CHAPTER 8 INVENTORY

CICA HANDBOOK, Part II and IFRS Inventory Interest/Borrowing Costs Inventory Onerous contractual obligations Inventory Biological assets/Agriculture Section 3031 and IAS 2 Section 3850 and IAS 23 PE GAAP N/A and IAS 11 PE GAAP N/A and IAS 41

LEARNING OBJECTIVES 1. Define inventory and identify categories of inventory. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. Identify the decisions that are needed to determine the inventory value to report on the balance sheet under a lower of cost and net realizable value. Identify the physical inventory items should be included in ending inventory. Determine the components of inventory cost. Distinguish between perpetual and periodic inventory systems and account for them. Identify and apply GAAP cost formula options and indicate when each cost formula is appropriate. Explain why inventory is measured at the lower of cost and market, and apply the lower of cost and net realizable value standard. Explain the accounting issues for purchase commitments. Identify inventories that are or may be valued at amounts other than the lower of cost and net realizable value. Identify the effects of inventory errors on the financial statements and adjust for them. Apply the gross profit method of estimating inventory. Identify the type of inventory disclosures required by accounting standards for private enterprises (private entity GAAP) and IFRS. Explain how inventory analysis provides useful information and apply ratio analysis to inventory.

14. Identify differences in accounting between accounting standards for private enterprises (private entity GAAP) and IFRS, and what changes are expected in the near future. 15. 16. Apply the retail method of estimating inventory (Appendix 8A) Identify other primary sources of GAAP for inventory (Appendix 8B)
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Major Categories of Inventory Inventories are defined in the CICA Handbook 3031.06 and IAS 2.6 as assets: (a) held for sale in the ordinary course of business; (b) in the process of production for sale; or (c) in the form of materials or supplies to be consumed in the production process or in rendering of services. Inventories are asset that are held for sale in the ordinary course of business or goods that will be used or consumed in the production of goods to be sold. in the form of materials or supplies to be consumed in the production process or in rendering of services. Merchandise inventory refers to the goods held for resale by a merchandising business, which ordinarily purchases its inventory in a form ready for sale. The inventory of a manufacturing firm is composed of three separate items: raw materials, work in process, and finished goods. Recognition and Measurement Determining the value to report on the balance sheet requires answers to the following questions: 1. 2. 3. 4. Which physical goods should be included as part of inventory? What costs should be included as part of inventory cost? What cost formula should be used? Has there been any impairment in value of the inventory items?

Inventory is recognized and carried at cost. In situations where the net realizable value (the net amount of cash to be received from the sale of inventory) of inventory declines below cost, the inventory should be written down to its net realizable value. Goods Included in Ending Inventory Normally, goods are included in inventory when they are received from the supplier. However, at the end of the period, appropriate accounting requires that all goods in which the company has the risks and rewards of ownership (i.e., legal title) be included in ending inventory. Goods in transit at the end of the period, shipped f.o.b. shipping point, should be included in the buyer's ending inventory. If the goods are shipped f.o.b. destination, they belong to the seller until received by the buyer. Consigned Goods belongs to the consignor and should be excluded from the consignee's inventory.
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Special sale agreements. Three of the more common special sale agreements are a) sales with buybacks (product financing arrangements), b) sales with high rates of return, and c) sales with delayed payment terms. In the case of sales with buybacks, the inventory is the sellers. In the other two cases, the inventory is the buyers if returns or collectability can be measured.

