COURSE DESCRIPTION. Rev 2.0 March 2017

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1 COURSE DESCRIPTION This CE course provides information on inventory management. Information discussed includes inventory methods and accounting systems, cost of goods sold, and inventory turnovers and ratios. Rev 2.0 March 2017 COPYRIGHT 2017 National Center for Competency Testing Reproduction or translation of any part of this work beyond that permitted by Sections 107 or 108 of the 1976 United States Copyright Act without the permission of the copyright owner is unlawful. No part of this work may be reproduced or used in any form or by any means-graphic, electronic, or mechanical, including photocopying, recording, taping, or information storage and retrieval systems without written permission of the publisher.

2 COURSE TITLE: Overview of Inventory Management and Cost of Goods Sold Author: Debra Thomas, AAS, EA, NRB Number of Clock Hours Credit: 2.0 Course # P.A.C.E. Approved: Yes X No OBJECTIVES Upon completion of this continuing education course, the professional should be able to: 1. Define inventory, inventory turnover ratio, and cost of goods sold. 2. Identify the two inventory accounting systems. 3. Identify the three basic valuation methods of inventory. 4. List the accounts used in inventory recordkeeping. 5. Perform calculations to the valuation methods of inventory 6. Describe the flow of inventory costs to finished goods inventory. 7. Describe the effect of sales on the cost of goods sold. 8. Perform calculations for inventory ratio and cost of goods sold. Disclaimer The writers for NCCT continuing education courses attempt to provide factual information based on literature review and current professional practice. However, NCCT does not guarantee that the information contained in the continuing education courses is free from all errors and omissions. 2

3 INTRODUCTION TO INVENTORY Inventory is defined as the raw material or finished goods that a business has available for sales. Careful tracking of inventory is necessary to identify what is available for sale and the income from what has been sold. At the beginning and ending of the tax year, a business should confirm the inventory by performing a physical count. The inventory amount in the accounting records is then adjusted to agree with the actual inventory. If inventory items have been removed for personal use, this number must be subtracted from the total purchases. Two general ledger records are used to track inventory. 1. Purchases: Records of actual purchase of inventory; this record is used to calculate the cost of goods sold, an item on the income record. 2. Inventory: The value of inventory on hand; the value is shown on the balance sheet portion of the financial statement as a current asset. INVENTORY TRACKING Physical inventory is tracked using one of two systems: periodic or perpetual. Periodic Inventory With the periodic inventory system, the inventory account is commonly updated or adjusted one time at the end of the tax year. Some businesses may update or adjust more frequently (monthly, quarterly, etc.) if needed. Purchases of inventory are recorded in the purchase accounts that are closed at the end of the tax year, and the inventory account adjusted at that time. With the periodic inventory system, there is no cost of goods sold account to be updated when inventory is sold. A review of the general ledger accounts will not identify the amount of inventory on hand or the cost of goods sold. Advantages and disadvantages of the use of periodic inventory follow. Advantages Less recordkeeping (usually) Simple and straightforward Disadvantages Assigning a cost to the ending inventory may be difficult Less able to manage inventory control from theft, etc. Information needed for financial statements is not readily available Perpetual Inventory With the perpetual inventory system, the inventory account is continuously adjusted. The inventory account is reduced when products are sold and increased when new products are received. Purchase accounts do not exist. However, there is a cost of goods sold account that is debited at the time of each sale. 3

4 With the perpetual inventory system, two journal entries occur when a purchase is made. 1. An entry to record the sale and the cash or accounts receivable. 2. An entry to reduce the inventory and to increase the cost of goods sold. A periodic physical inventory count is recommended to identify irregularities that may result from theft, damage, or loss of inventory from other sources such as personal use, etc. Journal entries reflect a credit to inventory and a debit to the cost of goods sold. Advantages and disadvantages of the use of perpetual inventory follow. Advantages Improved control Inventory levels monitored easily Financial statements can be prepared without estimating or counting inventory Disadvantages Requires detailed records VALUING INVENTORY There are three basic approaches to valuing inventory allowable by the United States Financial Accounting Standards Board (FASB) Generally Accepted Accounting Principles (GAAP): First In, First Out; Last In, First Out; and Weighted Average. The method selected for use by a business affects the balance sheets and income statements, thus influencing the tax liability and profitability of the business. First In, First Out With First In, First Out (FIFO) method of inventory evaluation, the first inventory purchased/produced is the first inventory sold/used/or disposed. FIFO assumes the assets remaining in inventory are matched to the assets most recently purchased (or produced). In a period of inflation FIFO results in a smaller cost of sales which increases income. If prices decline however, FIFO produces a higher cost of sales which decreases income. Businesses that sell perishable products or products that may become obsolete commonly use the FIFO method of inventory valuation as it assure less wastage of product. FIFO is considered a more straight-line approach to inventory valuation and it is very useful when tracking of inventory items is simple. The major disadvantage of using FIFO is the business taxable income is typically higher, assuming costs of inventory have inflated over time. In addition, when inventory is returned or exchanged, accounting for costs is more complex. The following inventory sheet provides an example of FIFO use. The example demonstrates that with inflation the cost per unit increases to make the cost of goods sold higher thus producing a higher income. Note: This example shows no markup on the sale price of the inventory units. 4

