Chapter 6: Inventory Accounting and Cost of Goods Sold

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Sometimes, you know, the most interesting stories in business, they aren't about those like huge successes, you know what I mean?

It's those head -scratching moments that really make you think.

Yeah, for sure.

Like, take Under Armour back in 2016.

Their revenue was climbing like almost 22 percent, which, you know, on the surface sounds fantastic.

Yeah, totally a win, right?

Right.

But then, their stock price, it just tanked.

Oh, wow.

I'm talking a massive 78 percent drop in value in less than a year.

Ouch.

So, like, what was going on there?

What's the story beneath those revenue numbers?

Well, that stock drop is a prime example of how just focusing on top -line growth, it doesn't always tell you the whole story.

Right.

What's interesting here is even though Under Armour was selling more,

their profitability was clearly taking a hit.

Okay.

So, costs must have been rising faster than revenue.

And as we dig deeper, we'll see how inventory and how they were managing it plays a big role in that.

Makes sense.

And that leads us to, well, why we're here today.

You are amazing listeners.

Send us some really interesting material on inventory and the cost of goods sold, you know, the COGS.

Yeah.

Basically, you want to understand what they are, how they work and how they impact a company's bottom line.

Absolutely.

It's crucial stuff.

So, in this deep dive, that's our mission, to give you a clear, practical understanding of these core accounting concepts.

Because remember, it's not just about numbers.

It's about seeing what those numbers tell us about how a business is really running.

Exactly.

And for any company selling physical products, not services, but like Under Armour with their clothes and shoes, these concepts are absolutely essential.

Unlike service businesses, companies dealing with physical goods, you know, merchandisers, they have two key accounts we need to focus on.

Cost of goods sold, which directly affects their profitability on the income statement, and then inventory, which is a major asset on their balance sheet.

Okay.

So, seeing how these two interact is like the key to getting the bigger financial picture.

Got it.

So, let's start by talking about accounting for inventory.

What's the basic flow we need to understand here?

Okay.

Think of inventory as like stuff a company owns and plans to sell, you know, those Under Armour hoodies sitting in their warehouse waiting for a customer.

Okay.

As long as they're just sitting there unsold, they're an asset on the balance sheet.

But when one of those hoodies is sold,

the cost of that specific hoodie moves from the balance sheet, and it becomes an expense on the income statement.

Okay.

And that expense, that's what we call cost of goods sold, caught you just.

This shift from asset to expense, that's how we track the cost of making those sales happen.

All right, that makes sense.

So, let's say Under Armour bought those fleece hoodies, let's say for $30 each, while they're just chilling in the warehouse, they're an asset.

Right.

But then they sell one for, let's say, $50.

Okay.

What's the financial impact of that?

When that sale happens, that $50, that gets recorded as sales revenue on their income statement.

But that $30 Under Armour initially paid for that hoodie, that now becomes part of their cost of goods sold.

And the difference, the $20 between the selling price and what they paid for it, that's their gross profit.

Okay.

This gross profit, you might hear it called gross margin, it's essentially the first level of profit a company makes from selling their stuff before considering all the other costs like marketing and salaries.

Got it.

And looking at Under Armour's financials from 2016,

their balance sheet showed they had inventory valued at like $917 .5 million.

And on their income statement, their QGIS was about $2 ,584 .7 million.

So that's almost $2 .6 billion, representing the cost of everything they sold to get that $4 .83 billion in debt revenue.

And it's interesting because when we talk units of inventory, it's not just about physically counting items at the end of a period, which seems kind of obvious.

But companies also need to determine what they legally own.

Like if Under Armour has some gear in their stores that another company actually owns and Under Armour just gets a cut of the sales, that's called consignment inventory.

Those items wouldn't be on Under Armour's books.

Ah, so they're just helping with the sale, not actually owning the stuff.

What about when goods are being shipped?

When does ownership officially transfer?

It all depends on the shipping terms, specifically FOB, which stands for free on board.

