Ch. 3 Assets and Liabilities
3.1 Inventory and COGS
Learning Objectives
After finishing this section, students will be able to:
- Identify the different stages of inventory that appear on the balance sheet.
- Understand the difference between period and product cost.
- Begin to understand the complexity of cost of goods sold.
Accounting for inventory is a critical function of management. Inventory accounting is significantly complicated by the fact that it is an ongoing process of constant change, in part because (1) most companies offer a large variety of products for sale, (2) product purchases occur at irregular times, (3) products are acquired for different prices, and (4) inventory acquisitions are based on sales projections, which are always uncertain and often sporadic. Merchandising companies must meticulously account for every individual product that they sell, equipping them with essential information, for decisions such as these:
- What is the quantity of each product that is available to customers?
- When should inventory of each product item be replenished and at what quantity?
- How much should the company charge customers for each product to cover all costs plus profit margin?
- How much of the inventory cost should be allocated toward the units sold (cost of goods sold) during the period?
- How much of the inventory cost should be allocated toward the remaining units (ending inventory) at the end of the period?
- Is each product moving robustly or have some individual inventory items’ activity decreased?
- Are some inventory items obsolete?
Inventory
Inventory consists of items that are purchased for resale. Note that inventory is different from supplies. Supplies are items that are purchased to be used in the operation of the business, not to be sold to customers. The following are common sequences of events for merchandising businesses. When you are the buyer, you will (1) purchase product on account; (2) return product; and (3) pay for the product. When you are the seller, you will (1) sell product on account and reduce the inventory balance; (2) accept returns and increase the inventory balance; and (3) receive payment for sales.
In merchandising companies, inventory is a company asset that includes beginning inventory plus purchases, which include all additions to inventory during the period. Every time the company sells products to customers, they dispose of a portion of the company’s inventory asset. Goods available for sale refers to the total cost of all inventory that the company had on hand at any time during the period, including beginning inventory and all inventory purchases. These goods were normally either sold to customers during the period (occasionally lost due to spoilage, theft, damage, or other types of shrinkages) and thus reported as cost of goods sold, an expense account on the income statement, or these goods are still in inventory at the end of the period and reported as ending merchandise inventory, an asset account on the balance sheet.
As an example, assume that Harry’s Auto Parts Store sells oil filters. Suppose that at the end of January 31, 20×8, they had 50 oil filters on hand at a cost of $7 per unit. This means that at the beginning of February, they had 50 units in inventory at a total cost of $350 (50 × $7). During the month, they purchased 20 filters at a cost of $7, for a total cost of $140 (20 × $7). At the end of the month, there were 18 units left in inventory. Therefore, during the month of February, they sold 52 units that cost $364.
| Description | # of Units | Cost per Unit | Total Cost |
|---|---|---|---|
| Beginning Inventory, January 31, 20×8 | 50 | $7 | $350 |
| + Purchases, February 20×8 | 20 | $7 | 140 |
| Total Goods Available for Sale | 70 | – | 490 |
| – Ending Inventory, February 28, 20×8 | 18 | $7 | 126 |
| Cost of Goods Sold, February 28, 20X8 | 52 | – | $364 |
Cost of Goods Sold
Harry’s Auto Parts Store sells each oil filter for $21 each. Therefore, during the month of February, the company sold 52 units that produced revenue of $1,092.
| Partial Income Statement | ||
| Harry’s Auto Parts Store | ||
| For February 20X8 | ||
| Revenue | $1,092 | |
|---|---|---|
| Cost of Goods Sold | 364 | |
| Gross Profit | $728 | |
3.1a Example
Spy Who Loves You sells GPS tracking devices. The GPS unit cost $21 to purchase and sells for $36 each. How many GPS units are in ending inventory?
