Question 1. What Is The Significance Of Fob Shipping Point And Fob Destination?
Accountants report a merchandiser’s and a manufacturer’s revenues when a sale is made. The term, FOB Shipping Point, indicates that the sale occurred at the shipping point—at the seller’s shipping dock. FOB Destination indicates that the sale will occur when it arrives at the destination—at the buyer’s receiving dock.
Accountants also assume that the cost of transporting the goods corresponds to these terms. If the sale occurred at the shipping point (seller’s shipping dock), then the buyer should take responsibility for the cost of transporting the goods. (The buyer will record this cost as Freight-In or Transportation-In.) If the sale doesn’t occur until the goods reach the destination (terms are FOB Destination), then the seller should be responsible for transporting the goods until they reach the buyer’s unloading dock. (The seller will record the transportation cost as Freight-Out, Transportation-Out, or Delivery Expense.)
Question 2. What Is The Cost Of Goods Sold?
The cost of goods sold is the cost of the merchandise that a retailer, distributor, or manufacturer has sold.
The cost of goods sold is reported on the income statement and can be considered as an expense of the accounting period. By matching the cost of the goods sold with the revenues from the goods sold, the matching principle of accounting is achieved.
The sales revenues minus the cost of goods sold is gross profit.
Cost of goods sold is calculated in one of two ways. One way is to adjust the cost of the goods purchased or manufactured by the change in inventory of finished goods. For example, if 1,000 units were purchased or manufactured but inventory increased by 100 units then the cost of 900 units will be the cost of goods sold. If 1,000 units were purchased but the inventory decreased by 100 units then the cost of 1,100 units will be the cost of goods sold.
The second way to calculate the cost of goods sold is to use the following costs: beginning inventory + the cost of goods purchased or manufactured = cost of goods available – ending inventory.
When costs change during the accounting period, a cost flow will have to be assumed. Cost flow assumptions include FIFO, LIFO, and average.
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Question 3. What Is The Cost Of Sales?
Cost of sales is the caption commonly used on a manufacturer’s or retailer’s income statement instead of the caption cost of goods sold or cost of products sold.
The cost of sales for a manufacturer is the cost of finished goods in its beginning inventory plus the cost of goods manufactured minus the cost of finished goods in ending inventory.
The cost of sales for a retailer is the cost of merchandise in its beginning inventory plus the net cost of merchandise purchased minus the cost of merchandise in its ending inventory.
The cost of sales does not include selling expenses or general and administrative expenses, which are commonly referred to as SG&A.
Question 4. What Is The Difference Between Gross Margin And Markup?
Gross margin or gross profit is defined as sales minus cost of goods sold. If a retailer sells a product for $10 which had a cost of $8, the gross profit or gross margin is $2. The gross profit ratio or the gross margin ratio expresses the gross profit or gross margin amount as a percentage of sales. In our example the gross margin ratio is 20% ($2 divided by $10).
Markup is used several ways. Some retailers use markup to mean the difference between a product’s cost and its selling price. In our example, the product had a cost of $8 and it had a markup of $2 resulting in a selling price of $10. The $2 markup is the same as the $2 gross profit. However, the markup percentage is often expressed as a percentage of cost. In our example the $2 markup is divided by the cost of $8 resulting in a markup of 25%. (Some retailers may use the term markup to mean the increase in the original selling. For example, if the $10 selling price was increased to $11 because of high demand and limited supply, they would say the markup was $1.)
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Question 5. What Is The Difference Between Product Costs And Period Costs?
A manufacturer’s product costs are the direct materials, direct labor, and manufacturing overhead used in making its products. (Manufacturing overhead is also referred to as factory overhead, indirect manufacturing costs, and burden.) The product costs of direct materials, direct labor, and manufacturing overhead are also “inventoriable” costs, since these are the necessary costs of manufacturing the products.
Period costs are not a necessary part of the manufacturing process. As a result, period costs cannot be assigned to the products or to the cost of inventory. The period costs are usually associated with the selling function of the business or its general administration. The period costs are reported as expenses in the accounting period in which they 1) best match with revenues, 2) when they expire, or 3) in the current accounting period. In addition to the selling and general administrative expenses, most interest expense is a period expense.
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Question 6. What Is The Gross Margin Ratio?
The gross margin ratio is also known as the gross profit margin or the gross profit percentage.
The gross margin ratio is computed by dividing the company’s gross profit dollars by its net sales dollars.
To illustrate the gross margin ratio, let’s assume that a company has net sales of $800,000 and its cost of goods sold is $600,000. This means its gross profit is $200,000 (net sales of $800,000 minus its cost of goods sold of $600,000) and its gross margin ratio is 25% (gross profit of $200,000 divided by net sales of $800,000).
