Cost Accounting: Inventory and COGS

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Questions and Answers

What happens to the cost of inventory once it is sold?

It is recorded as cost of goods sold on the income statement. (correct)

It remains on the balance sheet.

It is transferred to owner's equity.

It is written off as an expense.

What is the impact on gross profit if higher cost units are sold?

Gross profit increases.

Gross profit decreases. (correct)

Gross profit cannot be determined.

Gross profit remains the same.

What do the terms FIFO, LIFO, and average cost refer to?

Methods for calculating gross profit.

Methods for valuing accounts receivable.

Methods for determining fixed assets.

Methods for inventory costing. (correct)

What is added to the beginning inventory to determine the cost of goods available for sale?

Current period inventory purchases. Signup and view all the answers

Which of the following statements about inventory costing is true?

Inventory costing methods can influence reported profitability. Signup and view all the answers

How long does Pfizer hold its inventory before it is sold?

96 days Signup and view all the answers

What does a negative cash conversion cycle indicate for a company like Apple?

The company can invest its cash from sales before paying suppliers. Signup and view all the answers

By how many days did Pfizer’s cash conversion cycle improve in 2022 compared to 2021?

16 days Signup and view all the answers

What was the result of Pfizer's action to delay paying its suppliers in 2022?

It improved the cash conversion cycle. Signup and view all the answers

What is the duration for which Pfizer's cash is tied up in inventories and receivables?

71 days Signup and view all the answers

What assumption does the FIFO inventory costing method make about unsold inventory?

Unsold inventory consists of the most recently purchased goods. Signup and view all the answers

What is the average cost per unit if the total goods available for sale is $80,000 and the total number of units is 700?

$114.286 per unit Signup and view all the answers

Which inventory costing method typically yields the highest gross profit during periods of inflation?

FIFO Signup and view all the answers

Under the LIFO method, what type of inventory is assumed to be sold first?

The most recently acquired inventory Signup and view all the answers

How does LIFO inventory valuation typically compare to FIFO during periods of rising costs?

Lower than FIFO Signup and view all the answers

What effect does FIFO have on COGS and gross profit compared to other methods?

FIFO results in lower COGS and higher gross profit. Signup and view all the answers

What is likely to diminish the gross profit effect of using FIFO in recent years?

Improved inventory control processes Signup and view all the answers

What is the total COGS if goods available for sale amount to $80,000 and ending inventory under the average cost method is $28,571?

$55,000 Signup and view all the answers

What does a LIFO liquidation typically result in during an inflationary environment?

Boosted gross profit Signup and view all the answers

Which inventory valuation method does Snap-On primarily use for its U.S. inventory?

LIFO Signup and view all the answers

To convert LIFO to FIFO, which of the following formulas is correct?

FIFO Inventory = LIFO Inventory + LIFO Reserve Signup and view all the answers

What is typically larger for Snap-On when analyzed in terms of balance sheet and income statement effects?

Balance sheet effects Signup and view all the answers

Why is analyzing Days Inventory Outstanding (DIO) important?

It indicates product mix and inventory quality. Signup and view all the answers

What does inventory turnover measure?

The number of times inventory is sold during a period Signup and view all the answers

What does Days Inventory Outstanding (DIO) specifically assess?

The time required to sell average inventory Signup and view all the answers

Which of the following best describes the relationship between asset turnover and productivity?

Higher asset turnover correlates with higher productivity. Signup and view all the answers

Which method is generally more accurate for calculating Accounts Payable Turnover?

Using Purchase Signup and view all the answers

What is the effect of a lower cash conversion cycle on a company?

It generates cash and profit quickly. Signup and view all the answers

Which of the following factors does NOT impact the Cash Conversion Cycle?

Seasonality of sales Signup and view all the answers

Why is COGS often used as a proxy for Purchase in AP turnover calculations?

COGS is readily available and comparable across firms. Signup and view all the answers

What occurs during one complete cash conversion cycle?

Inventory is purchased and sold, and accounts payable and receivable are settled. Signup and view all the answers

What could potentially increase cash flow during the cash conversion cycle?

Realizing sales and gross profit. Signup and view all the answers

Which characteristic of a business model does NOT directly influence the Cash Conversion Cycle?

