Ifsa Chapter9

CHAPTER 9
INVENTORIES
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COSTS INCLUDED IN INVENTORIES

Costs included in Inventories and
recognized as expenses when
goods are sold:
Costs of purchase, e.g.
- purchase price, net of
discounts
- import duties and taxes
- transport and handling
- insurance during transport
Costs of conversion
Other costs incurred in
bringing the inventories to their
present location and condition
Copyright 2013 CFA Institute
Costs excluded from Inventories

and recognized as expenses in
period incurred:
Abnormal costs incurred as a
result of waste of materials,
labor or other production
conversion inputs
Storage costs (unless required
as part of the production
process)
All administrative overhead
and selling costs
COSTS INCLUDED IN INVENTORIES: EXAMPLE

Assume that during a year, a table manufacturing company
- produced 900,000 finished tables incurring
- raw material costs of 9 million,
- direct labour conversion costs of 18 million, and
- production overhead costs of 1.8 million.
- scrapped 1,000 tables (attributable to abnormal waste) incurring
- raw material costs of 10,000 and
- labor and overhead conversion costs of 20,000.
- spent
- 1 million for freight delivery charges on raw materials and
- 500,000 for storing the finished goods as inventory.
The company does not have any work-in-progress inventory at year end.
What costs should be expensed in the period incurred?
What costs should be included in inventory and expensed when the goods are
sold?

Total costs that
should be expensed
- scrapped 1,000 tables (attributable to abnormal waste)
30,000
incurring
500,000
530,000
- spent
- 1 million for freight delivery charges on raw
materials and
- 500,000 for storing the finished goods as
inventory.
What costs should be expensed in the period incurred?

- scrapped 1,000 tables (attributable to abnormal waste)
incurring
- spent
- 1 million for freight delivery charges on raw materials and
- 500,000 for storing the finished goods as inventory.
Total inventory costs

9,000,000
18,000,000
1,800,000
1,000,000
29,800,000
The company does not have any work-in-progress inventory at

year end.
What costs should be included in inventory and expensed when
the goods are sold?
INVENTORY COST FLOW
Beginning
Inventory
Goods
Purchased
Balance Sheet
Goods
Available
For
Sale
Ending
Inventory
Cost of
Goods Sold
Income Statement
SUMMARY TABLE ON INVENTORY

VALUATION METHODS
Method
Description
Specific Identification
Actual costs of items specifically identified as sold

allocated to COGS.
FIFO (First in-First out)
Assumes that earliest items purchased were sold

first. First in to inventory = first out to COGS.
LIFO (Last In-First Out)*
Assumes most recent items purchased were sold

first. Last in to inventory = first out to COGS.
Weighted Average Cost
Averages total costs over total units available.
*LIFO not permitted under IFRS

INVENTORY VALUATION METHODS: SPECIFIC

IDENTIFICATION
Purchases
100 kg @
110/kg
Goods Available
600 kg @
58,000 total
100 kg @ 110/kg
180 kg @ 100/kg
240 kg @ 90/kg
520 kg @ 50,600
Total =
600 kg @
58,000
Ending inventory
(cost)
200 kg @
100/kg
300 kg @
90/kg
Sales: 520 kg @ 240/kg

Cost of Goods Sold
20 kg @ 100/kg
60 kg @ 90/kg
80 kg @ 7,400
INVENTORY VALUATION METHODS: WEIGHTED AVERAGE

COST
Purchases
100 kg @
110/kg
Goods Available
600 kg @
58,000 total.
AVERAGE
96.667/kg

Cost of Goods Sold
520 kg @
96.667/kg
= 50,267
200 kg @
100/kg
300 kg @
90/kg
Total =
600 kg @
58,000
Ending inventory
(cost)
80 kg @
96.667/kg
= 7,733
INVENTORY VALUATION METHODS: FIFO

Purchases
100 kg @
110/kg
Goods Available
600 kg @
58,000 total
100 kg @ 110/kg
200 kg @ 100/kg
220 kg @ 90/kg
520 kg @ 50,800
Total =
600 kg @
58,000
Ending inventory
(cost)
200 kg @
100/kg
300 kg @
90/kg