If it's FOB shipping point, ownership transfers from, say, the factory making the hoodies to Under Armour as soon as those hoodies leave the factory's dock.

So Under Armour would count those hoodies as part of their inventory even before they get to their warehouse.

Exactly.

But if it's FOB destination, the factory still owns the goods until they reach Under Armour's warehouse.

It's like ordering something online.

If it's FOB shipping point, once it leaves their warehouse, it's yours, even if it hasn't arrived yet.

Interesting.

So legal ownership is the key factor.

Now there's also this concept of cost per unit.

You mentioned it can get tricky because companies buy inventory at different times and prices.

So how do they handle that?

It's a great question.

Let's say Under Armour buys a bunch of t -shirts in January for $10 each, then more in March for $12.

When they sell one, which cost do they use?

That's where different inventory cost methods come in.

Okay.

So before we dive into those, can you remind us of that basic formula for cod juice?

Of course.

It's beginning inventory, what you have at the start, plus purchases, what you bought during the period, minus ending inventory, what's left at the end, and that equals your cost of goods sold.

What you started with, plus what you added, minus what's left, equals what you sold.

Makes sense.

The material you shared also talked about periodic and perpetual inventory systems.

What's the difference there?

In a periodic system, companies aren't constantly tracking their inventory.

Instead, they mainly track their purchases.

And then at the end of, say, a month or a year, they do a physical count of what's left.

They use that count, their purchase records, and the beginning inventory in that cod juice formula to figure out what they sold.

So it's like taking a snapshot at the end.

What about perpetual?

Perpetual is much more sophisticated.

They use tech, like barcode scanners and software, to constantly update inventory levels.

Every time they receive inventory, it's scanned and added to the system.

And when something's sold, it's scanned at checkout, and the system instantly updates everything.

Sales, cod GS, inventory, it's happening in real time.

Wow, that's much more efficient.

It is.

What are the advantages of that?

Big ones are real -time tracking, so companies always know what they have, and that helps them with purchasing and production decisions.

It's also great for catching errors.

If a physical count doesn't match the system, something's off.

And unfortunately,

it can help spot theft or spoilage much faster.

Because of all this, and because technology is so accessible now, most businesses, especially big retailers like Under Armour, they use perpetual systems.

Totally.

So in a perpetual system, you're constantly recording inventory stuff.

What entries happen when a sale happens?

Two entries happen at the same time.

First, they record the sale itself.

They debit either cash, if it was a cash sale, or accounts receivable, if it was on credit, and they credit sales revenue for the selling price.

Second, they update inventory.

They debit cost of goods sold for what that inventory actually cost them, and credit the inventory account to reduce its balance by that same cost.

Got it.

So the income statement and balance sheet are updated together with each sale.

Now when a company buys inventory, the cost isn't always just the sticker price they paid the supplier, right?

What else gets included?

That's right.

The cost of inventory includes everything they spent to get that inventory ready for sale.

It starts with the purchase price, obviously, but it also includes things like freight in, that's the cost of shipping it from the supplier to their warehouse, plus any insurance cost for the goods while they're in transit.

Also import duties, if applicable, taxes, except for sales tax, which is an inventory cost, and any handling fees.

But there are also things that reduce the cost, like purchase returns if goods are damaged and sent back,

or allowances, price reductions from the supplier for minor problems, and discounts for paying early.

All of this together determines the actual cost of their inventory.

It's all those costs up to the point where it's ready to be sold.

What about costs that happen after that, like advertising, or salaries for salespeople, or the cost of shipping an online order to a customer, are those part of inventory cost too?

No.

Those are considered selling or operating expenses.

Once the inventory is ready to go, costs for marketing, selling, and distributing those goods, those are recorded as expenses on the income statement when they happen.

They're not added to the inventory value.

That distinction is important for calculating their true profit.

Okay, makes sense.

So now we understand how inventory is accounted for and what costs are included.

Let's get into those inventory cost methods.

That's where things get a bit more complex, right?

Yeah, definitely.

