cost of goods sold

What Is a Weighted Average?

Most people know how to do a simple average, but have trouble with a weighted average. Weighted averages are all around us, although you may not have realized it. In most classes, your grade is calculated using a weighted average. Not all assignments count the same when calculating your final grade. Some assignments count more than others. Your professor is giving more weight to tests than to homework. Your final exam might have more weight than a regular exam.

In accounting, weight is given based on the number of units. Say we sold two units last month, one was $100 and one was $500. What is the average cost? $500 + $100 = $600 / 2 = $300. How would the average change if we sold two units at $100 and one at $500? The average would be closer to $100 because there are two units pulling the average down. $500 + $100 + $100 = $700 / 3 = $233.33. We gave more weight to the $100 units because there were more of them.

When dealing with large numbers of units, rather than adding them up individually, we can calculate the total cost of the units and divide by the total number of units. What if we had 20 units at $100 and 10 units at $500. You might notice that the ratio of $100 units to $500 units is still the same (2:1). Let’s do the calculation to confirm that the weighted average will be the same.

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The total cost of all the units is $7,000 and there are 30 units. Divide $7,000 by 30 and the weighted average is $233.33.

Weighted Average Periodic

Weighted average periodic is probably the easiest of all the inventory methods. Since the calculation is done at the end of the period, we figure out the total cost of goods available for sale and divide by the number of units. It is helpful to separate the purchases from the sales.

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Goods available for sale is 415 units with a total cost of $3,394.00. If we divide $3,394.00 by 415, we get a weighted average cost of $8.18 (rounded) per unit. The rest of the calculation is very simple at this point. The company sold 245 units. We will use $8.18 as the cost of each unit, therefore the total cost of goods sold is $2.004.10. There are 170 units remaining in ending inventory (415 – 245). We will use $8.18 as the cost of those units as well which gives is an ending inventory balance of $1,390.60.

If we add cost of goods sold and ending inventory, the total is $3,394.70. Because we rounded up when calculating cost per unit, we should expect our total to be a bit higher than goods available for sale. When doing weighted average, always make sure to tie back to goods available for sale.

Weighted Average Perpetual

If weighted average periodic is the easiest of all the methods, weighted average perpetual is the hardest. It is not that the method is hard, it is just annoying because you must calculate a new weighted average cost for each sale, based on the units available for sale at that time. When doing weighted average perpetual, do not separate the purchases and sales.

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Perpetual inventory systems require cost of goods sold to be calculated each time there is a sale. Therefore, at the time of each sale, we must calculate the weighted average cost of the units on hand at the time of the sale. On January 7, the company sold 100 units. We must calculate the average cost of the 225 units on hand as of that date.

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We calculate the average cost by taking total cost divided by the number of units on hand. This gives us a weighted average cost of $8.03 per unit. Does this make sense? The simple average would be $8.05, but there are twice as many units at $8.00, so the weighted average should be closer to $8.00 than it is to $8.10. Doing a mental check to make sure your numbers make sense is a great habit to start!

Now we can calculate the cost of the sale by taking the average cost per unit multiplied by the number of units sold.

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Next, calculate the value of the remaining units. There are 125 units left. We will assign $8.03 per unit because that is the weighted average cost of those units on January 7. We will use this figure in the calculation for January 17. For the sale on January 17, we need to do another weighted average calculation.

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Add the 50 units purchased on January 12 to the 125 units remaining and calculate the total cost of all those units. Then divide cost by the total number of units. The weighted average cost on January 17 is $8.09. The inclusion of the units costing $8.25 increased the weighted average cost slightly. Using $8.09 as the unit cost, calculate the cost of the sale.

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Cost of goods sold for the January 17 sale is $525.85.

One more sale on January 31, so we need to do this calculation one more time. Start with the remaining units at $8.09 then add in the additional purchases.

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Cost of goods sold for the January 31 sale is $660.80.

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We can now calculate total cost of goods sold for the month of January by adding cost of goods sold for each sale.

