MBA Financial Accounting - Chapter 6

Cost of Sales and Inventories.

21 July 2012

Philippine School of Business Administration - Manila

From Asset to Expense

©2008 Deloitte & Touche

Introduction of Presenter:

Johann Y. Rosales2 Financial Accounting - Cost of Sales and Inventories


Introduction of Presenter:

The Younghusbands3 Financial Accounting - Cost of Sales and Inventories


Audit Life with MDAC – Deloitte PH .

4 Financial Accounting - Cost of Sales and Inventories

©2008 Deloitte & ToucheFinancial Accounting - Cost of Sales and Inventories5


What is Inventories?PAS 2 defines inventories as follows:

“Inventories are assets which are held for sale in the

ordinary course of business, in the process of

production for such sale or in the form of materials or

supplies to be consumed in the production process or in

the rendering of services.”


What is Cost of Sales?

“is the cost of the services/goods that

was billed or sold to customers.”


Definition of terms:• Beginning Inventory

– Quantities of Merchandise on hand at the beginning of the period

• Purchases– New Purchases

• Available for Sale = Beginning Inventory + Purchases– Most that a company can sell during an accounting period

• Ending Inventory– Remaining Unsold Merchandise


Types of Companies

1.) Merchandising

2.) Manufacturing

3.) Service


MERCHANDISING COMPANY


- their goal is to purchase inventory and resell it at a higher price to customers

- Sells goods in substantially the same physical form as that in which it acquires them.

P 50 P 150


Merchandise Inventory

Financial Accounting - Cost of Sales and Inventories11




Inventory Cost of Goods Sold

- Merchandise inventory

- Goods that the company own.

- Acquisition cost of the unsold goods

- The Acquisition cost of the goods that are already sold.




When to include the inventories in the books?

F.O.B Destination

F.O.B Shipping Point

When you OWN the inventories!

But when do you OWN the

inventories?!?




Acquisition Cost

Invoice Price Cost

Add: Freight - In

Total Cost of Purchase

Less: Purchase Discounts

Purchase returns and Allowances




Cost of goods sold formula

Cost of Beginning Inventory

Add: Cost of Purchases

Cost of Goods Available for Sale

Less: Cost of Ending Inventory

Cost of Goods Sold




BI + N Purchases = Goods Available for Sale = Inventory, End + COGS

Beginning Inventory

Net Purchases

Goods Available for Sale (GAS)

Now, how do we split the GAS into Inventory, End and COGS???

Ending Inventory

Cost of Goods Sold




Systems for Accounting Inventories

Periodic Perpetual

- Physical count is necessary to determine the ending inventory.

- Generally used when the individual inventory items turn over rapidly and have small peso investment.

- Physical count is not necessary to determine the ending inventory.

- Commonly used where the inventory items treated individually represent a relatively large peso investment.




Systems for Accounting Inventories

Periodic Perpetual

- Does not keep a running record of all goods bought and sold.

- Keeps a running record of all goods bought and sold. Utilizes Perpetual Inventory Card.


MERCHANDISING COMPANY - Systems for Accounting Inventories


Sample transactions

Periodic Perpetual1. Purchase of merchandise on account, P300,000.

Purchases 300,000 Merchandise Inventory 300,000

Account Payable 300,000 Account Payable 300,000

2. Payment of freight on the purchase, P20,000

Freight in 20,000 Merchandise Inventory 20,000

Cash 20,000 Cash 20,000

or

Cost of Goods Sold 20,000

Cash 20,000

3. Return of merchandise purchsed to supplier, P30,000

Accounts payable 30,000 Accounts payable 30,000

Purchase return 30,000 Merchandise Inventory 30,000




Sample transactions Cont…

Periodic Perpetual4. Sale of merchandise on account, P400,000, at 40% gross profit.

