The next two chapters continue our study of assets by investigating the measurement and reporting
issues involving inventories and the related expense—cost of goods sold. Inventory refers to the
assets a company (1) intends to sell in the normal course of business, (2) has in production for future
sale, or (3) uses currently in the production of goods to be sold.
1. Explain the difference between a perpetual inventory system and a periodic inventory system.
2. Explain which physical quantities of goods should be included in inventory.
3. Determine the expenditures that should be included in the cost of inventory.
4. Differentiate between the specific identification, FIFO, LIFO, and average cost methods used to
determine the cost of ending inventory and cost of goods sold.
5. Discuss the factors affecting a company’s choice of inventory method.
6. Understand supplemental LIFO disclosures and the effect of LIFO liquidations on net income.
7. Calculate the key ratios used by analysts to monitor a company’s investment in inventories.
8. Determine ending inventory using the dollar-value LIFO inventory method.
9. Discuss the primary difference between U.S. GAAP and IFRS with respect to determining the
cost of inventory.
TYPES OF INVENTORY
Merchandise inventory — Goods purchased in finished
form for resale.
Raw materials — The cost of components purchased
from other manufacturers that will become part of the
Work in process — The products that are not yet
complete. It includes the cost of raw materials, the cost
of labor that can be directly traced to the goods in
process, and an allocated portion of other manufacturing
costs, called manufacturing overhead.
Finished goods — Once the manufacturing process is
complete, the costs accumulated in work in process are
transferred to finished goods.
INVENTORY COST FLOW FOR A
Raw Work in Finished Cost of
Materials Process Goods Goods Sold
------------------------- ----------------------- ---------------------- -----------------------
(1) $XX $XX (4) $XX $XX (7) $XX $XX (8) $XX
(2) $XX $XX (5)
(1) Raw materials purchased
(2) Direct labor incurred
Manufacturing (3) Manufacturing overhead incurred
Overhead (4) Raw materials used
------------------------- (5) Direct labor applied
(3) $XX $XX (6) (6) Manufacturing overhead applied
(7) Work in process transferred to finished goods
(8) Finished goods sold
PHYSICAL QUANTITIES INCLUDED IN INVENTORY
Generally, physical quantities included in inventory consist of
items in the possession of the company.
Goods in transit
If the goods are shipped f.o.b. (free on board) shipping
point, then legal title to the goods changes hands at the
point of shipment when the seller delivers the goods to
the common carrier.
If the goods are shipped f.o.b. destination, the seller is
responsible for shipping and legal title does not pass
until the goods arrive at the customer's location.
Goods on consignment
Goods on consignment should be included in inventory
of the consignor even though not in the company's
physical possession. The consignor records a sale only
when the consignee sells the goods.
A company includes in inventory the cost of
merchandise it anticipates will be returned.
EXPENDITURES INCLUDED IN INVENTORY
The cost of inventory includes all expenditures necessary to
bring inventory to its desired condition and location for sale.
The purchase price of goods.
Freight charges on incoming goods borne by the
Insurance costs while the goods are in transit.
The costs of unloading, unpacking, and preparing
merchandise for sale.
Cost is reduced by purchase returns and purchase discounts.
COST FLOW ASSUMPTIONS
The Browning Company began 2011 with $22,000 of inventory. The cost of
beginning inventory (BI) is composed of 4,000 units purchased for $5.50 each.
Merchandise transactions during 2011 were as follows:
Purchase Units Unit Cost* Total Cost
Jan. 17 1,000 $6.00 $ 6,000
Mar. 22 3,000 7.00 21,000
Oct. 15 3,000 7.50 22,500
Totals 7,000 $49,500
* includes purchase price and cost of freight.
Date of Sale Units
Jan. 10 2,000
Apr. 15 1,500
Nov. 20 3,000
Beginning inventory Cost of inventory
($22,000) \ on hand at end of period
Cost of goods /
Cost of goods sold
($49,500) / during the period
Total ending inventory plus
cost of goods sold = $71,500
COST FLOW ASSUMPTIONS
The average cost method assumes that items sold and items
in ending inventory come from a mixture of all the goods
available for sale.
The first-in, first-out (FIFO) method assumes that items
sold are those that were acquired first. Ending inventory
consists of the most recently acquired items.
The last-in, first-out (LIFO) method assumes that items sold
are those that were most recently acquired. Ending inventory
consists of the items acquired first.
In a periodic system, ending inventory and cost of goods
sold are determined using one of the three cost flow
assumptions compared on the next slide:
COMPARISON OF COST FLOW METHODS
The three cost flow methods are compared below assuming a
periodic inventory system.
AVERAGE FIFO LIFO
Cost of goods sold $42,250 $38,500 $46,500
Ending inventory 29,250 33,000 25,000
Total $71,500 $71,500 $71,500
During periods of generally rising costs FIFO cost of goods
sold results in a lower cost of goods sold than LIFO.
LIFO cost of goods sold will include the more recent higher
unit cost purchases.
FIFO ending inventory includes the most recent higher cost
purchases which results in a higher ending inventory than
LIFO CONFORMITY RULE
If a company uses LIFO to measure its taxable income, IRS
regulations require that LIFO also be used to measure income
reported to investors and creditors.
In 1981, the LIFO conformity rule was liberalized to permit
LIFO users to present designated supplemental disclosures
that report in a note the effect of using another method on
inventory valuation rather than LIFO.
Inventories Disclosure — The Great Atlantic & Pacific Tea
Summary of Significant Accounting Policies(in part)
Store inventories are stated principally at the lower of cost or market.
