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Cost of sales


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Cost of sales

  2. 2. Types of Companies <ul><li>Merchandising company </li></ul><ul><ul><li>Sells goods in same form as acquired. </li></ul></ul><ul><li>Manufacturing company </li></ul><ul><ul><li>Converts raw material into finished goods. </li></ul></ul><ul><li>Service company </li></ul><ul><ul><li>Provides intangible services. </li></ul></ul>
  3. 3. Inventory Issues <ul><li>What is inventory? </li></ul><ul><li>What costs are included in inventory? </li></ul><ul><li>How do we separate COGS from End. Inv? </li></ul>
  4. 4. Inventories Definition <ul><li>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. </li></ul>
  5. 5. Methods of Determining Amounts In Inventory <ul><li>Periodic inventory method or </li></ul><ul><li>Perpetual inventory method. </li></ul><ul><li>Measurement of inventories and cost of sales are related. </li></ul>
  6. 6. Cost Flow Assumptions <ul><li>Specific identification. </li></ul><ul><li>Average cost. </li></ul><ul><li>First-in, first-out (FIFO). </li></ul><ul><li>Last-in, last-out (LIFO). </li></ul>
  7. 7. Types of Companies/Inventories <ul><li>Merchandising </li></ul><ul><ul><li>Sells goods in same form in which they are acquired. </li></ul></ul><ul><ul><li>Inventory costs (and costs of goods sold) = acquisition costs. </li></ul></ul>
  8. 8. Types of Companies/Inventories (Continued) <ul><li>Manufacturing company converts raw materials and purchased parts into finished goods. </li></ul><ul><ul><li>3 types of inventories; </li></ul></ul><ul><ul><ul><li>Materials. </li></ul></ul></ul><ul><ul><ul><li>Work-in-process. </li></ul></ul></ul><ul><ul><ul><li>Finished goods. </li></ul></ul></ul>
  9. 9. Types of Companies/Inventories (Continued) <ul><li>Service organizations (hotels, beauty parlors, plumbers) </li></ul><ul><ul><li>May have materials inventories. </li></ul></ul>
  10. 10. Types of Companies/Inventories (Continued) <ul><li>Professional service firms (accounting firms, legal firms) </li></ul><ul><ul><li>Intangible inventory costs are costs incurred for client but not yet billed called jobs-in-progress or unbilled costs. </li></ul></ul>
  11. 11. Supplies <ul><li>Tangible items that will be consumed in the course of normal operations. </li></ul><ul><ul><li>e.g., office and janitorial supplies, lubricants, repair parts. </li></ul></ul><ul><li>Not sold and not accounted for as part of cost of goods sold. </li></ul>
  12. 12. Merchandise Companies <ul><li>Inventories accounted for at cost. </li></ul><ul><ul><li>Cost includes cost of </li></ul></ul><ul><ul><ul><li>Acquiring merchandise (invoice cost of goods, freight-in) </li></ul></ul></ul><ul><ul><ul><li>Making goods ready for sale. ( unpacking and marking) </li></ul></ul></ul><ul><ul><ul><li>Adjust for: </li></ul></ul></ul><ul><ul><ul><ul><li>Returns and allowances </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Cash discounts from supplier. </li></ul></ul></ul></ul>
  13. 13. Methods of Accounting for Purchase (or cash) Discounts <ul><li>Net of discount </li></ul><ul><ul><li>Charge discounts not taken when paid. </li></ul></ul><ul><li>Record at invoice price </li></ul><ul><ul><li>Record discount when taken. </li></ul></ul>
  14. 14. Terminology <ul><li>Purchase = receipt of merchandise not to placing of a PO. </li></ul><ul><ul><li>Usually title transfers when goods are shipped (FOB shipping point). </li></ul></ul>
  15. 15. Relationship of Inventory and Cost of Goods Sold <ul><li>Beginning inventory + net purchases = goods available for sale </li></ul><ul><li>Goods available for sale = cost of goods sold + ending inventory. </li></ul><ul><li>Equivalently: Beg. inventory + net purchases -ending inventory = cost of goods sold. </li></ul><ul><ul><li>Net purchases = gross purchases -purchase returns and allowances + freight-in </li></ul></ul>
  16. 16. Measurement Issue <ul><li>Dividing goods available for sale between COGS and End. Inventory. </li></ul><ul><li>2 approaches: </li></ul><ul><ul><li>Periodic inventory method. </li></ul></ul><ul><ul><li>Perpetual inventory method. </li></ul></ul>
