3. Four Methods to Determine the Cost of Goods Sold (COGS)

Chapter 8-Oct 31

1. Inventory: all goods that a company owns and holds for sale.

2. Inventory Subsidiary Ledger: a separate subsidiary account is maintained for each item in the inventory.

3. Four methods to determine the cost of goods sold (COGS)

4. In a perpetual inventory system, inventory entries parallel the flow of costs.

Cost of Goods Available for Sale
Aug. / 1 / Beg. Inventory / 10 / units @ / $ 91 / = / $ 910
Aug. / 3 / Purchased / 15 / units @ / $ 106 / = / $ 1,590
Aug. / 17 / Purchased / 20 / units @ / $ 115 / = / $ 2,300
Aug. / 28 / Purchased / 10 / units @ / $ 119 / = / $ 1,190
Retail Sales of Goods
Aug. / 14 / Sales / 20 / units @ / $ 130 / = / $ 2,600
Aug. / 31 / Sales / 23 / units @ / $ 150 / = / $ 3,450

What’s the cost of goods sold? What’s the cost of ending inventory?

4.1 The Principle of Consistency limits companies’ ability to switch accounting methods from period to period.

4.2 The lower of cost or market (LCM): Before reporting a value for Inventory on the balance sheet, companies consider any needed reductions for obsolescence. They also make sure to adjust the inventory value to the lower of cost or market.

We can apply the lower-of-cost-or-market rule to individual inventory items, the categories of inventory items, or to the total inventory.

4.3 Free On Board (FOB) Shipping Point vs. Destination:

If the shipping terms are Free On Board shipping point, that means ownership transfers from the seller to the buyer when the seller provides the goods to the carrier. It also means that the buyer will pay the transportation cost.

On the other hand, if the shipping terms are Free On Board destination, that means ownership transfers from the seller to buyer when the buyer receives the goods. It also means that the seller will pay the transportation cost.

5. Periodic inventory systems

Remember that because the periodic system does not maintain a cost of goods sold account, cost of goods sold must be calculated at the end of the period.

6. The effects on the income statement of errors in inventory valuation.

Errors in Measuring Inventory
Beginning Inventory / Ending Inventory
Effect on Income Statement / Overstated / Understated / Overstated / Understated
Goods Available for Sale / + / - / NE / NE
Cost of Goods Sold / + / - / - / +
Gross Profit / - / + / + / -
Net Income / - / + / + / -
Effect on Balance Sheet
Ending Inventory / NE / NE / + / -
Retained Earnings / - / + / + / -

7. Estimate the cost of goods sold and ending inventory by the gross profit method and by the retail method.

Gross profit method:

a. determine the Cost of Goods Available for Sale;

b. estimate Cost of Goods Sold by multiplying Net Sales by the cost ratio;

c. deduct the Cost of Goods Sold estimate from the Cost of Goods Available for Sale to determine Ending Inventory.

Retail Method:

a. determine the cost ratio. Cost ratio=Goods Available for Sale at Cost / Goods Available for Sale at Retail;

b. multiply ending inventory at retail by the cost ratio to arrive at Estimated Ending Inventory at cost.

8. Financial analysis

Inventory Turnover rate= Cost of Goods Sold/ Average Inventroy

Avg. Number of Days to Sell Inventory= Days in the year/ Inventory Turnover

2