c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Learning Objectives
1. Describe the importance of control over inventory.
2. Describe three inventory cost flow assumptions
and how they impact the income statement and
balance sheet.
3. Determine the cost of inventory under the
perpetual inventory system, using the FIFO, LIFO,
and weighted average cost methods.
4. Determine the cost of inventory under the periodic
inventory system, using the FIFO, LIFO, and
weighted average cost methods.

Learning Objectives
5. Compare and contrast the use of the three
inventory costing method.
6. Describe and illustrate the reporting of
merchandise inventory in the financial
statements.
7. Describe and illustrate the inventory turnover
and the number of days’ sales in inventory in
analyzing the efficiency and effectiveness of
inventory management.

c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Control of Inventory
o Two primary objectives of control over inventory
are:
 Safeguarding the inventory from damage or theft.
 Reporting inventory in the financial statements.

Safeguarding Inventory
o The purchase order authorizes the purchase of
the inventory from an approved vendor.

Safeguarding Inventory
o The receiving report establishes an initial record
of the receipt of the inventory.

Safeguarding Inventory
o Recording inventory using a perpetual inventory
system is also an effective means of control.
The amount of inventory is always available in
the subsidiary inventory ledger.

Safeguarding Inventory
o Controls for safeguarding inventory should
include security measures to prevent damage
and customer or employee theft. Some
examples of security measures include the
following:
 Storing inventory in areas that are restricted to only
authorized employees.
 Locking high-priced inventory in cabinets.
 Using two-way mirrors, cameras, security tags, and
guards.

Reporting Inventory
o A physical inventory or count of inventory
should be taken near year-end to make sure
that the quantity of inventory reported in the
financial statements is accurate.

c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

INVENTORY COST
FLOW ASSUMPTIONS

Inventory Cost Flow Assumptions

Inventory Cost Flow Assumptions
o Assume that one unit is sold on May 30 for $20.
Depending upon which unit was sold, the gross
profit varies from $11 to $6 as shown below:

Inventory Cost Flow Assumptions
o Under the specific identification inventory cost
flow method, the unit sold is identified with a
specific purchase.

Inventory Cost Flow Assumptions
o Under the first-in, first out (FIFO) inventory cost
flow method, the first units purchased are
assumed to be sold first and the ending
inventory is made up of the most recent
purchases.

Inventory Cost Flow Assumptions
o Under the last-in, first out (LIFO) inventory cost
flow method, the last units purchased are
assumed to be sold first and the ending
inventory is made up of the first units
purchased.

Inventory Cost Flow Assumptions
o Under the weighted average inventory cost flow
method, the cost of the units sold and in ending
inventory is a weighted average of the purchase
costs.

INVENTORY COST
FLOW ASSUMPTIONS
(continued)

INVENTORY COST
FLOW ASSUMPTIONS
(continued)

INVENTORY COST
FLOW ASSUMPTIONS
(concluded)

c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Inventory Costing Methods
o For purposes of illustration, the data for Item
127B are used, as shown below. We will
examine the perpetual inventory system first.

FIRST-IN, FIRST-OUT
METHOD
(continued)

FIRST-IN, FIRST-OUT
METHOD
(continued)

FIRST-IN, FIRST-OUT
METHOD
(continued)

FIRST-IN, FIRST-OUT
METHOD
(continued)

FIRST-IN, FIRST-OUT
METHOD
(continued)

FIRST-IN, FIRST-OUT
METHOD
(continued)

FIRST-IN, FIRST-OUT
METHOD
(continued)

LAST-IN, FIRST-OUT
METHOD
(continued)

LAST-IN, FIRST-OUT
METHOD
(continued)

LAST-IN, FIRST-OUT
METHOD
(continued)

LAST-IN, FIRST-OUT
METHOD
(continued)

LAST-IN, FIRST-OUT
METHOD
(continued)

LAST-IN, FIRST-OUT
METHOD

LAST-IN, FIRST-OUT
METHOD
(continued)

Weighted Average Cost Method
o When the weighted average cost method is
used in a perpetual system, an average unit
cost for each item is computed each time a
purchase is made.
o This unit cost is then used to determine the cost
of each sale until another purchase is made and
a new average is computed. This averaging
technique is called a moving average.

WEIGHTED AVERAGE
COST METHOD

c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

First-In, First-Out Method
o Using FIFO, the earliest batch purchased is
considered the first batch of merchandise sold.
The physical flow does not have to match the
accounting method chosen. This time we will be
examining the periodic inventory system.

Cost of merchandise
available for sale
First-In, First-Out Method
o Beginning inventory and purchases of Item
127B in January are as follows:

First-In, First-Out Method
o The physical count on January 31 shows that
800 units are on hand. (Conclusion: 1,300 units
were sold.) What is the cost of the ending
inventory?

First-In, First-Out Method
o Now we can calculate the cost of merchandise
sold as follows:

FIRST-IN, FIRST-OUT
METHOD

Last-In, First-Out Method
o Using LIFO, the most recent batch purchased is
considered the first batch of merchandise sold.
The actual flow of goods does not have to be
LIFO. For example, a store selling fresh fish
would want to sell the oldest fish first (which is
FIFO), even though LIFO is used for accounting
purposes.