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The value of ending inventory is the number of units remaining multiplied by the average cost at the time of the last sale, in this case $8.26. Add cost of goods sold and ending inventory to see if it matches goods available for sale. In this case, there was some rounding so things may not be exact.

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Be patient when doing weighted average, especially under the perpetual method. Tie back to goods available for sale to ensure you did your calculations correctly. Do a quick mental check to make sure your weighted average cost per unit makes sense. If you take a few seconds to do these things, you will greatly increase the chance that your calculations are correct.

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Weighted Average Inventory Calculation

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Last-in, first-out (LIFO) is an inventory method popular with companies that experience frequent increases in the cost of their product. LIFO is used primarily by oil companies and supermarkets, because inventory costs are almost always rising, but any business can use LIFO. Remember, there is no correlation between physical inventory movement and cost method.

To visualize how LIFO works, think of one of those huge salt piles that cities and towns keep to salt icy roads. The town gets a salt delivery and puts it on top of the pile. When the trucks need to be filled, does the town take the salt from the top or bottom of the pile? The trucks are filled from the top of the pile. The last delivery in is the first to be used. This is the essence of LIFO. When calculating costs, we use the cost of the newest (last-in) products first.

When costs are rising, LIFO will give the highest cost of goods sold and the lowest gross profit. LIFO will also result in lower taxes than the other inventory methods.

LIFO Using a Periodic Inventory System

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For all periodic methods we can separate the purchases from the sales in order to make the calculations easier. Under the periodic method, we only calculate inventory at the end of the period. Therefore, we can add up all the units sold and then look at what we have on hand.

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We sold 245 units during the month of January. Using LIFO, we must look at the last units purchased and work our way up from the bottom. Start with the 50 units from January 26th and work up the list. We would then take the 90 units from January 22nd, and 50 units from January 12th. That gives us 190 units. We are still 55 short, so we will take 55 from January 3rd.

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The cost of goods sold for the 245 units, using LIFO, is $2,032.00. Now we need to look at the value of what is left in ending inventory. We have 20 units left from the January 3rd purchase and all the units from beginning inventory.

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Gross profit (sales less cost of goods sold) under LIFO is $2,868.00. Under LIFO, our cost of goods sold is higher than it was under FIFO and our ending inventory is lower than under FIFO. Gross profit is lower under LIFO than FIFO, which would result in lower income taxes because overall profit would be lower.

Adding cost of goods sold and ending inventory gives us $3,394.00 which ties back to goods available for sale. Everything has been accounted for in our calculation.

LIFO Perpetual

Under a perpetual inventory system, inventory must be calculated each time a sale is completed. The method of looking at the last units purchased is still the same, but under the perpetual system, we can only consider the units that are on hand on the date of the sale.

LIFO1

Imagine you were actually working for this company and you had to record the journal entry for the sale on January 7th. We would do the entry on that date, which means we only have the information from January 7th and earlier. We do not know what happens for the rest of the month because it has not happened yet. Ignore all the other information and just focus on the information we have from January 1st to January 7th.

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LIFO means last-in, first-out. Based on the information we have as of January 7th, the last units purchased were those on January 3rd. We will take the cost of those units first, but we still need another 25 units to have 100. Those units will come from beginning inventory.

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The cost of the January 7th sale is $807.50. Now, we can move on to the next sale, updating our inventory figures. There are no units remaining from the January 3rd purchase and 125 left in beginning inventory. Before the January 17th sale, we purchased 50 units on January 12th.

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We need 65 units for this sale. Since we are using LIFO, we must take the last units in, which would be the units from January 12th. Then we would take the remaining 15 units needed from beginning inventory.

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One more sale remaining. Again, we will update the remaining units before considering the sale.

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The company sold 80 units on January 31st. Which units should we use for cost using LIFO? The last units in were from January 26th, so we use those first, but we still need an additional 30. We take those from January 22nd.

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To calculate total cost of goods sold, add the cost of each of the sales.

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You could also add $807.50 plus $532.50 plus $673.00 which also equals $2,013.00.

