Includes items a company intends for sale to customers. For example, clothes at The Limited , shoes at Payless ShoeSource , building supplies at Home Depot , and so on.
Also includes items that are not yet finished products. For instance, lumber at a cabinet manufacturer, and rubber at a tire manufacturer are part of inventory because the firm will use them to make a finished product for sale to customers.
Part A Understanding Inventory and Cost of Goods Sold 6-
LO1 Trace the flow of inventory costs from manufacturing companies to merchandising companies 6- Inventory Merchandise company Manufacturing company Wholesaler Retailer Raw material Work in progress Finished goods
Relationship between Inventory and Cost of Goods Sold 6-
LO3 Determine the cost of goods sold and ending inventory using different inventory cost methods Specific Identification First in, first out (FIFO) Last in, first out (LIFO) Average Cost Specific Identification Method 6- Inventory cost method
First units purchased are the first ones sold. Beginning inventory sells first, followed by the inventory from the first purchase during the year, followed by the inventory from the second purchase during the year, and so on.
Mario’s Game Shop, which 800 units were sold?
They were the first 800 units purchased, and that all other units remain in ending inventory.
If Mario sold 800 units, we assume all the 600 units purchased on October 19 (the last purchase) were sold, along with 200 units from the April 25 purchase. That leaves 100 of the units from the April 25 purchase and all 100 units from beginning inventory assumed to remain in ending inventory.
Perpetual inventory system and Periodic inventory system 6- Perpetual Inventory System It maintains a continual—that is, perpetual—tracking of inventory. A continual tracking helps a company to better manage its inventory levels. Periodic Inventory System It does not continually modify inventory amounts, but instead periodically adjusts for purchases and sales of inventory at the end of the reporting period based on a physical count of inventory on hand.
LO5 Record inventory transactions using a perpetual inventory system. To see how to record inventory transactions using a perpetual inventory system, we will look again at the inventory transactions for Mario’s Game Shop. 6-
Inventory Purchases To record the purchase of new inventory, we debit inventory (an asset) to show that the company’s balance of this asset account has increased. At the same time, if the purchase was paid in cash, we credit cash. Or more likely, if the company made the purchase on account, we credit accounts payable, increasing total liabilities. Thus, Mario records the first purchase of 300 units for $2,700 on April 25 as: 6-
Simple Adjustment from FIFO to LIFO. Mario’s ending balance of inventory using FIFO is $2,200. Under LIFO, it is only $1,600. As a result, if Mario wants to adjust its FIFO inventory records to LIFO for preparing financial statements, it needs to adjust inventory downward by $600 (decreasing the balance in ending inventory from $2,200 to $1,600). 6-
Additional Inventory Transactions – Freight Charges Mario pays $300 for freight charges associated with the purchase of inventory on April 25 6-
Additional Inventory Transactions – Purchase Discounts. Mario on April 30, pays for the units purchased on April 25, less a 2% purchase discount. 6-
Additional Inventory Transactions – Purchase Returns. Mario decides on October 22 to return 50 defective units from the 600 units purchased on October 19 for $11 each 6-
LO8 Analyze management of inventory using the inventory turnover ratio and gross profit ratio
If managers purchase too much inventory, the company runs the risk of the inventory becoming obsolete and market value falling below cost.
Analysts as well as managers often use the inventory turnover ratio to evaluate a company’s effectiveness in managing its investment in inventory.
Investors often rely on the gross profit ratio to determine the core profitability of a company’s operations.
Inventory turnover ratio shows the number of times the firm sells its average inventory balance during a reporting period. Average days in inventory indicates the approximate number of days the average inventory is held. 6- Inventory turnover ratio = Cost of goods sold Average inventory Average days in inventory = 365 Inventory turnover ratio
Analyze the inventory of Best Buy and Radio Shack Corporation
We can analyze the inventory of Best Buy and Radio Shack Corporation by calculating these ratios for both companies.
Best Buy sells a large volume of commonly purchased products.
Radio Shack sells a variety of high-end specialty products, including electronics, toys and other home and personal care products that typically are not carried by most other retailers.
Below are relevant amounts for each company.
Computation of the Inventory Turnover Ratio The turnover ratio is more than twice as high for Best Buy. On average, it takes Radio Shack an additional 56 days to sell its inventory. 6-
Computation of Gross Profit Ratio Gross profit ratio: Important indicator of the company’s successful management of inventory.
Measures the amount by which the sale price of inventory exceeds its cost per dollar of sales.
Higher the ratio, higher is the “markup” a company is able to achieve on its inventories.
6- Gross profit ratio = Gross profit Net sales
Calculation of Gross Profit Ratio for Best buy and Radio Shack For Best Buy, this means that for every $1 of sales revenue, the company spends $0.76 on inventory, resulting in a gross profit of $0.24. In contrast, the gross profit ratio for Radio Shack is 46%. 6-
LO9 Record inventory transactions using a periodic inventory system.
Recall that under a perpetual inventory system we maintain a continual—or perpetual —record of inventory purchased and sold. In contrast, using a periodic inventory system we do not continually modify inventory amounts. Instead, we periodically adjust for purchases and sales of inventory at the end of the reporting period, based on a physical count of inventory on hand.
Comparing Perpetual and Periodic inventory system – Inventory Purchase and Sales 6-
Comparing Perpetual and Periodic inventory system – Freight charges, Purchase discounts and returns 6-
Comparing Perpetual and Periodic inventory system – Period-End Adjustment
A period-end adjustment is needed only under the periodic system .
Adjusts the balance of inventory to its proper ending balance.
Records the cost of goods sold for the period, to match inventory costs with the related revenues.
Closes (or zeros out) the temporary purchases accounts (Purchases, Freight-in, Purchase Discounts, and Purchase Returns).
LO10 Determine the financial statement effects of inventory errors
Errors can unknowingly occur in inventory amounts if there are mistakes in a physical count of inventory or in the pricing of inventory quantities.
The formula for cost of goods sold, follows
Determine the financial statement effects of inventory errors Summary of Effects of Inventory Error in the Current Year. Relationship between Cost of Goods Sold in the Current Year and the Following Year 6-