Inventory and Cost of Goods Sold – Comprehensive Study Notes

Inventory and Cost of Goods Sold

Service Company vs. Merchandising Company

Understanding the distinction between service and merchandising companies is fundamental in financial accounting, as it affects revenue recognition and inventory management.

• Service Company: Provides a service to the customer; no physical goods are transferred. Examples include tutoring, house cleaning, and legal services.

• Revenue Recognition: Revenue is recognized when the service is performed, not when cash is received.

• Merchandising Company: Sells tangible goods to customers. Examples include clothing stores, grocery stores, and large retailers like Wal-Mart.

• Revenue Recognition: Revenue is recognized when the goods are delivered to the customer.

• Cost of Goods Sold (COGS): An expense account showing the cost paid for goods sold. Goods flow from Inventory into COGS when sold.

Net Sales – Sales Discounts

Sales discounts incentivize early payment and are denoted using standard notation (e.g., "2/10, n/30").

• Discount Notation: "2/10, n/30" means a 2% discount if paid within 10 days; otherwise, net amount due in 30 days.

• Journal Entries: Sales and receipts are recorded using either the gross or net method, depending on whether discounts are anticipated at the time of sale.

• Example: If ABC Company sells goods with terms 3/10, net 45, and payment is received within the discount period, the discount is recognized accordingly.

Net Sales – Sales Returns and Allowances

Sales returns and allowances reduce the total revenue recognized from sales.

• Sales Returns: Occur when customers return goods for a refund.

• Sales Allowances: Occur when customers keep goods but receive a price reduction due to quality issues.

• Net Sales Formula:

$\text{Net Sales} = \text{Sales Revenue} - \text{Sales Discounts} - \text{Sales Returns and Allowances}$

Cost of Goods Sold – Perpetual vs. Periodic Inventory Systems

Inventory systems determine how and when inventory and COGS are updated.

• Perpetual Inventory System: Updates inventory and COGS after every transaction. Barcodes and technology make this system common.

• Periodic Inventory System: Updates inventory and COGS at the end of the accounting period, based on a physical count.

• Inventory Equation:

$\text{Beginning Inventory} + \text{Additions} - \text{Subtractions} = \text{Ending Inventory}$

Perpetual Inventory – Purchases, Returns, Allowances, and Freight

Purchases, returns, and freight costs are recorded directly in the Inventory account in a perpetual system.

• Purchases: Debit Inventory when goods are purchased for resale.

• Purchase Returns: Credit Inventory when goods are returned to suppliers.

• Purchase Allowances: Credit Inventory when suppliers reduce the price due to quality issues.

• Freight Costs: If buyer pays (FOB Shipping Point), add to Inventory. If seller pays (FOB Destination), record as Delivery Expense.

Perpetual Inventory – Purchase Discounts

Purchase discounts are incentives for early payment and reduce the Inventory account in a perpetual system.

• Discount Notation: "2/10, n/30" means a 2% discount if paid within 10 days.

• Journal Entry: When payment is made within the discount period, Inventory is credited for the discount amount.

Perpetual Inventory – Purchases Summary

At period end, the Inventory account is reconciled using the BASE equation:

• BASE Equation:

$\text{Beginning Balance} + \text{Additions} - \text{Subtractions} = \text{Ending Balance}$

• Subtractions: Include purchase discounts, returns, allowances, and COGS.

Periodic Inventory – Purchases, Returns, Allowances, and Freight

In a periodic system, purchases and related transactions are recorded in separate accounts, not directly in Inventory.

• Purchases Account: Debited for all goods bought for resale.

• Purchase Returns and Allowances: Credited for goods returned or price reductions.

• Purchase Discounts: Credited for discounts received for early payment.

• Freight In: Used to accumulate shipping costs paid by the buyer.

Periodic Inventory – Purchases Summary

At period end, the Inventory account is updated based on a physical count, and COGS is calculated:

• COGS Formula:

$\text{COGS} = \text{Beginning Inventory} + \text{Purchases} - \text{Purchase Discounts} - \text{Purchase Returns and Allowances} - \text{Ending Inventory}$

• Ending Inventory: Determined by physical count.

Cost Flow Assumptions: FIFO, LIFO, and Average Cost

Cost flow assumptions determine how costs are assigned to COGS and ending inventory.

• FIFO (First-In, First-Out): Oldest inventory costs are assigned to COGS first.

• LIFO (Last-In, First-Out): Newest inventory costs are assigned to COGS first.

• Average Cost: COGS and inventory are valued at the average cost of all units available for sale.

$\text{Average Cost} = \frac{\text{Total Cost}}{\text{Quantity}}$

• Perpetual System: Uses a moving average updated after each purchase.

• Periodic System: Uses a weighted average at period end.

Inventory Turnover Ratio

The Inventory Turnover Ratio measures how efficiently inventory is managed.

• Formula:

$\text{Inventory Turnover} = \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}$

$\text{Average Inventory} = \frac{\text{Beginning Inventory} + \text{Ending Inventory}}{2}$

• Interpretation: Higher turnover indicates more efficient inventory management.

Gross Profit Percentage

The Gross Profit Percentage shows the proportion of sales revenue that exceeds COGS.

• Formula:

$\text{Gross Profit Percentage} = \frac{\text{Net Sales} - \text{COGS}}{\text{Net Sales}} \times 100$

• Interpretation: Indicates how much gross profit is earned per dollar of sales.

Profit Margin

The Profit Margin ratio measures net income as a percentage of net sales.

• Formula:

$\text{Profit Margin} = \frac{\text{Net Income}}{\text{Net Sales}} \times 100$

• Interpretation: Shows how much net income is earned per dollar of sales.

Average Days in Inventory

This ratio indicates the average number of days inventory is held before being sold.

• Formula:

$\text{Average Days in Inventory} = \frac{365}{\text{Inventory Turnover Ratio}}$

• Interpretation: Fewer days indicate more efficient inventory management.

Days’ Payable Outstanding (DPO)

DPO measures how long a company takes to pay its suppliers.

• AP Turnover Formula:

$\text{AP Turnover} = \frac{\text{Purchases or COGS}}{\text{Average AP}}$

$\text{Average AP} = \frac{\text{Beginning AP} + \text{Ending AP}}{2}$

• DPO Formula:

$\text{Days' Payable Outstanding} = \frac{365}{\text{AP Turnover Ratio}}$

• Interpretation: Higher DPO may indicate stronger liquidity or greater leverage with suppliers.