| Transaction Type |
Number of GPS Units |
|---|---|
| Beginning Inventory, July 1 | 150 |
| Sold to Customer | – |
| July 5 | 150 |
| July 15 | 275 |
| Purchase from Vendor | – |
| July 10 | 225 |
| July 25 | 210 |
| Ending Inventory, July 31 | ? |
3.1a Homework
Rusty’s sells hamburgers. The following transactions occurred on the first day of March.
| Transaction Type |
Number of Hamburgers |
| Beginning Inventory, March 1 | 420 |
|---|---|
| Sold to Customer | – |
| Morning | 150 |
| Afternoon | 275 |
| Evening | 260 |
| Purchase from Vendor | – |
| A | 225 |
| B | 210 |
| Ending Inventory, March 1 | ? |
Instructions:
- How many hamburgers were sold?
- How many hamburgers are in ending inventory?
- If the cost of each hamburger is $4, what is the amount of beginning inventory and cost of goods sold?
- If each hamburger is sold for $7, what is the gross profit?
Purchase Price
Purchase price is the amount of money you agree to pay your vendors for product. Just like we give discounts to our customers, our vendors can also give discounts to use. Any discount given by the vendor will be subtracted from the purchase price.
Perpetual and Periodic Inventory Systems
A perpetual inventory system automatically updates and records the inventory account every time a sale, or purchase of inventory, occurs. You can consider this “recording as you go.” The recognition of each sale or purchase happens immediately upon sale or purchase. When a company uses the perpetual inventory system and makes a purchase, they will automatically update the Inventory account. Companies that have a perpetual inventory system have money available to put into a robust accounting system, think big corporations like Costco, Lowes, etc.
A periodic inventory system updates and records the inventory account at certain, scheduled times at the end of an operating cycle. The update and recognition could occur at the end of the month, quarter, and year. There is a gap between the sale or purchase of inventory and when the inventory activity is recognized. Under a periodic inventory system, purchases will be updated, while inventory will remain unchanged until the company counts and verifies its inventory balance. This count and verification typically occur at the end of the annual accounting period, which is often on December 31 of the year. Companies that have a periodic inventory system have little money available to put into an accounting system, think new start-ups that do not have extra money to spend on an inventory system.
In this book, we will use the perpetual inventory system for all inventory calculations.
Purchasing Inventory
To better illustrate merchandising activities, let’s follow California Business Solutions (CBS), a retailer providing computers and desktop printers to meet small business needs. On April 1, CBS purchases 10 printers at a cost of $620 each. CBS has an account with the vendor. Inventory increases for 6,200 ($620 × 10), and Accounts Payable increases because the company is liable to pay this bill later.
| Balance Sheet | Income Statement | Stmt of Cash Flows | |||||||||||||
| Cash | + | Inventory | = | Accounts Payable | + | Common Stock | + | Retained Earnings | Revenue | – | Expense | = | Net Income | Cash | OA,IA,FA |
| 6,200 | = | 6,200 | |||||||||||||
Understanding Costs
Any discussion of costs begins with the understanding that most costs will be classified in one of three ways: fixed costs, variable costs, or mixed costs. Because fixed and variable costs are the foundation of all other cost classifications, understanding whether a cost is a fixed cost or a variable cost is very important.
Fixed Cost vs Variable Cost
A fixed cost is an unavoidable operating expense that does not change in total over the short term, even if a business experiences variation in its level of activity. A variable cost is one that varies in direct proportion to the level of activity within the business. Typical costs that are classified as variable costs are the cost of raw materials used to produce a product, labor applied directly to the production of the product, and overhead expenses that change based upon activity.
Period vs Product Costs
Period Costs
Period costs are simply all of the expenses that are not product costs, such as selling and administrative expenses. It is important to remember that period costs are treated as expenses in the period in which they occur. In other words, they follow the rules of accrual accounting practice by recognizing the cost (expense) in the period in which they occur regardless of when the cash changes hands.