  17. 17. Periodic Inventory Method <ul><li>Determine amount of ending inventory and deduce costs of goods sold. </li></ul><ul><ul><li>Count inventory (i.e., a physical inventory is taken) at the end of the period. </li></ul></ul><ul><ul><li>Multiply count times cost for each item to determine total amount of inventory. </li></ul></ul><ul><ul><ul><li>Beginning inventory of current period = ending inventory of preceding period. </li></ul></ul></ul><ul><ul><li>COGS = COGA - End. Inventory </li></ul></ul>
  18. 18. Perpetual Inventory Method <ul><li>Measure amount actually delivered to customers; deduce ending inventory. </li></ul><ul><li>Perpetual inventory record is kept for each item in the inventory. </li></ul><ul><ul><li>Advantages of perpetual inventory method: </li></ul></ul><ul><ul><ul><li>Detailed record is useful. </li></ul></ul></ul><ul><ul><ul><li>Built in check. </li></ul></ul></ul><ul><ul><ul><li>Identifies shrinkage by item. </li></ul></ul></ul><ul><ul><ul><li>Income statement can be prepared without taking a physical inventory. </li></ul></ul></ul>
  19. 19. Retail Method <ul><li>Variation of perpetual method. </li></ul><ul><li>Record purchases at cost and at retail. </li></ul><ul><li>Adjust retail prices for markdowns. </li></ul><ul><li>Calculate gross margin percent and its complement (the cost of goods sold as a percent of retail). </li></ul><ul><ul><li>Cost of goods sold = Retail sales for the period * cost of goods sold percent. </li></ul></ul><ul><ul><li>Ending inventory = Beginning inventory + purchases -cost of goods sold. </li></ul></ul>
  20. 20. Gross Profit Method <ul><li>Similar to retail method except uses an average or normal gross profit percentage in the calculation. </li></ul>
  21. 21. Manufacturing Companies <ul><li>Product costs or cost of goods sold = materials and parts used + conversion costs </li></ul><ul><ul><li>Conversion costs = production labor + overhead (other costs incurred in manufacturing). </li></ul></ul>
  22. 22. 3 Types of Manufacturing Inventory Accounts <ul><li>Materials inventory or raw materials. </li></ul><ul><ul><li>Not yet used in production. </li></ul></ul><ul><ul><li>Adjusted for returns and freight-in. </li></ul></ul><ul><li>Work-in-process. </li></ul><ul><ul><li>Goods started but not yet finished. </li></ul></ul><ul><ul><li>Costed at total costs incurred. </li></ul></ul><ul><li>Finished goods </li></ul><ul><ul><li>Manufactured but not yet shipped. </li></ul></ul><ul><ul><li>Costed at total costs incurred. </li></ul></ul>
  23. 23. Flow Through Accounts <ul><li>Pattern: </li></ul><ul><ul><li>Tfrd Out = beg inv + tfrd in - end inv </li></ul></ul>
  24. 24. Raw Materials Inventory <ul><li>Tfrd Out = beg inv + tfrd in - end inv </li></ul><ul><li>Materials used = beg inv + purchases -end inv </li></ul>
  25. 25. Work in Process <ul><li>Tfrd Out = beg inv + tfrd in - end inv </li></ul><ul><li>Cost of goods manufactured = beg inv + ( materials used + labor + overhead) - end inv </li></ul>
  26. 26. Finished Goods <ul><li>Tfrd Out = beg inv + tfrd in - end inv </li></ul><ul><li>Cost of goods sold = beg inv + Cost of goods manufactured - end inv </li></ul>
  27. 27. Product Costing Systems <ul><li>Perpetual inventory system for manufacturing companies. </li></ul><ul><li>(Chapters 17-19) </li></ul>
  28. 28. Product Costs <ul><li>= inventory costs = inventoriable costs. </li></ul><ul><li>Expensed (COGS) in period when FG sold. </li></ul><ul><li>GAAP requires full production costing. </li></ul><ul><ul><li>Materials cost. </li></ul></ul><ul><ul><li>Labor costs incurred directly in producing the product. </li></ul></ul><ul><ul><li>Other production or indirect or indirect production or production overhead costs. </li></ul></ul>
  29. 29. Period Costs <ul><li>Costs that are expensed in the period incurred. </li></ul><ul><ul><li>Much of SG&A (Selling, General & Administrative) Expenses on IS. </li></ul></ul>
  30. 30. Professional Service Firms <ul><li>E.g., law and accounting firms. </li></ul><ul><ul><li>Labor , overhead, and incidental product costs but no materials cost. </li></ul></ul><ul><ul><li>Expensed in period billed (i.e., when revenues are recognized). </li></ul></ul>
  31. 31. Inventory Costing Methods (Cost Flow Assumptions) <ul><li>Specific identification. </li></ul><ul><li>Average cost. </li></ul><ul><li>FIFO </li></ul><ul><li>LIFO </li></ul>