What are the Costs to include in Inventory? Inventories are recorded at cost when acquired. Both IFRS and private entity GAAP indicate that inventory cost includes all expenditures that are reasonable and necessary in acquiring the goods and converting them to a saleable condition. Such charges would include freight charges on the goods purchased and labour and other production costs incurred in processing the goods up to the time of sale. Additional costs to include in inventory are: Purchase discounts are treated as a reduction in the purchase price of inventory. Either the gross or net method may be used in handling discounts. Gross method: Purchases and accounts payable are recorded at the gross amount. Purchase discounts taken are credited to the Purchase Discounts account, which is reported in the income statement as a reduction of purchases. Net method: Purchases and accounts payable are recorded at the net amount. Purchase discounts not taken are debited to the Purchase Discounts Lost account, which is reported in the other expense section of the income statement. Vendor rebates can be recognized before they are received as a vendor receivable if they meet both the definition of an asset and its recognition criteria, Otherwise they are not recorded as the effect would be to overstate income. Product costs are costs that attach to inventory and are recorded in the inventory account (i.e. they are capitalized). For example, freight charges on goods purchased, other direct costs of acquisition, and non-recoverable taxes would all be recorded in inventory. Under IFRS, product costs also include any eventual decommissioning or restoration costs incurred as a result of production, even though the related expenditures may not be incurred until far into the future. Under private entity GAAP, such costs are generally added to the cost of the property, plant, and equipment.
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Borrowing costs. Capitalization of interest cost associated with the acquisition of an asset when a significant period of time will be required to get the asset ready for its intended use may occur under IFRS, although interest cost can be expensed when incurred if the inventories are manufactured or produced in large quantities and on a repetitive basis. Private entity GAAP requires that if interest is capitalized, it be disclosed. Standard Costs: Unit costs for material, labour, and manufacturing overhead are predetermined. These costs are based on the costs that should be incurred per unit of finished goods when the plant is operating at normal capacity. Reporting inventory at costs is acceptable when it is calculated using normal levels of materials and supplies, labour, efficiency, and capacity utilization. Unallocated overheads are expensed as they are incurred. Service Providers Work-in-Process: Work-in-process inventories comprised of production costs that include service personnel and overhead costs associated with the direct labour. Supervisory and other overhead costs are allocated using the same principles as for manufactured products. Costs EXCLUDED from inventory - storage costs (unless related to storage before next stage of production), - abnormal spoilage or wastage of materials, labour, or other production costs, - interest costs when inventories that are ready for use or sale are purchased on delayed payment terms. Basket purchases allocate the cost based on the relative sales value of the basket of products purchased. Perpetual Inventory System A perpetual inventory system is a means for generating up-to-date records related to inventory quantities and, possibly, amounts. Under this inventory system, all purchases and sales of goods are recorded directly in the inventory account as they occur. Reconciliation between the recorded inventory amount and the actual amount of inventory on hand is normally performed at least once a year. This is accomplished by taking a physical inventory, and involves counting all inventory items and comparing the amount counted with the amount shown in the detailed inventory records. The records are corrected to agree with the physical count. Periodic Inventory System A periodic inventory system does not maintain detailed records of inventory acquisitions or dispositions during the period. Ending inventory is determined by a physical count, which usually takes place once a year. Cost of goods sold is a residual amount, calculated by adding the beginning inventory to the net purchases during the period and then deducting the ending inventory. Therefore, emphasis is on the value calculated for ending inventory, either through an actual count or an estimation. Supplementary System Quantities ONLY
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Most companies need more current information regarding their inventory levels to protect against stock-outs or over-purchasing and to aid in the preparation of monthly or quarterly financial statements. As a consequence, many companies use a supplementary system quantities only, which increases and decreases in quantities only, not dollars. Comparison of Journal Entries for Perpetual and Periodic Systems:

Cost Formulas
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Determining the cost of inventory items that have been sold as well as those remaining in ending inventory is sometimes a difficult process. Thus, the consistent use of a cost formula is required in accounting for inventories. Choices include: specific identification first-in, first-out (FIFO) weighted average cost Regardless of the method chosen, the ending inventory in units is always the same, however the cost is different. Specific Identification This method requires that each item sold needs to be identified and the original cost assigned to it. It is most appropriate when the goods are not interchangeable and are easily identifiable (e.g., by serial number or special markings). In manufacturing, it would include special orders and products manufactured under a job cost system. Items sold are allocated to cost of goods sold, and items on hand to inventory. FIFO Use of the FIFO inventory method assumes that the oldest inventory costs are the first costs recorded for goods sold. Under this method, the cost flow formula may approximate the normal physical flow of goods. A major advantage of the FIFO method is that the ending inventory is stated in terms of an approximate current cost figure. However, because FIFO tends to reflect more recent costs on the balance sheet, a basic disadvantage of this method is that recent costs are not matched against recent revenues on the income statement. The FIFO inventory method will give the same result regardless of whether a periodic or perpetual inventory is used. Weighted Average Cost The average cost method prices items in inventory on the basis of the average cost of the goods available for sale during the period. The weighted average cost formula takes into account that the volume of goods purchased at each price is different. This method requires that a new average unit cost be calculated each time a purchase is made because the cost of goods sold at average cost has to be recognized each time a sale is made. Justification for use of the average cost is that the costs it assigns to inventory closely follows physical flow of an interchangeable inventory. It is also simple to apply, objective, and not as subject to income manipulation as some of the other inventory costing methods. Selecting a Cost Formula The new inventory standards limit the choice of cost formula between specific identification required for inventory that is not interchangeable, weighted average, and FIFO. The requirement to use the same cost formula for all inventories having a similar nature further limits the choice. The primary objective of financial reporting of inventories is to provide a value that is representationally faithful and to thereby increase reliability. The inventory valuation method that leads to the accomplishment of this objective should be the one selected. Once selected, the inventory method should be applied consistently.
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LIFO Until recently, LIFO was an allowed alternative but it is no longer permitted under private entity GAAP and IFRS. This means that in the U.S., GAAP standard differs from the International and Canadian standards for private entities. Justification for the elimination of this method is that it does not reliably represent actual inventory flows. Use of the LIFO inventory method assumes that the most recent inventory costs are the first costs recorded for goods sold. Therefore, the older inventory costs remain in inventory, and they likely do not fairly represent the recent cost of inventories if there
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have been price changes. The Canada Revenue Agency has never allowed this method for tax purposes and so the method has never been widely used in Canada. Nonetheless, the AcSB will permit Canadian public companies trading on U.S. as well as on Canadian stock exchanges to use this method. Lower of Cost and Net Realizable Value Net realizable value (NRV) is the estimated selling price in the ordinary course of business less the estimated costs of completion and disposal is allowed in certain circumstances even when NRV is above cost. When there is an active and controlled market with a quoted price that applies to all quantities and the costs of disposal are not significant, NRV valuation of inventory can be used. Examples include inventories of farm crops and certain rare minerals. Impairment in value When the future revenue associated with inventory is below its original cost, the inventory should be written down to reflect this loss. Thus, the historical cost principle is adjusted when the future utility (revenue-producing ability) of the asset is no longer as great as its original cost. This is known as the lower of cost and market. Use of this method is an example of proper asset valuation, the conservatism constraint, and matching. There are two methods are used to record inventory at market when market is below cost. The two methods are: direct method: substitutes the market value figure for cost when valuing the inventory. Thus, the loss is buried in the cost of goods sold, and no individual loss account is reported in the income statement. indirect or allowance method: an entry is made debiting a loss and crediting an allowance account for the difference between cost and market. Separately recording the loss and a contra account is preferable, as it does not distort the cost of goods sold and clearly displays the loss from market