CHAPTER 7 INVENTORY

March 11, 2024

Topics / Learning objectives:

1. Why is inventory important to a company? Why is it relevant?

2. Difference between perpetual [constant, on-going] inventory and periodic [defined period, once
in a while] inventory systems
3. Different methods to determine the cost of ending inventory. [balance or amount on statement
of financial position [aka balance sheet]]
4. Lower of cost or net realizable value. [is there situation where we have to discount the selling
price].
5. How to determine gross margin and why is it important. ratio
6. Internal controls related to inventory.
7. Calculate and interpret inventory turnover ratio and days to sell inventory ratio. Ratio.

[from p. 7-3 of the Burnley textbook]

“Inventory is any item purchased by a company for resale to customers or to be used in the
manufacture of a product that is then sold to customers.” Retailer or wholesaler – buy
inventory to sell to customers. If business is a manufacturer – buy raw material to manufacture
or make into a product [finished goods] for sale to a customer.

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1. Why is inventory important to a company? [p. 7-4]
Inventory is often the largest asset for a manufacturing company, a wholesaler, or a retailer. For a
company to do well, there should be enough sales at a good price. Remember from Chapter 4 that
gross margin is the difference between the sales price and the original price paid to buy the
merchandise. The gross margin must be high enough to pay for the selling and overhead costs
(operating expenses), interest expense and income taxes and leave enough profit for the
shareholders.
What costs should be included in inventory [p. 7-6]
Cost principle – record an asset for what was paid for that asset. Cost includes more than just the
invoice price billed by the supplier. Include any shipping cost and provincial sales tax [non-
refundable].

FOB shipping point versus FOB destination. The company who pays shipping on the merchandise
owns those goods while in transit. FOB stands for “free on board” and indicates who the owner of
the merchandise is at any point. This is important not only to make sure the company records the
merchandise property but also for insurance purposes in case the inventory gets lost or damaged.

 FOB shipping point – once the item leaves the seller’s location, the buyer automatically
owns the good.
 FOB destination – the buyer only owns the goods once they have arrived at their location.

Example – A company in Edmonton buys $10,000 of merchandise from a supplier in Vancouver.

Vancouver (supplier) Edmonton company (buyer)

(Shipped goods on Dec. 28/21) Jan. 4/22- arrives at premises

If the goods were shipped FOB Vancouver (or FOB shipping point or FOB seller) – the buyer is the
legal owner of those goods once they have been shipped by the seller. Important for insurance. The
merchandise would be shown on the buyer’s balance sheet on December 31, 2021.

If the goods were shipped FOB Edmonton (or FOB destination or FOB buyer) -- the buyer is the legal
owner once the goods have been received at their premises. In this example, the Edmonton company

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would not show the inventory on their December 31, 2021, balance sheet since they are not yet the
legal owner of the merchandise.

Goods that haven’t arrived yet at the buyer’s premises are called “goods in transit”.

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AP7-1A [p. 7-37 to 7-38]

First Ownership orders merchandise from several suppliers from around the world. Each
of the suppliers has different shipping or transportation terms. At the end of December,
First Ownership had the following outstanding orders:

Date Order Placed Amount Shipping Terms

December 1, 2020 $75,000 FOB shipping point

December 10, 2020 $95,000 FOB shipping point

December 15, 2020 $25,000 FOB destination

December 19, 2020 $45,000 FOB shipping point

December 24, 2020 $35,000 FOB destination

Required

On December 31, 2020, what amount would First Ownership include in its inventory from the
outstanding orders?

AP7-1A SOLUTION
Include all FOB shipping point orders as the inventory becomes the buyer’s responsibility
[when ownership changes] when the item leaves the seller. Exclude all FOB destination
orders as the inventory doesn’t become the buyer’s responsibility until it is received.

December 1, 2020 $75,000

December 10, 2020 95,000

December 19, 2020 45,000

Total inventory amount $215,000

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2. Difference between perpetual inventory and periodic inventory systems
Periodic [once in a while] system [p. 7-8]
Inventory is counted periodically, usually at the end of the year, so that the inventory units
[ending inventory] and total cost of the merchandise [cost of goods sold] can be determined.

Perpetual [on going or continuous] system [p. 7-9]

Counting inventory is not needed to determine the cost of the goods sold because the inventory
records are constantly updated when purchases and sales are made. But a physical count is needed
at least annually to make sure the recorded inventory is in fact accurate. If inventory counted is less
than what is shown in the accounting records, the inventory amount in the accounting records
should be reduced for the “shrinking” (i.e. damage, theft, obsolescence).

3. Different methods to determine the cost of ending inventory.

There are three common methods to account for the cost of inventory:
1. First-in, first-out (FIFO) – the goods are sold in the order they were purchased. Sales are
made from the oldest inventory first.
2. Weighted-average – all goods purchased are pooled into a group to determine
an average cost. [total cost / number of units]
3. Specific identification – the inventory remaining can be identified to a specific
purchase date.
There is no one best method. The method used should be based on the type of inventory:
 If goods are identical, for example tins of Campbell’s Soup, use weighted average or FIFO.
 If goods are unique, such a car dealer’s lot full of vehicles, use specific identification.

