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Chapter 8

MGT220H5 Chapter 8: Chapter 8 (Inventory) - MGT220 (2018)

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Christopher Small

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Prof. Christopher Small MGT220 Page 1 of 19
Chapter 8 - Inventory
Chapter 8 - Inventory
Inventory; Ending Inventory; Inventory Errors; Inventory Cost; Perpetual VS. Periodic
Systems; Cost Formulas; LCNRV; Estimating Inventory; and Inventory Analysis
What is Radio Frequency Identification (RFID)?
Retailers are using radio-frequency identification (RFID), which involves putting special tags on
merchandise with antennas & computer chips that track their movement through radio signals.
RFID makes it easier for retailers to switch to a perpetual inventory system, since the tags can keep a
constant count of items. It’s also transforming inventory cost formulas, helping stores move to a
specific identification method for goods that typically had to be valued based on their average cost.
An RFID tag allows a retailer to see exactly how much each item cost & how much it sold for.
Whereas traditional inventory counting can be less than 50% accurate, RFID can increase inventory
accuracy to over 95%, which significantly reduces stockouts.
RFID also reduces the carrying costs of having too much inventory. RFID helps retailers locate
products on shelves, in the backroom, and in warehouses.
What’s a Stockout?
What happens when an item runs out of stock.
What types of companies have inventory?
As a general rule, companies in industries such as manufacturing, retail, and wholesale often have
significant amounts of inventory.
What is the Just-In-Time Basis?
Some companies, such as Toyota Motor Corp., follow a strategy of producing inventories on a just-
in-timebasis. This means they wait until a customer orders a product & then arrange to manufacture
the product. Thus, their inventories are only ~4.6% of total assets.
Inventory Categories
Inventory for Retailers & Wholesalers
Retailers and wholesalers have inventory that is ready for sale.
o Merchandising Inventory: Value associated with products ready to sell, but still unsold.
Inventory for Manufacturers
Manufacturing companies have inventories in various stages of completion.
o Raw Materials Inventory: Amounts for goods & materials that are on hand but have not yet gone
into production. Items that are used in the manufacturer's conversion process to produce components,
subassemblies, or finished products. [ ]
o Work-in-Process Inventory: Cost of the raw material on which production has started but is not yet
complete, plus the direct labour cost applied specifically to this material & its applicable share of
manufacturing overhead costs.
o Finished Goods Inventory: Value associated with the completed but still unsold units on hand.