5 Date Purchase Sale Balance Units Cost per unit Total Units Cost per unit Total Units Cost per unit Total Beginning Jan 1 50 $3.00 $ $3.00 $ Purchase Jan $3.10 $ $3.10 $ $3.00 $ $3.10 Sale Jan $3.00 $ Purchase Jan $3.20 $ $3.10 $ $ @ $3.20 $ Sale Jan @$ @$3.20 $ End 20 $3.20 $64.00 FIFO is accepted by the International Financial Reporting Standards (IFRS), allowing businesses to conduct sales to countries outside of the United States. A large part of the world uses the IRFS framework. Last In, First Out Last In, First Out (LIFO) inventory valuation is based on the premise that the most recent inventory produced/purchased is the first inventory sold/used/disposed. The inventory remaining at the end of the year is the inventory at the beginning of the year, rather than at the end. In a period of inflation LIFO will result in a larger cost of sales which reduces income. This will show a lower ending inventory and a higher cost of goods sold, thus providing the business with a lower gross profit and a lower taxable income. The following inventory sheet provides an example of LIFO use. The example demonstrates that with inflation the cost per unit decreases to make the cost of goods sold lower thus producing a lower income. Note: This example shows no markup on the sale price of the inventory units. Date Purchase Sale Balance Units Cost per unit Total Units Cost per unit Total Units Cost per unit Total Beginning Jan 1 50 $3.00 $ $3.00 $ Purchase Jan $3.10 $ $3.10 $ $ Sale Jan $3.10 $ Purchase Jan $3.20 $ $3.00 $ $3.00 $3.20 $ Sale Jan $3.20 $3.00 $ End 20 $3.00 $

6 Many businesses use LIFO to defer the payment of income taxes in an inflationary environment. However, the Internal Revenue Service (IRS) places restrictions on how and when LIFO can be used, and only a few select large companies in the US are able to use LIFO. Some businesses use LIFO for inventory management but translate it to FIFO for IRS reporting. LIFO is not recognized by the IFRS thus restricting businesses that use it from interactions with much of the world. The US federal government has proposed repealing LIFO and adopting IFRS leading to much debate among both large and small businesses. Weighted Average With the Weighted Average method, the cost of units available for sale is divided by the number of units available for sale, yielding the weighted average cost per unit. This results in a value somewhere between the values of the oldest and newest units in stock. When the inventory turns over rapidly, this approach resembles FIFO more than LIFO. Businesses may choose the use of Weighted Average method if 1) their inventory is basic and the need to use LIFO or FIFO is not necessary, 2) the inventory units are intermingled and it is difficult to assign a specific cost to each, or 3) the inventory units are so identical to each other that it is difficult to assign a cost to each unit. The Weighted Average method is allowable by IFRS. The following inventory sheet provides an example of Weighted Average use. Note: This example shows no markup on the sale price of the inventory units. Date Purchase Sale Balance Units Cost per unit Total Units Cost per unit Total Units Cost per unit Total Beginning Jan 1 50 $3.00 $ $3.00 $ Purchase Jan $3.10 $ $3.10 $ $3.05 $ Sale Jan $3.05 $ Purchase Jan $3.20 $ $3.05 $ $3.13 $ Sale Jan $3.13 $ End 20 $3.13 $62.60 INTRODUCTION TO COST OF GOODS SOLD The dollar amount of goods and services sold by a business is known as sales or revenue. This data is needed as it identifies the amount of money brought in by a business as a result of the consumers demands for the product or service that it s 6

