Mark Krilanovich ©May 7, 2010 BUS 103 Chapter 18: Inventory, COGS, and COGAS The background story We are a merchandise company. That means we purchase items (for example, tables, chairs, and sofas) many at a time (at a "cost"), and then sell them (at a "selling price") a few at a time for more than we purchased them (a "markup amount"), thus making a profit. That is the process we studied in Chapter 8 on "markups," page 205: Selling Price (S) = Cost (C) + Markup (M) "Markup" (M) is the same as the "Gross Profit" that we computed on the Income Statement in Chapter 16, page 390. Although we could purchase tables and chairs from our supplier individually when each customer wanted to buy one from us, that would be inefficient. It would make our customer wait while our supplier shipped us our tables and chairs. Instead, we purchase some tables and chairs in advance of when we'll sell them, and keep the extras in our "Inventory" (warehouse) until we sell them. During each "accounting period" (usually one year), we purchase items and add them to our Inventory, and we sell items out of our Inventory. We keep track of how much they cost us (C), and how much we sold them for (S). At the end of the accounting period, we look at the items in our Inventory, and compare them with the items we had in our Inventory at the start of that accounting period, and consider how much each item cost us to purchase. (The good reason we do this comparison is explained in accounting courses.) Then we prepare our Income Statement (page 390). On it, we compute the total cost to us of all the goods we could have sold ("Cost of Goods Available for Sale" or "COGAS"), and then the total cost to us of all the goods we did sell ("Cost of Goods Sold" or "COGS"). These computations lead us to compute our Net Income. As in Chapter 16, because we added Purchases to our Inventory during the accounting period, the total Cost of Goods Available for Sale is: COGAS = Beginning Inventory + Purchases made during the period Because we sold items out of our Inventory, the total Cost of Goods Sold is: COGS = COGAS - Ending Inventory For both COGS and COGAS, "cost" means "the amount we paid to purchase the goods." Four different ways to figure our Cost Because the cost of items may change during the accounting period, we may have purchased each item at a different cost. When we compute COGS or COGAS, we need to compute our total cost of having purchased a group of many items, some having been purchased at different costs. How do we figure the total cost of many items purchased at different times and perhaps different costs? Accounting rules allow us our choice of four different ways to figure the cost of a group of items: 1. The Average-Weighted Method (average the different costs of all the items), 2. FIFO (pretend the first item into inventory was the first item sold from inventory), 3. LIFO (pretend the last item into inventory was the first item sold from inventory), 4. The Specific-Identification Method (add the cost of each unique item).
©2009-2010 by Mark Krilanovich Chapter 18, page 2 In each of the following three example cases: • We made four purchases during the year, of different sizes and different costs. • During the year we sold 500 items. The goal is to compute: "For the items we sold, how much did they cost us to purchase?" 1. Weighted-Average Method: We use the average cost of all items purchased.
200 items 300 items 100 items 400 items 500 items
@$10/item @$12/item @$13/item @$8/item @$21/item Jan. 1 Jan. 1 Feb. 21 June 1 July 3 Nov. 4 Dec. 31 beginning balance 4 purchases during the year
(200)x($10) + (300)x($12) + (100)x($13) + (400)x($8) + (500)x($21) = $13.73/item (200 items + 300 items + 100 items + 400 items + 500 items)
2. LIFO: "Last-in, first-out" or "Last-bought, first-sold."
200 items 300 items 100 items 400 items 500 items
@$10/item @$12/item @$13/item @$8/item @$21/item
Jan. 1 Jan. 1 Feb. 21 June 1 July 3 Nov. 4 Dec. 31 beginning balance 4 purchases during the year
We pretend the items we sold were the last items we bought. We sold 500 items, so we compute their per-item cost from our purchase of the last 500 items, and we record all 500 sold items as having cost us $21/item.
3. FIFO: "First-in, first-out" or "First-bought, first-sold."
200 items 300 items 100 items 400 items 500 items
@$10/item @$12/item @$13/item @$8/item @$21/item Jan. 1 Jan. 1 Feb. 21 June 1 July 3 Nov. 4 Dec. 31 beginning balance 4 purchases during the year
We pretend the items we sold were the first items we bought. We sold 500 items, so we compute their per-item cost from our purchases of the first 200+300=500 items, and record all 500 sold items as costing us the average of those first 500 items: [(200 items)x($10/item) + (300 items)x($12/item)] / (200 items + 300 items) = $11.20/item.
Time-line concept by Daniel Wrentmore, J.D. Chapter 18, page 3 4. The Specific-Identification Method" (each item is unique). Suppose we are an antique car dealer. Last year's purchases were as follows:
1956 Ford 1959 1961 Dodge 1961 1960 Fairlane Thunderbird Dart Thunderbird Volkswagen
@$1200 @$1400 @$900 @$1800 @$1500 Jan. 1 Jan. 1 Feb. 21 June 1 July 3 Nov. 4 Dec. 31 beginning balance 4 purchases during the year
If at the end of the year, we see that we've sold the 1961 Dodge Dart and the 1960 Volkswagen, we add the cost of each $900 + $1500 = $2400 to get our Purchases. Then we compute COGAS and COGS with the formulas on the first page:
COGAS = Beginning Inventory + Purchases = $1200 + $1400 + $900 + $1800 + $1500 = $6800
COGS = COGAS - Ending Inventory = $6800 - $2400 = $4400
We would use this same pair of computations for any of the four costing methods.
Time-line concept by Daniel Wrentmore, J.D.