  32. 32. Specific Identification <ul><li>Big ticket items. </li></ul><ul><li>Uniquely identified items. </li></ul><ul><ul><li>May offer opportunity to manipulate costs. </li></ul></ul>
  33. 33. Average Cost <ul><li>(Beginning inventory amount + purchases) / units available for sale = per unit inventory costs = per unit cost of goods sold </li></ul><ul><ul><li>Periodic method. </li></ul></ul><ul><ul><ul><li>Computed for the entire period. </li></ul></ul></ul><ul><ul><li>Perpetual method. </li></ul></ul><ul><ul><ul><li>A new unit cost can be calculated after each purchase. </li></ul></ul></ul>
  34. 34. First-in, First-out (FIFO). <ul><li>Expenses costs of oldest purchases first. </li></ul><ul><li>Most recently purchased goods are in inventory. </li></ul><ul><ul><li>Likely but not necessary to follow actual flow of goods. </li></ul></ul><ul><ul><li>Ending inventory approximates current cost of goods. </li></ul></ul>
  35. 35. Last-in, Last-out (LIFO). <ul><li>Assumes most recently purchased goods are sold first </li></ul><ul><li>Inventory based on costs of oldest purchases. </li></ul><ul><ul><li>Cost of goods sold usually does not reflect physical flow. </li></ul></ul><ul><ul><li>Ending inventory may be costed at amounts of years ago. </li></ul></ul><ul><ul><ul><li>Inventory may be well below current costs. </li></ul></ul></ul>
  36. 36. LIFO Reserve <ul><li>FIFO for management. </li></ul><ul><li>LIFO financial reporting. </li></ul><ul><ul><li>LIFO reserve = FIFO inventory amount - LIFO inventory amount. </li></ul></ul>
  37. 37. Arguments for FIFO <ul><li>Usually follows physical flow of goods. </li></ul><ul><li>If prices are based on oldest cost, results in best matching. </li></ul><ul><li>More accurate balance sheet valuation. </li></ul><ul><li>Non-theoretical/practical argument: </li></ul><ul><ul><li>Results in highest income during periods of rising prices. </li></ul></ul>
  38. 38. Arguments for LIFO <ul><li>If prices are based on current costs, results in best matching of revenues and costs and therefore most useful income statement. </li></ul><ul><li>Closest to reflecting current or replacement costs of goods sold. </li></ul><ul><ul><li>However, it is still historical costs and does differ from current costs. </li></ul></ul>
  39. 39. Arguments for LIFO (continued) <ul><li>During periods of price increases: </li></ul><ul><ul><li>Higher costs of goods sold. </li></ul></ul><ul><ul><li>Lower taxable income. </li></ul></ul><ul><ul><li>Lower income taxes. </li></ul></ul><ul><ul><li>Higher cash flows. </li></ul></ul><ul><ul><ul><li>If LIFO for tax purposes than also financial reporting. </li></ul></ul></ul>
  40. 40. Why Not More LIFO? <ul><li>Most countries do not permit. </li></ul><ul><ul><li>Would require a double set of books. </li></ul></ul><ul><li>Prices of some items are not increasing. </li></ul><ul><li>Because of IRS conformity requirement, lower earnings reported to shareholders. </li></ul>
  41. 41. Lower of Cost or Market (LCM) <ul><li>Market price may be below cost due to: </li></ul><ul><ul><li>Physical deterioration. </li></ul></ul><ul><ul><li>Change in consumer tastes. </li></ul></ul><ul><ul><li>Technological obsolescence. </li></ul></ul><ul><li>LCM is a reflection of conservatism concept. </li></ul><ul><li>Market is defined as replacement cost. </li></ul>
  42. 42. Upper and Lower Bounds <ul><li>Ceiling or upper bound: </li></ul><ul><ul><li>Net realizable value (NRV). </li></ul></ul><ul><ul><ul><li>NRV = estimated selling price - estimated costs of selling. </li></ul></ul></ul><ul><ul><ul><li>So inventory not above cash that will be received. </li></ul></ul></ul><ul><li>Floor or lower bound: </li></ul><ul><ul><li>NRV - normal profit margin. </li></ul></ul><ul><ul><ul><li>So inventory not written down artificially low. </li></ul></ul></ul>
  43. 43. Steps in Applying LCM <ul><li>Compute market, floor and ceiling amounts. </li></ul><ul><li>Select the middle amount as market. </li></ul><ul><li>Select lower of cost or market. </li></ul>
  44. 44. Analysis of Inventory <ul><li>Inventory turnover = Cost of goods sold / Inventory </li></ul><ul><ul><li>Can use average or ending inventory. </li></ul></ul><ul><ul><li>Measures efficiency of asset usage. </li></ul></ul><ul><li>Differs by industry. </li></ul><ul><li>Days’ inventory = Inventory / (Cost of goods sold  365) </li></ul>