Cost of Goods Sold
80 kg @ 90/kg
80 kg @ 7,200
10
INVENTORY VALUATION METHODS: LIFO

Purchases
100 kg @
110/kg
Goods Available
600 kg @
58,000 total
20 kg @ 110/kg
200 kg @ 100/kg
300 kg @ 90/kg
520 kg @ 49,200
Total =
600 kg @
58,000
Ending inventory
(cost)
200 kg @
100/kg
300 kg @
90/kg

Cost of Goods Sold
80 kg @ 110/kg
80 kg @ 8,800
11
INVENTORY VALUATION METHODS: SUMMARY
Inventory Valuation Method

Specific
ID
Weighted
Average Cost
FIFO
LIFO
Cost of sales
50,600
50,267
50,800
49,200
Ending inventory
7,400
7,733
7,200
8,800
Goods available for sale
58,000
58,000
58,000
58,000
Gross profit
74,200
74,533
74,000
75,600
12
PERIODIC AND PERPETUAL INVENTORY

SYSTEMS
Periodic inventory system: inventory values and costs of sales are
determined at the end of an accounting period.
- Purchases are recorded in a purchases account.
- The total of purchases and beginning inventory is the amount of
goods available for sale during the period.
- The ending inventory amount is subtracted from the goods available
for sale to arrive at the cost of sales. The quantity of goods in ending
inventory is usually obtained or verified through a physical count of
the units in inventory.
Perpetual inventory system: inventory values and cost of sales are
continuously updated to reflect purchases and sales.
13

SYSTEMS: EXAMPLE
Cost of Goods Sold Using LIFO valuation method
Perpetual versus Periodic Inventory Systems
Purchased
Units
Jan 100
Cost
Remaining
Units
Units
$110
Apr
July 200
Sold
100
80
$100
Nov
COGS - perpetual
20
220
100
120
COGS
=80@$110 = $8,800
=100 @$100 = $10,000
=$8,800+$10,000=$18,800
14

SYSTEMS: EXAMPLE
Cost of Goods Sold Using LIFO valuation method
Perpetual versus Periodic Inventory Systems
Purchased Sold Remaining
Units Cost Units
Jan
100 $110
Apr
July
COGS -periodic
100
80
200 $100
Nov
Units
20
NA
220
100
120
Goods
available
Ending
inventory
COGS
NA
= 0+ 100 *$110 + 200*$100
=$31,000
= 100 *$110 + 20*$100
= $13,000
= $31,000 - $13,000
= $18,000
15
EFFECTS OF INFLATION OF INVENTORY COSTS

ON THE FINANCIAL STATEMENTS
Costs
FIFO
FIFO:
Earlier,
lower
costs in
COGS
FIFO:
Later,
higher
costs in
inventory
Time
Period end
16
LIFO RESERVE
LIFO reserve is the difference between inventory amount
as reported using LIFO and the inventory amount that
would have been reported using FIFO.
FIFO inventory value - LIFO inventory value = LIFO
reserve.
Companies using the LIFO method must disclose the
amount of the LIFO reserve.
An analyst can use the disclosure to adjust a companys
reported cost of goods sold and ending inventory from
LIFO to FIFO.
17
LIFO RESERVE EXAMPLE: DISCLOSURE

Inventories
Inventories are stated at the lower of cost or market. Cost is principally
determined using the last-in, first-out (LIFO) method. The value of inventories
on the LIFO basis represented about 70% of total inventories at December 31,
2008 and about 75% of total inventories at December 31, 2007 and 2006.
If the FIFO (first-in, first-out) method had been in use, inventories would have
been $3,183 million, $2,617 million and $2,403 million higher than reported at
December 31, 2008, 2007 and 2006, respectively.
Caterpillar Inc. 2008 Annual Report
Note 1. D.
18
LIFO RESERVE EXAMPLE: ADJUST INVENTORY