 

You may have noticed that perpetual inventory gave you a slightly lower cost of goods sold that periodic did. Under periodic, you wait until the end of the period and then take the most recent purchases, but under perpetual, we take the most recent purchases at the time of the sale. Under periodic, none of the beginning inventory units were used for cost purposes, but under perpetual, we did use some of them. Those less expensive units in beginning inventory led to a lower cost of goods sold under the perpetual method. You will also notice that ending inventory is slightly higher. Look at the differences in the units that are left in ending inventory.

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Under perpetual we had some units left over from January 22nd, which we did not have under periodic.

When using a perpetual inventory system, dates matter! Make sure to only consider the units on hand at the time of the sale and work backwards accordingly.

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Calculating Inventory Cost

Inventory costs are constantly changing. Companies must decide how inventory costs will be calculated for the purposes of expensing that inventory when it is sold. There are a number of accepted methods and the method of calculation does not have to match how products actually leave the building. Companies pick a method based on profit and tax objectives. We will look at four methods of calculating costs and the advantages and disadvantages of each method.

Important Terminology

There are a number of important terms that will be used when discussing inventory cost. It is crucial that you know this terminology in order to master this topic. All of these terms can be used to describe a dollar value or a number of units.

Beginning inventory is the amount of inventory a company has at the start of the period. Remember that inventory is an asset and appears on the balance sheet. Purchases are additional units of inventory that have been acquired during the period. If you add beginning inventory and purchases, the total is called Goods Available for Sale. Goods Available for Sale is an important concept because we can use this figure as a check figure when doing calculations.

Goods Available for Sale is the total of all the goods that could have been sold during the period. Some of those units will be sold, which is called Cost of Goods Sold. The items that were not sold are still in inventory. Since it is the end of the period, we refer to this as Ending Inventory. If you add cost of goods sold and ending inventory, it should match the amount in Goods Available for Sale. Whenever you are doing calculations involving inventory, you should make sure you have accounted for everything by adding Cost of Goods Sold and Ending Inventory to ensure it matches Goods Available for Sale.

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Periodic and Perpetual Inventory

The rules for periodic and perpetual inventory methods still apply when we look at cost determination. Remember that under the periodic inventory system, cost of goods sold is determined at the end of the year via an adjusting entry. Therefore, when entering sales entries, inventory and cost of goods sold is not a factor. Companies that use the perpetual inventory system are always updating inventory balances. Every sales transaction includes the entry for cost of goods sold. Therefore, under the perpetual system, we must figure out the cost of inventory for every sales entry.

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What Is a Discount?

We all love discounts, but why would a business offer offer a discount on their products? Typically, a business might offer a discount to increase sales, make an unhappy customer happy or incentivize a customer to pay quickly.

Understanding Payment Terms

Typically when customers purchase inventory, they are not expected to pay cash. The seller extends credit to the buyer, but extending credit comes at a cost for the seller. The seller does not have the cash and therefore must pay its bills from other sources, either cash reserves or borrowing. The seller may lose out on interest earned on cash reserves or possibly even pay interest on loans or lines of credit. In order to decrease the time a receivable is outstanding, a company may offer a discount for fast payment. When a company offers this type of discount, it is listed in the payment terms on the bill:

Payment terms: 2/10, n/30

What does this mean? Well, first notice the comma. That means there are two parts to the payment terms. So let’s look at each part, starting with 2/10. This does not mean that the bill is due on February 10. It means “2% discount if paid in 10 days”. Therefore, if the date of the bill is February 15 and you pay the bill on or before February 25, you get a 2% discount off the balance due. What happens if you don’t pay in the first 10 days? For that, we have to look at the statement after the comma: n/30. The “n” in the statement stands for net. So the statement tells us that the net, or entire, amount is due in 30 days. Taking it all together, the statement is as follows:

Payment terms: If paid within 10 days, we will give you a 2% discount, or you can pay the full balance within 30 days.

Can you see why businesses prefer 2/10, n/30? Takes up a lot less space on a bill. What happens if you don’t pay with bill within 30 days? After 30 days, your payment is now late and the seller can add on late charges or interest, depending on state law.