And the choice of method can significantly impact their reported profits, their taxes, even their cash flow.

There are four main methods.

Specific identification,

average cost, FIFO, that's first in, first out, and LIFO, last in, first out.

Companies really need to consider which one reflects their business and the type of inventory they have.

Okay, let's start with specific identification.

When would a company use that?

Specific identification is for unique, high -value items where you can track the exact cost of each individual piece.

Think cars, each one has a unique VIN and purchase price.

Or high -end furniture, custom jewelry, or even real estate.

Like a shop selling vintage guitars, they'd know exactly how much they paid for each guitar.

When they sell one, they match that specific cost to the cost of goods sold.

So the rest of their guitars are valued at their original purchase prices.

Makes sense for things that are easily identifiable and valuable individually, but you're saying it's not practical for everything.

Right.

Imagine a grocery store trying to track the cost of every can of soup or bag of chips.

Yeah, good point.

For companies with tons of identical low -cost items, they use those other methods that make assumptions about how inventory flows instead of tracking each item individually.

Okay, let's use that Under Armour t -shirt example you mentioned before to show the differences between those.

Can you remind us of the details?

Sure.

Let's say this Under Armour Outlet store starts the month with 10 t -shirts in their beginning inventory, each costing $10.

During the month, they make two purchases.

First they buy 25 more t -shirts at $14 each, and later another 25 at $18 each.

So they've got 60 t -shirts available to sell, with a total cost of $900.

By the end of the month, they sold 40, leaving 20 in their ending inventory.

The question is, how much was their cost of goods sold for those 40 t -shirts, and how much is their ending inventory worth under each method?

Got it.

Let's start with average cost.

How do they figure that out?

Average cost is pretty straightforward.

You calculate a new average cost per unit after each purchase.

You take the total cost of goods available, the $900,

and divide it by the total number of units, the 60 t -shirts.

In this case, that average cost is $15 per t -shirt.

It levels out the cost differences.

Then how do we get the CODGS and ending inventory?

For CODGS, multiply the number of units sold, 40 t -shirts.

By the average cost, $15.

So CARGS is $600.

And ending inventory is the number of units left, 20 t -shirts, times that same average cost, $15, giving you $300.

Okay, so it's pretty simple.

What about FIFO?

FIFO, first in, first out, assumes that the first units they bought are the first ones they sell.

Like a grocery store, they sell the oldest produce first to avoid waste.

So for those 40 t -shirts, we assume they sold all 10 from the beginning inventory at $10 each.

Okay.

Then all 25 from that first purchase at $14 each, and then five more from the second purchase at $18 each to reach $40 sold.

Got it.

So how do we calculate the CODGS with FIFO?

Add up the costs of those units, 10 units times $10,

plus 25 units times $40, plus five units times $18.

That comes to $540 for the cost of goods sold.

And what about the 20 t -shirts left over?

Since the first ones in are the first ones out, the remaining 20 would be from the most recent purchases.

In this case, the last 20 from that second purchase at $18 each.

Okay.

So ending inventory is 20 units times $18, which equals $360.

Notice how the ending inventory value under FIFO reflects the most recent costs.

Okay, that makes sense.

Now, LIFO, last in, first out, is the opposite, right?

Right.

LIFO assumes the last ones in are the first ones sold.

So we assume they sold all 25 from the second purchase at $18 each, then 15 from the first purchase at $14 each to reach our $40 sold.

So how do we calculate CODGS with LIFO?

Add up those costs, 25 units times $18, plus 15 units times $14, and that gives us $660 for the cost of goods sold.

Okay.

And what about the ending inventory?

Since the last ones in are the first ones out, the remaining 20 would be from the oldest inventory.

That means all 10 from the beginning inventory at $10 each, and then 10 from that first purchase at $14 each.

Got it.

So ending inventory is 10 units times $10,

plus 10 units times $14, which equals $240.

Under a LIFO, the ending inventory uses those older costs.

So same sales and purchases, but different methods give us different numbers for both CODGS and ending inventory.

