Inventories and Cost of Goods Sold
A D V E R T I S E M E N T
Manufacturing companies have three types of inventory:
materials, work in process and finished goods. Retailers have one inventory:
merchandise. In all cases, inventory is something the company will re-sell to
someone else. Inventory cost is an asset until it is sold; after merchandise is
sold, the cost becomes an expense, called Cost of Goods Sold (COGS). A journal
entry transfers costs from the Balance Sheet to the Income Statement.
Chapter 8 focuses on inventories of merchandise, those
inventories held by retailers for sale to their customers. This would include
grocery stores, clothing stores, in fact all the stores you would visit in the
mall, or shop at on a regular basis, are retailers. That covers a large and
broad group of businesses.
There are several important points, or events, in the life on
an inventory item. The company must first order and buy the item. It then holds
the item on a shelf or warehouse, until a customer wants to but the item. Once
the item is sold, the cost is transferred to COGS. So the three important times
in an item's life are buying, holding and selling.
Let's think for a moment about a hypothetical inventory item,
we'll call it Item X. If you buy, hold and sell Item X all in the same year, say
2002, the entire transaction relating to Item X will be a completed and realized
transaction. If the customer has paid for Item X there will be absolutely no
accounting left to do, except show the sale and related COGS on the 2002 Income
Statement. Nothing about Item X will affect the company in the future.
Everything about Item X relates only to the past.
If Item X costs you $40, and you sell it for $65, you made a
Gross Profit on the item of $25.
Income Statement 2002
|Selling Price of Item X
|Less: Cost of Item X
|Gross Profit from selling Item X
This is the information that will be included in the 2002
Income Statement. Nothing will be left on the Balance Sheet.
Now let's think for a moment about Item Z. Assume you buy
Item Z for late in 2002, and you are still holding it. There will be no sale to
report, so the cost will remain on the Balance Sheet. If Item Z cost $50 that is
the amount that will be shown on the Balance Sheet.
Balance Sheet Dec. 31, 2002
|Inventory at December 31, 2002
|Cost of Item Z
If Item Z is sold in 2003, the cost will flow to the Income
Statement for 2003, and the gross profit will be reported on that income
In the example above, you determined a value for Item Z at the
end of the year. It is important for companies to count the physical inventory
at the end of the year (Chapter 6). They must also place a dollar value on that
inventory. The inventory value will be reported on the Balance Sheet at the end
of the year.
It is also important to know the correct value of merchandise
sold. That is the cost used to determine Gross Profit. Without enough Gross
Profit a company can't pay it's operating expenses, such as salaries and wages,
rent and utilities, etc. We will discuss Gross Profit a little more later in
There are four methods commonly used to calculate a value for
ending inventory. A company should select and use the method that best matches
their merchandise and how it is sold.
4 methods of inventory valuation
|How it works
|the cost of each individual inventory item is
tracked separately; the exact cost of each item is used in the value of
|auto sales, gems and jewelry, works of art, unique,
one of a kind items
|First In, First Out (FIFO)
|cost of earliest purchases flow to COGS; we assume
that the items remaining at the end are the last ones bought in the year
|eggs, milk, meat, produce; this is the default
flow assumption, unless a different method is specified
|Last In, First Out (LIFO)
|cost of last purchases flow to COGS; we assume that
the items remaining at the end are the earliest ones bought in the year
|clothing, seasonal items; a highly specialized
method of retail inventory
|cost of items bought are averaged across the year;
the average cost is used at the end of the year; a moving weighted
average is sometimes used
|lumber, nails, nuts and bolts (simple average);
gasoline (moving average)
Using a Cost Flow Assumption
- must meet cost-benefit rule
- accounts for quantities of homogeneous products
- matches the physical flow of goods
- can be used with either Periodic or Perpetual costing
The Specific Identification method assumes that each inventory
item is special enough, unique enough, and costly enough to merit tracking one
at a time. But does that apply to each and every item? What about a ream (500
sheets) of typing paper. Is it necessary to place a value on each and every
sheet of paper?
Most business would answer "No" to that question. The cost of
keeping that much detailed information would exceed the usefulness, or benefit,
of the information. We call that the cost-benefit rule. The cost of an
accounting system (or any other venture) should be outweighed by the benefits,
or it is not cost-effective to follow that course of action.
For most companies, the Specific Identification method is far
too costly and the additional information that could be gained is of little
value. Most companies use a cost flow assumption. This simply means that
the flow of inventory follows a certain pattern. Companies will buy merchandise
in a manner consistent with the merchandise itself.
For instance, a grocery store will buy only the amount of milk
it can sell in a week. Because milk spoils quickly, the store will buy small
amounts each week, and make sure the milk it has for sale is the freshest milk
Further, one gallon of milk is basically the same as the next
gallon (with only minor differences). We say that milk is a homogeneous product.
All the milk can be viewed as a single product group, that follows an almost
identical weekly sales and spoilage pattern.
The grocery will use a flow assumption to value its milk
inventory at the end of the year. They will use FIFO, assuming that the milk on
hand is the last milk that was bought during the year.