7 producing or selling. It is also important to know how much it costs to sell the goods and services by the company. This cost is called the cost of goods sold (COGS) or cost of sales. The equation for COGS follows. Beginning Inventory + Inventory Purchases Ending Inventory = COGS The Cost of Goods Sold does not include: 1. Selling, i.e., expenses not directly related to the products or services sold such as rent, lease, utilities, salary, marketing, etc. 2. Research and development 3. Interest, taxes, and depreciation, i.e., the cost of paying interest on loans, taxes owed, and depreciation on buildings and equipment A business must include all direct and indirect costs associated with the inventory to correctly value inventory at cost. Some businesses manufacture their own goods to sell. These businesses can deduct the COGS from their gross receipts. To determine these costs, the value of inventory at the beginning and end of the year must be calculated. There are several factors that go into determining COGS including: Inventory at the beginning of the year Inventory items withdrawn for personal use Labor costs and materials; and supplies (only in manufacturing businesses) Inventory at the end of the year Inventory, net purchases, cost of labor, materials and supplies, and other costs added together It is important to pay attention to the cost of sales as when it increases, it reduces a business s earnings. Ideally, a business s sales should grow faster than its cost of sales. Following is an example of the importance in the growth of COGS along with the growth in sales. 7

8 Larry owns a lawn mowing business and rents the lawn mowers. He charges $75.00 to mow a large lawn. The mower rental charge and cost to fill the mower with gas is $ Larry s sales revenue = $75.00 COGS = $30.00 Profit per customer = $45.00 The lawn mower rental company increases the rental fee by $ Larry s COGS is now $40.00, decreasing his profit to $ If Larry wants to maintain his $45.00 profit, he will need to increase his charge for mowing a large lawn to $ He is concerned that a $10.00 increase in his charge will cause him to lose customers. Larry decides to compromise and raise his cost by $5.00 to a charge of $ His profit will decrease from $45.00 to $40.00 but he believes he will not lose any of his customers. To determine the cost of goods sold, all costs involved in creating products eventually sold by a business must be included. The costs included in COGS are those that are tied to the production of the goods including the following Shipping costs needed to get the goods (raw materials) to the manufacturer in order to produce the inventory Freight-in, express-in, and cartage-in of raw materials, supplies used in production, and merchandise purchased for resale However, the postage or shipping costs to deliver a finished product to a buyer are not included in COGS. Inventory is increased by merchandise or raw materials purchased. Labor costs are usually included in the COGS calculation only in manufacturing or mining businesses. In manufacturing, labor costs include the direct and indirect costs used in the fabrication of inventory or goods produced for eventual resale or retail sale to customers. Materials and supplies used in the actual manufacture of goods are also included in COGS. 8

9 An example of the COGS calculation for a retail business follows. Dougie's Dog Boutique, Inc. is a dog retail store. At the beginning of the year, the boutique has $50,000 in inventory. During the year, the boutique purchases an additional $10,000 of inventory. At year end, the owner s final physical inventory count identified $15, in ending inventory. Therefore, the cost of goods sold is $45, Beginning inventory Plus: net purchases Goods available for sale Less: ending inventory Cost of goods sold $50, $10, $60, $15, $45, INVENTORY TURNOVER Inventory turnover is a measure of the number of times inventory is sold or used in a given time period such as a year. The equation for inventory turnover equals the cost of goods sold divided by the average inventory. Inventory turnover indicates both the business s ability to manage inventory and frequency of inventory replenishment. Three frequently used inventory ratios include inventory turnover, average inventory, and average days to sell inventory. Each ratio provides slightly different information that is useful in managing inventory. All inventory ratios are important to evaluate as they are important in identifying the time it takes to turn inventory into cash for the business. Inventory Turnover The information needed to calculate a company s inventory turnover can be found on the financial statement. Cost of goods sold is found on the income statement and the ending inventory can be found on the balance sheet. The inventory turnover calculation follows. Inventory Turnover = COGS Average Inventory or COGS/Average Inventory Average Inventory Turnover Average inventory accounts can be used to identify the amount of inventory available over a period of time longer than a month. It can be useful to determine if seasonal variations affect the inventory turnover ratio. Average Inventory = (Beginning Inventory + Ending Inventory) 2 9