Accounts receivable 400,000 SAME ENTRY

Sales 400,000

Cost of Goods Sold 240,000

Merchandise Inventory 240,000

5. Return of merchandise sold from customer, P25,000.

Sales return 25,000 SAME ENTRY

Accounts receivable 25,000

Merchandise Inventory 15,000

Cost of goods sold 15,000

6. Adjustment of ending inventory, P65,000.

Merchandise Inventory 65,000 No Entry

COGS/IS 65,000





Cost of Goods Sold - Periodic Method

Purchase 300,000 Freight in 20,000

Less: Purchase return 30,000 Total Goods Available for Sale 290,000

Less: Inventory, end 65,000 Cost of goods sold 225,000





Cost of Goods Sold - Perpetual Method

Merchandise Inventory Cost of Goods Sold

0 Beg. Ending 65,000 240,000 Sales Sales returns

15,000

300,000 Purchases Purchase Returns

30,000

20,000 Freight in Sales 240,000 Balance 225,000

15,000 Sales return

335,000 335,000




Advantages of Perpetual Inventory system

1. Inventory monitoring

2. Strong system controls

3. Availability of Ending Inventory and Cost of Sales balances


Inventory Estimation

An alternative to physical count




INVENTORY ESTIMATION TECHNIQUES

1. Retail Inventory Method – In this method, purchases are recorded at both their cost and their retail selling price. The gross margin percentage of the goods available for sale is calculated from these records.

2. Gross Profit Method – is based on the assumption that the rate of gross profit remains approximately the same from period to period and therefore the ratio of cost of goods sold to net sales is relatively constant from period to period.




Retail Inventory method

Beginning inventory valued at cost and retail price

Records vital for Retail Inventory method:

Purchases during the period at cost and at retail price

Adjustments to the original retail price:

Other adjustments

Additional Markup

Markdown Markdown Cancelation

Markup Cancelation

Departmental transfer

Breakage Damaged goods

Theft

Shrinkage Employee discount




Retail Inventory method – Basic Formula

Goods available for sale at ratail or selling price xx

Less: Net Sales (Gross sales minus Sale returns only) xx

Ending Invenory at selling price xx

Multiply by cost ratio xx

Ending Invenory at Cost xx

Cost ratio =Goods available for sale at cost

Goods available for sale at selling price




Retail Inventory method – Terminologies

1. Initail markup – original markup on the cost of goods.

2. Original retail – the sales price at which the goods are first offered for sale.

3. Additional markup – increase in sales price above the original sales price.

4. Markup cancelation – decrease in sales price above the original sales price.

5. Net additional markup or net markup – markup minus markup cancelation.

6. Markdown – decrease in sales price below the original sales price.

7. Markdown cancelation – increase in sales price that does not increase the sales price above the original sales price.

8. Net markdown – markdown minus markdown cancelation.

9. Maintained markup – difference between cost and sales price after adjustment for all the above items. Sometimes this is referred to as “markon.”




Retail Inventory method – Basic Formula Cost 200

1. Initial markup 40

2. Original retail or sales price 240

3. Additional markup 60

New sales price 300

4. Markup canclation 40

New sales price (not below the original sales price) 260

5. Net Markup (60-40) 20

If at this point, the item is marked down to 210

Markup canclation 20

6. Markdown (decrease in sales price below the original sales price) 30 50New sales price 210

7. Markdown cancelation (increase in sales price that does not increase the new sales price above the original sales price of 240)

20

New sales price 230

8. Net markdown (30-20) 10

9. Maintained markup (230 - 200) 30




Retail Inventory method – Basic Formula

210

0

200

300

240

260

230

Cost

Original retail price

Initial Markup

P40

New selling price 1

P60

Additional Markup

P40

Markup Cancelation

P20 Net Markup

Markup Cancelation

P20

New selling price 2

New selling price 3

Net

M

arkd

own

P30

Markdown Cancelation

P20

New selling price 4Markdown

Mai

ntai

ned

mar

kup

P10

P30




Retail Inventory method – Treatment of other items1. Purchase discount – deducted from purchases at cost only.2. Purchase return – deducted from purchases at cost and at retail.3. Purchase allowance – deducted from purchases at cost only.4. Freight in – addition to purchases at cost only5. Departmental transfer out or debit – addition to purchases at cost and at retail.6. Departmental transfer out or credit – deduction from purchases at cost and retail.7. Sales discount and sales allowance – disregarded, meaning, not deducted from sales.8. Sales return – deducted from sales. If the account is “sales return and allowance,” the same

should be deducted from sales.9. Employee discounts – added to sales. Employee discounts are special discounts usually not

recorded because they are directly deducted from the sales price.