A company should be continuously monitoring its gross margin ratio to be certain it will result in a gross profit that will be sufficient to cover its selling and administrative expenses.
Since gross margin ratios vary between industries, you should compare your company’s gross margin ratio to companies within your industry. However, you should keep in mind that there can also be differences within your industry. For example, your company may use LIFO while most companies in your industry use FIFO. Perhaps your company focuses its sales efforts on smaller customers who also require special administrative services. In that case, your company’s gross margin ratio should be larger than your industry’s in order to cover the higher selling and administrative expenses.
Question 7. What Is Cost Accounting?
Cost accounting involves the techniques for:
- determining the costs of products, processes, projects, etc. in order to report the correct amounts on the financial statements, and
- assisting management in making decisions and in the planning and control of an organization.
For example, cost accounting is used to compute the unit cost of a manufacturer’s products in order to report the cost of inventory on its balance sheet and the cost of goods sold on its income statement. This is achieved with techniques such as the allocation of manufacturing overhead costs and through the use of process costing, operations costing, and job-order costing systems.
Cost accounting assists management by providing analysis of cost behavior, cost-volume-profit relationships, operational and capital budgeting, standard costing, variance analyses for costs and revenues, transfer pricing, activity-based costing, and more.
Cost accounting had its roots in manufacturing businesses, but today it extends to service businesses. For example, a bank will use cost accounting to determine the cost of processing a customer’s check and/or a deposit. This in turn may provide management with guidance in the pricing of these services.
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Question 8. What Is Absorption Costing?
Absorption costing means that all of the manufacturing costs are absorbed by the units produced. In other words, the cost of a finished unit in inventory will include direct materials, direct labor, and both variable and fixed manufacturing overhead. As a result, absorption costing is also referred to as full costing or the full absorption method.
Absorption costing is often contrasted with variable costing or direct costing. Under variable or direct costing, the fixed manufacturing overhead costs are not allocated or assigned to (not absorbed by) the products manufactured. Variable costing is often useful for management’s decision-making. However, absorption costing is required for external financial reporting and for income tax reporting.
Question 9. How Do You Compute A Selling Price If You Know The Cost And The Required Gross Margin?
To compute the selling price, let’s assume that a product has a cost of $100 and the seller wants to have a 30% gross margin on its selling price, or 30% of SP. The relationship between a selling price, cost, and gross margin or gross profit is: SP – cost = gross profit or gross margin. If the gross margin is 30% of SP, the cost of $100 will be 70% of SP.
Algebra allows us to compute the selling price as follows:
SP – cost = gross margin
SP – $100 = 30% of SP
1SP – $100 = 0.3SP
1SP – 0.3SP = $100
0.7 SP = $100
0.7SP/0.7 = $100/0.7
SP = $142.85.
To verify that a selling price of $142.85 will give us the correct gross margin, we subtract the cost of $100 from the $142.85 selling price. The result is a gross profit of $42.85 which when divided by the selling price gives us the required gross margin of 30% ($42.85/$142.85 ).
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Question 10. How Do I Calculate The Cost Of Goods Sold For A Manufacturing Company?
The calculation of the cost of goods sold for a manufacturing company is: Beginning Finished Goods Inventory + Cost of Goods Manufactured = Finished Goods Available for Sale – Ending Finished Goods Inventory = Cost of Goods Sold.
The formula can be rearranged to read: Cost of Goods Manufactured +/- the change in Finished Goods Inventory = Cost of Goods Sold. If the Finished Goods Inventory decreased, then the amount of this decrease is added to the Cost of Goods Manufactured. If the Finished Goods Inventory increased, then the amount of this increase is deducted from the Cost of Goods Manufactured.
Question 11. What Is Job Order Costing?
Job order costing or job costing is a system for assigning manufacturing costs to an individual product or batches of products. Generally, the job order costing system is used only when the products manufactured are sufficiently different from each other. (When products are identical or nearly identical, the process costing system will likely be used.)
Since there is a significant variation in the products manufactured, the job order costing system will create a job cost record for each item, job or special order. The job cost record will report the direct materials and direct labor actually used plus the manufacturing overhead assigned to each job.
An example of an industry where job order costing is used is the building construction industry since each building is unique. The manufacturers of custom equipment or custom cabinetry are also examples of companies that will keep track of production costs by item or job.
The job cost records also serve as the subsidiary ledger or documentation for the cost of the work-in-process inventory, the finished goods inventory, and the cost of goods sold.
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Question 12. What Are Conversion Costs?