Product Costs
Product costs are all those costs associated with the acquisition or production of products. When products are purchased for resale, the cost of goods is recorded as an asset on the company’s balance sheet. It is not until the products are sold that they become an expense on the income statement. By moving product costs to the cost of goods sold account, the cost of the product is easily matched to the sales revenue.
There are three product costs associated with making an item:
1. Direct materials
2. Direct labor
3. Manufacturing overhead
Direct materials are the raw materials and component parts that are directly economically traceable to a unit of production. Managers can easily trace the cost of the materials directly to a specific unit (cake, car, or chair) produced. Since the amount of direct materials required will change based on the number of units produced, direct materials are almost always classified as a variable cost. They remain fixed per unit of production but change in total based on the level of activity within the business.
Direct labor is the work of the employees who are directly involved in the production of goods or services. In fact, for many industries, the largest cost incurred in the production process is labor. Like direct materials, direct labor is typically treated as a variable cost because it varies with the level of activity. However, there are some companies that pay a flat weekly or monthly salary for production workers, and for these employees, their compensation could be classified as a fixed cost.
Manufacturing overhead (sometimes referred to as factory overhead) includes all of the costs that a manufacturing business incurs, other than the variable costs of direct materials and direct labor required to build products. These overhead costs are not directly traceable to a specific unit of production, but they are incurred to support the production of goods. Some of the items that are included in manufacturing overhead are supervisor salaries, depreciation on the factory, maintenance on the factory, insurance on the factory, and utilities on the factory. It is important to note that manufacturing overhead does not include any of the selling or administrative expenses of the business.
To better illustrate merchandising activities, let’s look at California Business Solutions (CBS). On April 5, CBS purchases parts to assemble 10 computers. CBS has an account with the vendor. Inventory increases for 4,000 ($400 × 10), and Accounts Payable increases because the company is liable to pay this bill later.
| Balance Sheet | Income Statement | Stmt of Cash Flows | |||||||||||||
| Cash | + | Inventory | = | Accounts Payable | + | Common Stock | + | Retained Earnings | Revenue | – | Expense | = | Net Income | Cash | OA,IA,FA |
| 4,000 | = | 4,000 | |||||||||||||
On April 14, CBS issues payroll of $10,000 of which $7,000 was paid to production workers and $3,000 was paid to office workers. Inventory increases for $7,000 because the amount of wages paid to production workers increases the value of the inventory, Administrative Payroll Expense increases for $3,000, and Cash decreases for $10,000.
| Balance Sheet | Income Statement | Stmt of Cash Flows | |||||||||||||
| Cash | + | Inventory | = | Accounts Payable | + | Common Stock | + | Retained Earnings | Revenue | – | Admin Payroll Expense | = | Net Income | Cash | OA,IA,FA |
| 4,000 | = | 4,000 | |||||||||||||
| -10,000 | 7,000 | = | -3,000 | – | 3,000 | = | -3,000 | -10,000 | OA | ||||||
On April 20, CBS paid their rent of $5,600 with cash. CBS uses 70% of the building for manufacturing and 30% of the building for administration. Inventory increases for $3,920 because the cost of the rent needs to be added to the cost of the product, Administrative Rent Expense increases for $1,680, and Cash decreases for $5,600.
| Balance Sheet | Income Statement | Stmt of Cash Flows | |||||||||||||
| Cash | + | Inventory | = | Accounts Payable | + | Common Stock | + | Retained Earnings | Revenue | – | Admin Rent Expense | = | Net Income | Cash | OA,IA,FA |
| 4,000 | = | 4,000 | |||||||||||||
| -10,000 | 7,000 | = | -3,000 | – | 3000 | = | -3,000 | -10,000 | OA | ||||||
| -5,600 | 3,920 | = | -1,680 | – | 1,680 | = | -1,680 | -5,600 | OA | ||||||
If $12,000 of product was sold for cash with a cost of $4,680, the horizontal model and income statement would look as follows.
