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1
Module 9
INVENTORIES
COSTS INCLUDED IN INVENTORIES
Costs included in Inventories and Costs excluded from Inventories
recognized as expenses when and recognized as expenses in
goods are sold: period incurred:
• Costs of purchase, e.g. • Abnormal costs incurred as a
- purchase price, net of result of waste of materials,
discounts labor or other production
- import duties and taxes conversion inputs
- transport and handling • Storage costs (unless required
- insurance during transport as part of the production
• Costs of conversion process)
• Other costs incurred in • All administrative overhead
bringing the inventories to their and selling costs
present location and condition
Copyright © 2020 CFA Institute 3
COSTS INCLUDED IN INVENTORIES: EXAMPLE
Assume that during a year, a table manufacturing company preparing its financial
statements in accordance with IFRS:
- 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?
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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 Total costs that
- production overhead costs of €1.8 million. should be expensed
- scrapped 1,000 tables (attributable to abnormal waste) incurring €30,000
- raw material costs of €10,000 and 500,000
- labor and overhead conversion costs of €20,000. €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?
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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,
Total inventory costs
- direct labour conversion costs of €18 million, and
€9,000,000
- production overhead costs of €1.8 million.
18,000,000
- scrapped 1,000 tables (attributable to abnormal waste) incurring
1,800,000
- raw material costs of €10,000 and
1,000,000
- labor and overhead conversion costs of €20,000.
€29,800,000
- 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 included in inventory and expensed when the goods are
sold?
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INVENTORY COST FLOW
Beginning Ending
Inventory Goods
Inventory
Available
Goods For
Sale Cost of
Purchased
Goods Sold
Balance Sheet Income Statement
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SUMMARY TABLE ON INVENTORY
VALUATION METHODS
Method Description
Actual costs of items specifically identified as sold
Specific Identification
allocated to COGS.
Assumes that earliest items purchased were sold
FIFO (First in-First out)
first. First in to inventory = first out to COGS.
Assumes most recent items purchased were sold
LIFO (Last In-First Out)*
first. Last in to inventory = first out to COGS.
Weighted Average Cost Averages total costs over total units available.
*LIFO not permitted under IFRS
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INVENTORY VALUATION METHODS: SPECIFIC
IDENTIFICATION
Sales: 520 kg @ ¥240/kg
Purchases Goods Available Cost of Goods Sold
100 kg @ 100 kg @ ¥110/kg
600 kg @
¥110/kg 180 kg @ ¥100/kg
¥58,000 total
240 kg @ ¥90/kg
520 kg @ ¥50,600
200 kg @
¥100/kg
Total =
Ending inventory
600 kg @
300 kg @ (cost)
¥58,000
¥90/kg
20 kg @ ¥100/kg
60 kg @ ¥90/kg
80 kg @ ¥7,400
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INVENTORY VALUATION METHODS: WEIGHTED
AVERAGE COST
Sales: 520 kg @ ¥240/kg
Purchases Goods Available Cost of Goods Sold
600 kg @
100 kg @
¥58,000 total. 520 kg @
¥110/kg
AVERAGE ¥96.667/kg
¥96.667/kg = ¥50,267
200 kg @
¥100/kg
Total =
Ending inventory
600 kg @
300 kg @ (cost)
¥58,000
¥90/kg
80 kg @
¥96.667/kg
= ¥7,733
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INVENTORY VALUATION METHODS: FIFO
Sales: 520 kg @ ¥240/kg
Purchases Goods Available Cost of Goods Sold
100 kg @ 100 kg @ ¥110/kg
600 kg @
¥110/kg 200 kg @ ¥100/kg
¥58,000 total
220 kg @ ¥90/kg
520 kg @ ¥50,800
200 kg @
¥100/kg
Total =
Ending inventory
600 kg @
300 kg @ (cost)
¥58,000
¥90/kg
80 kg @ ¥90/kg
80 kg @ ¥7,200
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INVENTORY VALUATION METHODS: LIFO
Sales: 520 kg @ ¥240/kg
Purchases Goods Available Cost of Goods Sold
100 kg @ 20 kg @ ¥110/kg
600 kg @
¥110/kg 200 kg @ ¥100/kg
¥58,000 total
300 kg @ ¥90/kg
520 kg @ ¥49,200
200 kg @
¥100/kg
Total =
Ending inventory
600 kg @
300 kg @ (cost)
¥58,000
¥90/kg
80 kg @ ¥110/kg
80 kg @ ¥8,800
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INVENTORY VALUATION METHODS: SUMMARY
Inventory Valuation Method
Weighted
Specific ID FIFO LIFO
Average Cost
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
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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.
