The document discusses inventory valuation methods and the flow of inventory costs. It provides examples of specific identification, average cost, FIFO, and LIFO inventory methods. Under specific identification, the actual cost of the item sold is matched to the sale. Average cost assigns all units the average cost. FIFO assigns the earliest costs to cost of goods sold and most recent to inventory. LIFO assigns most recent costs to cost of goods sold and earliest to inventory. The examples illustrate the journal entries and calculations for each method.

1. Slide
8-1
Chapter
INVENTORIES AND THE
8 COST OF GOODS SOLD
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

2. Slide
8-2
Inventory Defined
Inventory
Goods owned Current
and held for sale asset
to customers
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

3. Slide
8-3
The Flow of Inventory Costs
BALANCE SHEET
As purchase costs
Current assets:
(or manufacturing Inventory
costs) are incurred $ $
as goods
INCOME STATEMENT are sold
Revenue $
Cost of goods sold
Gross profit
Expenses
Net income
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

4. Slide
8-4
The Flow of Inventory Costs
In a perpetual inventory system, inventory entries
parallel the flow of costs.
GENERAL JOURNAL
P
Date Account Titles and Explanation R Debit Credit
Entry on Purchase Date
Inventory $$$$
Accounts Payable $$$$
Entry on Sale Date
Cost of Goods Sold $$$$
Inventory $$$$
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

5. Slide
8-5
Which Unit Did We Sell?
When identical units of inventory have
different unit costs, a question naturally
arises as to which of these costs should be
used in recording a sale of inventory.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

6. Slide
8-6
Inventory Subsidiary Ledger
A separate subsidiary account is maintained
for each item in inventory.
Item LL002 Primary supplier Electronic City
Description Laser Light Secondary supplier Electric Company
Location Storeroom 2 Inventory level: Min: 25 Max: 200
Purchased Sold Balance
Cost of
Unit Unit Goods Unit
Date Units Cost Total Units Cost Sold Units Cost Total
Sept. 5 100 $ 30 $ 3,000 100 $ 30 $ 3,000
Sept. 9 75 50 3,750 100 30 3,000
75 50 3,750
Sept. 10 10 ? ? ? ? ?
? ? ?
How can we determine the unit cost for the Sept. 10 sale?
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

7. Slide
8-7
Inventory Cost Flows
We use one of these inventory valuation
methods to determine cost of inventory sold.
Specific Average
identification cost
FIFO LIFO
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8. Slide
8-8
Information for the Following
Inventory Examples
The Bike Company (TBC)
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

9. Slide
8-9
Specific Identification
When a unit
is sold, the
specific cost of
the unit sold is
added to cost
of goods sold.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

10. Slide
8-10
Specific Identification – Example
On August 14, TBC sold 20 bikes for $130 each.
Nine bikes originally cost $91 and 11 bikes
originally cost $106.
Continue
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

11. Slide
8-11
Specific Identification – Example
The Cost of Goods Sold for the August 14 sale is
$1,985, leaving $515 and 5 units in inventory.
Let’s look at the entries for
Continue the Aug. 14 sale.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

12. Slide
8-12
Specific Identification – Example
Retail
Cost
A similar entry is
made after each sale. Continue
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

13. Slide
8-13
Specific Identification – Example
Cost of Goods
Sold for
August 31 =
$2,610
Additional purchases were made on August 17 and 28.
Costs associated with sales on August 31 were as follows: 1 @ $91,
3 @ $106, 15 @ $115, & 4 @ $119.
McGraw-Hill/Irwin
Continue © The McGraw-Hill Companies, Inc., 2002

14. Slide
8-14
Specific Identification – Example
Income Statement
COGS = $4,595
Balance Sheet
Inventory = $1,395 1 @ $ 106 = $ 106
5 @ $ 115 = 575
6 @ $ 119 = 714
End. Inv. © The$ 1,395 Companies, Inc., 2002
McGraw-Hill
McGraw-Hill/Irwin

15. Slide
8-15
Not really. Specific
Since specific identification is hard to use
identification is so when we sell a lot of
easy, can’t we use it inventory that has lots of
all the time? different costs.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

16. Slide
8-16
Average-Cost Method
When a unit is sold,
the average cost of each unit
in inventory is assigned to
cost
of goods sold.
Cost of Goods Units on hand
Available for ÷ on the date of
Sale sale
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

17. Slide
8-17
Average-Cost Method – Example
The average cost per unit
must be computed prior
to each sale. $100 = $2,500 ÷ 25
On August 14, TBC sold 20 bikes for $130 each.
Continue
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

