Cost of Sales & Inventories

• Accounting for inventory & cost of sales in three types of

firms:
• Merchandising
• Manufacturing
• As both these firms sell tangible goods, their Income
Statement sometimes use the term ‘Cost of Goods Sold’
rather than ‘Cost of Sales’
• Service rendering
• Deals exclusively with ‘cost of sales’
• Inventories often termed as ‘jobs in progress’ or ‘unbilled
costs’ – corresponding to W-I-P in a manufacturing firm;
• Can not have ‘finished goods inventory’.
 Merchandising Company
• Acquisition Cost:
• the invoice cost of the goods purchased plus;
• freight and other carrying costs of bringing the
goods to the point of sale and unpacking the
goods and marking prices on them.
• These later costs may be excluded from
merchandise product costs and reported as
general operating expenses.
• The purchase cost is adjusted for returns,
allowances & cash discounts given by suppliers
 Basic measurement problem of
goods available for sale
How to divide the amounts of goods available for sale between (1) ending inventory & (2)
COGS - As it affects both amount of inventory reported on the B/S & amount of profit
reported on the I/S.
Ending
inventory

Rs. ?
Available Purchase
for sale Rs. 7,400
Rs. 11,400 Cost of goods
sold Rs. ?
Beginning
inventory
Rs. 4,000

Inventory reservoir
 Two Approaches
1. Periodic Inventory Method : Deducing COGS by taking
a physical entry ( a physical count of merchandise is
made)
• Accounting treatment (at the end of the period):
• First the opening inventory is closed to COGS by
debiting the COGS and crediting the opening
Merchandising inventory;
• Then the temporary purchases along with the
purchase returns, carrying costs etc. are closed to
COGS by debiting COGS & Purchase returns and
crediting Purchase & the Carrying Cost;
Accounting treatment (at the end of
the period)………………….
• Now, the remaining physical inventory is
entered as Closing Merchandise Inventory
by debiting Merchandising Inventory and
crediting COGS;

• The COGS will be adjusted the net COGS

will be closed to Income Summary/P&L
Account by debiting the Income Summary
and crediting the COGS Account.
 2. Perpetual Inventory Method
• A record is maintained of each item procured as
inventory item – this record is a subsidiary ledger
account, & merchandise inventory is its control account.

• Purchases are directly entered on this record and also

debited to merchandise Inventory; the off setting credit is
to Accounts Payable or Cash;

• Deliveries of goods to customers are entered on this

record and are credited to Merchandise Inventory; the
offsetting debit is to COGS. The balance in the record at
the end is the ending inventory.
 Perpetual Inventory Method…….

Perpetual Inventory Card

(Assumed that the receipt & issue price of inventory is same)

Date Receipts Issues Balance

Jan Units Unit Total Units Unit Total Units Unit Total
Cost(Rs) (Rs) Cost(Rs) (Rs) Cost(Rs) (Rs)
2 40 100 4,000
12 32 100 3,200 8 100 800
14 70 100 7,000 78 100 7,800
25 56 100 5,600 22 100 2,200
27 2 100 200* 20 100 2,000

* Refers to purchase return

Accounting Entries under Perpetual
Inventory Method
• Here no separate Purchases Account is needed; purchases are
directly debited to Merchandise Inventory.
• For Purchase: Debit Merchandise Inventory & Credit Accounts
Payable/ Cash
• For Issue to Customers: Debit COGS & Credit Merchandise
Inventory
• For Purchase Returns: Debit Accounts Payable & credit
Merchandise Inventory
• In most of the Perpetual Inventory Systems, the carrying cost is not
recorded in the perpetual inventory card – rather is accumulated in a
separate account to be adjusted with COGS.
• Entry: Debit COGS & Credit Carrying cost
• At the end, like Periodic Inventory System, the COGS is closed to
Income Summary by Debiting Income Summary/ P&L A/c &
Crediting COGS.
Periodic vs. Perpetual Approaches
• As per matching concept both the approaches
match COGS with Sales revenue.

• Under Periodic Inventory System, ending

inventory is obtained by a physical count, and
the COGS is obtained by deduction.