The LIFO method would assume that the milk bought in the
first week of the year is the same milk on the shelf at the end of the year.
Obviously year old milk will probably be coagulated into a solid, stinking block
of green muck. So we know that LIFO would be an incorrect flow assumption for
milk. So when will the LIFO assumption will be valid?
Let's now picture a clothing store. There are basically 4
clothing seasons: Winter, Spring, Summer and Autumn. There is a line of clothing
for each season. Further, clothing styles change each year. Except for a few
items (socks, handkerchiefs, belts) customers will prefer to buy this year's
fashions, rather than last year's fashions. Here's how that works into the LIFO
At the end of the year the clothing store looks at its
merchandise. If their year ends in December, they have Winter clothes in the
show room. But when they look in the storage room, most of the clothes there are
from earlier seasons that year. So Last In, First Out means, the most current
seasons clothes (Last In) are the ones that people want now (First Out). After
all, you wouldn't be buying last summer's clothes in the middle of winter, would
you? Most people will wait until the following year and buy clothes in style in
the coming summer.
Some merchandise is nearly identical and is carried in large
quantities, like lumber, nails, nuts and bolts or gasoline. If you have a tank
on gasoline with say 50 gallons in it, and you add 200 more gallons, you can't
separate the first 50 gallons out from the rest of it. It all just becomes on
take with 250 gallons of gasoline in it. So companies use the average cost
method to account for things like this.
If you run a gas station, your costs will change every week.
You will always have some left in the tank from the week before, and the
delivery truck will dump more gas in your tank at this week's prices. Gas
stations use a moving average method - they take the moving average from last
week, and calculate a new moving average after adding this weeks batch of
gasoline to the tank. So a moving average updates the cost frequently, and
applies that particular average cost to that week's gasoline sales. Next week
they will calculate a new moving average and apply it to next week's gasoline
At one time my office was next to a company that sold nuts,
bolts, screws, nails, washers and other types of small hardware items. They
bought directly from the manufacturers, mostly foreign. Their goods came packed
in small wooden barrels. Believe me, a small wooden barrel full of nails is
They repackaged the items into small plastic bags for resale
to stores, and ultimately to end consumers. They had a very sophisticated set of
scales that would accurately weigh out the pieces into the desired quantity. For
instance ,they could weigh out 10 flat washers accurately, and drop them into a
small plastic bag. It was much quicker and easier than counting pieces manually.
How do you think they counted and valued their ending
inventory? They weighted all the opened containers (no need to weigh a full,
unopened one), and used their cost per pound, to calculate the value of their
ending inventory. This may seem a bit unconventional, but it is a very good
method, and entirely acceptable.
Some bulk products and how they might be measured for average
|gasoline, oil, milk, orange juice
|cubic yard, cubic meter
|nails, nuts and bolts
|wheat, oats, corn, other grains
|electric, telephone or TV cable
The importance of time when working with inventory methods
When it comes to inventory values, time is of the essence.
That's a legal term, and means that time is more than just important, it is
essential. You can't sell something you don't have, right? You can sell only
what you have on hand in your inventory. Once an item is sold we have to
determine how much cost to transfer from the Inventory account to the COGS
Using the Periodic system
If you use a Periodic inventory system, you value your inventory
only once a year - at the end of the year! So the job is fairly easy, and you
should have little problem making the calculation. You apply a cost flow
assumption once at the end of the year, and it pertains only to the physical
merchandise still on hand at the end of the year.
It doesn't matter when sales take place, or when inventory is
purchased. We ignore all that when we use the Periodic system. All we have to
care about is what inventory is on hand at the end of the year.
Using the Perpetual System
If you use the Perpetual system you have to track each and every
purchase and sale of inventory. Time is definitely of the essence. We will use a
cost flow and apply it continuously, updating the Sales, Inventory and COGS
accounts daily, as merchandise is purchased and sold.
This can be a daunting task, and usually is done by
sophisticated and expensive computerized systems. When you go to a grocery or
department store, notice that all the products have a bar code, which is scanned
by an electronic cash register. All the merchandise is scanned into the the
computer inventory records when it arrives at the store, and is scanned out as
it is sold. The inventory records are continuously updated, along with the
The type of system a company uses will depend on how much it
can afford to spend. Obviously, not all companies can or need to spend $50,000
to $100,000 for each scanning cash register, plus the cost of the computer and
software itself. Installing such a system can easily cost $1 million or more per
store. That's a high price tag, so most companies use a Periodic system, and
update their inventory only once a year.
Let's say a company uses the Periodic system. In the middle of
the year they go to the bank seeking a loan for expansion. The banker asks to
see a set of financial statements. Taking a complete physical inventory can be a
huge, time-consuming task. The company may simply not have time to drop
everything and take a physical inventory at this time. Do they have any options?
In fact, they do. They can estimate the inventory on hand.
They can reconstruct the inventory based on their purchase and sales records for
the year to date. There are a couple of methods used to do this. They are both
The Gross Profit method is one method. The store needs to
know it's gross profit rate or cost ratio (the inverse of gross profit rate).