18. Slide
8-18
Average-Cost Method – Example
The average cost per
unit is $100. $100 = $2,500 ÷ 25
Let’s look at the entries
Continue for the Aug. 14 sale. Inc., 2002
McGraw-Hill/Irwin © The McGraw-Hill Companies,

19. Slide
8-19
Average-Cost Method – Example
Retail
Cost
A similar entry is
made after each sale. Continue
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

20. Slide
8-20
Average-Cost Method – Example
Additional purchases were made on August 17 and
August 28.
On August 31, an additional 23 units were sold.
Continue
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

21. Slide
8-21
Average-Cost Method – Example
$114 = $3,990 ÷ 35
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

22. Slide
8-22
Average-Cost Method – Example
The average cost per $114 = $3,990 ÷ 35
unit is $114.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

23. Slide
8-23
Average-Cost Method – Example
Income Statement
COGS = $4,622
Balance Sheet
Inventory = $1,368
$114 × 12 = $1,368
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

24. Slide
8-24
First-In, First-Out Method (FIFO)
Oldest Costs of
Costs Goods Sold
Recent Ending
Costs Inventory
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

25. Slide
8-25
FIFO – Example
The Cost of Goods Sold for the August 14 sale is $1,970,
leaving $530 and 5 units in inventory.
On August 14, TBC sold 20 bikes for $130 each.
Continue
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

26. Slide
8-26
FIFO – Example
Retail
Cost
A similar entry is
made after each sale. Continue
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

27. Slide
8-27
FIFO – Example
Additional purchases were made on Aug. 17 and Aug. 28.
CostOn August 31, an additional 23 units were = $2,600
of Goods Sold for August 31 sold.
McGraw-Hill/Irwin
Continue © The McGraw-Hill Companies, Inc., 2002

28. Slide
8-28
FIFO – Example
Income Statement
COGS = $4,570
Balance Sheet
2 @ $ 115 = $ 230
10 @ $ 119 = 1,190
Inventory = $1,420
End. Inv. $ 1,420
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

29. Slide
8-29
Last-In, First-Out Method (LIFO)
Recent Costs of
Costs Goods Sold
Oldest Ending
Costs Inventory
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

30. Slide
8-30
LIFO – Example
The Cost of Goods Sold for the August 14 sale is
$2,045, leaving $455 and 5 units in inventory.
On August 14, TBC sold 20 bikes for $130 each.
Continue
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

31. Slide
8-31
LIFO – Example
Retail
Cost
A similar entry is
made after each sale. Continue
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

32. Slide
8-32
LIFO – Example
Additional purchases were made on Aug. 17 and Aug. 28.
Cost of Goodsan additional August 31sold.
On Aug. 31,
Sold for 23 units were = $2,685
Continue © The McGraw-Hill Companies, Inc., 2002
McGraw-Hill/Irwin

33. Slide
8-33
LIFO – Example
Income Statement
COGS = $4,730
Balance Sheet 5 @ $ 91 = $ 455
Inventory = $1,260 7 @ $ 115 = 805
End. Inv. $ 1,260
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

34. Slide Inventory Valuation Methods: A Summary
8-34 Costs Allocated to:
Valuation Cost of Goods
Method Sold Inventory Comments
Specific Actual cost of Actual cost of units Parallels physical flow
identification the units sold remaining Logical method when units
are unique
May be misleading for
identical units
Average cost Number of units Number of units on Assigns all units the same
sold times the hand times the average unit cost
average unit cost average unit cost Current costs are averaged
in with older costs
First-in, First-out Cost of earliest Cost of most Cost of goods sold is based
(FIFO) purchases on recently on older costs
hand prior to the purchased units Inventory valued at current
sale costs
May overstate income during
periods of rising prices; may
increase income taxes due
Last-in, First-out Cost of most Cost of earliest Cost of goods sold shown at
(LIFO) recently purchases recent prices
purchased units (assumed still in Inventory shown at old (and
inventory) perhaps out of date) costs
Most conservative method
during periods of rising
prices; often results in lower
McGraw-Hill/Irwin income taxes Companies, Inc., 2002
© The McGraw-Hill

35. Slide
8-35
The Principle of Consistency
Once a company has
adopted a particular
accounting method, it
should follow that
method consistently,
rather than switch
methods from one
year to the next.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

36. Slide
8-36
Just-In-Time (JIT) Inventory
Systems
This inventory arrived
just in time for us to use
in the manufacturing
process.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

37. Slide
8-37
Taking a Physical Inventory
The primary reason for taking a physical inventory
is to adjust the perpetual inventory records for
unrecorded shrinkage losses, such as theft,
spoilage, or breakage.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

38. Slide
8-38
LCM and Other Write-Downs
of Inventory
Reduces the value
Obsolescence
of the inventory.
Lower of Cost Adjust inventory
or Market value to the lower
(LCM) of historical cost or
current
replacement cost
(market).
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