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AP7-2A

Soft Touch Company sells leather furniture. The following schedule relates to the
company's inventory for the month of April:

Cost Sales

April 1 Beginning inventory 75 units $45,000

[45,000/75=$600 paid per unit]
3 Purchase 50 units 31,250
[31,250/50=$625 paid per unit]
5 Sale 30 units $33,000
11 Purchase 25 units 16,250
[16,250/25 = $650 paid per unit]
15 Sale 55 units 68,750
22 Sale 40 units 48,000
28 Purchase 50 units 33,750
[33,750/50 = $675 paid per unit]
At the end of the month, they have 75 units of inventory on hand.

Soft Touch uses the perpetual inventory system.

Required

a. Calculate Soft Touch Company's cost of goods sold, gross margin, and ending inventory
using:
i. FIFO

ii. weighted average. Round per unit cost to two decimal places.

b.Which cost formula produced the higher gross margin?

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AP7-2A SOLUTION

a. i. FIFO
Cost of goods sold

= (30 x $600) + [(45 x $600) + (10 x $625)] + (40 x $625) = $76,250

Sales Revenue = $33,000 + $68,750 + $48,000 = $149,750

Gross margin = Sales Revenue - COGS

Gross margin = $149,750 – $76,250 = $73,500

Ending Inventory = (50 units X $675) + (25 units X $650) = $50,000

ii. Weighted-average

# Units Costs Cost per Sales

unit
Apr 1 Beg. Inv. 75 $45,000 $600
Apr 3 Purchase 50 31,250 625
125 76,250 610
5 Sale (30) (18,300) 33,000
95 57,950 610
11 Purchase 25 16,250 650
120 74,200 618.33
15 Sale (55) (34,008) 68,750
22 Sale (40) (24,733) 48,000
25 15,459
28 Purchase 50 33,750
Ending 75 49,209 656.12 149,750

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Weighted-average cost of goods sold:

Apr 5 sale 30 units X $610 = $18,300

Apr 15 sale 55 units X $618.33 = $34,008
Apr 22 sale 40 units X $618.33 = $24,733

Total cost of goods sold = $77,041

Gross margin = $149,750 – $77,041 = $72,709

EI = $49,209 from the table or (75 units X $656.12/unit = $49,209)

b. Under FIFO, the gross margin is $73,500.

Gross margin % = $73,500 / $149,750 = 49.08%

Under weighted average, the gross margin is $ $72,709.

Gross margin % = $72,709 / $149,750 = 48.55%

FIFO produces the higher gross margin.

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4. Lower of cost or net realizable value

Inventory should be shown at the lower of the cost of the merchandise or its net realizable value
(selling price less costs incurred to sell the product, such as advertising, shipping). Otherwise, it
would be misleading to the reader if they assume the realizable value would be at least equal to
what is shown on the balance sheet at cost.

Example: - items in stock and their quantity and cost:

Total cost Total NRV
Item A 10 units cost per unit = $10 $ 100 NRV per unit = $12 $120
Item B 20 units cost per unit = $25 $ 500 NRV per unit = $22 440
Item C 50 units cost per unit = $15 $ 750 NRV per unit = $14 700
Total $1,350 $1,260

2 approaches can be used to apply the lower of cost or net realizable value (NRV):
1. Item by item – look at each item individually and take the lowest of its cost or NRV:
A 10 units x $10 = $100
B 20 x $22 = 440
C 50 x $14 = 700
Lower of cost or NRV $1,240 WOULD BE SHOWN ON THE BALANCE SHEET

2. Grand totals – add up the total cost = $1,350 of all items and the total NRV =$1,260 of
all items and take the lowest total amount: $1,260

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AP7-10B [Lower of cost and net realizable value]

T2T Hockey Inc. has the largest selection of hockey equipment of any retailer in the city in which it
operates. T2T reported the following cost and net realizable value information for inventory at
December 31:

Required

a. Calculate the ending inventory balance for hockey sticks and helmets using the lower of cost and net
realizable value for each item.

b. Calculate the ending inventory balance for hockey sticks and helmets using the historical unit costs
provided.

c. Compare the difference in the ending inventory amounts. Which amount provides a more faithful
representation of the inventory value? Explain.

Source: from Burnley p. 7-44

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AP7-10B
a.

Item (a)Unit (b)Unit Lower of # of Ending

Cost ($) NRV ($) (a)and(b) Units Inventory
($) ($)
Lower of
cost or NRV
X # units
Sticks:
Bauer
CCM
Warrior
Helmets:
Adidas
Nike
Mission
Total

The lower of cost and net realizable value amount on an individual item basis to be reported
on the statement of financial position is $23,385.
b.