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PERIODIC AND PERPETUAL INVENTORY
SYSTEMS: EXAMPLE
Cost of Goods Sold Using LIFO valuation method: Perpetual versus Periodic
Inventory Systems
Purchased Sold Remaining
Units Cost Units Units COGS - perpetual
Jan 100 $110 100
Apr 80 20 =80@$110 = $8,800
July 200 $100 220
Nov 100 120 =100 @$100 = $10,000
COGS =$8,800+$10,000=$18,800
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PERIODIC AND PERPETUAL INVENTORY
SYSTEMS: EXAMPLE
Cost of Goods Sold Using LIFO valuation method: Perpetual versus Periodic
Inventory Systems
Purchased Sold Remaining
Units Cost Units Units COGS -periodic
Jan 100 $110 100
Apr 80 20 NA
July 200 $100 220
Nov 100 120 NA
Goods = 0+ 100 *$110 + 200*$100
available =$31,000
Ending = 100 *$110 + 20*$100
inventory = $13,000
= $31,000 - $13,000
COGS = $18,000
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EFFECTS OF INFLATION OF INVENTORY COSTS
ON THE FINANCIAL STATEMENTS
FIFO
FIFO:
FIFO:
Earlier,
Later,
lower
Costs
higher
costs in
costs in
COGS
inventory
Time
Period end
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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 company’s
reported cost of goods sold and ending inventory from
LIFO to FIFO.
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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 65% of total inventories at December 31,
2018 and 2917.
If the FIFO (first-in, first-out) method had been in use, inventories would have
been $2,009 million and $1,934 million higher than reported at December 31,
2018 and 2017, respectively.
Caterpillar Inc. 2018 Annual Report on form 10-K
Note C.
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LIFO RESERVE EXAMPLE: ADJUST INVENTORY
• Caterpillar disclosed: “If the FIFO (first-in, first-out) method had been in
use, inventories would have been $2,009 million and $1,967 million
higher than reported on December 31, 2018 and 2017, respectively.”
• Caterpillar’s balance sheet shows inventories of $10,022 million and
$10,018 million at December 31, 2018 and 2017, respectively.
• Adjust inventory from LIFO to FIFO by adding the amount of the LIFO
reserve to the reported inventory.
31 December ($ millions) 2018 2017
Total inventories as reported (LIFO) 10,022 10,018
From Note C disclosure (LIFO reserve) 2,009 1,934
Total inventories adjusted (FIFO) 12,031 11,952
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LIFO RESERVE EXAMPLE: ADJUST COST
OF GOODS SOLD
• Caterpillar disclosed: “If the FIFO (first-in, first-out) method had been in
use, inventories would have been $2,009 million and $1,934 million
higher than reported at December 31, 2018 and 2017, respectively.”
• Caterpillar’s income statement shows Cost of Goods Sold of $36,997
million and $31,260 million for the years ending December 31, 2018
and 2017, respectively.
• Adjust Cost of Goods Sold from LIFO to FIFO by deducting the amount
of change in LIFO reserve.
31 December ($ millions) 2018 2017
Cost of goods sold as reported (LIFO) 36,997 31,260
(-Increase) decrease in LIFO reserve* -75 205
Cost of goods sold as adjusted (FIFO) 36,922 31,465
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LIFO RESERVE EXAMPLE:
ADJUST NET INCOME
• Caterpillar disclosed: “If the FIFO (first-in, first-out) method had been in use,
inventories would have been $2,009 million and $1,934 million higher than
reported at December 31, 2018 and 2017, respectively.”
• Caterpillar’s income statement shows gross profit (total sales less cost of
sales) of $17,725 million and $14,202 million for the years ending December
31, 2018 and 2017, respectively.
• Caterpillar’s effective tax rates were approximately 24% for 2018 and 28% for
2017.
• Adjust gross profit from LIFO to FIFO by incorporating the adjustment in Cost
of Goods Sold (COGS), on an after-tax basis.
31 December ($millions ) 2018 2017
Net income as reported (LIFO) 7,822 4,082
Adjustment to COGS for increase/decrease in LIFO
75 -205
reserve
Taxes on adjusted operating profit -18 57
Net income as adjusted (FIFO) 7,879 3,934
Copyright © 2020 CFA Institute 22
LIFO RESERVE EXAMPLE:
ADJUST LIABILITIES AND EQUITY
• Caterpillar disclosed: “If the FIFO (first-in, first-out) method had been in
use, inventories would have been $2,009 million and $1,934 million
higher than reported at December 31, 2018 and 2017, respectively.”
• Caterpillar’s December 31, 2018 balance sheet shows total liabilities of
$64,429 million, and total equity of $14,080 million.
• Caterpillar’s effective tax rates were approximately 24% for 2018 and
28% for 2017.
• Adjust liabilities from LIFO to FIFO by incorporating a tax liability for
the amount of accumulated tax savings over the years. Adjust equity
by including the cumulative after-tax gross profits.
31 December ($millions ) 2018 31 December ($millions ) 2018
Liabilities as reported (LIFO) $64,429 Equity as reported (LIFO) $14,080
Accumulated deferred taxes $560 Retained earnings $1,449
Liabilities as adjusted (FIFO) $64,989 Equity as adjusted (FIFO) $15,529
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COMPARATIVE RATIOS
• Calculate Caterpillar’s Inventory Turnover, Gross Profit margin, and
Net Profit margin for 2018 under the LIFO and FIFO methods.
• Caterpillar’s 2018 revenues were $51,822 million from machinery
sales and $2,900 from financial products.