Caterpillar disclosed: If the FIFO (first-in, first-out) method had been in
use, inventories would have been $3,183 million, $2,617 million and
$2,403 million higher than reported on December 31, 2008, 2007 and
2006, respectively.
Caterpillars balance sheet shows inventories of $8,781 million, $7,204
million, and $6,351 million, at December 31, 2008, 2007, and 2006,
respectively.
Adjust inventory from LIFO to FIFO by adding the amount of the LIFO
reserve to the reported inventory.
31 December ($ millions)
Total inventories as reported (LIFO)
From Note 1. D disclosure (LIFO reserve)
Total inventories adjusted (FIFO)
2008 2007 2006

8,781 7,204 6,351
3,183 2,617 2,403
11,964 9,821 8,754
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LIFO RESERVE EXAMPLE: ADJUST COST OF

GOODS SOLD
$2,403 million higher than reported at December 31, 2008, 2007 and
2006, respectively.
Caterpillars income statement shows Cost of Goods Sold of $38,415
million and $32,626 million for the years ending December 31, 2008
and 2007, respectively.
Adjust Cost of Goods Sold from LIFO to FIFO by deducting the amount
of change in LIFO reserve.
31 December ($ millions)
Cost of goods sold as reported (LIFO)
Less: Increase in LIFO reserve*
Cost of goods sold as adjusted (FIFO)
2008
2007
38,415 32,626
566
214
37,849 32,412
20
LIFO RESERVE EXAMPLE: ADJUST NET

INCOME
Caterpillar disclosed: If the FIFO (first-in, first-out) method had been in use,
inventories would have been $3,183 million, $2,617 million and $2,403 million
higher than reported at December 31, 2008, 2007 and 2006, respectively.
Caterpillars income statement shows net Income of $3,557 million and
$32,626 million for the years ending December 31, 2008 and 2007,
respectively.
Caterpillars effective tax rates were approximately 20% for 2008 and 30% for
2007 and earlier.
Adjust net income from LIFO to FIFO by incorporating the adjustment in Cost
of Goods Sold (COGS), on an after-tax basis.
31 December ($millions )
Net income as reported (LIFO)
Reduction in COGS (increase in operating profit)
2008
3,557
566
2007
3,541
214
Taxes on increased operating profit

Net income as adjusted (FIFO)
113
4,010
64
3,691
21
LIFO RESERVE EXAMPLE: ADJUST LIABILITIES

AND EQUITY
$2,403 million higher than reported at December 31, 2008, 2007 and
2006, respectively.
Caterpillars December 31, 2008 balance sheet shows total liabilities of
$61,171 million, and total equity of $6,087 million.
Caterpillars effective tax rates were approximately 20% for 2008 and
30% for 2007 and earlier.
Adjust liabilities from LIFO to FIFO by incorporating a tax liability for
the amount of accumulated tax savings over the years. Adjust equity
by including the cumulative after-tax gross profits.
Liabilities as reported (LIFO)
Accumulated deferred taxes
Liabilities as adjusted (FIFO)
2008
$61,171
$898
$62,069
Equity as reported (LIFO)
Retained earnings
Equity as adjusted (FIFO)
2008
$6,087
$2,285
$8,372
22
COMPARATIVE RATIOS
Calculate Caterpillars Inventory Turnover, Gross Profit margin, and
Net Profit margin for 2008 under the LIFO and FIFO methods.
Caterpillars 2008 revenues were $48,044 million from machinery
sales and $3,280 from financial products.
Inventory turnover
LIFO
FIFO
4.81
3.47
= 38,415
= 37,849
[(8,781 + 7,204) 2] [(11,964 + 9,821) 2]
Gross profit margin
20.04%
21.22%
= [(48,044 38,415) = [(48,044 37,849)