Item Unit Cost ($) # of Units Ending Inventory ($)

Sticks
Bauer
CCM
Warrior
Helmets
Adidas
Nike
Mission

The ending inventory balance for skates and helmets using the historical unit costs provided
is $24,750.

c. Because current assets such as inventory should be reported on the statement of

financial position at no more than the amount of cash expected to be generated from
their use or sale, the lower of cost and net realizable value amount of $23,385
represents more faithfully, the inventory value for financial reporting purposes.

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5. How to determine gross margin and why is it important. [p. 7-22 to 7-23]
Gross margin [introduced in Chapter 4] is the difference between what the merchandise is sold for
(selling price to customer) minus the cost of buying the merchandise (cost of the goods sold).
Questions
a) What costs are not included in the gross margin?
b) Why should gross margin be relatively high?
c) What factors would increase the gross margin?
d) What factors would decrease the gross margin?
6. Internal controls related to inventory
The purpose of having internal controls for inventory is to minimize the risk that inventory will not
be lost, stolen, damaged, or become obsolete. Some common internal control procedures include:
 Physical controls such as fenced compounds, security guards, use of cameras, locked storage
facilities, using electronic tags, GPS tags, break in alarms
 Regular inventory counts [verification as to how much we have, condition, if it exists]
 Separate duties as to who orders the goods, who checks the goods and who records it in the
inventory system [segregate the duties so that no one persons does too many tasks which
could allow them to hide some irregular]
 Pay only for goods received
 RFID tags
7. Calculate and interpret inventory turnover ratio and days to sell inventory ratio
Inventory turnover ratio = Cost of goods sold
Average inventory
How often do we sell all our inventory in a year.
Days to sell inventory = 365
Inventory turnover ratio
How many days does it take to sell all the inventory

Both ratios measure the same thing in two different ways – – how quickly is inventory moving
out of the warehouse/retail space and sold to customers.

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AP7-16B [Inventory turnover, gross margin, and shrinkage]

From Burnley p 7-46

The following information was taken from the accounting records of Pembroke Ltd.. and Deep River Ltd.
at October 31, 2020. The two companies are competitors.

Required

a. Calculate the gross margin, gross margin ratio, and inventory turnover ratio at October 31, 2020, for:

i. Pembroke Ltd.

ii. Deep River Ltd.

b. During the December 31, 2020, inventory count at Deep River Ltd., $86,000 of inventory shrinkage
was identified. It has not been recorded in the inventory account.

i. Prepare the entry to record the inventory shrinkage of $86,000.

ii. Recalculate Deep River's gross margin, gross margin ratio, and inventory turnover ratio after the
adjusting journal entry is made. (Hint: You need to adjust the ending inventory balance for 2020 and the
cost of goods sold.)

iii. Describe what happened to Deep River's gross margin ratio and inventory turnover ratio after
adjusting for the inventory shrinkage.

c. Which company do you think is doing a better job in terms of managing inventory? Explain your
answer.

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AP7-16B
a.

i. Pembroke Ltd ii. Deep River Ltd

Gross margin:
Sales revenue - COGS

Gross margin ratio:

Gross margin/Sales revenue

Average inventory

Inventory turnover ratio:

COGS/Average inventory

Days to sell inventory

365/inventory turnover ratio

b.
i. Cost of Goods Sold 86,000
Inventory 86,000

i. Revised cost of goods sold: $4,500,000 + $86,000 = $4,586,000

Revised average inventory: ($150,000 + $475,000 - $86,000)/2
= $269,500
Gross margin: $7,256,700 - $4,586,000 = $2,670,700
Gross margin ratio: $2,670,700/$7,256,700 = 36.8%
Inventory turnover ratio: $4,586,000/$269,500 = 17.0 times
ii. When the correction is made to reduce the inventory valuation by $86,000, the costs
associated with the decline in value become part of the cost of goods sold. With a higher
cost of sales, the amount remaining to cover the other expenses and contribute to profit
(the gross margin) goes down by the same amount.

Therefore, the cost of goods sold percentage of sales increases and the gross margin
ratio decreases.
The inventory turnover ratio on the other hand, appears to improve as it is now a larger
number. This is deceptive and caused by increasing the numerator and decreasing the
denominator as a result of recognizing the impairment in the inventory’s value.

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c. Without additional information and assuming Pembroke did not require a valuation
adjustment this year, it appears Pembroke is slightly better at managing inventory in terms
of gross margin. After the adjustment Deep River’s inventory turnover is 17.0 times
compared to Pembroke’s inventory turnover of 16.4 times. Deep River’s gross margin
ratio is significantly higher than Pembroke’s at 36.8% versus only 12.3% for Pembroke.
However, the fact that Deep River’s management was required to recognize an $86,000
impairment – or 18.1% of its ending inventory value, probably indicates that there was
mismanagement on Deep River’s part for that significant shrinkage factor. It appears that
Pembroke is better at managing its inventory.

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