LIFO FIFO
Inventory turnover 3.43 3.08
= 36,997 ÷ = 36,922 ÷
[(11,529 + 10,018) ÷ 2] [(12,031 + 11,952) ÷ 2]
Gross profit margin 28.61% 28.75%
= [(51,822 – 36,997) ÷ = [(51,822 – 36,922) ÷
51,822] 51,822]
Net profit margin 14.29% 14.40%
= (7,822 ÷ 54,722) = (7,879 ÷ 54,722]
Copyright © 2020 CFA Institute 24
COMPARATIVE RATIOS
• Calculate Caterpillar’s Current Ratio and Total liabilities-to-
equity for 2018 under the LIFO and FIFO methods.
• In 2018, Caterpillar reported $38,603 million current assets,
$28,218 million current liabilities, 64,429 million total liabilities,
and $14,080 million total equity.
LIFO FIFO
Current ratio 1.37 1.44
= [(38,603 + 2,009) ÷
= (38,603 ÷ 28,218)
28,218]
Total liabilities-to-equity ratio 4.58 4.19
= [(64,429 + 560) ÷
= (64,429 ÷ 14,080)
(14,080 + 1,449)]
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LIFO LIQUIDATION
Units in to Units out of
inventory: inventory:
Purchase or Sales
Manufacture
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.”
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LIFO LIQUIDATION
Units in to Units out of
inventory: inventory:
Purchase or Sales
Manufacture
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.”
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EXAMPLE: LIFO LAYERS AND LIFO LIQUIDATION
Assume a three year scenario during which a company’s:
• 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.
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EXAMPLE: LIFO LAYERS
AND LIFO LIQUIDATION
Units Cost per unit Total costs
Beginning inventory 0
Units purchased 10,000 $5 $50,000
Units sold 9,000 $5 $45,000
Ending inventory Year 1 1,000 $5,000
Beginning inventory Year 2 1,000 - $5,000
Units purchased 10,000 $6 $60,000
Units sold 9,000 $6 $54,000
Ending inventory Year 2 2,000 $11,000
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.
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EXAMPLE: LIFO LAYERS
AND LIFO LIQUIDATION
Units Cost per unit Total costs
Beginning inventory 0
Units purchased 10,000 $5 $50,000
Units sold 9,000 $5 $45,000
Ending inventory Year 1 1,000 $5,000
Beginning inventory Year 2 1,000 - $ 5,000
Units purchased 10,000 $6 $60,000
Units sold 9,000 $6 $54,000
Ending inventory Year 2 2,000 $11,000
Beginning inventory Year 3 2,000 $11,000
Units purchased 8,000 $7 $56,000
Units sold 10,000 $67,000
Ending inventory Year 3 0 0
In Year 3, the old layers at $5 from Year 1 and
$6 from Year 2 flow to cost of goods sold
Copyright © 2020 CFA Institute 30
EXAMPLE: LIFO LAYERS
AND LIFO LIQUIDATION
Revenue per Gross
Year unit Total revenue COGS Gross profit margin
1 $10 $ 90,000 $ 45,000 $ 45,000 50%
2 $12 $ 108,000 $ 54,000 $ 54,000 50%
3 $14 $ 140,000 $ 67,000 $ 73,000 52%
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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
- US GAAP:
- For fiscal years beginning after 12.15.2016 inventories measured
using other than LIFO/retail inventory methods are measured at the
lower of cost or net realizable value.
- For inventories measured using LIFO/retail inventory methods, use
market value.
- Subsequent reversals prohibited
Copyright © 2020 CFA Institute 32
INVENTORY ADJUSTMENTS
The Volvo Group reported:
• Total inventories (net of allowance) at year end 2018 and 2017,
respectively, as reported on Balance Sheet: SEK 65,783 million and
SEK 48,287 million.
• Cost of sales for 2018, as reported on Income Statement: SEK
303,478
• Allowance for inventory obsolescence at year end 2018 and 2017,
respectively, as disclosed in note 17: SEK 3,926 million and SEK 3,489
million.
• Compare inventory turnover:
- Using numbers reported.
- Assuming all past inventory write downs were reversed in 2008.
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INVENTORY ADJUSTMENTS
The Volvo Group reported:
• Total inventories (net of allowance) at year end 2018 and 2017,
respectively, as reported on Balance Sheet: SEK 65,783 million and
SEK 48,287 million.
• Cost of sales for 2018, as reported on Income Statement: SEK
303,478
• Allowance for inventory obsolescence at year end 2018 and 2017,
respectively, as disclosed in note 17: SEK 3,926 million and SEK 3,489
million
• Compare inventory turnover
• Inventory Turnover = Cost of Goods Sold/ Average Inventory
• Using numbers reported, 5.32 = 303,478 ÷ [(65,783 + 48,287) ÷ 2]
• Assuming all past inventory write downs were reversed, using adjusted
numbers = 4.99 = 303,041 ÷ [(69,709 + 51,776) ÷ 2]
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INVENTORY DISCLOSURES: ANALYTICAL
CONSIDERATIONS
• Examine changes in inventory ratios relative to sales growth.
- High turnover + sales growth slower than industry: Is the company’s
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.
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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,
first-out (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.
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