Chapter 6:

Cost of Sales and Inventories

Kelompok 2:
 Alin Aun Adyana (1806248904)
 Dewi Noviyanti Sari (1806160996)
 Dyah Vita Astriana (1806249176)
 Meirna Larasati (1806161443)
Types of Companies
 Merchandising Company
• Retail stores, wholesalers, distributors, etc.
• Sells goods in the same physical form
• I: shows the cost of goods that have been acquired but not yet sold as of
the balance sheet date.
 Manufacturing Company
• converts raw materials into finished goods
• I: Materials, Work in Process, and Finished Goods
 Service Company
• Hotels, beauty parlors, hospitals, banks, etc.
• Furnish intangible services
• Materials inventories and jobs in progress or unbilled costs
SUPPLIES
• Tangible items that will be consumed in the course of normal operations
• Not sold as merchandise
• Not accounted for as the cost of goods manufactured
• Ex. office and janitorial supplies, lubricants, repair parts
Merchandising Companies
• Acquisition Cost
Merchandise  added to inventory at its cost (in accordance with the basic cost
concept.

• The Basic Measurement Problem, such as:

How to divide the amount of goods available for sale between (1) the ending
inventory and (2) cost of goods sold.
can be approached by:
1. Periodic inventory method
2. Perpetual inventory method

• Periodic Inventory Method

Determine the amount of ending inventory (i.e., the amount in the reservoir at
the end of the period) and deduce cost of goods sold by subtracting the ending
inventory from the goods available for sale.

• Perpetual Inventory Method

Measure the amount actually delivered to customers and deduce the ending
inventory by subtracting cost of goods sold from the goods available for sale.
Retail Method
• Method of inventory recording that enable purchases
to be recorded at their cost and selling price.

• Gross profit method: applying normal percentage to

the amount of sales to arrive at an approximation of
cost of goods sold.
Inventory Accounts –
Manufacturing Companies
• Inventory accounts
▫ Raw materials inventory
▫ Work-in-process inventory
▫ Finished goods inventory
• Journal entries:
▫ Materials used: sum of all materials issued during
the period.
Dr. Materials inventory xxx
Cr. Purchases xxx
Cr. Freight-in xxx
Cost of Goods Manufactured
• Journal entries
Dr. Work in process inventory xxx
Cr. Direct labor xxx
Cr. Indirect labor xxx
Cr. Factory heat, light, power xxx
Cr. Factory supplies used xxx
Cr. Factory insurance and taxes xxx
Cr. Depreciation, PPE xxx
 Cost of Goods Sold
- Add cost of goods manufactured to the beginning finished goods inventory so as to find the
total amount available for sale
- Subtracting ending finished good inventory.

dr COGS $573.000
cr Finished goods Inventory $573.000
Income Summary $573.000
cr COGS $573.000

Product Costing Systems

 The cost of each product is accumulated as it flows through the production process.
Amounts involved in journal entries obtained from cost records
Product Costs and Period Costs
 Product costs/inventory costs/inventoriable costs: cost of items in the process of
goods production
 According to GAAP, Cost of each product:
• material costs,
• cost incurred directly in bringing the product to its existing condition and location such
as labor costs,
• a fair share of costs incurred indirectly in bringing the product to its existing condition
and location such as factory management costs
Service Companies
Principally, cost of products in service firms = manufacturing firms
- Personal service organization: no inventories other than supplies inventory
- Building trade firms and Repair business
- Professional service firms

Inventory Costing Methods

• Specific Identification Method: a means of keeping track of item’s actual
costs when they are sold
• Average Cost Method: average cost of goods available for sale is
accumulated, and units in both cost of goods and ending inventory are cost
at this average costs.
• First in First Out Method/FIFO: The oldest goods are sold first, meaning
that the most recently goods are in the ending inventory.
• Last in First Out Method: COGS is based on the cost o the most recent
purchases, and ending inventory is cost at the cost of the oldest units
available.
 Comparison of Methods
 Arguments for FIFO
 It matches the cost of the goods that are physically sold with the revenues generated
by selling those goods.
 If a company’s management thinks of gross margin as the difference between selling
prices and the cost of the goods physically sold, then it should use FIFO, which will
report this same margin in the company’s income statement.
 The other primary argument for FIFO reflects a balance sheet orientation.
 Arguments for LIFO
 Proponents of LIFO also base their primary conceptual argument on the matching
concept. They argue that gross margin should reflect the difference between
sales revenues, which are necessarily current amounts, and the current cost of the
goods sold.
 LIFO matching argument assumes that a company’s management sets selling prices by
adding a margin to current costs rather than to historical costs. Then the
gross margin reported using LIFO will reflect management’s thinking with regard to
the nature of gross margin.
 Income Tax Considerations
 In periods of inflation, LIFO results in lower income than FIFO or average costs, and
thus results in lower income taxes.
 If the physical size of inventory remains constant or grows, LIFO reduces taxable
income indefinitely.
  The tax advantages of LIFO in periods of rising prices can improve a company’s
cash flow .
 Why Not More LIFO?
 The prices of the specific items in a company’s inventory are not necessarily
increasing.
 Will report lower taxable income and pay lower taxes by using FIFO rather
than LIFO.
 Will reduce taxable income and thus lower income tax payments, the
company also must report the lower LIFO income to its shareholders because of the
LIFO conformity rule.

Lower of Cost or Market

 The LIFO and FIFO methods are alternative ways of measuring cost. The general
inventory valuation principle, deriving from the conservatism concept, is that
inventory is reported on the balance sheet at the lower of its cost or its market value.
 Inventory is reported at its cost. It is reduced below cost (i.e., written down)
only when here is evidence that the value of the items, when eventually sold or
otherwise disposed of, will be less than their cost. When the evidence exists,
inventory is stated at market. Since the goods in inventory have not in fact been
sold, their true market value is not ordinarily known and therefore must be
estimated.
 Accounting Research Bulletin sets upper and lower boundaries on “market”:
1. It should not be higher than the estimated selling price of the item less the costs
associated with selling it. This amount is called the net realizable value.
2. It should not be lower than the net realizable value less a normal profit margin.
 As is true for the rules for marketable securities, which are applied to the individual
securities in a portfolio, the rule for inventory is applied to each item in inventory (i.e.,
each unique part number or product number).
Analysis of Inventory
 Inventory Turnover = Cost of goods sold : Inventory
 Some companies calculate this ratio on the basis of the ending inventory, others on the
basis of the average inventory.
 Inventory turnover indicates the velocity with which merchandise moves through a
business.
 Inventory Turnover can be expressed as the number of days’ inventory on hand.
Days’ Inventory = Inventory : (Cost of good sold : 365)

Gross Margin Percentage

 Company’s gross margin ( sales less cost of goods sold) = net sales revenue.
 The gross margin percentage measures the percentage of each sales dollar a company
earns before considering period costs.