As of February 28, 2009, and February 28, 2008, cost of 61.0% and
61.1% of our inventories, respectively, was determined using the first-in,
first-out (“FIFO”) method and the cost of 39.0% and 38.9% of our
inventories was determined using the last-in, first-out (“LIFO”) method.
At February 28, 2009, and February 23, 2008, if valued on a FIFO basis,
the LIFO inventory carrying values would have been approximately $10
million and $2 million higher, respectively.
LIFO LIQUIDATION PROFIT
A decline in inventory quantity results in LIFO liquidation
profit in periods of rising costs.
National Distributors, Inc., uses the LIFO inventory method. The
company began 2011 with inventory of 10,000 units that cost $20
per unit. During 2011 30,000 units were purchased for $25 each
and 35,000 units were sold.
National’s LIFO cost of goods sold for 2011 consists of:
30,000 units @ $25 per unit = $750,000
5,000 units @ $20 per unit = 100,000
Included in cost of goods sold are 5,000 units from beginning inventory
purchased at $20 that have now been liquidated.
If the company had purchased at least 35,000 units, no liquidation would
have occurred. Then cost of goods sold would have been $875,000 (35,000
units x $25 per unit) instead of $850,000. The difference between these two
cost of goods sold figures of $25,000 ($875,000 - 850,000) is the before tax
LIFO liquidation profit.
Assuming a 40% income tax rate, the net effect of the liquidation is to
increase net income by $15,000 [$25,000 x (1 - .40)].
A material effect on net income of LIFO layer liquidation must be disclosed
in a note.
Inventory Cost Flow Assumptions. IAS NO. 2 does not permit the use of LIFO.
Because of this restriction, many U.S. multinational companies employ the use of
LIFO only for all or most of their domestic inventories and FIFO or average cost for
their foreign subsidiaries. General Mills provides an example with a disclosure note
included in a recent annual report:
Inventories (in part)
All inventories in the United States other than grain are valued at the lower of cost,
using the last-in, first-out (LIFO method, or market… Inventories outside of the
United States are valued at the lower of cost, using the first-in, first-out (FIFO)
method, or market.
This difference could prove to be a significant impediment to U.S. convergence to
international standards. Unless the U.S. Congress repeals the LIFO conformity rule,
convergence would cause many corporations to lose a valuable tax shelter, the use of
LIFO for tax purposes. If these companies were immediately taxed on the difference
between LIFO inventories and inventories valued using another method, it would cost
companies billions of dollars. Some industries would be particularly hard hit. Most
oil companies and auto manufacturers, for instance, use LIFO. As an example, it
would cost Exxon Mobil over $4 billion. The companies affected most certainly will
lobby heavily to retain the use of LIFO for tax purposes.
DECISION MAKERS’ PERSPECTIVE —
SUPPLEMENTAL LIFO DISCLOSURES
Supplemental LIFO disclosures can be used to convert LIFO
inventory and cost of goods sold amounts.
The Great Atlantic & Pacific Tea Company, Inc
For the Year Ended
February 28, February 23,
($ in millions) 2009 2008
Inventories $474 $505
Net sales 9,516 6,401
Cost of goods sold 6,613 4,431
The Great Atlantic & Pacific Tea Company (GAPT) uses a combination of
LIFO and FIFO cost methods to value its inventory. We can convert GAPT's
inventory and cost of goods sold to a 100% FIFO basis before comparing to a
competitor by using the information provided in Graphic 8-6 (Slide T8-15).
($ in millions) 2009 2008
Inventories (as reported) $474 $505
Add: Conversion to FIFO 10 2
Inventories (100% FIFO) $484 $507
Cost of goods sold for 2009 would have been $8 million lower had GAPT used
FIFO instead of LIFO for its LIFO inventories. While beginning inventory
would have been 2 million higher, ending inventory also would have been
higher by $10 million. An increase in beginning inventory causes an increase
in cost of goods sold, but an increase in ending inventory causes a decrease in
cost of goods sold.
DECISION MAKERS’ PERSPECTIVE —
The gross profit ratio indicates the percentage of each sales
dollar available to cover other expenses and provide a profit.
The inventory turnover ratio helps to evaluate a company's
effectiveness in managing its investment in inventory.
Gross profit ratio = Gross profit
Inventory turnover ratio = Cost of goods sold
DOLLAR-VALUE LIFO (DVL)
Many LIFO applications are based on this approach.
Inventory is viewed as a quantity of value instead of a
physical quantity of goods.
The DVL inventory pool is viewed as comprising layers of
dollar value from different years.
An inventory pool is identified in terms of economic
similarity rather than physical similarity (subject to the same
cost change pressures).
DVL simplifies the recordkeeping procedures because no
information is needed about unit flows.
DVL minimizes the probability of the liquidation of LIFO
inventory layers, through the aggregation of many types of
inventory into larger pools.
Under unit LIFO we determine whether a new LIFO layer
was added by comparing the ending quantity with the
Under DVL we determine whether a new LIFO layer was
added by comparing the ending dollar amount with the
beginning dollar amount.
However, if the cost level has changed, we need a way to
determine whether an increase observed is a real increase or
one caused by an increase in costs.
So before we compare the beginning and ending inventory
amounts, we need to deflate the ending inventory amount by
any increase in costs so that both the beginning and ending
amounts are based on the same level of costs.
We accomplish this by using cost indexes. A cost index for a
particular layer year is determined as follows:
Cost in layer year
Cost index in layer year =
Cost in base year
The cost index for the base year (the year DVL is initially
adopted) is set at 100.