10 Average Days to Sell Inventory Also called Days Sales of Inventory (DSI) or Days Inventory Outstanding (DIO), this ratio provides data on the average number of days it took to sell the average inventory during a specified one-year period. The Inventory Turnover Ratio is determined by dividing COGS by the inventory quantity. Inventory Turnover Ratio = COGS Inventory The chart below compares the inventory turnover ratios of Company A and Company B. Company A Company B Cost of Goods Sold 72,358 48,953 Inventory 19,572 11,487 Inventory Turnover Ratio 72,358 19,572 = ,953 11,487 = 4.26 The ratios identify that Company B sold their inventory more frequently or more times during the year than did Company A. Generally speaking, the higher the ration, the better. With the inventory ratio known, the average number of days to sell the inventory can be calculated. Average days to sell inventory = 365 Inventory Turnover Ratio Company A: = Company B: = INVENTORY TURNOVER MANAGEMENT A high inventory turnover ratio is considered a positive indicator of effective inventory management. It can indicate the efficiency and profitability of a company. However, a high inventory turnover ratio does not always mean better performance. It may indicate inadequate inventory levels, which can result in a decline in sales due to competition with other businesses. A low inventory turnover ratio may indicate a company carries too much inventory, suggesting poor inventory management or low sales. Excess inventory can tie up the business's cash and make it vulnerable. Items in inventory may carry storage cost, and the risk of getting spoiled, broken, stolen, or simply going out of style. It is recommended practice for a business to compare their turnover ratios with the turnover ratios of other businesses in the same industry. It is also recommended to utilize inventory ratios on a quarterly basis as calculating the ratios at the end of the year may be misleading due to seasonal and/or holiday sales. 10

11 Inventory turnover ratios also provide the business owner with information as to how they can increase sales through inventory control. Following are some tips for managing inventory turnover. Make inventory a priority. The more inventory available for the business, the less cash the business has available. Assure the inventory tracking is accurate. Perform a physical count and invest in barcode scanning/electronic data interchange (EDI) inventory systems. Maintain up-to-date accounting records, including receipt of inventory and sales records. Examine inventory quantities. Identify what is selling, what is not selling, and seasonal variations. Adjust inventory purchases based on inventory turnover ratios. Overstocking inventory should be avoided. Identify par levels. Review inventory suppliers including the delivery of inventory. If inventory can be delivered quickly, a business may be able to minimize the inventory quantities available on hand, i.e., implement a just-in-time inventory order with the supplier. Assure all accounting records are backed up in case of a natural disaster or computer system malfunction. CONCLUSION This overview provided basic information on inventory management. Making inventory a priority is important for all businesses, big or small. Tracking inventory is necessary to clearly show income when a business produces or sells products. Inventory turnover ratios help the business owner determine how sales can be increased through inventory control. Having good inventory management can help prevent failure of a company. Learning, implementing, and evaluating inventory give a business an advantage over its competitors. REFERENCES IRS Publication 334 (2013), Tax Guide for Small Business: Accessed 06 May Cost of Goods Sold (Cost of Sales) Accessed 06 February TeenVestor Accessed 06 January AccountingExplained: Inventory Turnover Ratio Accessed 06 February Inventory Turnover Accessed 06 February LIFO and FIFO Inventory Accounting Methods Overview of Two Methods of Accounting for and Tracking Inventory Accessed 06 February

12 FIFO vs LIFO Accessed 06 February Five Steps to Painless Inventory Management Accessed 06 February TEST QUESTIONS Overview of Inventory and Cost of Goods Sold # Directions: Before taking this test, read the instructions on how to complete the answer sheets correctly. If taking the test online, log in to your User Account on the NCCT website Select the response that best completes each sentence or answers each question from the information presented in the module. If you are having difficulty answering a question, go to and select Forms/Documents. Then select CE Updates and Revisions to see if course content and/or test questions have been revised. If you do not have access to the internet, call Customer Service at Raw materials or finished goods to be sold are known as. a. turnovers b. COGS c. inventory d. purchases 2. The two general ledger records required for tracking inventory are. a. Purchases and Inventory b. Revenue and Miscellaneous c. COGS and Sales d. Inventory and Accounts Receivable 3. On which portion of the financial statement is the value of inventory shown? a. Income Statement b. Balance Sheet c. Profit and Loss d. Liability 4. Which of the following methods is used to track physical inventory on hand? a. Periodic or Perpetual b. Last In, First Out (LIFO) c. First In, First Out (FIFO) d. COGS 12