| Balance Sheet | Income Statement | Stmt of Cash Flows | |||||||||||||
| Cash | + | Inventory | = | Accounts Payable | + | Common Stock | + | Retained Earnings | Revenue | – | Admin Rent Expense | = | Net Income | Cash | OA,IA,FA |
| 4,000 | = | 4,000 | |||||||||||||
| -10,000 | 7,000 | = | -3,000 | – | 3000 | = | -3,000 | -10,000 | OA | ||||||
| -5,600 | 3,920 | = | -1,680 | – | 1,680 | = | -1,680 | -5,600 | OA | ||||||
| 12,000 | = | 12,000 | 12,000 | – | = | 12,000 | 12,000 | OA | |||||||
| -4,680 | = | -4,680 | – | 4,680 | = | -4,680 | |||||||||
| Income Statement | ||
| California Business Solutions | ||
| For April 20XX | ||
| Revenue | – | $12,000 |
|---|---|---|
| Cost of Goods Sold | – | 4,680 |
| Gross Profit | – | 7,320 |
| Selling, General, and Administrative Expenses | – | – |
| Admin Payroll Expense (Fixed) | 3,000 | – |
| Admin Rent Expense (Fixed) | 1,680 | – |
| Total Selling, General, and Administrative Expenses | – | 4,680 |
| Net Income | – | $2,640 |
3.1b Examples
Riggins Metals reports the following costs for the month of August.
- Assembly line workers: 50,000
- Assembly line supervisor: 6,000
- Insurance on factory: 1,200
- Administrative office rent: 1,500
- Iron to make product: 10,000
- Factory rent: 2,500
- Administrative salaries: 25,000
- Sales people base salaries: 5,000
- Sales commissions: 8,000
- Administrative Rent: 7,000
- Depreciation for Factory Equipment: $2,300
- Depreciation for Office Equipment: $300
Instructions:
- What are the total productions cost (aka cost that go to inventory?)
3.1b Homework
The following transactions for Forest Furniture occurred.
| Sept. 1 | Purchased $3,500 of direct materials on account to make furniture. |
|---|---|
| Sept. 8 | Monthly rent of $4,000 for the factory was paid. All sales staff and management work from home. |
| Sept. 15 | Worker’s comp insurance of $1,500 was paid. $1,200 was for factory works and $300 was for sales staff and management. |
| Sept. 22 | Payroll of $3,500 was issued. This amount includes: 70% for factory workers, 15% for the sales staff and commission, and 15% for management. |
Instructions:
- Using the Horizontal Model, prepare entries for the above transactions.
- As of September 30, what is the amount of inventory on the balance sheet?
Licensing and Attribution:
Content on this page is adapted from the following openly licensed resource(s):
Principles of Accounting, Volume 1: Financial Accounting by Mitchell Franklin, Patty Graybeal, and Dixon Cooper licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License
Principles of Accounting, Volume 2: Managerial Accounting by Mitchell Franklin, Patty Graybeal, and Dixon Cooper licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License
is a company asset that includes beginning inventory plus purchases, which include all additions to inventory during the period.
represents the amount a company paid for the manufactured items that it sold.
is the amount of markup on the manufactured goods.
automatically updates and records the inventory account every time a sale, or purchase of inventory, occurs.
updates and records the inventory account at certain, scheduled times at the end of an operating cycle.
is an unavoidable operating expense that does not change in total over the short term, even if a business experiences variation in its level of activity.
is one that varies in direct proportion to the level of activity within the business.
are simply all of the expenses that are not product costs, such as all selling and administrative expenses.
are all those costs associated with the acquisition or production of goods and products.
are the raw materials and component parts that are directly economically traceable to a unit of production.
is the work of the employees who are directly involved in the production of goods or services.
(sometimes referred to as factory overhead) includes all of the costs that a manufacturing business incurs, other than the variable costs of direct materials and direct labor required to build products.