Conversion costs are the combination of direct labor costs plus manufacturing overhead costs.
You can think of conversion costs as the manufacturing or production costs necessary to convert raw materials into products. Expressed another way, conversion costs are a manufacturer’s product or production costs other than the costs of raw materials.
The term conversion costs often appears in the calculation of the cost of an equivalent unit in a process costing system.
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Question 13. How Do You Calculate The Cost Of Carrying Inventory?
The cost of carrying or holding inventory is the sum of the following costs:
- Money tied up in inventory, such as the cost of capital or the opportunity cost of the money.
- Physical space occupied by the inventory including rent, depreciation, utility costs, insurance, taxes, etc.
- Cost of handling the items.
- Cost of deterioration and obsolescence.
Often the costs are computed for a year and then expressed as a percentage of the cost of the inventory items. For example, a company might express the holding costs as 20%. If the company has $300,000 of inventory cost, its cost of carrying or holding the inventory is estimated to be $60,000 per year.
The cost of carrying inventory will vary from company to company. For instance, if a company has a large cash balance with no attractive investment options, has excess space for storage, and its products have a low probability for deterioration or obsolescence, the company’s holding or carrying costs are very low. A company with enormous debt, little space, and products subject to deterioration will have very high holding costs.
For decision making, such as determining the economic order or production quantity, it is important to determine the incremental holding costs for a year. In other words, what will be the additional holding costs expressed as an annual cost for the items being purchased or produced.
Question 14. What Is Gross Profit?
Gross profit is net sales minus the cost of goods sold. (Some people use the term gross margin and gross profit interchangeably. Others use gross margin to mean the gross profit ratio or the gross profit as a percentage of net sales.)
Gross profit is presented on a multiple-step income statement prior to deducting sellling, general and administrative expenses and prior to nonoperating revenues, nonoperating expenses, gains and losses.
To illustrate gross profit, let’s assume that a manufacturer’s net sales are $60,000 and its cost of goods sold (using absorption costing) is $39,000. The manufacturer’s gross profit is $21,000 ($60,000 minus $39,000). The gross profit ratio or gross profit percentage is 35% ($21,000 divided by $60,000).
Question 15. Are Transportation-in Costs Part Of The Cost Of Goods Sold?
Transportation-in or freight-in costs are part of the cost of goods purchased. The cost of goods (or any asset) includes all costs necessary to get an asset in place and ready for use. Transportation-in costs are allocated to the products purchased and will “cling” to the products. Those products in inventory (items not yet sold) will include their share of the transportation-in costs (as part of the inventory cost). The products that have been sold, will include their share of the transportation-in costs (as part of the cost of goods sold).
Transportation-out or freight-out costs are not product costs and are not inventoriable. Transportation-out costs are costs of selling the products and will appear as a selling expense (perhaps as Delivery Expense) in the period in which they occur.
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Question 16. Why And How Do You Adjust The Inventory Account In The Periodic Method?
At the end of an accounting period (month, year, etc.) the inventory account is adjusted so that the balance sheet will report the cost (or lower) of the goods actually owned by the company.
When an adjusting entry is used, the related income statement account will be a cost of goods sold account. An example of such an account is Inventory Change or Inventory (Increase) Decrease.
To illustrate the inventory adjustment, let’s assume that the cost of a company’s actual inventory at the end of the year is $40,000. However, its general ledger asset account Inventory has a debit balance of $35,000. The company’s inventory adjusting entry will 1) debit Inventory for $5,000 and 2) credit Inventory Change for $5,000. [You can think of the $5,000 credit balance in this income statement account as a reduction of the company’s debit balance in its Purchases account. In other words, not all of the purchases should be matched with the period’s sales since we know that the inventory has increased by $5,000.]
Next, let’s assume that another company’s cost of its actual ending inventory is $62,000. However, its inventory account has a debit balance of $70,000. This will require an adjusting entry to 1) credit Inventory for $8,000 and 2) debit Inventory Change for $8,000. The $8,000 debit in this income statement account will be an addition to the cost of the goods purchased. In other words, not only was it necessary to match the cost of purchases with sales, it was also necessary to match the additional $8,000 of cost that was removed from inventory.
Textbooks often change the balance in the account Inventory (under the periodic method) through closing entries. (One closing entry removes the amount of beginning inventory and one closing entry records the cost of the ending inventory. ) We believe that an adjusting entry is more logical and efficient, especially when monthly and year-to-date financial statements are prepared using accounting software.
Question 17. What Is The Difference Between Periodic And Perpetual Inventory Systems?
The difference between the periodic and perpetual inventory systems involves the general ledger account Inventory.
