CONCEPTUAL
Merchandise inventory refers to goods owned by
a company and held for resale. Three special cases merit our
attention. Goods in transit are reported in inventory of
the company that holds ownership rights. Goods on consignment
are reported in the consignor’s inventory. Goods damaged
or obsolete are reported in inventory at their net realizable value.
Costs of merchandise
inventory include expenditures necessary to bring an item to a
salable condition and location. This includes its invoice cost
minus any discount plus any added or incidental costs necessary to
put it in a place and condition for sale.
ANALYTICAL
When purchase costs are rising or falling,
the inventory costing methods are likely to assign different costs to
inventory. Specific identification exactly matches costs and
revenues. Weighted average smooths out cost changes. FIFO assigns
an amount to inventory closely approximating current replacement cost. LIFO assigns the most
recent costs incurred to cost of goods sold and likely better matches current
costs with revenues.
An error in the amount of ending inventory
affects assets (inventory), net income (cost of goods sold), and equity
for that period. Since ending inventory is next period’s beginning inventory,
an error in ending inventory affects next period’s cost of goods sold and net income. Inventory
errors in one period are offset in the next period.
We prefer a high inventory turnover,
provided that goods are not out of stock and customers are not
turned away. We use days’ sales in inventory to assess the
likelihood of goods being out of stock. We prefer a small number of days’ sales
in inventory if we can serve customer needs and provide a buffer
for uncertainties.
PROCEDURAL
Costs are assigned to the Cost of Goods Sold account
each time a sale occurs in a perpetual system. Specific identification
assigns a cost to each item sold by referring to its actual cost (for
example, its net invoice cost). Weighted average assigns a cost to
items sold by dividing the current balance in the Inventory account by the
total items available for sale to determine cost per unit. We
then multiply the number of units sold by this cost per unit to get
the cost of each sale. FIFO assigns cost to items sold assuming
that the earliest units purchased are the first units sold. LIFO
assigns cost to items sold assuming that the most recent units
purchased are the first units sold.
Inventory is reported at market cost when market
is lower than recorded cost, called the lower of cost or market (LCM)
inventory. Market is typically measured as replacement cost. Lower of
cost or market can be applied separately to each item, to major
categories of items, or to the entire inventory.
Periodic inventory systems allocate the cost of
goods available for sale between cost of goods sold and ending
inventory at the end of a period. Specific identification and FIFO
give identical results whether the periodic or perpetual system is used. LIFO
assigns costs to cost of goods sold assuming the last units purchased for the period are the first
units sold. The weighted average cost per unit is computed by dividing the total
cost of beginning inventory and net purchases for the period by
the total number of units available. Then, it multiplies cost per unit by the
number of units sold to give cost of goods sold.
The retail inventory method involves three
steps: (1) goods available at retail minus net sales at retail
equals ending inventory at retail, (2) goods available at cost
divided by goods available at retail equals the cost-to-retail ratio, and (3) ending inventory at retail multiplied by
the cost to-retail ratio equals estimated ending inventory at cost.
The gross profit method involves two steps: (1) net sales at retail
multiplied by 1 minus the gross profit ratio equals estimated cost of
goods sold, and (2) goods available at cost minus estimated cost
of goods sold equals estimated ending inventory at cost.
Guidance
Answers to Decision Maker and Decision Ethics
Cost Analyst
Explain to your supervisor that when inventory costs are
increasing, FIFO results in an inventory
valuation that
approximates replacement cost. The most recently purchased goods are assigned to ending
inventory under FIFO and are likely closer to replacement values than earlier costs that would be
assigned to inventory if LIFO were used.
Inventory Manager
It seems your company can save (or at least postpone) taxes by
switching to LIFO, but the switch is likely to reduce bonus money that you
think you have earned and deserve.
Since the U.S. tax code requires companies that use LIFO for tax reporting also to
use it for financial reporting, your options are further constrained. Your
best decision is to tell your superior
about the tax
savings with LIFO. You also should discuss
your bonus plan and how this is likely to hurt you unfairly. You might propose to
compute inventory under the LIFO method
for reporting purposes
but use the FIFO method for your bonus
calculations. Another solution is to revise the bonus plan to reflect the company’s use of
the LIFO method.
Entrepreneur
Your inventory turnover is markedly higher than the norm, whereas days’
sales in inventory approximates the norm. Since your turnover is already 14%
better than average, you
are probably best served by directing attention to days’ sales in inventory. You should see
whether you can reduce
the level of inventory
while maintaining service to customers. Given your higher turnover, you should be
able to hold less inventory.
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