Only the net sales price is recorded. Consequently, the amount of sales is understated. Thus, the employee discounts are added back to sales.

10. Normal shortage, shrinkage, spoilage, breakage – This is deducted from goods available for sale at retail. Any normal shortage is usually absorbed or included in cost of goods sold.

11. Abnormal shortage, shrinkage, spoilage, breakage – This is deducted from goods available for sale at both cost and retail so as not to distort the cost ratio.




Retail Inventory method – Approaches

1.Conservative or conventional or lower of cost or market

2.Average cost approach

3.FIFO approach




Retail Inventory method – Sample problem

Crock Buster sells pots that cost $7.50 for $10. This yields a cost-to-retail percentage of 75%. The beginning inventory totaled $200,000 (at cost), purchases were $300,000 (at cost), and sales totaled $460,000 (at retail).

The only "givens“ are highlighted in yellow. These three data points are manipulated by the cost-to-retail percentage to solve for ending inventory cost of $155,000. Be careful to note when the percentage factors are divided and when they are multiplied.







Gross profit method

Financial Accounting - Cost of Sales and Inventories35




Gross profit method – Basic formula

Goods available for sale (GAS) – Please refer to slide 14 to 16

Cost of sales (COS)

• Gross profit based on sales

Net sales * Cost ratio = COS

• Gross profit based on cost

Net sales / Sales ratio = COS




Gross profit method – Basic formula

Multiply by Divide by

Note: Sales Allowance and Sales Discount are ignored, that is, not deducted from sales.




Gross profit method – Sample problem

Assume that Tiki's inventory was destroyed by fire. Sales for the year, prior to the date of the fire were $1,000,000, and Tiki usually sells goods at a 40% gross profit rate. Therefore, Tiki can readily estimate that cost of goods sold was $600,000. Tiki's beginning of year inventory was $500,000, and $800,000 in purchases had occurred prior to the date of the fire. The inventory destroyed by fire can be estimated via the gross profit method, as shown.




Gross profit method – Sample problem


Types of Companies

1.) Merchandising

2.) Manufacturing

3.) Service

©2008 Deloitte & ToucheFS Finance Bill Event 11 December 2008 41


MANUFACTURING COMPANY


- is the use of machines, tools and labor to produce goods for use or sale.

- Converts raw materials and purchased parts into finished goods.

Finish good

Direct materials

Labor Overhead

http://en.wikipedia.org/wiki/Machine

http://en.wikipedia.org/wiki/Tool




Inventory Cost of Goods Sold

- Materials

- Work in Process

- Finished Goods

- Factory or Manufacturing supplies

- The total manufacturing cost of the goods that are sold.







1

1. Materials 400AP/Cash 400

2. Work in process 300Materials 300

23

4

5

3. Work in process 300Payroll/ Direct labor 100Factory utilities 50Factory insurance/Taxes 30Depreciation 20

4. Finished Goods 800

Work in process 800

6. Cost of goods sold 5Work in process 5

6

5. Cost of goods sold 1000

Finished Goods 1000




Product Cost and Period Cost

Product cost Items of cost included in the cost of producing

goods.

cost that are related to making or acquiring the products or providing the services that directly generate the revenues of an entity.

Period cost Costs that are related to other business functions such

as selling and administration.

Period costs are generally more closely associated with a particular time period rather than with making or acquiring a product or performing a service.


Types of Companies

1.) Merchandising

2.) Manufacturing

3.) Service


SERVICE ORGANIZATION


- refers to a firm engaged in a high or moderate degree of conversion using a significant amount of labor.

- A service company’s output may be tangible (an architecturaldrawing) or intangible (insurance protection).


SERVICE ORGANIZATION


1. Personal Service Organization

Three types of Service Organization

2. Building trade and repair businesses

3. Professional service firms

©2008 Deloitte & Touche50 Financial Accounting - Cost of Sales and Inventories

Questions???

©2008 Deloitte & Touche51 Financial Accounting - Cost of Sales and Inventories

Thank you!!!

MBA Financial Accounting - Chapter 6

Documents

gross profit

retail inventory

original sales

original retail

maintained

net markup

employee discounts

selling price