Inventory & costing

INVENTORY & COSTING
• What is Inventory?
• What is COGS?
• What are the Standard Costing methods? (Cost flow Assumptions)
• Inventory calculation Systems/Methods
• Periodic
• Perpetual
• Methods of Estimating Inventory
• Gross Profit method
• Retail Method

WHAT IS INVENTORY?
• A current asset whose ending balance should report the cost of a merchandiser's products awaiting
to be sold.
• The cost of inventory should include all costs necessary to acquire the items and to get them ready
for sale.
• Inventory is merchandise purchased by merchandisers (retailers, wholesalers, distributors) for the
purpose of being sold to customers. The cost of the merchandise purchased but not yet sold is
reported in the account Inventory
• Inventory is reported as a current asset on the company's balance sheet. Inventory is a significant
asset that needs to be monitored closely. Too much inventory can result in cash flow problems,
additional expenses (e.g., storage, insurance), and losses if the items become obsolete. Too
little inventory can result in lost sales and lost customers.
• Because of the cost principle, inventory is reported on the balance sheet at the amount paid
to obtain (purchase) the merchandise, not at its selling price.
• Inventory is also a significant asset of manufacturers. The inventory of a manufacturer should
report the cost of its raw materials, work-in-process, and finished goods.

WHAT IS COGS (COST OF GOODS SOLD)
• Cost of goods sold is the cost of the merchandise that was sold to customers.
The cost of goods sold is reported on the income statement when the
sales revenues of the goods sold are reported.
• A retailer's cost of goods sold includes the cost from its supplier plus any additional
costs necessary to get the merchandise into inventory and ready for sale. For
example, let's assume that AAK purchases 1000 Carton Apple from a Supplier. If AAK
cost from the Supplier is AED80 for the Apple Per Carton plus AED5000 in shipping
costs, AAK reports AED85,000.00 in its Inventory account until the Apple is sold.
When the Apple is sold, the AED85000 is removed from inventory and is reported as
cost of goods sold on the income statement.

WHAT IS THE DIFFERENCE BETWEEN INVENTORY
AND THE COST OF GOODS SOLD?
• Inventory for a retailer or distributor is the merchandise that was purchased and has
not yet been sold to customers. For a manufacturer, inventory consists of raw
materials, packaging materials, work-in-process, and the finished goods that are
owned and on hand. Inventory is generally valued at its cost. If a business has
inventory it is often a major component of its current assets.
• The cost of goods sold is the cost of the merchandise or products that have been sold
to customers during the period of the income statement. For a company that sells
goods, the cost of goods sold is usually the largest expense on its income statement.
As a result, care must be taken when computing and matching the cost of goods sold
with the sales revenues.

WHAT ARE THE COSTING METHODS? (COST FLOW
ASSUMPTIONS)
• Weighted Average Costing (WAC)
• FIFO Costing
• LIFO Costing (Banned by IFRS)
• Specific Identification Method
• FACTS Batch Costing (Container/Serial No/Batch/Piece/IMEI)

IS THERE A DIFFERENCE BETWEEN THE
ACCOUNTS PURCHASES AND INVENTORY?
• The account Purchases is generally associated with the purchase of inventory items
under the periodic inventory system. Under the periodic system the account Inventory is
dormant until it is adjusted to the cost of the ending inventory at the end of
an accounting period.
Under the perpetual inventory system, the account Purchases won't exist. Rather, the cost
of inventory items purchased will be recorded directly into the account Inventory.
Under the periodic system, the cost in the account Purchases will be added to the cost of
the beginning inventory to arrive at the cost of goods available. The cost of the ending
inventory is computed through a physical count (or an estimate) and is subtracted from
the cost of goods available. The resulting amount is the cost of goods sold.
Under the perpetual system, the balance in the account Inventory should be the cost of
the ending inventory. Under the perpetual system, the cost of goods sold will have been
removed from the account Inventory when the items were sold and placed in the account
Cost of Goods Sold.