Let’s look at some examples using payment discounts.

Example #1:

Medici Music purchased instruments to sell in its stores from Whistling Flutes, LLC on August 13. The total purchase was $5,000 with terms 3/10, n/30. Medici paid for the purchase on August 20. Record the necessary journal entries for Medici Music.

The first step is to break down the information. Medici purchased inventory for $5,000 on August 13 and paid the bill on August 20. Looks like we have two transactions. Wait! We are dealing with inventory. Have you realized we are missing something? If not, take a second to see if you can figure it out. <Insert Jeopardy theme here> Is Medici using periodic or perpetual inventory? Remember, we are about to record an entry dealing with the movement or change in value of inventory! I know we are talking about payments here but we are still talking about inventory. That trumps the payment discussion!

We will look at this transaction under both methods so you can see the difference. Before we start looking at each method, let’s start by discussing what is the same under each of the methods. We have two transactions. The first transaction deals with the purchase of the inventory. The second transaction deals with the payment for the instruments already received.

When working with discounts, we generally calculate the discount and record it at the time of payment. Some textbooks may show you two different methods for recording the discount, one in which the discount is recorded at the time of the purchase and one where the discount is recorded at the time of the payment. I prefer the second method. When you record the discount at the time of the purchase and the discount is not taken because the buyer does not pay within the discount window, we must alter the payment entry to undo the discount taken in the first entry. By recording the discount at the time of the payment, we are only recording a discount that has actually been taken and we never need to undo something from the first entry.

Perpetual Inventory

First, we need to record the entry to show the purchase of the inventory.

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Notice that we used Inventory, because under the perpetual method, whenever the value of inventory is changing, we must show that change in the account.

Now let’s look at the second transaction. We are paying off what is owed but we are receiving a discount. We must show the accounts payable fully paid off, so we must debit Accounts Payable for $5,000. How are we paying the balance? With cash, so we must credit Cash for the amount of cash being paid. Because of the discount, the amount will be less than $5,000. If we take 3% of $5,000, we calculate the discount as $150. Therefore, the amount of cash needed to fulfill the obligation is $4,850.

What do we do with the $150? Remember the rules for perpetual inventory. If the value of the inventory is changing, we need to target the inventory account. Is the value of the inventory changing? Currently, we have $5,000 in the Inventory account for this purchase. Did we actually pay $5,000 for the inventory? Well, no, we didn’t. We actually paid $4,850 for the inventory. Therefore, the value of the inventory is not $5,000 but $4,850. We need to reduce the value of the inventory by $150 to reflect the discount received. Now, we have all the information we need to complete the second entry.

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Now the process is complete. The Accounts Payable balance is now zero and the Inventory balance is $4,850 which matches what we actually paid for the inventory.

Periodic Inventory

Under the periodic method, we do not update the value in the inventory account until we do the adjusting entries at the end of the period. Therefore, we should never use the inventory account in purchase transactions for companies that use the periodic method. Instead, we use the purchases account.

Let’s look at the first entry.

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Pretty similar to the perpetual method, except for the use of the purchases account. The second entry will also be similar to the perpetual method, except for one difference. Can you figure out what that difference would be?

We will not be using the Inventory account. Instead we will use an account related to the Purchases account. We do not use the Purchases account because we want to preserve the balance in that account, in case we need to match it up with purchase documents. In order to preserve the original balance in the Purchases account, we will use a contra account. A contra account is an account that is linked to an account but acts in the opposite way. It acts contrary to the account it is linked to. Since Purchases has a normal debit balance, the contra account will have a normal credit balance because it will be used to decrease the value in the Purchases account. The account we will use is called Purchase Discounts (very tricky, huh?). Here is the entry:

DISC4

The Sales Side

So far, we have looked at the purchase side of the transaction. What about the sales side? Let’s look at our original example again. This time, we will look at it from the seller’s perspective.