They start with the beginning inventory balance, add purchases, and deduct for
sales made using the cost ratio. The result is an estimate of the merchandise on
This method is especially useful when there has been a loss
due to theft, fire, flood and so forth. The Gross Profit or Retail methods can
be used to substantiate an insurance claim for loss in these situations.
Inventory turnover is not some sort of exotic pastry. It also
does not mean we physically pick up our inventory and turn it over or upside
down. Having dispensed with those misconceptions, just what is inventory
Each time you sell your entire inventory, you are said to
have "turned" or "turned over" your inventory. We measure this as the number of
times per year that this happens. We also measure it in a dollar amount, not by
the actual physical objects. A store might have a year-old can of "Uncle Simon's
Nasty Stuff That Only Your Aunt Ethel Will Eat". Not selling that can will have
not effect on inventory turnover, in the larger sense of the word.
[Managers are definitely interested in micro-inventory
management: looking at the sales pattern of individual items. Walmart has been
an aggressive pioneer in this area. Right now we are dealing with
macro-inventory management: looking at the dollar value of the entire inventory,
taken as a whole.]
Earlier I discussed how a grocery store stocks milk. The buy
enough for one week. There are 52 weeks in a year, so we would expect their
inventory turnover, for milk, to be roughly 52. We usually calculate this using
dollars, rather than tracking actual cartons of milk.
Number of Days in Inventory is the concept expressed
in number of days. It tells us how many days, on average, inventory stays on a
shelf before it is sold. Since there are 365 days in a year, we can divide 365
by the inventory turnover rate and get the number of days in inventory.
365 / 52 = 7 (rounded) or roughly 1 week
There are 52 weeks in the year, and the store wants to stock
enough for 1 week at a time. Their weekly milk inventory is sold 52 times a year
(turnover), or once every 7 days (days in inventory).
Let's look at a table and see some typical correlation's.
Notice the inverse relationship between turnover rate and days in
inventory. As one goes up, the other goes down.
|Days in Inventory
|quarter (3 months)
What I'm hoping you'll get from this is a little common
sense. Eggs would not have a turnover rate of 4. Perishable items will have a
high turnover rate and low number of days in inventory.
Automobiles, diamond rings, and works of art would probably
not have a turnover rate of 52. It can take much longer to sell these expensive
items. They will have a low turnover rate, and a high number of days in
How Turnover relates to Gross Profit
Profits depend on several things. One of the most important is
the relationship between turnover and gross profit. Higher turnover brings
greater profit. Lets look at a simple example.
A store buys Item X for $20, and sells it for $30. The Gross
Profit from each item is $10.
|Annual Turnover Rate
Guess what, we can just multiply the annual turnover rate and
the GP per unit ($10). That would be an easier calculation!
|Annual Turnover Rate
|$GP x TO Rate
|$10 x 1
|$10 x 2
|$10 x 4
|$10 x 6
|$10 x 12
|$10 x 52
If you sell 1 unit per year, you will only make $10
If you sell 1 unit per week you make $520 per
Which is better?
(I sincerely hope you chose $520 per year. If not, please
consult a physician. You may need professional help.)
Turnover is essential to profits. Higher turnover = higher
Let's look at an example
Jim buys pocket knives from the manufacturers and resells them
on e-bay. He buys by the case and pays $5 for each knife. At the both the start
and end of the year he had 30 knives on hand (to make this example a little
Jim bought and sold 800 knives during the year. He had 32
knives on hand at the start and end of the year, so his average inventory is 32
(32+32/2 = 32).
|COGS @ $5
|Avg Inventory @ $5
|$4000 / $160 =
|Days in inventory
|365 / 25 =
What this is telling us:
His average inventory was 32 knives last year.
He sells 32 knives every 25 days.
Each batch of 32 knives is in inventory 14.6 days.
If he sells 800 knives every year, that's about 800 / 365 = 2.19
knives per day.
This is consistent with our results. 32 knives / 14.6 days =
2.19 knives per day.
He sells about 2 x 32 = 64 knives each month (avg 66.6 knives
Inventory Management - a delicate balance
By now you should be seeing the correlation between Gross Profit
and sales. No matter what your gross profit is, making more sales will always
mean making more GP. Since each and every unit of product you sell earns you a
GP, you will always do better selling more, rather than less.
Inventory turnover is a measure of ow often your average
inventory is sold. Since business managers have access to all the detailed
operating information of their company, they can manage inventory on a product
by product basis. They can effectively look at the turnover of a single product,
and more accurately gauge their real average inventory held for that item.
There is one very important thing that all businesses have to
deal with: carrying the right amount of inventory - not too much, not too
If you carry too little inventory you will lose sales,
and that will reduce your GP.
If you carry too much inventory the surplus will tie
up your cash flow. You will have to warehouse, protect and insure the excess
inventory. And you run a high risk of spoilage, obsolescence, theft and damage.
A company will maximize its profits by carrying the correct
amount of each item in its inventory. This amount is determined by careful
analysis and tracking of customer's buying patters. Stores have to pay attention
to the seasonal and cyclic buying trends their customers display. Effective
inventory management requires both day-to-day attention, and ongoing analysis
of customer preferences and buying habits.