decline. The cost and market rule may be applied on an: individual item basis (item-by-item) category basis total of the inventory The item-by-item approach is the most conservative of the three methods, because market values above cost are never taken into account. This is the method recommended. The new accounting standards recognize, however, that it may be more appropriate in some circumstances to group similar or related items and then compare their cost and NRV as a group 1) if the items are closely related in terms of their use; 2) if they are produced and marketed in the same geographical area; and 3) the items cannot be evaluated separately from other items in the product line in a practical and reasonable way. Purchase Commitments Purchase commitments represent contracts for the purchase of inventory at a specified price in a future period. If the contract price exceeds the market price and a
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loss is reasonably expected to occur, the loss should be recognized in the period during which the market decline took place. The loss is shown on the income statement under other expenses and losses. The accrued liability on purchase contracts is reported on the balance sheet. Inventory Errors Errors in recording inventory can affect the balance sheet, the income statement, or both, because inventory is used in the preparation of both financial statements. For example, the failure to include certain inventory items in a year-end physical inventory count would result in the following items being overstated (O) or understated (U): ending inventory (U) working capital (U) cost of goods sold (O) gross profit (U) net income (U) retained earnings (U) Depending on the nature of errors, various ratios can be affected positively or negatively (e.g., current ratio, inventory turnover ratio, debt to total assets ratio, rate of return on total assets). Consequently, contracts related to management bonuses and debt covenants can be affected. The three most common types of inventory errors are: 1. Correct recording of purchases but incorrect measurement and/or recording of ending inventory count. 2. Recording purchase transactions in the wrong accounting period. However, ending inventory is measured and recorded correctly. 3. Failure to include an item as a recorded purchase combined with failure to include the item in the ending inventory count. Corrections of inventory errors may involve the use of two procedures: 1. Preparation of correcting journal entries. Generally, a purchase is recorded when the invoice arrives. If this does not coincide with passage of legal title by the end of the accounting period, correcting entries may be required to prevent "cut-off errors." 2. Computation of the correct amounts of inventory and related items including purchases, cost of goods sold, net income, retained earnings, accounts payable, working capital, and the current ratio. Estimating Inventory - Gross Profit Method Inventory must be counted, at least, annually. However, there are situations when management is in need of the value of inventory on a more frequent basis (e.g. interim reporting).
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The gross profit method can be used to estimate the amount of ending inventory when an approximation is needed. Such approximations are sometimes required by auditors (e.g., as a check on a physical count), or when inventory and inventory records are destroyed by fire or some other catastrophe, or when interim statements are being prepared. The gross profit method should never be used as a substitute for a yearly physical inventory unless the inventory has been destroyed. Disclosure, Presentation and Analysis Disclosure and Presentation Inventories often represent one of the most significant assets held by a business entity. Therefore, the accounting profession has mandated certain disclosure requirements related to inventories. The following disclosures are required in the financial statement with respect to inventories: the choice of accounting policies adopted to measure the inventory; the carrying amount of the inventory in total and by classification (such as supplies, material, work in process, and finished goods). c. The amount of inventories recognized as an expense in the period, including unabsorbed and abnormal amounts of production overheads; and d. The carrying amount inventory pledged as collateral for loans IFRS require additional disclosures, such as the carrying amount of inventory carried at fair value less costs to sell, and details about inventory writedowns and reversals of write downs. Additional information is required for biological assets and agricultural products. Analysis of Inventories Inventory planning and control is of vital importance to the success of a merchandising or manufacturing enterprise. If an excessive amount of inventory is accumulated, there is the danger of loss due to obsolescence. If the supply of inventory is inadequate, the potential for lost sales exists. This dilemma makes inventory an asset to which management must devote a great deal of attention. There are two ratios that are most commonly used to analyse inventory: Inventory Turnover Ratio The inventory turnover ratio measures the number of times inventory was sold during the period. Its purpose is to determine the liquidity of the investment in inventory. Seasonal factors should be considered when defining average inventory. Inventory turnover = cost of goods sold average inventory on hand a. b.