• Under Perpetual Inventory System, both

amounts are obtained directly from inventory
records.
 Retail Method
• A variation of the Perpetual method in that the COGS is
determined without taking a physical inventory.
• Purchases are recorded at both their cost and their retail
selling price.
• The gross margin percentage of the goods available for
sale is calculated from these records.
• The compliment of this percentage is applied to the sales
for the period to find the approximate COGS.
• A variation is Gross Profit Method, which applies a
‘normal’ gross margin percentage to the amount of sales
to arrive at an approximation of COGS.
Manufacturing Inventories & Flows
Raw Materials InventoryUsed
Opening Inventory of materials
Add, Purchases (adjusted with returns & carrying cost)
Less, Closing Inventory
Raw Materials Used (As per Periodic Method)
Transferred as W-I-P Inventory

Work In Process Inventory Used

Opening Inventory of W-I-P
Add, Transferred from R-M-I
Add, Conversion Cost
Less, Closing Inventory of W-I-P
Cost of Goods Manufactured
Transferred to Finished Goods Inventory

Finished Goods Inventory Used

Opening Inventory of Finished goods
Add, Transferred from W-I-P
Less, Closing Inventory of Finished goods
Finished goods inventory used for Sales
Considered as COGS in Income Summary
 Accounting for Inventories of
Manufacturing Company
1. Materials Used: Here Materials Inventory A/c is
opened first & all purchases with carrying costs
are transferred by debiting Materials Inventory
A/c and crediting the Purchases and Carrying
Cost A/cs respectively.

Now, after deducting the closing inventory as

per Periodic System, the remaining materials
inventory will be transferred to W-I-P Inventory
by debiting W-I-P Inventory and crediting
Materials Inventory.
 Accounting for Inventories of
Manufacturing Company………..
2. Cost of Goods Manufactured: This can be deduced by
identifying the materials used under the W-I-P and the
conversion cost (the goods completed & transferred to
Finished Goods Inventory).

• The entry for conversion is debiting the W-I-P

Inventory & crediting the Direct & Indirect Labour and
all factory related Expenses.

• After identifying the cost of goods manufactured, the

figure has to be deducted from W-I-P Inventory &
added to Finished Goods Inventory by debiting
Finished Goods Inventory & crediting W-I-P Inventory.
 Accounting for Inventories of
Manufacturing Company………..
3. Cost of Goods Sold: After determining the COGS quantity, an
entry is passed by debiting COGS & crediting Finished goods
Inventory.

• Then the balance of COGS is being transferred to the Income

Summary / P&L A/c by debiting Income Summary & crediting
COGS.

• The journal entries discussed here are as per Periodic Inventory

Method. However, accounting treatment under Perpetual
Inventory Method in a manufacturing concern is known as
‘PRODUCT COSTING SYSTEM’.

• Here cost of each product is accumulated as it flows through

production process – the amounts involved in the journal entries
are directly obtained from the perpetual inventory records.
 Product vs. Period Costs
• Product Cost: Cost included in the cost of producing goods – also referred
to as ‘Inventory Costs’ or ‘Inventoriable Costs’.

• Includes: 1) Materials cost; 2) Costs incurred directly in bringing the product

to its existing condition & location viz. direct labour cost; & 3) part of indirect
cost incurred in bringing the product to its existing condition & location viz.
factory management cost (production overhead).

• To arrive at gross margin, product costs are matched with & subtracted
from the sales revenue in the period in which goods are sold. Product costs
do not have an impact on income until the product has been sold.

• Other items of cost that are matched with revenue in a given accounting
period are called as ‘Period Cost’ identified as ‘Selling, general &
Administrative Expenses’.
 Service Companies
• Service costing is same as in manufacturing firm.

1. Personal service organization: costs do not flow through inventory

accounts - may identify the labour cost of the people directly
providing the service, and supplies costs as elements of ‘cost of
sales’, to distinguish them from office overhead cost.

2. Building Trade Firms & Repairing Business: analogous to

materials inventories in manufacturing firms - materials, when
issued& labour costs of tradespersons are recorded in ‘Job cost
sheet’.

3. Professional Service firms: no materials- only labour product

costs- accounting procedure is similar to the previous one. Client
is billed for job cost, and a mark-up for office overhead & profit.
 Inventory Costing Methods
1. Specific Identification Method: purchase cost of specific item is
identified – associated with big-ticket items viz. automobiles,
paintings, jewelry etc. – accordingly the closing inventory &
COGS is identified.
2. Average Cost Method: average cost of the goods available for
sale is computed & units in both COGS & ending inventory are
costed at this average cost – can be simple as well as weighted
average cost.
3. First In, First Out (FIFO) Method:
4. Last In, First Out (LIFO) Method:
• Although LIFO usually results in lower income taxes, some
companies do not use it because the LIFO conformity rule would
result in their reporting lower net income to their shareholders.
• If the market value of an inventory item is below cost, the item is
reported at its market value.