39. Slide
8-39
Goods In Transit
A sale should be recorded when title
to the merchandise passes to the
buyer.
F.O.B. F.O.B.
shipping destination
point  title point  title
passes to passes to
buyer at the Year buyer at the
point of End point of
shipment. destination.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

40. Slide
8-40
Periodic Inventory Systems
In a periodic inventory system, inventory entries
are as follows.
Note that an entry is not
made to inventory.
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41. Slide
8-41
Periodic Inventory Systems
In a periodic inventory system, inventory entries
are as follows.
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42. Slide
8-42
Periodic Inventory Systems
The inventory on
hand and the
cost of goods
sold for the year
are not
determined until
year-end.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

43. Slide
8-43
Periodic Inventory Systems
We use one of these inventory valuation
methods in a periodic inventory system.
Specific Average
identification cost
FIFO LIFO
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

44. Slide
8-44
Information for the Following
Inventory Examples
Computers, Inc.
Mouse Pad Inventory
Date Units $/Unit Total
Beginning
Inventory 1,000 $ 5.25 $ 5,250.00
Purchases:
Jan. 3 300 5.30 1,590.00
June 20 150 5.60 840.00
Sept. 15 200 5.80 1,160.00
Nov. 29 150 5.90 885.00
Goods
Available
for Sale 1,800 $ 9,725.00
Ending
Inventory 1,200 ?
Cost of
Goods Sold 600 ?
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

45. Slide
8-45
Specific Identification – Example
By reviewing actual
purchase invoices,
Computers, Inc. determines
that the 1,200 mouse pads
on hand at year-end have
an actual total cost of
$6,400.
Determine the cost of
goods sold for the year.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

46. Slide
8-46
Specific Identification – Example
Computers, Inc.
Mouse Pad Inventory
Date Units $/Unit Total
Beginning
Inventory 1,000 $ 5.25 $ 5,250.00
Purchases:
Jan. 3 300 5.30 1,590.00
June 20 150 5.60 840.00
Sept. 15 Goods Sold
Cost of 200 5.80 1,160.00
Nov. 29 150 5.90 885.00
-
$9,725 $6,400 = $3,325
Goods
Available
for Sale 1,800 $ 9,725.00
Ending
Inventory 1,200 $ 6,400.00
Cost of
Goods Sold 600 $ 3,325.00
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

47. Slide
8-47
Average-Cost Method
The average cost is
calculated at year-
end as follows:
Total Cost of Total Number
Goods of Units
Available for ÷ Available for
Sale Sale
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

48. Slide
8-48
Average-Cost Method – Example
Computers, Inc.
Mouse Pad Inventory
Avg. Cost $9,725 ÷ 1,800
Date Units $/Unit Total
= $5.40278 Beginning
Ending Inventory Inventory 1,000 $ 5.25 $ 5,250.00
Avg. Cost $5.40278 × 1,200 = Purchases:
$6,483 Jan. 3 300 5.30 1,590.00
June 20 150 5.60 840.00
Cost of Goods Sold
Sept. 15 200 5.80 1,160.00
Avg. Cost $5.40278 × 600 =
Nov. 29 150 5.90 885.00
$3,242 Goods
Available
for Sale 1,800 $ 9,725.00
Ending
Inventory 1,200
1,200 $ 6,483.00
?
Cost of
Goods Sold 600 $ 3,242.00
?
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

49. Slide
8-49
First-In, First-Out Method (FIFO)
Oldest Costs of
Costs Goods Sold
Recent Ending
Costs Inventory
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

50. Slide
8-50
FIFO – Example
Computers, Inc.
Remember: Start
Mouse Pad Inventory
with the 11/29 Date Units $/Unit Total
purchase and then Beginning
add other purchases Inventory 1,000 $ 5.25 $ 5,250.00
until you reach the Purchases:
number of units in Jan. 3 300 5.30 1,590.00
ending inventory. June 20 150 5.60 840.00
Sept. 15 200 5.80 1,160.00
Nov. 29 150 5.90 885.00
Goods
Available
for Sale 1,800 $ 9,725.00
Ending
Inventory 1,200 ?
Cost of
Goods Sold 600 ?
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

51. Slide
8-51
FIFO – Example
Cost of
Date Beg. Inv. Purchases End. Inv. Goods Sold
1,000@$5.25 600@$5.25
400@$5.25
Jan. 3 300@$5.30 300@$5.30
June 20 150@$5.60 150@$5.60
Sept. 15 200@$5.80 200@$5.80
Nov. 29 150@$5.90 150@$5.90
Units 1,200
150 600
Now, we have allocated
Costs $6,575 $3,150
the cost to all 1,200 let’s complete the
Now, units
of Goods Available for table.
Cost in ending inventory. Sale $9,725
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