Average Days to Sell Inventory Ratio This represents the average number of days to sell inventory, which in turn represents the average age of inventory, or the number of days it takes to sell inventory once it is purchased.
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# days required to sell inventory

365 inventory turnover

Appendix 8A Retail Inventory Method The retail inventory method is an inventory estimation technique based upon an observable pattern between cost and sales price that exists in most retail concerns. This method requires that a record be kept of: a) the total cost of goods available for sale, b) the total retail value of the goods available for sale c) the sales for the period. Basically, the retail method requires the determination of the cost to retail ratio of inventory available for sale. This ratio is calculated by dividing the cost of the goods available for sale by the retail value of goods available for sale. Once the ratio is determined, total sales for the period are deducted from the retail value of inventory available for sale. The resulting amount represents ending inventory priced at retail. When this amount is multiplied by the cost to retail ratio, an approximation of the cost of ending inventory results. Use of this method eliminates the need for a physical count of inventory each time an income statement is prepared. However, a physical count is made at least yearly to determine the accuracy of the records and to avoid overstatements due to theft, loss, and breakage. When a physical count is taken at the retail amount, this is converted to the chosen basis by multiplying it by the appropriate cost to retail ratio. An understanding of the terminology common to the retail method is necessary for appropriate application. The terms and their definitions are: a. Original Retail Price The price at which the item was originally marked for sale. This price consists of the item's cost plus an original mark-up or mark on. b. Mark-up An increase above the original retail price. c. Mark-up Cancellation A decrease in the selling price of an item that had been previously marked up above the original price. A mark-up cancellation will never reduce the selling price below the original retail price. d. Markdowns A decrease below the original retail price. e. Markdown Cancellation An increase in the selling price that follows a markdown.
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A markdown cancellation cannot exceed the original markdown. When the cost to retail ratio is calculated by including net mark-ups (mark-ups less mark-up cancellations) but excluding net markdowns, the retail inventory method approximates lower of average cost and market, with market being net realizable value less normal profit margin. This is known as the conventional retail inventory method. If both net mark-ups and net markdowns are included before the cost to retail ratio is calculated, the retail inventory method approximates average cost. The retail inventory method becomes more complicated when such items as freight-in, purchase returns and allowances, and purchase discounts are involved. In essence, the treatment of the items affecting the cost column of the retail inventory approach follows the calculation of cost of goods available for sale. Other items that require careful consideration include transfers-in, normal shortages, abnormal shortages, and employee discounts.

Conventional retail (average LCM): At Beginning Cost Inventory + Purchase Returns Purchases - Allowances, Discounts Purchase Returns, Purchases - Allowances, Discounts Freightin Abnormal Spoilage

At Beginning Retail Inventory +

Abnormal Spoilage +

Net Mark-ups

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ILLUSTRATION 8-1 INVENTORY RECORD SYSTEMS: JOURNAL ENTRIES Assumptions: Beginning inventory 100 units at $6 = Purchases 900 units at $6 = Sales 600 units at $12 Ending inventory 400 units at $6 = Perpetual Inventory System To record purchases To record sales Inventory 5,400 Accounts Payable 5,400 Accounts Receivable 7,200 Sales 7,200 Cost of Goods Sold Inventory (600 x $6) 3,600 3,600 $ 600 $5,400 = $7,200 $2,400 Periodic Inventory System Purchases 5,400 Accounts Payable 5,400 Accounts Receivable 7,200 Sales 7,200 No record is kept of the number of units sold or their cost. Therefore no journal entry is made to record the cost of goods sold at this time.

Supplementary System - quantities only. Inventory Accounts Payable Accounts Receivable Sales 5,400 5,400 7,200 7,200

Post this entry to the perpetual inventory records.

A record is kept of the fact that 600 units were sold, but their cost is not computed. Therefore no journal entry is made to record the cost of goods sold at this time.

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At the end of the period

Perpetual Inventory System Because inventory costs were computed and journal entries were made whenever units were sold, the records show that: (1) 900 units costing $5,400 were purchased. (2) 600 units costing $3,600 were sold. (3) 400 units costing $2,400 remain on hand. The balance in the inventory account is correctly stated at $2,400. No entry is required to adjust the Inventory account.

