Cost Accounting: Inventory and COGS

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.