That's pretty interesting.

Now I remember reading that using LIFO can sometimes be good for taxes.

Yes.

In the U .S., if a company uses LIFO for their taxes, the IRS makes them use it for their financial reporting too.

So the method they pick can directly impact their taxes.

When costs are going up, like in our t -shirt example where prices rose from $10 to $18,

LIFO usually means a higher CODGS, and a higher CODGS leads to lower taxable income, and that means lower taxes.

So it's good for taxes when prices are rising.

Why wouldn't everyone just use LIFO all the time then?

Well, there are a few reasons.

First, LIFO can backfire if costs go down.

In that case, it could lead to higher taxable income.

And also, LIFO might not always show the most accurate value of their ending inventory on the balance sheet, especially if prices have been rising for a long time.

In our example, the $240 ending inventory under LIFO uses those old costs, $10 and $14,

while the $360 under FIFO reflects those newer, more expensive t -shirts.

Right, so the balance sheet might not be showing the most current value of the inventory if a company uses LIFO.

The material also talked about how FIFO and LIFO measure CODGS and ending inventory differently.

What should we remember about that?

For measuring CODGS, LIFO is often seen as better at matching current costs with current revenue, especially when prices are rising.

Because it uses the most recent, probably more expensive, costs, it gives a more up -to -date picture of CODGS.

But for ending inventory, FIFO is usually better because it uses the most recent costs, giving a more accurate value.

Okay, so LIFO is good for the income statement, FIFO for the balance sheet.

You got it.

In times of inflation,

FIFO might show a higher profit, but it could be misleading because it's based on selling things that were cheaper to buy than they are now.

So LIFO income might be a more realistic view of their profit in that situation.

LIFO focuses on matching costs, while FIFO shows a more current value of what they have.

Now can companies use LIFO strategically to manage how much profit they report?

Definitely.

Since LIFO's CODGS is based on the most recent purchases,

managers can influence net income by timing when they buy inventory, especially near the end of a period.

For example, if costs are going up and they want to report lower income to pay less in taxes,

they could buy a lot of expensive inventory right before the year ends.

That bumps up their CODGS and lowers their net income.

Or if they want to show higher income, they might wait to buy that expensive inventory until the next year starts.

This can even lead to something called LIFO liquidation.

LIFO liquidation?

What's that?

It's when a company sells more inventory than it buys, and their ending inventory drops below what they had before.

They end up having to use some of their older, cheaper inventory to calculate CODGS.

This makes their CODGS lower and their net income higher, but it could also mean higher taxes.

It can boost profits temporarily, but it's not always good, especially if they're trying to minimize taxes in the long run with LIFO.

So it can make their profits look better than they really are.

The material also mentioned how other countries view LIFO.

Yes, it's important to know that LIFO is allowed under US GAAP, but it's not allowed under International Financial Reporting Standards, IFRS, which many other countries use.

So big US companies with operations in those countries often have to use a different method, like FIFO or average cost, for those parts of their business.

This can make things complicated when they try to combine their financials or compare performance across different parts of the company.

Okay, we've covered the four main inventory methods.

Now what about the general accounting principles in the US that relate to inventory?

What are the key things to remember?

A few principles are really important here.

Consistency, disclosure,

and representational faithfulness.

Let's start with consistency.

What does that mean for inventory?

Consistency means that once a company picks a method, like FIFO or LIFO, they should stick with it from one period to the next.

This makes it easier to compare their financials over time.

Makes sense.

So Under Armour should keep using FIFO if that's what they chose.

Exactly.

And if they do switch methods, they have to explain why in their financial statements and show how it changed the results.

That brings us to disclosure.

Right, disclosure.

What's that all about?

Disclosure is about transparency.

Companies have to include enough info in their financial statements so that outsiders, like investors and creditors, can understand their financial health.

This means they have to say which inventory methods they're using and also explain any Big events or transactions that could significantly affect their inventory value.

The goal is to provide relevant and accurate information.