SPECIFIC IDENTIFICATION METHOD
• Under this approach, you separately track the cost of each item in inventory, and
charge the specific cost of an item to the cost of goods sold when you sell the specific
item to which that cost has been assigned. This approach requires a massive amount
of data tracking, so it is only usable for very high-cost, unique items, such as
automobiles or works of art. It is not a viable method in most other situations.

SPECIFIC/BATCH IDENTIFICATION METHOD
(SAMPLE)
Doc type Date Unit Qty Rate Amount Batch# COGS Cumm Qty Cumm Cost
PI-150001 Jan-15 CTN 500.00 80.00 40,000.00 PI-150001 40,000.00 500.00 40,000.00
Sal-1001 Jan-15 CTN (400.00) 110.00 (44,000.00) PI-150001 (32,000.00) 100.00 8,000.00
PI-150002 Jun-15 CTN 550.00 75.00 41,250.00 PI-150002 41,250.00 650.00 49,250.00
Sal-1002 Jun-15 CTN (550.00) 108.00 (59,400.00) PI-150002 (41,250.00) 100.00 8,000.00
PI-150003 Jul-15 CTN 100.00 88.00 8,800.00 PI-150003 8,800.00 200.00 16,800.00
SAL-1003 Aug-15 CTN (50.00) 120.00 (6,000.00) PI-150003 (4,400.00) 150.00 12,400.00
PI-150004 Dec-15 CTN 150.00 99.00 14,850.00 PI-150004 14,850.00 300.00 27,250.00
27,250.00 27,250.00

FIRST IN, FIRST OUT METHOD
• Under the FIFO method, you are assuming that items bought first are also used or
sold first, which also means that the items still in stock are the newest ones. This
policy closely matches the actual movement of inventory in most companies, and so
is preferable simply from a theoretical perspective. In periods of rising prices (which
is most of the time in most economies), assuming that the earliest units bought are
the first ones used also means that the least expensive units are charged to the cost
of goods sold first. This means that the cost of goods sold tends to be lower, which
therefore leads to a higher amount of operating earnings, and more income taxes
paid. Also, it means that there tend to be fewer inventory layers than under the LIFO
method (see next), since you will continually use up the oldest layers.

FIRST IN, FIRST OUT METHOD (SAMPLE)
Doctype Date Unit Qty Rate Amount Up Doc COGS Cumm Qty Cumm Cost
PI-150001 Jan-15 CTN 500.00 80.00 40,000.00 PI-150001 40,000.00 500.00 40,000.00
Sal-1001 Jan-15 CTN (400.00) 110.00 (44,000.00) PI-150001 (32,000.00) 100.00 8,000.00
PI-150002 Jun-15 CTN 450.00 75.00 33,750.00 PI-150002 33,750.00 550.00 41,750.00
Sal-1002 Jun-15 CTN (550.00) 108.00 (59,400.00) PI-150001 (100)+ PI-150002 (450) (41,750.00) - -
PI-150003 Jul-15 CTN 100.00 88.00 8,800.00 PI-150003 8,800.00 100.00 8,800.00
SAL-1003 Aug-15 CTN (50.00) 120.00 (6,000.00) PI-150003 (4,400.00) 50.00 4,400.00
PI-150004 Dec-15 CTN 150.00 99.00 14,850.00 PI-150004 14,850.00 200.00 19,250.00
19,250.00 19,250.00

LAST IN, FIRST OUT METHOD
• Under the LIFO method, you are assuming that items bought last are sold first, which
also means that the items still in stock are the oldest ones. This policy does not
follow the natural flow of inventory in most companies; in fact, the method is
banned under International Financial Reporting Standards. In periods of rising
prices, assuming that the last units bought are the first ones used also means that
the cost of goods sold tends to be higher, which therefore leads to a lower amount of
operating earnings, and fewer income taxes paid. There tend to be more inventory
layers than under the FIFO method, since the oldest layers may not be flushed out
for years.

