Cost of sales

Cost of Sales and Inventory JOIN KHALID AZIZ COACHING CLASSES ICMAP STAGE 1,2,3,4,5 ICAP MODULE A,B,C,D PIPFA BBA & MBA B.COM & M.COM ACCOUNTING OF O/A LEVEL MA-ECONOMICS 0322-3385752 KARACHI, PAKISTAN .

Types of Companies
Merchandising company
Sells goods in same form as acquired.
Manufacturing company
Converts raw material into finished goods.
Service company
Provides intangible services.

Inventory Issues
What is inventory?
What costs are included in inventory?
How do we separate COGS from End. Inv?

Inventories Definition
Asset items held for sale in the ordinary course of business or goods that will be used or consumed in the production of goods to be sold.

Methods of Determining Amounts In Inventory
Periodic inventory method or
Perpetual inventory method.
Measurement of inventories and cost of sales are related.

Cost Flow Assumptions
Specific identification.
Average cost.
First-in, first-out (FIFO).
Last-in, last-out (LIFO).

Types of Companies/Inventories
Merchandising
Sells goods in same form in which they are acquired.
Inventory costs (and costs of goods sold) = acquisition costs.

Types of Companies/Inventories (Continued)
Manufacturing company converts raw materials and purchased parts into finished goods.
3 types of inventories;
Materials.
Work-in-process.
Finished goods.

Service organizations (hotels, beauty parlors, plumbers)
May have materials inventories.

Professional service firms (accounting firms, legal firms)
Intangible inventory costs are costs incurred for client but not yet billed called jobs-in-progress or unbilled costs.

Supplies
Tangible items that will be consumed in the course of normal operations.
e.g., office and janitorial supplies, lubricants, repair parts.
Not sold and not accounted for as part of cost of goods sold.

Merchandise Companies
Inventories accounted for at cost.
Cost includes cost of
Acquiring merchandise (invoice cost of goods, freight-in)
Making goods ready for sale. ( unpacking and marking)
Adjust for:
Returns and allowances
Cash discounts from supplier.

Methods of Accounting for Purchase (or cash) Discounts
Net of discount
Charge discounts not taken when paid.
Record at invoice price
Record discount when taken.

Terminology
Purchase = receipt of merchandise not to placing of a PO.
Usually title transfers when goods are shipped (FOB shipping point).

Relationship of Inventory and Cost of Goods Sold
Beginning inventory + net purchases = goods available for sale
Goods available for sale = cost of goods sold + ending inventory.
Equivalently: Beg. inventory + net purchases -ending inventory = cost of goods sold.
Net purchases = gross purchases -purchase returns and allowances + freight-in

Measurement Issue
Dividing goods available for sale between COGS and End. Inventory.
2 approaches:
Periodic inventory method.
Perpetual inventory method.

Periodic Inventory Method
Determine amount of ending inventory and deduce costs of goods sold.
Count inventory (i.e., a physical inventory is taken) at the end of the period.
Multiply count times cost for each item to determine total amount of inventory.
Beginning inventory of current period = ending inventory of preceding period.
COGS = COGA - End. Inventory

Perpetual Inventory Method
Measure amount actually delivered to customers; deduce ending inventory.
Perpetual inventory record is kept for each item in the inventory.
Advantages of perpetual inventory method:
Detailed record is useful.
Built in check.
Identifies shrinkage by item.
Income statement can be prepared without taking a physical inventory.

Retail Method
Variation of perpetual method.
Record purchases at cost and at retail.
Adjust retail prices for markdowns.
Calculate gross margin percent and its complement (the cost of goods sold as a percent of retail).
Cost of goods sold = Retail sales for the period * cost of goods sold percent.
Ending inventory = Beginning inventory + purchases -cost of goods sold.

Gross Profit Method
Similar to retail method except uses an average or normal gross profit percentage in the calculation.

Manufacturing Companies
Product costs or cost of goods sold = materials and parts used + conversion costs
Conversion costs = production labor + overhead (other costs incurred in manufacturing).