Supplementary System - quantities only. The records show that: (1) 900 units costing $5,400 were purchased. (2) 600 units were sold. (3) 400 units remain on hand. Periodic inventory procedures must be used to determine that the cost of the 400 units in ending inventory is $2,400. The balance in inventory account is $6,000 (beginning inventory plus purchases). The following entries are required to adjust the inventory account (see Illustration 8-2): Cost of Goods Sold 6,000 Inventory 6,000 (Beginning & Purchases) Inventory (Ending) Cost of Goods Sold 2,400 2,400

Periodic Inventory System The records show only that 900 units costing $5,400 were purchased. A physical count must be taken to determine that 400 units remain on hand. Periodic inventory procedures must be used to determine that the cost of the 400 units in ending inventory is $2,400. The balance in the inventory account is $600 from the beginning of the period.) The following entries are required to adjust the inventory account (see Illustration 8-2): Cost of Goods Sold Inventory (Beginning) 600 600

Inventory (Ending) 2,400 Cost of Goods Sold 2,400 Cost of Goods Sold Purchases 5,400 5,400

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ILLUSTRATION 8-2 INVENTORY RECORDING SYSTEMS: T-ACCOUNTS Transaction A: Beginning Inventory B: Purchases C: Sales D: Ending inventory 100 units at $6 = $ 600 900 units at $6 = $5,400 600 units at $12 = $7,200 400 units at $6 = $2,400

PERIODIC
SALES 7,200 C ACCOUNTS RECEIVABLE C 7,200 INVENTORY A D COST OF GOODS SOLD D 3,600 600 600 D 2,400

ACCOUNTS PAYABLE 5,400 B

PURCHASES B 5,400 5,400 D

PERPETUAL
SALES 7,200 C ACCOUNTS RECEIVABLE C 7,200 INVENTORY A 600 B 5,400 3,600 D 2,400 COST OF GOODS SOLD C 3,600 ACCOUNTS PAYABLE 5,400 B NO CLOSING ENTRY REQUIRED C

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ILLUSTRATION 8-3 ADJUSTING AND CLOSING THE INVENTORY ACCOUNTS Adjusting the Ending Inventory Beginning Inventory Permanent Inventory Account Adjust for beginning Adjust for ending Inventory by crediting inventory by debiting Inventory and debiting Inventory and crediting Cost of Goods Sold Cost of Goods Sold
Cost of Goods Sold

Close these accounts by crediting the account and Crediting Cost of Goods Sold
Accounts with Normal Debit balances: Purchases Transportation-in

Close these accounts by debiting the account

Accounts with Normal Credit Balances: Purchase Discounts Purchase Allowances Returned Purchases (Purchases Returns)

Beginning Inventory and Temporary Accounts with

Ending Inventory and Temporary Accounts with Normal Credit Balances: 1. An overstatement of these items results in an understatement of Costs of Goods Sold and an overstatement of net income. 2. An understatement of these items results in an overstatement of Costs of Goods Sold and an understatement of net income.

Normal Debit Balances: 1. An overstatement of these items results in an overstatement of Cost of Goods Sold and an understatement of net income. 2. An understatement of these items results in an understatement of Costs of Goods Sold and an overstatement of net income.

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ILLUSTRATION 8-4 EFFECT OF INVENTORY ERRORS Error Beginning Inventory is understated. Effect on Income Statement Cost of Goods Sold is understated. Effect on Balance Sheet Retained Earnings is correct, assuming that Ending Inventory for the preceding period was understated.* Retained Earnings is correct, assuming that Ending Inventory for the preceding period was overstated. Accounts Payable is understated. Retained Earnings is overstated. Accounts Payable is overstated. Retained Earnings is understated. Inventory is understated. Retained Earnings is understated. Inventory is overstated. Retained Earnings is overstated.

Beginning Inventory is overstated.

Cost of Goods Sold is overstated. Gross Profit and Net Income are understated. Cost of Goods Sold is understated. Gross Profit and Net Income are overstated.

Purchases are understated

Purchases are overstated.

Cost of Goods Sold is overstated. Gross Profit and Net Income are understated.