48,044]
48,044]
Net profit margin
6.93%
7.81%
= (3,557 51,324)
= (4,010 51,324]
23
COMPARATIVE RATIOS
Calculate Caterpillars Current Ratio and Total liabilities-toequity for 2008 under the LIFO and FIFO methods.
In 2008, Caterpillar reported $31,633 million current assets,
$26,069 million current liabilities, 61,171 million total liabilities,
and $6,087 million total equity.
Current ratio
Total liabilities-to-equity ratio
LIFO
FIFO
1.21
1.34
= (31,633 26,069)
= [(31,633 + 3,183)
26,069]
10.05
7.41
= (61,171 6,087)
= [(61,171 +898)
(6,087 + 2,285)]
24
LIFO LIQUIDATION
Units in to
inventory:
Purchase or
Manufacture
Units out of
inventory:
Sales
Inventory
When the number of inventory units manufactured or purchased in

a period exceeds the number of units sold, the LIFO reserve may
increase with each increase in quantity creating a new LIFO
layer.
25
LIFO LIQUIDATION
Units in to
inventory:
Purchase or
Manufacture
Units out of
inventory:
Sales
Inventory
When the number of units sold in a period exceeds the number of

units purchased or manufactured, the costs from older LIFO layers
will flow to COGS (some of the older units held in inventory are
assumed to have been sold), called LIFO liquidation.
26
EXAMPLE: LIFO LAYERS AND LIFO LIQUIDATION

Assume a three year scenario during which a companys
cost of goods increased by $1 per unit each year from $5 to $6 to $7.
priced its goods to achieve a 50% gross profit per unit (i.e. 100%
markup).
In years 1 and 2, the company buys 10,000 units but sells only 9,000
units. In year 3, the company buys 8,000 units, sells 10,000.
27
The ending inventory includes a layer of old costs

at $5 per unit x 1,000 units and another layer of
costs at $6 per unit x 1,000.
28

Units
Beginning inventory
Units purchased
Units sold
0
10,000
9,000
Ending inventory Year 1

Beginning inventory Year 2
Units purchased
Units sold
1,000
1,000
10,000
9,000
Cost per unit
Total costs
$5
$5
$50,000
$45,000
$6
$6
$5,000
$ 5,000
$60,000
$54,000
2,000
$11,000
Beginning inventory Year 3

Units purchased
2,000
8,000
$11,000
$56,000
Units sold
10,000
$7
$67,000
0
In Year 3, the old layers at $5 from Year 1 and
$6 from Year 2 flow to cost of goods sold
29
Year
Revenue
per unit Total revenue
COGS
Gross
profit
Gross
margin
$10
$ 90,000
$ 45,000
$ 45,000
50%
$12
$ 108,000
$ 54,000
$ 54,000
50%
$14
$ 140,000
$ 67,000
$ 73,000
52%
30
INVENTORY ADJUSTMENTS
Inventory is measured and carried on the balance sheet at the lower of
cost of market.
- IFRS:
- Lower of cost or net realizable value
- Subsequent reversals allowed
- U.S. GAAP:
- Lower of cost or market, defined as current replacement cost
subject to upper and lower limits
- Upper limit of market: net realizable value
- Lower limit of market: net realizable value less a normal profit
margin
- Subsequent reversals prohibited
31
The Volvo Group reported:
Total inventories (net of allowance) at year end 2008 and 2007,
respectively, as reported on Balance Sheet: SEK 55,045 million and
SEK 43,645 million.
Cost of sales for 2008, as reported on Income Statement: SEK
237,578
Allowance for inventory obsolescence at year end 2008 and 2007,
respectively, as disclosed in footnote: SEK 3,522 million and SEK
2,837 million
Compare inventory turnover
- Using numbers reported
- Assuming all past inventory write downs were reversed in 2008.
32
The Volvo Group reported:
Total inventories (net of allowance) at year end 2008 and 2007,
respectively, as reported on Balance Sheet: SEK 55,045 million and
SEK 43,645 million.
Cost of sales for 2008, as reported on Income Statement: SEK
237,578
Allowance for inventory obsolescence at year end 2008 and 2007,
respectively, as disclosed in footnote: SEK 3,522 million and SEK
2,837 million
Compare inventory turnover
Inventory Turnover = Cost of Goods Sold/ Average Inventory
Using numbers reported, 4.81 = 237,578 [(55,045 + 43,645) 2]
Assuming all past inventory write downs were reversed, using adjusted
numbers = 4.51 = 236,893 [(58,567 + 46,482) 2]
33
INVENTORY DISCLOSURES: ANALYTICAL