52. Slide
8-52
FIFO – Example
Computers, Inc.
Completing the table
Mouse Pad Inventory
summarizes the Date Units $/Unit Total
computations just Beginning
made. Inventory 1,000 $ 5.25 $ 5,250.00
Purchases:
Jan. 3 300 5.30 1,590.00
June 20 150 5.60 840.00
Sept. 15 200 5.80 1,160.00
Nov. 29 150 5.90 885.00
Goods
Available
for Sale 1,800 $ 9,725.00
Ending
Inventory 1,200 $ 6,575.00
Cost of
Goods Sold 600 $ 3,150.00
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

53. Slide
8-53
Last-In, First-Out Method (LIFO)
Recent Costs of
Costs Goods Sold
Oldest Ending
Costs Inventory
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

54. Slide
8-54
LIFO – Example
Remember: Start with Computers, Inc.
Mouse Pad Inventory
beginning inventory
Date Units $/Unit Total
and then add other Beginning
purchases until you Inventory 1,000 $ 5.25 $ 5,250.00
reach the number of Purchases:
units in ending Jan. 3 300 5.30 1,590.00
inventory. June 20 150 5.60 840.00
Sept. 15 200 5.80 1,160.00
Nov. 29 150 5.90 885.00
Goods
Available
for Sale 1,800 $ 9,725.00
Ending
Inventory 1,200 ?
Cost of
Goods Sold 600 ?
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

55. Slide
8-55
LIFO – Example
Cost of
Date Beg. Inv. Purchases End. Inv. Goods Sold
1,000@$5.25 1,000@$5.25
Jan. 3 300@$5.30 200@$5.30
100@$5.30
June 20 150@$5.60 150@$5.60
Sept. 15 200@$5.80 200@$5.80
Nov. 29 150@$5.90 150@$5.90
Units 1,200
1,000 600
100
Now, we have allocated
Costs $6,310 $3,415
Next, let’s
the cost to all 1,200 units complete the
Cost in endingAvailable for Sale
of Goods inventory. $9,725
table.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

56. Slide
8-56
LIFO – Example
Computers, Inc.
Completing the table
Mouse Pad Inventory
summarizes the Date Units $/Unit Total
computations just Beginning
made. Inventory 1,000 $ 5.25 $ 5,250.00
Purchases:
Jan. 3 300 5.30 1,590.00
June 20 150 5.60 840.00
Sept. 15 200 5.80 1,160.00
Nov. 29 150 5.90 885.00
Goods
Available
for Sale 1,800 $ 9,725.00
Ending
Inventory 1,200 $ 6,310.00
Cost of
Goods Sold 600 $ 3,415.00
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

57. Slide
8-57
Importance of an Accurate
Valuation of Inventory
Errors in Measuring Inventory
Beginning Inventory Ending Inventory
Effect on Income Statement Overstated Understated Overstated Understated
Goods Available for Sale + - 0 0
Cost of Goods Sold + - - +
Gross Profit - + + -
Net Income - + + -
Effect on Balance Sheet
Ending Inventory 0 0 + -
Retained Earnings - + + -
An error in ending inventory in a year will result in the
same error in the beginning inventory of the next year.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

58. Slide
8-58
For interim f
inancial
statements,
we may need
to estimate e
nding
inventory an
d cost of
goods sold.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

59. Slide
8-59
The Gross Profit Method
Determine cost of goods
available for sale.
Estimate cost of goods sold
by multiplying the net sales
by the cost ratio.
Deduct cost of goods sold
from cost of goods available
for sale to determine ending
inventory.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

60. Slide
8-60
Gross Profit Method – Example
In March of 2003, Chemico’s inventory was
destroyed by fire. Chemico’s normal gross profit
ratio is 30% of net sales. At the time of the fire,
Chemico showed the following balances:
Sales $ 31,500
Sales returns 1,500
Beginning Inventory 12,000
Net cost of goods purchased 20,500
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

61. Slide
8-61
Gross Profit Method – Example

× 70%


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62. Slide
8-62
Inventory Turnover Rate
Measures how quickly a company
sells its merchandise inventory.
Average Inventory = (Beg. Inv. + End. Inv.) ÷ 2
A ratio that is low compared to competitors
suggests inefficient use of assets.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

63. Slide
8-63
Accounting Methods Can Affect
Analytical Ratios
Remember that identical
companies that use different
inventory methods (e.g.,
FIFO and LIFO) will have
different inventory turnover
ratios.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

64. Slide
8-64
End of Chapter 8
Careful! If you
drop the inventory
we will have another
write down.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002