3 Types of Manufacturing Inventory Accounts
Materials inventory or raw materials.
Not yet used in production.
Adjusted for returns and freight-in.
Work-in-process.
Goods started but not yet finished.
Costed at total costs incurred.
Finished goods
Manufactured but not yet shipped.
Costed at total costs incurred.

Flow Through Accounts
Pattern:
Tfrd Out = beg inv + tfrd in - end inv

Raw Materials Inventory
Materials used = beg inv + purchases -end inv

Work in Process
Cost of goods manufactured = beg inv + ( materials used + labor + overhead) - end inv

Finished Goods
Cost of goods sold = beg inv + Cost of goods manufactured - end inv

Product Costing Systems
Perpetual inventory system for manufacturing companies.
(Chapters 17-19)

Product Costs
= inventory costs = inventoriable costs.
Expensed (COGS) in period when FG sold.
GAAP requires full production costing.
Materials cost.
Labor costs incurred directly in producing the product.
Other production or indirect or indirect production or production overhead costs.

Period Costs
Costs that are expensed in the period incurred.
Much of SG&A (Selling, General & Administrative) Expenses on IS.

Professional Service Firms
E.g., law and accounting firms.
Labor , overhead, and incidental product costs but no materials cost.
Expensed in period billed (i.e., when revenues are recognized).

Inventory Costing Methods (Cost Flow Assumptions)
Specific identification.
Average cost.
FIFO
LIFO

Specific Identification
Big ticket items.
Uniquely identified items.
May offer opportunity to manipulate costs.

Average Cost
(Beginning inventory amount + purchases) / units available for sale = per unit inventory costs = per unit cost of goods sold
Periodic method.
Computed for the entire period.
Perpetual method.
A new unit cost can be calculated after each purchase.

First-in, First-out (FIFO).
Expenses costs of oldest purchases first.
Most recently purchased goods are in inventory.
Likely but not necessary to follow actual flow of goods.
Ending inventory approximates current cost of goods.

Last-in, Last-out (LIFO).
Assumes most recently purchased goods are sold first
Inventory based on costs of oldest purchases.
Cost of goods sold usually does not reflect physical flow.
Ending inventory may be costed at amounts of years ago.
Inventory may be well below current costs.

LIFO Reserve
FIFO for management.
LIFO financial reporting.
LIFO reserve = FIFO inventory amount - LIFO inventory amount.

Arguments for FIFO
Usually follows physical flow of goods.
If prices are based on oldest cost, results in best matching.
More accurate balance sheet valuation.
Non-theoretical/practical argument:
Results in highest income during periods of rising prices.

Arguments for LIFO
If prices are based on current costs, results in best matching of revenues and costs and therefore most useful income statement.
Closest to reflecting current or replacement costs of goods sold.
However, it is still historical costs and does differ from current costs.

Arguments for LIFO (continued)
During periods of price increases:
Higher costs of goods sold.
Lower taxable income.
Lower income taxes.
Higher cash flows.
If LIFO for tax purposes than also financial reporting.

Why Not More LIFO?
Most countries do not permit.
Would require a double set of books.
Prices of some items are not increasing.
Because of IRS conformity requirement, lower earnings reported to shareholders.

Lower of Cost or Market (LCM)
Market price may be below cost due to:
Physical deterioration.
Change in consumer tastes.
Technological obsolescence.
LCM is a reflection of conservatism concept.
Market is defined as replacement cost.

Upper and Lower Bounds
Ceiling or upper bound:
Net realizable value (NRV).
NRV = estimated selling price - estimated costs of selling.
So inventory not above cash that will be received.
Floor or lower bound:
NRV - normal profit margin.
So inventory not written down artificially low.

Steps in Applying LCM
Compute market, floor and ceiling amounts.
Select the middle amount as market.
Select lower of cost or market.

Analysis of Inventory
Inventory turnover = Cost of goods sold / Inventory
Can use average or ending inventory.
Measures efficiency of asset usage.
Differs by industry.
Days’ inventory = Inventory / (Cost of goods sold  365)

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Cost of sales

by Khalid Aziz on Dec 22, 2011

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Cost of sales — Presentation Transcript