Example #2:

Medici Music purchases instruments to sell in its stores from Whistling Flutes, LLC on August 13. The total purchase was $5,000 (with a cost of $3,000), terms 3/10, n/30. Medici paid for the purchase on August 20. Record the necessary journal entries for Whistling Flutes, LLC.

When recording sales transactions, we still must be concerned with whether the company uses perpetual or periodic inventory. We will review perpetual inventory first.

Perpetual Inventory

Under the perpetual method, when inventory changes or the value changes, we must record that change. When a business sells merchandise, inventory is leaving the building, therefore the amount and value of the inventory left is changing. There will be two parts to the August 13 entry. The first part will record the sale and increase in an asset (Accounts Receivable). The second part will record the change in Inventory and the cost of the sale. Let’s look at the entry:

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The value of Inventory dropped $3,000, which moves to the income statement as an expense.

Now let’s look at the entry on August 20. This is the date that Whistling Flutes, LLC gets paid in full. However, because of the discount, the Company will not receive the full $5,000. Therefore, we must show the obligation fully paid even though the amount received is less than the amount in Accounts Receivable. The amount of the discount is 3% of $5,000 or $150. The amount of cash received is $4,850. Is Inventory changing? No, the payment on August 20 has no effect on Inventory. We will use a contra account, Sales Discounts, to record the discount amount.

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By using a contra account, the company knows how much its sales were over the course of the year and how much was lost because of discounts and other items. This is good information for managers to have in order to make decisions about the effectiveness of company policy.

Periodic Inventory

How would the entry be different under a periodic system? On the sales side, the only difference is the fact that we would not track the change in inventory at the time of the sale. The rest of the entry is exactly the same. Let’s look at both entries together, since we already discussed the methodology. Again, the only difference is that we do not track the changes in inventory under the periodic system.

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Read Transactions Slowly!

The biggest problem students have with this topic is confusing purchase and sale transactions. I have had students do the problem perfectly, except they give me the journal entries for the purchase when I ask for the sale or vice versa. Spend extra time if needed to make sure that you understand what the transaction actually means. Do not jump right into the entries until you know what is happening in the transaction. Typically, a problem will state which company you should do the entries for. Go back through the transactions to see if the company is the buyer or seller. Sometimes, I will even note that when I am reading the problem. Read the transactions carefully or you may lose a lot of points on a problem you know how to do.

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What is Inventory?

Inventory is an asset account composed of items a company is planning to sell to customers. In financial accounting, we deal primarily with merchandising companies. A merchandiser is a company that purchases products from other companies to sell to customers. There are two major types of merchandisers: wholesalers and retailers. Wholesalers are middlemen. They purchase products from manufacturers and then sell them to retailers. Retailers sell products to the end users, either individual consumers or businesses who will use the product.

Perpetual and Periodic Inventory Systems

Every business that deals with inventory must decide how it will track its inventory. Large retailers and even some small retailers have computer systems which track inventory coming into the business and each item as it is sold. This is called a perpetual inventory system. According to Merriam-Webster, perpetual means “happening all the time or very often.” When a company using perpetual inventory, like Target, gets products shipped to them, all products are scanned into the computer system to let the system know how many units of each product the store has. When items are purchased, the computer system not only records the sale of the product (the revenue), it also records the decrease in inventory. When you purchase a roll of paper towels, the checkout system tells the store there is one less roll of paper towels in inventory.

What if the business doesn’t have a computerized inventory system? It would be very difficult to manually record how many of each item the company has at all times. These businesses use a periodic inventory system. The company tracks the dollar value of purchases and then counts what is left over at the end of the year. If the business knows what it had at the beginning of the year and how much it purchased, this tells the business how much product it could have sold. We call this goods available for sale. When we subtract how much we have left, called ending inventory, from goods available for sale, we can calculate how much we sold. We call this cost of goods sold.

Beginning Inventory + Purchases = Goods Available for Sale – Ending Inventory = Cost of Goods Sold

We call this a periodic system because we only know the exact balances in inventory at the end of each period, usually the end of the year. The business must do an inventory count and do an entry to adjust the inventory account to the proper dollar value. The offset account for this adjusting entry is cost of goods sold.