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Prof. Christopher Small MGT220 Page 2 of 19
Chapter 8 - Inventory
Inventory Planning & Control
Management want to have wide variety & sufficient quantity on hand, so customers have great
selection & always find what they want. However, the higher levels of inventories held, the higher the
carrying cost (ex: in investment, storage, insurance, taxes, obsolescence, risk of theft & damage).
Inefficient purchasing procedures, faulty manufacturing techniques, or inadequate sales efforts may
leave management with excessive/unusable inventories. Companies must monitor inventory levels to:
o Minimize Carrying Cost.
o Meet Customer Demands.
Information for Decision-Making
Financial statement users (ex: creditors & investors) are also interested in inventory information.
Information about inventory must therefore be presented so that it is transparent regarding the nature
of the business. The existence of various types of inventory that the company owns must be clearly
represented and information as to how this inventory has been measured must also be disclosed.
Costs of Goods Available for Sale or Use
The cost of goods available for sale or use must be allocated between the goods that were sold or
used and those that are still on hand. Cost of goods available for sale or use is calculated as follows:
𝐂𝐨𝐬𝐭 𝐨𝐟 𝐆𝐨𝐨𝐝𝐬 𝐀𝐯𝐚𝐢𝐥𝐚𝐛𝐥𝐞 𝐟𝐨𝐫 𝐒𝐚𝐥𝐞 𝐨𝐫 𝐔𝐬𝐞
= 𝐶𝑜𝑠𝑡𝑠 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑜𝑛 𝐻𝑎𝑛𝑑 𝑎𝑡 𝑡ℎ𝑒 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑜𝑓 𝑡ℎ𝑒 𝑃𝑒𝑟𝑖𝑜𝑑
+ 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝐴𝑐𝑞𝑢𝑖𝑟𝑒𝑑/𝑃𝑟𝑜𝑑𝑢𝑐𝑒𝑑 𝐷𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑃𝑒𝑟𝑖𝑜𝑑
Cost of Goods Sold (COGS)
𝐂𝐎𝐆𝐒 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝐴𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑓𝑜𝑟 𝑆𝑎𝑙𝑒 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑃𝑒𝑟𝑖𝑜𝑑
− 𝐶𝑜𝑠𝑡𝑠 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑜𝑛 𝐻𝑎𝑛𝑑 𝑎𝑡 𝑡ℎ𝑒 𝑒𝑛𝑑 𝑜𝑓 𝑡ℎ𝑒 𝑃𝑒𝑟𝑖𝑜𝑑
Calculating the Cost of Ending Inventory
Calculating the cost of ending inventory takes several steps. It can be a complex process that requires
answers to each of the following questions:
o Which physical goods should be included as part of inventory? Who owns inventory still in transit at the
Statement of Financial Position (SFP) date, or inventory on consignment? What about inventory under special sales
o What costs should be included as part of inventory cost? Consider purchase discounts & vendor rebates, product
versus period costs, capacity considerations in allocating overhead & standard costs.
o What cost formula should be used? Consider specific identification, average cost, or first-in first-out (FIFO).
Determining the Final Value Reported on the SFP
Determining the final value to be reported on the SFP, there is one additional question:
o Has there been an impairment in value of any of the inventory items? Inventory can’t be reported on the SFP at
more than the net cash amount that’s expected to be recovered from its sale or use.

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Prof. Christopher Small MGT220 Page 3 of 19
Chapter 8 - Inventory
Accounting Definition of Inventory
Inventories are assets
a) Held for sale in the ordinary course of business;
b) in the process of production for such sale; or
c) in the form of materials/supplies to be consumed in the production process or in the rendering of services.
As assets, inventories represent a future benefit, which the entity has control over or access to. The
inventory purchase is the transaction that gives rise to the recognition of an inventory asset, when the
risks & rewards have passed onto the purchaser.
Physical Goods included in Inventory
When risks & rewards of ownership (therefore control) have passed to the purchaser, inventory is
recognized. Usually purchased goods would be included as inventory when legal title passes. In
practice, however, acquisitions are often recorded when the goods are received (possession) because it
may be difficult to identify the exact time when the legal title passes to the buyer. When the goods are
received, the entity has control over & access to the future benefits. Generally, legal title has often
passed by then as well.
Goods in Transit
Sometimes purchased goods are in transit at the end of a fiscal period, so the company doesnt have
possession. In these situations, we may look to the legal title to determine whether the goods should
be recognized as inventory. Legal title is determined by the shipping terms that have been agreed
upon between the buyer & seller.
Note: F.O.B. stands forfree on board’.
F.O.B. Shipping Point
Legal title passes to the buyer when the seller delivers the goods to the common carrier (transporter),
who then acts as an agent for the buyer.
Goods in transit are recognized by purchaser.
F.O.B. Destination
Legal title passes when the goods reach the destination.
Goods in transit aren’t recognized by purchaser.
Shipping point & destination are often indicated by naming a specific location. Ex: f.o.b. Regina.
Cut-off Schedule
An accountant normally prepares a purchase cut-off schedule for the end of each period to ensure
goods received from suppliers around the end of the year are recorded in the appropriate period. Cut-
off procedures can be extensive & include the following controls:
o Curtailing & controlling the receipt and shipment of goods around the time of the count.
o Marking freight and shipping documents asbeforeor “afterthe inventory count.
o Ensuring that receiving reports on goods received before the count are linked to invoices that are also recorded in
the same period.
Because goods that are bought f.o.b. shipping point may still be in transit when a period ends, the cut-
off schedule is not completed until a few days after the period’s end. This gives time for goods in
transit at year end to be received.
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