In a periodic system the account Inventory will:
- have a constant balance (the ending balance from the previous period)
- not include the cost of purchases (they are recorded in a Purchases account)
- be adjusted at the end of the accounting period (so the balance reports the costs actually in inventory)
- require a physical inventory at least once per year (and estimates within the year)
- require a cost flow assumption (FIFO, LIFO, average)
- require a calculation of the cost of goods sold (to be used on the income statement)
In a perpetual system the account Inventory will:
- be debited when there is a purchase of goods (there is no Purchases account)
- be credited for the cost of the items sold (and the account Cost of Goods Sold will be debited)
- have its balance continuously or perpetually changing because of the above entries
- require a physical inventory to correct any errors in the Inventory account
- require a cost flow assumption (FIFO, LIFO, average)
It is possible that a company will use the periodic system in its general ledger and use a different computer system outside of its general ledger to track the flow of goods in and out of inventory.
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Question 18. How Do You Report A Write-down In Inventory?
A write-down in a company’s inventory is recorded by reducing the amount reported as inventory. In other words, the asset account Inventory is reduced by a credit or a contra inventory account is credited. The debit in the entry to write down inventory is reported in an account such as Loss on Write-Down of Inventory, an income statement account.
If the amount of the Loss on Write-Down of Inventory is relatively small, it can be reported as part of the cost of goods sold. If the amount of the Loss on Write-Down of Inventory is significant, it should be reported as a separate line on the income statement.
Since the amount of the write-down of inventory reduces net income, it will also reduce the amount reported as owner’s equity or stockholders’ equity. Hence for the balance sheet and in the accounting equation, the asset inventory is reduced and the owner’s or stockholders’ equity is reduced.
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Question 19. What Is The Cost Of Goods Manufactured?
In managerial accounting and cost accounting, the cost of goods manufactured is a schedule, statement, or calculation of the production costs for the products that were completed in an accounting period. In other words, the cost of goods manufactured is the manufacturing costs associated with the products that moved from the manufacturing area to the finished goods inventory during the period.
The formula for the cost of goods manufactured is the costs of: direct materials used + direct labor used + manufacturing overhead assigned = the manufacturing costs incurred in the current accounting period + beginning work-in-process inventory – ending work-in-process inventory.
AccountingCoach PRO includes a form for preparing a schedule of the Cost of Goods Manufactured.
A manufacturer’s cost of goods sold is computed by adding the finished goods inventory at the beginning of the period to the cost of goods manufactured and then subtracting the finished goods inventory at the end of the period.
Question 20. What Is The Monthly Close?
In accounting the monthly close is the processing of transactions, journal entries and financial statements at the end of each month. Under the accrual method of accounting, it is imperative that the financial statements reflect only the transactions and journal entries having relevance to the current month’s revenues and expenses, and end-of-the-month assets and liabilities. Expressed another way, the monthly close must achieve a proper cutoff of each month’s financial activities.
To ensure that the monthly financial statements are accurate and timely, companies will use standard journal entries, recurring journal entries, and checklists for the tasks that must be completed.
If a company has inventories, its monthly close will be more challenging as it will have to be certain that the costs are recorded in the same month as the goods are added to the inventories. In short, the accrual of expenses becomes immensely important when goods are received and are sold.
Another important step in the monthly close is to compare the amounts and percentages on the current financial statements to those of earlier months. For example, if the current income statement shows the cost of goods sold as 88% instead of the typical 81%, the current month’s amounts need to be reviewed before releasing the financial statements. Often the comparison of the balance sheet amounts to those of earlier months will provide insight as to unusual amounts shown on the income statement.
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Question 21. What Is Interest Expense?
Interest expense is the cost of debt that has occurred during a specified period of time.
To illustrate interest expense under the accrual method of accounting, let’s assume that a company borrows $100,000 on December 15 and agrees to pay the interest on the 15th of each month beginning on January 15. The loan states that the interest is 1% per month on the loan balance. The interest expense for the month of December will be approximately $500 ($100,000 x 1% x 1/2 month). The interest expense for the month of January will be $1,000 ($100,000 x 1%).
Since interest on debt is not paid daily, a company must record an adjusting entry to accrue interest expense and to report interest payable. Using our example above, at December 31 no interest was yet paid on the loan that began on December 15. However, the company did incur one-half month of interest expense. Therefore, the company needs to record an adjusting entry that debits Interest Expense $500, and credits Interest Payable for $500.
Question 22. What Are Operating Expenses?
Operating expenses are the costs associated with a company’s main operating activities and which are reported on its income statement.