Does a perpetual inventory system negate the need for a physical count? Absolutely not! All businesses must count inventory at least once a year. There are many reasons why physical inventory would not match the computer records. Theft, damaged goods and cashier error can all cause inventory errors. I worked for a number of retailers in high school and college and each of them did inventory counts multiple times a year to look for inventory errors.

Journal Entries: Purchasing Inventory

We stated earlier that under the perpetual system, changes in inventory are always recorded. Therefore, if inventory levels are changing, either because inventory is increasing or decreasing, we must include the Inventory account in the journal entry. Let’s look at some examples.

Example #1 – Perpetual Inventory

On July 17, ABC company purchases $1200 worth of inventory on account. Record the journal entry for this company, which uses a perpetual inventory system.

Break down this statement. What is happening here? ABC is purchasing inventory, which means it is acquiring or getting inventory. Therefore, the balance in inventory is going up. What is the company exchanging for this inventory? Because the transaction is on account, ABC is not paying for the inventory today. Instead, the company is promising to pay for the inventory in the future. The account we use for that promise is accounts payable. Here is the journal entry:

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Notice we used the inventory account in the journal entry because the company uses the perpetual inventory system. How would this entry be different if we used the periodic system?

Example #2 – Periodic Inventory

On July 17, ABC company purchases $1200 worth of inventory on account. Record the journal entry for this company, which uses a periodic inventory system.

Remember the formula we used to calculate cost of goods sold under the periodic inventory system:

Beginning Inventory + Purchases = Goods Available for Sale – Ending Inventory = Cost of Goods Sold

In order to do this calculation, we must keep purchases separate from inventory. Therefore, we need an account to place those purchases in. We will use an account called Purchases (not very creative, is it?). That is the only difference in the journal entry.

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At the end of the year, we will close out the purchases account to update the balance in inventory after a physical count has been completed. We will discuss that process at the end of this discussion.

Journal Entries: Selling Inventory

In a perpetual inventory system, we must always include inventory in our journal entries when the balance in the account is changing. When we sell inventory to generate revenue, the balance in the inventory account is decreasing. Therefore, we need to add that information to the entry. Let’s look at an example.

Example #3 – Perpetual Inventory

On August 2, ABC company, which uses a perpetual inventory system, sells $1,000 worth of inventory to KLI, LLC on account. The inventory cost ABC $600.

Break down the transaction. What is happening here? ABC sold stuff to another company on account. The stuff ABC sold was purchased for $600. Therefore, ABC has a $1,000 sale and the cost of that sale is $600. First record the sale, then record the inventory adjustment. Here is the journal entry:

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Because the company uses a perpetual inventory system, we not only have to record the sale, we also have to record the change in inventory. Now let’s look at the transaction under a periodic inventory system.

Example #4 – Periodic Inventory

On August 2, ABC company, which uses a periodic inventory system, sells $1,000 worth of inventory to KLI, LLC on account. The inventory cost ABC $600.

When using a periodic inventory system, the company only updates the inventory balances periodically or occasionally. That means that we are not tracking inventory with every journal entry. Inventory is only updated at the end of the period (quarterly or annually). Since we are not constantly tracking the inventory balances, we do not include the change in inventory in our journal entry.

Under periodic inventory, the sales transaction looks just like those we have done previously for service based companies. All we need to do is record the revenue.

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That’s it. Record the revenue and you are done.

Final Thoughts

When working with inventory, it is important to keep the difference between perpetual and periodic straight in your mind.

Under perpetual inventory, we are constantly updating the balance in inventory. Anytime the quantity or value of inventory changes, it must be recorded to the Inventory account. This includes purchasing inventory, selling inventory and transactions related to returns and purchase discounts.

Under periodic inventory, we are only updating the balance in inventory periodically. Therefore, the only time you should use the Inventory account is when doing the adjusting entry to close out the Purchases account. When purchasing or selling inventory, do not use the inventory account. For purchases, use the Purchases account. When selling inventory, only record the sale. Inventory is not part of the transaction.

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