And representational faithfulness, that's about making sure the numbers are accurate, right?

Right.

It means the financial information should reflect what's really happening in the business.

For inventory, this means the inventory value on the balance sheet and the COGS on the income statement should be as close as possible to the actual costs and flow of goods given the method they're using.

The information should be complete, unbiased, and without any major errors.

These principles all make sense.

Now, the material mentioned the lower of cost or market rule, or LCM, what's that for?

The LCM rule is for when the value of inventory drops below what the company originally paid for it.

Okay.

This could happen if it becomes obsolete, gets damaged, or if people just aren't buying it anymore.

LCM says they have to report their inventory on the balance sheet at either its original cost, or its current market value, whichever is lower.

It's basically preparing for a potential loss.

So let's say Under Armour bought winter coats for three million dollars, but now they can only sell them for two million dollars.

What happens?

In that case, they'd have to write down the value of those coats from three million dollars to two million dollars on their balance sheet.

That one million dollar difference also gets added to their congis on the income statement, which reduces their profit.

It's like acknowledging that their inventory isn't worth as much anymore.

What if the opposite happened?

They bought shoes for two million dollars, but now they could sell them for three million dollars.

Would they increase the value?

LCM only works one way.

They only write down the value if it drops.

If it goes up, they don't adjust anything.

This is called conservatism in accounting.

They're more cautious about potential losses than potential gains.

Makes sense.

There was also something about differences between US GAAP and IFRS on how market value is defined and whether they can reverse these write downs later.

Yes, that's important to remember.

In US GAAP, market value can mean slightly different things depending on the inventory costing method.

For companies using LIFO, it's usually the current replacement cost.

For others, and under IFRS, it's typically the net realizable value, which is how much they think they can sell it for, minus any cost to finish and sell it.

Another difference is whether they can undo a write down.

Under US GAAP, generally they can't, but under IFRS, they might be able to if the reason for the write down is gone, although only up to the original amount.

This can make reported income more volatile for companies using IFRS.

Good to know.

So we understand how inventory is accounted for and valued.

How do we analyze a company's inventory management and efficiency?

What should we look at?

Analyzing inventory is crucial to understand how well the company is managing this big asset and how efficiently they're generating sales.

Two key metrics are gross profit percentage and inventory turnover.

Okay, let's start with gross profit percentage.

How's that calculated and what does it tell us?

You calculate it by taking gross profit, that's sales revenue minus COGS,

and dividing it by net sales revenue.

This tells you what portion of each dollar of sales is left after covering the direct costs of making or buying the goods they sold.

A higher percentage generally means they're more profitable.

Remember how Under Armour's gross profit percentage went down from 2014 to 2016?

That suggested their costs were rising faster than their sales.

Right, and even though their total gross profit went up, the fact that the percentage was shrinking was a warning sign.

It contributed to that stock price drop.

Absolutely.

Even a small change in the gross profit margin when you're talking about huge sales volumes can really impact their overall profit.

It's also helpful to compare Under Armour's percentage to a competitor like Nike, which had a very similar percentage that year.

It helps you see how they're doing relative to others in the industry.

Right, so gross profit percentage tells us about the profitability of each sale.

Now what about inventory turnover?

Inventory turnover measures how many times a company sells and replaces its average inventory in a year.

You calculate it by dividing COGS by the average inventory balance during that period.

A higher turnover usually means they're selling their inventory quickly, which is usually good.

A lower turnover might mean things are sitting around too long, costing the money to store, and possibly becoming obsolete.

What about Under Armour's inventory turnover?

It was 3 .12 times in 2015, and then dropped slightly to 3 .04 times in 2016.

This means it took them a bit longer to sell their inventory in 2016.

There's another metric called Days Inventory Outstanding, or DIO.

This tells us how many days on average it takes to sell their inventory.

It's calculated as 365 divided by inventory turnover.

For Under Armour, their DIO increased from 117 days in 2015 to 120 days in 2016.