CONSIDERATIONS
Examine changes in inventory ratios relative to sales growth.
- High turnover + sales growth slower than industry: Is the companys
level of inventory adequate?
- High turnover + sales growth same or faster than industry: Probably
indicates efficient inventory management
Examine changes in inventory components relative to other
components and relative to sales growth.
- Significant increase in finished goods inventories while raw materials
and work-in-progress inventories are declining could signify a
possible decline in demand
- Growth of finished goods inventory higher than sales growth could
also signify a possible decline in demand
34
SUMMARY
Total cost of inventories comprises all costs of purchase, costs of conversion,
and other costs incurred in bringing the inventories to their present location
and condition.
The choice of inventory valuation method determines how the cost of goods
available for sale during the period is allocated between inventory and cost
of sales. It affects the financial statements and any financial ratios that are
based on them.
IFRS allow three inventory valuation methods (cost formulas): first-in, firstout (FIFO); weighted average cost; and specific identification.
U.S. GAAP allow the three methods above plus the last-in, first-out (LIFO)
method.
Companies that use the LIFO method must disclose in their financial notes
the amount of the LIFO reserve. This information can be used to adjust
reported LIFO inventory and cost of goods sold balances to the FIFO method
for comparison purposes.
35

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CHAPTER 9

COSTS INCLUDED IN INVENTORIES

Copyright 2013 CFA Institute

Costs excluded from Inventories

COSTS INCLUDED IN INVENTORIES: EXAMPLE

COSTS INCLUDED IN INVENTORIES: EXAMPLE

COSTS INCLUDED IN INVENTORIES: EXAMPLE

Total inventory costs

The company does not have any work-in-progress inventory at

INVENTORY COST FLOW

Copyright 2013 CFA Institute

SUMMARY TABLE ON INVENTORY

Actual costs of items specifically identified as sold

FIFO (First in-First out)

Assumes that earliest items purchased were sold

LIFO (Last In-First Out)*

Assumes most recent items purchased were sold

Weighted Average Cost

Averages total costs over total units available.

*LIFO not permitted under IFRS

INVENTORY VALUATION METHODS: SPECIFIC

Sales: 520 kg @ 240/kg

INVENTORY VALUATION METHODS: WEIGHTED AVERAGE

Sales: 520 kg @ 240/kg

Copyright 2013 CFA Institute

INVENTORY VALUATION METHODS: FIFO

Sales: 520 kg @ 240/kg

Copyright 2013 CFA Institute

INVENTORY VALUATION METHODS: LIFO

Sales: 520 kg @ 240/kg

Copyright 2013 CFA Institute

INVENTORY VALUATION METHODS: SUMMARY

Inventory Valuation Method

Goods available for sale

Copyright 2013 CFA Institute

PERIODIC AND PERPETUAL INVENTORY

Copyright 2013 CFA Institute

PERIODIC AND PERPETUAL INVENTORY

Copyright 2013 CFA Institute

PERIODIC AND PERPETUAL INVENTORY

Copyright 2013 CFA Institute

EFFECTS OF INFLATION OF INVENTORY COSTS

Copyright 2013 CFA Institute

Copyright 2013 CFA Institute

LIFO RESERVE EXAMPLE: DISCLOSURE

Copyright 2013 CFA Institute

LIFO RESERVE EXAMPLE: ADJUST INVENTORY

Copyright 2013 CFA Institute

2008 2007 2006

LIFO RESERVE EXAMPLE: ADJUST COST OF

Copyright 2013 CFA Institute

LIFO RESERVE EXAMPLE: ADJUST NET

Taxes on increased operating profit

Copyright 2013 CFA Institute

LIFO RESERVE EXAMPLE: ADJUST LIABILITIES

= [(48,044 38,415) = [(48,044 37,849)

Copyright 2013 CFA Institute

Total liabilities-to-equity ratio

Copyright 2013 CFA Institute

When the number of inventory units manufactured or purchased in

Copyright 2013 CFA Institute

When the number of units sold in a period exceeds the number of

EXAMPLE: LIFO LAYERS AND LIFO LIQUIDATION