Last-In, First-Out Method
o Assume again that the physical count on
January 31 is 800 units (and that 1,300 units
were sold). What is the cost of the merchandise
sold?

LAST-IN, FIRST-OUT
METHOD

Weighted Average Cost Method
o The weighted average cost method uses the
weighted average unit cost for determining cost
of merchandise sold and the ending
merchandise inventory.

Average cost
per unit
Ending
Inventory
Weighted Average Cost Method

Weighted Average Cost Method

c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Comparing Inventory Cost Methods
o Using the perpetual inventory system illustration
with sales of $39,000 (1,300 units x $30), the
differences in ending inventory, cost of
merchandise sold, and gross profit are
illustrated in the next three slides.

PARTIAL INCOME
STATEMENTS (FIFO)

PARTIAL INCOME
STATEMENTS
(WEIGHTED AVERAGE COST)

PARTIAL INCOME
STATEMENTS (LIFO)

COMPARING
INVENTORY COST
METHODS

Comparing Inventory Cost Methods
o When the FIFO method is used during a period
of inflation or rising prices, FIFO will show a
larger profit than the other two inventory costing
methods.

Comparing Inventory Cost Methods
o When the LIFO method is used during a period
of inflation or rising prices, LIFO will show a
lower profit than the other two inventory costing
methods.
o During a period of rising prices, using LIFO
offers an income tax savings compared to the
other two inventory costing methods.

Comparing Inventory Cost Methods
o The weighted average cost method of inventory
costing is a compromise between FIFO and
LIFO. Net income for the weighted average cost
method is somewhere between the net incomes
of LIFO and FIFO.

c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Reporting Merchandise Inventory
o Cost is the primary basis for valuing and
reporting inventories in the financial statements.
However, inventory may be valued at other than
cost in the following cases:
 The cost of replacing items in inventory is below the
recorded cost.
 The inventory cannot be sold at normal prices due to
imperfections, style changes, or other causes.

Valuation at Lower of Cost or Market
o Market, as used in lower-of-cost-or-market
method, is the cost to replace the merchandise
on the inventory date.

Valuation at Lower of Cost or Market
o Cost and replacement cost can be determined
for the following:
 Each item in the inventory.
 Each major class or category of inventory.
 Total inventory as a whole.

VALUATION AT
LOWER OF COST OR
MARKET

Valuation at Net Realizable Value
o Merchandise that is out of date, spoiled, or
damaged should be written down to its net
realizable value. This is the estimated selling
price less any direct costs of disposal, such as
sales commissions or special advertising.

Original cost $1,000
Estimated selling price 800
Selling expenses 150
Valuation at Net Realizable Value
o Assume the following data about an item of
damaged merchandise:
o The merchandise should be valued at its net
realizable value of $650 ($800 – $150).

Merchandise Inventory on the Balance Sheet
o Merchandise inventory is usually presented in
the Current Assets section of the balance sheet,
following receivables.

Merchandise Inventory on the Balance Sheet
o The method of determining the cost of the
inventory (FIFO, LIFO, or weighted average)
and the method of valuing the inventory (cost or
the lower of cost or market) should be shown.

MERCHANDISE
INVENTORY ON THE
BALANCE SHEET

Inventory Errors
o Some reasons that inventory errors may occur
include the following:
 Physical inventory on hand was miscounted.
 Costs were incorrectly assigned to inventory.
 Inventory in transit was incorrectly included or
excluded from inventory.
 Consigned inventory was incorrectly included or
excluded from inventory.

Inventory Errors
o Inventory errors often arise from consigned
inventory. Manufacturers sometimes ship
merchandise to retailers who act as the
manufacturer’s agent.

Inventory Errors
o The manufacturer, called the consignor, retains
title until the goods are sold. Such merchandise
is said to be shipped on consignment to the
retailer, called the consignee.

INVENTORY
ERRORS

LO 6

BALANCE SHEET
EFFECTS

c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Inventory Turnover
o Inventory turnover measures the relationship
between cost of merchandise sold and the
amount of inventory carried during the period. It
is calculated as follows:
Inventory Turnover =
Cost of Merchandise Sold
Average Inventory

Inventory Turnover
o Inventory turnover for Best Buy is shown below
(in millions).

Number of Days’
Sales in Inventory
Average Inventory
Average Daily Cost of
Merchandise Sold
=
Inventory Turnover
o The number of days’ sales in inventory
measures the length of time it takes to acquire,
sell, and replace the inventory. It is computed as
follows:

Inventory Turnover
o The number of days’ sales in inventory for Best
Buy is computed below (in millions).

c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Retail Method of Inventory Costing
o The retail inventory method of estimating
inventory cost requires costs and retail prices to
be maintained for the merchandise available for
sale.
o A ratio of cost to retail price is then used to
convert ending inventory at retail to estimate the
ending inventory cost.

RETAIL METHOD OF
INVENTORY COSTING

Gross Profit Method of Inventory Costing
o The gross profit method uses the estimated
gross profit for the period to estimate the
inventory at the end of the period.

GROSS PROFIT
METHOD OF
INVENTORY COSTING

c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.