A consistently low turnover rate might signal problems.

So comparing Under Armour to Nike, how did their inventory turnover look in 2016?

Nike had a turnover of 3 .79 times, which translates to a DIO of 96 days.

So even though their gross profit percentages were similar, Nike was selling their inventory much faster than Under Armour.

So even in the same industry, there can be big differences in how efficiently they're managing their inventory.

Now, the material you sent talked about a cost of goods sold, COGS, model for making management decisions.

How does that work?

The COGS model, remember, it's beginning inventory plus purchases equals cost of goods available, then cost of goods available minus ending inventory equals cost of goods sold.

It helps managers understand the relationship between all those inventory pieces and how they affect their card GS and profit.

It gives them a framework for managing inventory and its cost.

We saw an example with that Under Armour outlet store where their profit was lower because they were discounting things.

How would a store manager actually use this model?

One way is for planning and budgeting their purchases.

Let's say the manager has a sales forecast, a target for their ending inventory, and they know what their beginning inventory is.

They can use the model to figure out how much more they need to buy to reach their goals.

Okay.

You just rearrange the basic card GS formula to solve for purchases.

They can estimate their card GS based on their sales forecast and how much those goods typically cost.

This helps them avoid running out of stock or having too much inventory sitting around.

It's all about finding that balance.

The material also mentioned using the gross profit method to estimate inventory if, say, there's a fire.

How does that work?

If they can't physically count their inventory, like after a fire, they can use their historical gross profit percentage to estimate.

They start with their beginning inventory and add the cost of any purchases made before the fire.

That gives them the total cost of goods available for sale.

Then they take their sales revenue up to that point and multiply it by their historical cost of goods sold percentage, which is 100 % minus their gross profit percentage.

That gives them an estimated cost of goods sold.

Then they subtract that estimated cost from the total cost of goods available to get an estimate of the inventory they likely had at the time of the fire.

It's like using their past profitability to guess their current inventory level.

Pretty clever.

Now, the last big topic is about what happens if they mess up their inventory count.

Errors in ending inventory can really mess up their financial statements.

So if they overstate their ending inventory, what happens?

If they say they have more inventory left than they really do, it makes their cost of goods sold look lower, which then makes their profit look higher than it actually is.

And the opposite happens if they understate their ending inventory.

So a mistake in counting can really distort their profit for that year.

What about the following years?

Does the error just disappear?

It's interesting.

These errors kind of balance themselves out over two years.

Whatever your ending inventory is for one period, that becomes your beginning inventory for the next.

So if you overstate your ending inventory in year one, you'll overstate your beginning inventory in year two, which will make your profit look lower in year two.

The total profit over those two years ends up being correct, but the profit for each individual year is wrong.

So even though it balances out eventually, it messes things up in the short term.

So to sum up, what's the most important takeaway for our listeners, both in terms of Under Armour and any company that deals with inventory?

The key takeaway is that really understanding inventory counting and the CoGS model is so for understanding a company's profitability, efficiency, and overall financial health.

Like we saw with Under Armour, even with strong sales growth, problems with costs and inventory management can seriously affect their profitability and ultimately hurt their value.

Yeah, sales aren't everything.

It's the cost behind those sales and how well they manage their resources that really matters.

Exactly.

And the choice of inventory costing method, consistently applying accounting principles like LCM and carefully looking at ratios like gross profit percentage and inventory turnover.

Those are all essential.

This applies to managers making decisions and also to investors evaluating a company.

These accounting concepts tell a real story about how a business is doing.

Right.

It's more than just numbers.

So thinking about all the different inventory costing methods, the importance of accurate valuation and those key metrics we discussed, what questions would you now ask when looking at a company's financials, especially one that sells physical products?

It's worth looking at the footnotes in those statements to see what methods they're using and how their inventory and related costs have been changing.

Those details can reveal a lot more than just the headline numbers.

Well, thanks for taking this deep dive with us into inventory and cost of goods sold.

We hope you have a clearer understanding of these concepts now.