Accounting for merchandise inventory

The accounting for merchandise inventory is primarily concerned with determining the cost of goods sold and the ending merchandise inventory. As stated previously, the cost of goods sold is important because it is usually the largest expense on the income statements of merchandising companies. For example, Wal-Mart, the largest retailer in the world, uses approximately 77 percent of its sales revenue just to cover its cost of goods sold. This means, for Wal-Mart, approximately \$.77 of every dollar received from customers is used to pay for the products sold to them. Since Wal-Mart's cost of goods sold is approximately 77 percent of its sales revenue, Wal-Mart must cover all its operating expenses and income taxes expense from less than the remaining 23 percent in order to generate any net income for owners. Fortunately, Wal-Mart's sales revenue was so large (\$345 billion) it was able to cover its cost of goods sold, operating expenses, and income taxes expense and still result in net income of \$11 billion in the year ended January 31, 2007.

The cost of ending merchandise inventory is important because it is usually one of the largest assets on merchandise companies' balance sheets. In the case of Wal-Mart, for example, merchandise inventory (\$34 billion) was approximately 23 percent of the company's total assets on January 31, 2007.

Determining the cost of goods sold and ending merchandise inventory is quite easy when a company's unit costs do not change. For example, if unit costs do not change, the cost of goods sold is simply the number of units sold multiplied by the cost per unit. Similarly, the cost of ending inventory is simply the number of units on hand multiplied by the cost per unit. When unit costs change over time, however, determining the cost of goods sold and the cost of ending merchandise inventory are not so simple.

Consider the information shown below. The company began December operations with 20 units of inventory on hand, each unit of which cost the company \$18. The company purchased an additional 30 units at \$16 each on December 4 and 50 units at \$15 each on December 17. Thus, the company's costs per unit decreased in December from \$18 per unit to \$15 per unit. When its 20 beginning inventory units were combined with its 80 purchased units (30 + 50), the company had 100 units it could have sold to its customers in December. The company sold 70 units in December, 25 units on December 6 and 45 units on December 24.

Which unit costs should be used in determining the cost of goods sold in December (70 units)?

Which unit costs should be used in determining the ending merchandise inventory cost (30 units: 100 units available for sale – 70 units sold to customers)?

 Merchandise Inventory December 1 Inventory 20 @ \$18 = \$360 December 4 Purchase 30 @ \$16 = \$480 25 @ ?? December 6  Cost of Good Sold December 17 Purchase 50 @ \$15 = \$750 45 @ ?? December 24  Cost of Good Sold December 30 Inventory 30 @ ??

The difficulties facing the company can be seen by considering the 25 units sold on December 6. There are several alternatives for determining the cost of these 25 units. For example, the cost could be the cost of the 20 units on hand on December 1 plus the cost of 5 units purchased on December 4 (\$440: 20 units x \$18 = \$360 plus 5 units x \$16 = \$80). On the other hand, the cost of the 25 units could be the cost of 25 units purchased on December 4 (\$400: 25 units x \$16 = \$400). It is even possible that the cost of the 25 units could be the cost of 11 units on hand on December 1 plus the cost of 14 units purchased on December 4 (\$422: 11 units x \$18 = \$198 plus 14 units x \$16 = \$224) or any other combination of 25 units and their related costs. The fact is, unless the cost of each individual item sold is known, to determine the cost of goods sold an assumption must be made about which unit costs should be assigned to the units sold to customers.

In business there are several different methods of determining the cost of goods sold and ending inventory when unit costs are changing. Two methods commonly used by companies are first-in, first-out (FIFO) and last-in, first-out (LIFO).

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