Ending Inventory Is understated

Cost of Goods Sold is overstated. Gross profit and Net Income are understated. Cost of Goods Sold is understated. Gross Profit and Net Income are overstated.

Ending Inventory Is overstated.

* If beginning inventory for the current period is understated, then ending inventory for the preceding period must also have been understated. Retained Earnings at the end of the preceding period was therefore understated. Retained Earnings will be correct at the end of the current period after the current periods overstated Net Income is closed into the Retained Earnings account.

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ILLUSTRATION 8-5 CALCULATION OF ENDING INVENTORY Inventory Data 1/1 1/10 1/15 1/20 1/31 Begin with 1,000 units @ $5 Purchase 200 units @ $8 Sell 400 units Purchase 300 units @ $6 Ending inventory is 1,100 units (1,000 + 200 - 400 + 300)

Ending inventory calculations for 1,100 units FIFO (periodic or perpetual) = (300 @ $6) + (200 @ 8) + (600 @ $5) = $6,400 Weighted average (periodic) =
($5 1,000) + ($8 200) + ($6 300) = $5.60 1,100 units = $6,160 1,500 Weighted average (perpetual) = ($5 1,000) + ($8 200) = [$5.50 800 units ] + [$6 300] = 6,200 1,200

SUMMARY PERIODIC Average FIFO Cost Goods available for sale ($5 1,000) + ($8 200) + ($6 300) Ending inventory Cost of goods sold $8,400 6,400 $2,000 $8,400 6,160 $2,240 PERPETUAL Average FIFO Cost $8,400 $8,400 6,400 $2,400 6,200 $2,200

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ILLUSTRATION 8-6 THE GROSS PROFIT METHOD There is one general approach to estimating the cost of ending inventory using the gross profit method. It makes use of the percent of gross profit on sales. If given the percent mark-up on cost, calculate the percent of gross profit on sales. Assume that the following information is given: Beginning inventory Purchases Sales Percent of mark-up on cost $ 60,000 90,000 100,000 25%

You are to use the gross profit method to solve for the cost of ending inventory. 1. Calculate percent of gross profit on sales (if not given): Gross profit on Sales =
= % of mark - up on cost 100% of mark - up on cost

25% 25% = = 20% 100% + 25% 125%

2. Calculate cost of goods sold: Cost of Goods Sold = Sales

(100% - % Gross profit on Sales)

(100% - 20%)

= $100,000 = $100,000 = $80,000

80%

3. Calculate estimated cost of ending inventory: + = Cost of beginning inventory Cost of purchases Cost of goods available for sale Cost of goods sold Estimated cost of ending inventory $ 60,000 + 90,000 150,000 - 80,000 $ 70,000

ILLUSTRATION 8-7 NUMERICAL EXAMPLE OF THE GROSS PROFIT AND CONVENTIONAL RETAIL INVENTORY METHODS
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Assume that the following information is given: Beginning Inventory At Cost At Retail Net Purchases At Cost At Retail Net Mark-ups Net Markdowns GROSS PROFIT METHOD % Gross profit on sales = Avg. Selling Price - Avg. Cost = $2/$10 = 20% Avg. Selling Price Cost of goods sold Ending inventory = $280,000 (100% - 20%) = $280,000 = $224,000 (using gross profit on sales) Net Sales at Retail $100,000 125,000 $300,000 360,000 15,000 10,000 Average Cost per Unit Average Selling Price per Unit $ 8.00 $10.00 $280,000

80%

= $100,000 + $300,000 - $224,000 = $176,000

CONVENTIONAL RETAIL METHOD Ending inventory at retail = $125,000 + $360,000 + $15,000 - $10,000 - $280,000 = $210,000 Cost-to-retail ratio = $100,000 + $300,000 = $400,000 $125,000 + $360,000 + $15,000 $500,000

= 80% Ending inventory at lower of average cost and market (net realizable value less normal profit) = 80%

$210,000 = $168,000

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