Sales prices of products Signup and view all the answers

In which situation could using COGS be a good proxy for Purchase?

When inventory levels do not fluctuate dramatically. Signup and view all the answers

Study Notes

Flow of Costs

Inventory purchased or produced is recorded on the balance sheet.
When inventory is sold, its cost is transferred from the balance sheet to the income statement as the cost of goods sold (COGS).

Cost of Goods Sold

Beginning inventory is the ending inventory balance from the prior period.
Current period inventory purchases (or manufacturing costs) are added to the beginning inventory balance to calculate the cost of goods available for sale.
Goods available for sale are either sold (COGS) or remain unsold (ending inventory).

Gross Profit and Managerial Choice

Gross profit is calculated by subtracting COGS from sales revenue.
Higher cost units transferred from the balance sheet result in higher COGS and lower gross profit.
Lower cost units transferred to COGS result in higher gross profit.
Companies have a choice in determining the cost of goods sold and the cost of ending inventory.
Three common inventory costing methods are FIFO, LIFO, and average cost.

First-In, First-Out (FIFO)

FIFO assumes that the first units purchased are the first units sold.
Ending inventory reflects the most recently purchased units.

Last-In, First-Out (LIFO)

LIFO assumes that the last units purchased are the first units sold.
Ending inventory reflects the earliest acquired units.

Average Cost

The average cost method calculates the average cost of inventory available for sale.
This average cost is then used to determine COGS and ending inventory.

Financial Statement Effects of Inventory Costing

Three inventory costing methods result in different gross profit amounts.
FIFO generally has the lowest COGS and highest gross profit because it matches older, lower-cost inventory with current selling prices.
Low inflation rates and focus on reducing inventory quantities have minimized the gross profit impact of FIFO in recent years.

Balance Sheet Effects

LIFO inventories can be significantly lower than FIFO inventories during periods of rising costs.
In an inflationary environment, selling older inventory pools can boost gross profit as older, lower costs are matched against current selling prices. This is known as a LIFO liquidation.

Analyst Adjustments

Companies using LIFO for US inventory may need adjustments to convert to FIFO for analysis purposes.
The LIFO reserve (the difference between LIFO inventory and FIFO inventory) is used to make these adjustments.
The following formulas are used for conversion:
- FIFO Inventory = LIFO Inventory + LIFO Reserve
- FIFO COGS = LIFO COGS - Increase in LIFO Reserve

Inventory Turnover and Days Inventory Outstanding (DIO)

Inventory turnover measures how many times a company sells its inventory during a period.
DIO measures the average number of days required to sell the average inventory available for sale.

Interpreting DIO

A high DIO can indicate:
- Slow-moving inventory.
- Inefficient inventory management.
- Potential for obsolescence.
- Difficulties with demand forecasting.

Using Purchase vs. COGS in AP Turnover

Accounts Payable Turnover can be calculated using Purchase or COGS.
Using Purchase is more accurate as it matches the activity that directly impacts accounts payable.
Using COGS is more common because it is readily available and comparable across firms.
COGS is a good proxy for purchase when inventory levels don't fluctuate dramatically.

Cash Conversion Cycle (CCC)

CCC measures the time needed to convert raw materials into cash from a sale.
Components of the CCC include:
- Days Inventory Outstanding (DIO).
- Days Sales Outstanding (DSO).
- Days Payable Outstanding (DPO).
A lower CCC is generally preferable as it indicates quicker conversion of inventory into cash and a more efficient operating cycle.

Factors Influencing CCC

Credit terms offered to customers.
Types of inventory carried and product depth and breadth.
Time period for supplier payments.

Analyzing CCC

Compare trends in CCC over time.
Compare CCC to industry peers with similar business models.

Positive vs. Negative CCC

A positive CCC is common for most firms.
A negative CCC, where a company collects cash from sales before needing to pay suppliers, can be viewed positively.

Improving CCC

Reducing DIO through efficient inventory management.
Shortening DSO by accelerating collection of accounts receivables.
Extending DPO by delaying payments to suppliers.

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Description

This quiz explores the flow of costs related to inventory purchase, the calculation of Cost of Goods Sold (COGS), and the impact on gross profit. It covers key concepts, including the calculation of available goods for sale and the managerial choices influencing inventory costing methods like FIFO and LIFO.