTER 6
Reporting and Interpreting
COGS & Inventory
I.
II.
Understanding Inventory
Three Inventory Methods
III.
2012Ying Li
First-In, First-Out Method
Last-In, First-Out Method
Average Cost Method
Other Issues
6-
Specific Identification
Values inventory at the specific cost of each particular
unit. Is usually used for high-ticket items with low
volume.
Automobiles
Jewelry
Real estate
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An Example
OIC Company sells telephones.
On December 1, 2009, it has 10 units of telephones
on hand, which OIC purchased at $10 each before.
During December, it purchased 50 units of
telephones, and sold 40 units.
On December 31, it has 20 telephones left.
The next slide provides more details.
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6-
More on the Example
Beginning inventory (10 units @ $10 per unit) $100
Purchases:
No. 1 (25 units @ $14 per unit)
$350
No. 2 (25 units @ $18 per unit)
$450
Total purchases
800
Cost of goods available for sale (60 units)
900
Ending inventory (20 units @ $? per unit)
?
Cost of goods sold (40 units @ $? per unit)
__ ?
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6-
Questions
1) How much is COGS?
2) How much is ending inventory?
Hint: To answer whichtwo questions, youbeginning 10 units,that, out of the 40 from
need to figure out and which ones are
telephones sold, these ones are from the inventory cost has changed during the month.
the two purchases. This matters because
Three methods accepted by GAAP
1. First-in, first-out (FIFO) cost
ANSWER:
2. Last-in, first-out (LIFO) cost
3. Average cost
2012Ying Li
6-
First-in, First-out (FIFO)
Inventory purchased first (first-in) are assumed
to be sold first (first out to COGS).
COGS is based on the costs of the earliest
purchases.
Ending inventory is based on the costs of the
latest purchases.
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6-
First -In, First-Out (FIFO) Cost
Beginning inventory (10 units @ $10) per unit)
Purchases:
No. 1 (25 units @ $14 per unit)
$350
No. 2 (25 units @ $18 per unit)
450
Total purchases
800
Cost of goods available for sale (60 units)
Ending inventory (20 units @ $? per unit)
Cost of goods sold (40 units @ $? per unit)
$100
900
?
?
FIFO Cost Method
Cost of goods available for sale (60 units)
$900
Ending inventory (cost of the last 20 units available):
20 units @ 18 per unit (from purchase No. 2)
(360)
Cost of goods sold (cost of the first 40 units available):
10 units @ $10 per unit (all of beginning inventory)
$100
25 units @ $14 per unit (all of purchase No. 1)
350
5 units @ $18 per unit (from purchase No. 2)
90
Cost of goods sold
$540
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6-
Last-in, First-out (LIFO)
Inventory purchased last (last-in) are assumed
to be sold first (first out to COGS).
COGS is based on the costs of the latest (or
most up-to-date) purchases.
Ending inventory is based on the costs of the
earliest purchases.
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6-
Last-In, First-Out (LIFO) Cost
Beginning inventory (10 units @ $10) per unit)
Purchases:
No. 1 (25 units @ $14 per unit)
$350
No. 2 (25 units @ $18 per unit)
450
Total purchases
800
Cost of goods available for sale (60 units)
Ending inventory (20 units @ $? per unit)
Cost of goods sold (40 units @ $? Per unit)
$100
900
?
?
LIFO Cost Method
Cost of goods available for sale (60 units)
$900
Ending inventory (cost the of first 20 units available):
10 units @ $10 per unit (all of beginning inventory)
$100
10 units @ $14 per unit (from purchase No. 1)
140
Ending inventory
(240)
Cost of goods sold (cost of the last 40 units available):
25 units @ $18 per unit (all of purchase No. 2)
$450
15 units @ $14 per unit (from purchase No. 1)
210
Cost of goods sold
$660
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6-
Earnings Mgt. Under LIFO
How to manage earnings up?
During a bad year, managers can delay a large
purchase of high-cost inventory until the next year,
thereby delaying the increased COGS until the next
year.
How to manage earnings down?
When inventory prices are rising, managers can
purchase a large amount of inventory near the end of
the year to increase COGS. Net income and income
taxes will be lowered.
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6-
The Average-cost Method
This method is based on the average cost of
inventory, defined as:
cost of goods available for sale
number of units available for sale
Ending Inventory = (average cost * units in
ending inventory)
COGS = (average cost * units sold)
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6-
The Average-cost Method (cont.)
Beginning inventory (10 units @ $10 per unit)
Purchases:
No. 1 (25 units @ $14 per unit)
$350
No. 2 (25 units @ $18 per unit)
450
Total purchases
800
Cost of goods available for sale (60 units)
Ending inventory (20 units @ $? per unit)
Cost of goods sold (40 units @ $? per unit)
$100
900
?