WEIGHTED AVERAGE METHOD
• Under the weighted average method, there is only one inventory layer, since the cost
of any new inventory purchases are rolled into the cost of any existing inventory to
derive a new weighted average cost, which in turn is adjusted again as more
inventory is purchased.

WEIGHTED AVERAGE METHOD (SAMPLE)
Doc type Date Unit Qty Rate Amount COGS Cumm Qty Cumm Cost Cost Rate
PI-150001 Jan-15 CTN 500.00 80.00 40,000.00 40,000.00 500.00 40,000.00 80.00
Sal-1001 Jan-15 CTN (400.00) 110.00 (44,000.00) (32,000.00) 100.00 8,000.00 80.00
PI-150002 Jun-15 CTN 550.00 75.00 41,250.00 41,250.00 650.00 49,250.00 75.77
Sal-1002 Jun-15 CTN (550.00) 108.00 (59,400.00) (41,673.08) 100.00 7,576.92 75.77
PI-150003 Jul-15 CTN 100.00 88.00 8,800.00 8,800.00 200.00 16,376.92 81.88
SAL-1003 Aug-15 CTN (50.00) 120.00 (6,000.00) (4,094.23) 150.00 12,282.69 81.88
PI-150004 Dec-15 CTN 150.00 99.00 14,850.00 14,850.00 300.00 27,132.69 90.44
27,132.69 27,132.69

PERIODIC - INVENTORY SYSTEMS/METHODS
• Under this system the amount appearing in the Inventory account is not updated
when purchases of merchandise are made from suppliers. Rather, the Inventory
account is commonly updated or adjusted only once—at the end of the year. During
the year the Inventory account will likely show only the cost of inventory at the end
of the previous year.
• Under the periodic inventory system, purchases of merchandise are recorded in one
or more Purchases accounts. At the end of the year the Purchases account(s) are
closed and the Inventory account is adjusted to equal the cost of the merchandise
actually on hand at the end of the year. Under the periodic system there is no Cost of
Goods Sold account to be updated when a sale of merchandise occurs.
• In short, under the periodic inventory system there is no way to tell from the general
ledger accounts the amount of inventory or the cost of goods sold.

PERPETUAL - INVENTORY SYSTEMS/METHODS
• Under this system the Inventory account is continuously updated. The Inventory
account is increased with the cost of merchandise purchased from suppliers and it is
reduced by the cost of merchandise that has been sold to customers. (The Purchases
account(s) do not exist.)
• Under the perpetual system there is a Cost of Goods Sold account that is debited at
the time of each sale for the cost of the merchandise that was sold. Under the
perpetual system a sale of merchandise will result in two journal entries: one to
record the sale and the cash or accounts receivable, and one to reduce inventory and
to increase cost of goods sold.

WHAT IS THE DIFFERENCE BETWEEN PERIODIC
AND PERPETUAL INVENTORY SYSTEMS?
• The difference between the periodic and perpetual inventory systems involves the
general ledger account Inventory.
In a periodic system the account Inventory will: have a constant balance (the ending
balance from the previous period)
• not include the cost of purchases (they are recorded in a Purchases account)
• be adjusted at the end of the accounting period (so the balance reports the costs
actually in inventory)
• require a physical inventory at least once per year (and estimates within the year)
• require a cost flow assumption (FIFO, LIFO, average)
• require a calculation of the cost of goods sold (to be used on the income statement)

WHAT IS THE DIFFERENCE BETWEEN PERIODIC
AND PERPETUAL INVENTORY SYSTEMS? (CONT.)
• In a perpetual system the account Inventory will: be debited when there is a
purchase of goods (there is no Purchases account)
• be credited for the cost of the items sold (and the account Cost of Goods Sold will be
debited)
• have its balance continuously or perpetually changing because of the above entries
• require a physical inventory to correct any errors in the Inventory account
• require a cost flow assumption (FIFO, LIFO, average)
• It is possible that a company will use the periodic system in its general ledger and
use a different computer system outside of its general ledger to track the flow of
goods in and out of inventory.

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