Chp 8: Inventories Measurement(Key Concepts)

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Inventory

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Represent s quantities of goods acquired, manufactured, or in the process of being manufactured.

Ending inventory represents cost of inventory still on hand.

For manufacturer:

1. Raw materials

2. Work in process

3. Finished goods

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Cost of Goods Sold(COGS)

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Represents the cost of inventory during an reporting period.

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Raw Materials

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Represents the cost of components purchased from other manufactures that will become part of the finished product.

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Work-in-Process

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products that are not yet complete

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Finished goods

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The costs that have accumulated in work-in-process are transferred here.

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Perpetual inventory system

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Inventory account is continually adjusted for each change in inventory, whether it's caused by a purchase, a sale, or a return of merchandise by the company to its supplier.

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Periodic Inventory System

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Is not designed to track either the quantity or cost of merchandise.

Merchandise inventory account balance is not adjusted as purchases and sales are made but only periodically at the end of a reporting period.

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F.o.b(free on board) shipping point

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The legal title to the goods changes hands at the point of shipment when the seller delivers the goods to the common carrier, and the purchaser is responsible for shipping costs and transit insurance.

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F.o.b. Destination

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Seller is responsible for shipping and legal title does not pass until goods arrive at their destination(the customer's location).

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Consignment

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Goods are physically transferred to the consignee, but the transferor retains legal title.

sale is recorded by the consignor only when the goods are sold by the consignee and title passes to the customer.

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Product costs

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Costs included in inventory; associated with products and expensed as COGS only when the related products are sold.

Expenditures necessary to bring inventory to its condition and location for sale or use.

Include purchase price of goods, freight charges on incoming goods, insurance costs, costs of unloading costs, unpacking costs, and costs of preparing merchandise inventory for sale or raw materials inventory for use.

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Freight-in or transportation-in

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In a periodic system, freight costs are added to this temporary account.

generally part of cost of inventory

added to MI under perpertual system and freight-in account for periodic system.

closed to COGS

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Purchase Return

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When buyer returns goods to seller, a reduction in net purchases is recorded.

In periodic system, purchases returns account temporarily accumulates these amounts; are subtracted from purchases when determining net purchases

under perpetual system, both inventory and A/P are reduced.

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Purchase discounts

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Represent reductions in the amount to be paid if remittance is made within a designated period of time.

Can be recorded using either the gross method or the net method.

Under gross method, discounts not taken viewed as part of cost of inventory, while under net method, they are reported as interest expense and cost of inventory includes net after-discount amount.

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Specific Identification method

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To match each unit sold during the period or each unit on hand at the end of the period with its actual cost.

Most economically feasible when selling high-cost items at a low sales volume.

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Average cost method

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Assumes that COGS and ending inventory consist of a mixture of all the goods available for sale.

Periodic Average cost: weighted average only calculated at end of the period

COGAFS(Costs of goods available for sale)/quantity AFS(Available for sale)

Perpetual Average cost:

1. moving-average unit cost

2. calculated each time additional units are purchased

3. new average determined by:

a. summing the cost of previous inventory balance and the cost of new purchase

b. dividing this total cost(COGAFS) by the number of units on hand.(inventory units AFS)

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First-in, first-out(FIFO) method

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assumes that units sold are the first units acquired.

Ending inventory consists of the most recently acquired items.

same COGS and EI amounts for both periodic and perpetual FIFO.

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LIFO(last-in, first-out) method

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Assumes that units sold are the most recent units purchased.

Ending inventory consists of the items acquired first.

generally different COGS and EI amounts between periodic and perpetual LIFO.

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LIFO conformity rule

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If a company uses LIFO to measure its taxable income, then IRS regulations require that LIFO also be used to measure income reported to investors and creditors.

lower income tax motivation may be offset by a desire to report higher net income.

permits LIFO users to report non-LIFO inventory valuations in a disclosure note, but not on the face of the income statement.

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LIFO Reserve or LIFO allowance

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Contract account, where the conversion amount(difference between the internal method and LIFO) are recorded.

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LIFO liquidation

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Inventory costs with LIFO generally are out of date because they reflect old purchase transactions; not common for LIFO inventory balance to be based on unit costs actually incurred several years earlier.

when out-of-date inventory layers are liquidated due to decline in inventory quantities, COGS will partially match noncurrent costs with current selling prices.

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Just in Time(JIT) System

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Assists company with inventory management.

Used by manufacturers to coordinate production with suppliers so that raw materials or components arrive just as they are needed in the production process.

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Gross Profit Ratio

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Gross Profit/Net sales

Gross profit is sometimes called gross margin

Indicates relationship between net sales revenue and COGS.

indicates the percentage of each sales dollar available to cover expenses other than COGS and to provide a profit.

the higher the ratio, the higher the markup a company is able to achieve on its products.

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LIFO inventory pools

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Objective is to simplify recordkeeping by grouping inventory units into pools based on physical similarities of the individual units and to reduce the risk of LIFO layer liquidation.

Benefits may not be achieved, such as when a product in a pool is discontinued; the old costs that existed in prior layers of inventory would be recognized as COGS and product LIFO liquidation profit.

Even if product is replaced with another, the replacement may not be similar enough and this process of redefining inventory pools as changes in product mix occur can be expensive and time consuming.

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Dollar-Value LIFO(DVL)

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Extends the concept of inventory pools by allowing a company to combine a large variety of goods into one pool

A DVL pool is made up of items that are likely to face the same cost pressures.

Physical units are not used in calculating ending inventory, but rather the inventory is viewed as a quantity of value instead of a physical quantity of goods.

Instead of layers of units from different purchases, the DVL inventory pool is viewed as comprising layers of dollar value from different years.

Inventory pool identified in terms of economic similarity rather than physical similarity; same cost pressures.

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Inventory Turnover ratio

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COGS/Avg inventory

Inventory increases that outrun increases in COGS may indicate difficulties in generating sales.