13 5. A physical count of inventory can identify. a. theft b. damaged items c. loss of inventory d. All of the above 6. One of the methods of valuing inventory is. a. periodic b. weighted average c. perpetual d. physical 7. Which basis for valuing inventory is not allowed by GAAP? a. LIFO b. FIFO c. Standard Cost d. Weighted Average 8. FIFO is when the oldest inventory items are sold first and the newest inventory items are sold last. a. True b. False 9. Which method assumes inventory is sold in the order that is stocked; i.e., the oldest inventory items are sold first and the newest inventory items are sold last? a. LIFO b. FIFO c. Standard Cost d. Weighted Average 10. Cost of Goods Sold (COGS) is the cost to sell goods and services by a company. a. True b. False 11. The equation for COGS is. a. Beginning Inventory + Ending Inventory b. Ending Inventory Beginning Inventory c. Beginning Inventory + Inventory Purchases Ending Inventory d. Inventory Purchases + Ending Inventory Beginning Inventory 13

14 12. Which of the following is NOT included in determining COGS? a. Research and development b. Labor costs to make the product c. Materials and supplies to make the product d. Inventory withdrawn for personal use 13. Postage and/or shipping costs to deliver a finished product to a buyer are included in the Cost of Goods Sold. a. True b. False 14. Clyde s Cycle Center, Inc. is a bicycle retail business. At the beginning of the year, the business has $70,000 in inventory. During the year, the business adds $20,000 in additional inventory purchases. At the end of the year, the owners do a final physical inventory count, and they calculate that they have $55,000 in ending inventory. Which of the following is the COGS for Clyde s Cycle Center, Inc.? a. $90,000 b. $35,000 c. $15,000 d. $145,000 Use the following information to answer questions Company XYZ, Inc. uses a perpetual inventory system. They began business at the beginning of These are their purchases for first quarter. Purchase Date Quantity Unit Cost Total Cost January 3, $10 $1000 January 31, $11 $550 March 15, $12 $1200 Total on hand 250 $ XYZ, Inc. sells 50 units on February 15, If XYZ, Inc. uses the FIFO inventory method, what is the COGS? a. $600 b. $550 c. $500 d. $650 14

15 16. Referencing #15, what is the value of the ending inventory if this was the only sale in the first quarter? a. $500 b. $2250 c. $2170 d. $ XYZ, Inc. sells 50 units on February 15, If XYZ, Inc. uses the LIFO inventory method, what is the COGS? a. $2220 b. $600 c. $550 d. $ Referencing question 17, what is the value of the ending inventory if this was the only sale in the first quarter? a. $2200 b. $2170 c. $550 d. $ A business makes the following purchases. December 1, 30 units $4.00 each = $ December 15, 30 units $4.10 each = $ December 20, 10 units $4.20 each = $42.00 What is the weighted average cost per unit? a. $5.69 b. $4.07 c. $23.17 d. $ Inventory turnover is a measure of the number of times inventory is sold or used in a time period. a. True b. False 15

16 21. The information needed to calculate a company s inventory turnover includes. a. COGS and Ending Inventory b. Beginning Inventory, Purchases and Ending Inventory c. COGS, Beginning Inventory and Ending Inventory d. Beginning Inventory and Ending Inventory 22. Which of the following is the formula for inventory turnover? a. Beginning Inventory + Inventory Purchases Ending Inventory b. 365/Inventory Turnover Ratio c. COGS/Average Inventory d. (Beginning Inventory + Ending Inventory) / 2 Use the table below to answer questions Company A Company B Cost of Goods Sold 65,651 35,526 Inventory 28,362 15, What is the inventory turnover ratio for Company A? a b c d How many times did Company B sell their inventory during the year? a b c d How many days did it take for Company A and Company B to sell their inventory during a year? a. Company A 158 days Company B days b. Company A days Company B days c. Company A days Company B 158 days d. Company A days Company B days 26. A high inventory turnover ratio indicates a business may have too much inventory. a. True b. False 16

17 Inventory Turns Per Year 27. Which statement below is FALSE when managing inventory turnover? a. Backup all inventory records b. Review inventory suppliers c. Track inventory accurately d. Overstock your inventory Use the graph below answer questions Inventory Turnover Comparison Target Wal-Mart Kohls K-Mart Old Navy Macys The information in this graph is for example purposes only. 28. Which company sells its inventory in days? a. Kohls b. Old Navy c. Wal-Mart d. Macys 29. Target sells its inventory in. a days b days c days d days 30. Which company s inventory turnover ratio indicates too much inventory is being carried? a. Old Navy b. K-Mart c. Target d. Wal-Mart *end of test* 17

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