?
Weighted-Average Cost Method
Cost of goods available for sale (Weighted-average cost
is $15 per unit, i.e., $900 / 60)
$900
Ending inventory (20 units @ $15 per unit)
( 300)
Cost of goods sold (40 units @ $15 per unit)
$600
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6-
Net Income under the 3 Methods
FIFO
LIFO
Averagecost
Sales revenue
$1,000
$1,000
$1,000
Cost of goods sold:
Goods available for sale
$900
$900
$900
Ending inventory
360
240
300
Cost of goods sold
540
660
600
Gross profit
$ 460
$ 340
$ 400
Operating expenses
260
260
260
Income before taxes
$ 200
$ 80
$ 140
Income tax expense (40%)
80
32
56
Net Income
$ 120
$ 48
$ 84
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6-
Summary of the 3 Methods
Summary of Income Effects - When inventory prices are increasing
FIFO
Lowest cost of goods sold
Highest net income
Highest ending inventory
LIF0
Highest cost of goods sold
Lowest net income
Lowest ending inventory
Average-cost
Results fall between
the extremes of FIFO
and LIFO
Summary of Income Effects - When inventory prices are decreasing
FIFO
Highest cost of goods sold
Lowest net income
Lowest ending inventory
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LIF0
Lowest cost of goods sold
Highest net income
Highest ending inventory
Average-cost
Results fall between
the extremes of FIFO
and LIFO
6-
Summary of the 3 Method
1.
2.
3.
LIFO always best matches the current value of
COGS with current revenues.
FIFO always reports the most current ending
inventory on the balance sheet.
When inventory prices are rising,
NIFIFO > NI Weighted-average > NILIFO
When inventory prices are decreasing,
NILIFO > NI Weighted-average > NIFIFO
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6-
Summary of the 3 Methods
Recent survey of 600 large companies:
65% used FIFO
30% used LIFO
29% used weighted-average
3% used another method
Not uncommon for firms to use more than one method
When will inventory costing method not matter much?
2012Ying Li
No inflation or deflation, i.e. cost of items doesnt change
significantly
There is a fast rate of inventory turnover and small
inventory balances
CHAPTER 6
Reporting and Interpreting
COGS & Inventory
I.
II.
Understanding Inventory
Three Inventory Methods
III.
2012Ying Li
First-In, First-Out Method
Last-In, First-Out Method
Average Cost Method
Other Issues
6-
More on LIFO
The IRS requires companies using LIFO for tax-reporting
purposes to use LIFO for financial reporting. This is not true for
weighted-average or FIFO.
Few countries outside US allow use of LIFO; it is not permitted
under IFRS
LIFO layers In a year when purchases exceed sales, the number
of units in inventory increases. The amount added to inventory for
that year is called a LIFO layer.
LIFO liquidation When a company uses LIFO and its ending
inventory is below it beginning inventory, LIFO liquidation occurs.
It results in increased income.
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LIFO-related
Real Earnings Management
LIFO gives firms the opportunity to manage their
earnings through real production decisions.
If need to boost earnings at end of year, management can forgo
replenishing inventory at the end of the year and wait until the
beginning of the subsequent year
Analysts view firms that dip into their LIFO layers as having
lower quality earnings
Disentangling good business reasons for making inventory
decisions and earnings management reasons is difficult
Switching to just-in-time system
Unusually high input prices so delaying purchases
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Inventory Turnover
Inventory Turnover reflects how many times
average inventory is sold during the period.
COGS
(Beginning Inv. + Ending Inv.)/2
Question
Which of the companies on the previous slide have higher inventory turnover?
Normally industries that have high profit margins have lower turnover
and industries with low profit margins have higher turnover
2012Ying Li
6-
Measuring Operating Efficiency
Operating cycle refers to the following:
Cash Inventory A/R Cash
To measure how fast a company collects on accounts
receivable, we use accounts receivable turnover ratio:
Net Sales
(Beginning net A/R + Ending net A/R)/2
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5-
Measuring Profitability
Gross profit / gross margin
= Sales Revenue COGS
It is named gross ~ because operating
expenses have not yet been subtracted.
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6-
Gross Profit Percentage
Gross profit
Gross Profit Percentage = Net sales revenue
A 36% gross profit means that each dollar of sales generates
36 cents of gross profit and the goods cost the seller 64 cents.
Rule of Thumb: Compare the companys gross profit percentage
with the industry average or that of another competitor. A small
decrease may signal an important drop in net income.
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6-
$1.00
Gross Profit
on $1.00 of
Sales for 2
companies in
2002
Gross
Profit
$0.20
$0.75
$0.50
Cost of
goods sold
$0.80
$0.25
Wal-Mart
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Gross
Profit
$0.36
Cost of
goods sold
$0.64
Deckers
Outdoors
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