For example, a retailer’s main operating activities are the buying and selling of merchandise or goods. Therefore, its operating expenses will include:
- Cost of goods sold. These costs are reported as operating expenses on the income statement because of the matching principle. The revenues from the sale of merchandise must be matched with the cost of the merchandise that is sold.
- Selling, general and administrative expenses (SG&A). These costs are reported as operating expenses on the income statement because they pertain to operating the main business during that accounting period. These costs may have expired, may have been used up, or may not have a future value that can be measured.
Some authors define operating expenses as only SG&A. In other words, they do not include the cost of goods sold as an operating expense. Such a definition will be deficient for calculating a company’s operating income. Clearly, the calculation of operating income cannot omit the cost of goods sold.
Question 23. What Is The Difference Between Gross Profit Margin And Gross Margin?
The use of the terms such as gross margin and gross profit margin often varies by the person using the terms. Some people prefer to use gross margin instead of gross profit when referring to the dollars of gross profit. Often they want to avoid the use of the word profit because the selling and administrative expenses must also be covered. Recall that gross profit is defined as Net Sales minus Cost of Goods Sold.
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Question 24. What Is The Difference Between Net Cash Flow And Net Income?
Under the accrual method of accounting, net income is calculated as follows: revenues earned minus the expenses incurred in order to earn those revenues. If a company earns revenues in December but allows those customers to pay in 30 days, the cash from the December revenues will likely be received in January. In this situation the December revenues will increase the December net income, but will not increase the company’s December net cash flow.
Under accrual accounting, expenses are matched to the accounting period when the related revenues occur or when the costs have expired. For example, a retailer may have purchased and paid for merchandise in October. However, the merchandise remained in inventory until it was sold in December. The company’s net cash flow decreases in October when the company pays for the merchandise. However, net income decreases in December when the cost of the goods sold is matched with the December sales.
There are many other examples of expenses occurring in one accounting period but the payments occur in a different accounting period. In short, the statement of cash flows is a needed financial statement because the income statement does not report cash flows.
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Question 25. Are Salaries And Wages Part Of Expenses On The Income Statement?
Salaries and wages of the current accounting period are reported as expenses on a service company’s current income statement.
Salaries and wages of a manufacturer are more complicated. The salaries and wages of people in the administrative and selling functions are reported as expenses on the current income statement. However, the salaries and wages of people in the production departments are assigned to the products manufactured. When the products are sold, their production costs (including the manufacturing salaries and wages) will appear on the income statement as part of the cost of goods sold. The products not sold are reported as inventory on the balance sheet at their production costs (including the manufacturing salaries and wages).
Question 26. What Is An Equivalent Unit Of Production?
An equivalent unit of production is an indication of the amount of work done by manufacturers who have partially completed units on hand at the end of an accounting period. Basically the fully completed units and the partially completed units are expressed in terms of fully completed units. To illustrate, let’s assume that a manufacturer uses direct labor continuously in one of its production departments. During June, the department began with no units in inventory and it started and completed 10,000 units. It also started an additional 1,000 units that were 30% complete at the end of June. This department is likely to state that it manufactured 10,300 (10,000 + 300) equivalent units of product during June.
If the department’s direct labor cost was $103,000 during the month, it’s June direct labor cost per equivalent unit will be $10 ($103,000 divided by 10,300 equivalent units). This means that $100,000 (10,000 X $10) of labor costs will be assigned to the finished units and that $3,000 (300 X $10) will be assigned to the partially completed units.
You will find equivalent units in the production cost reports for the producing departments of manufacturers using a process costing system. Cost accounting textbooks are likely to present the cost calculations per equivalent unit of production under two cost flow assumptions: weighted-average and FIFO.
Question 27. What Is Inventory?
I think of inventory as a company’s goods on hand, which is often a significant current asset. Inventory serves as a buffer between a company’s sales of goods and its production or purchase of goods. Companies strive to find the proper amount of inventory to avoid lost sales, disruptions in production, high holding costs, etc.
Manufacturers usually have the following categories of inventories: raw materials, work-in-process, finished goods, and manufacturing supplies. The amounts of these categories are usually listed in the notes to its balance sheet.
A company’s cost of inventory is related to the company’s cost of goods sold that is reported on the company’s income statement.
Since the costs of the items purchased or produced are likely to likely to change, companies must elect a cost flow assumption for valuing its inventory and its cost of goods sold. In the U.S. the common cost flow assumptions are FIFO, LIFO, and average.
Sometimes a company’s inventory of goods is referred to as its stock of goods, which is held in its stockroom or warehouse.
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Question 28. Is The Cost Of Goods Sold An Expense?
While we often think of expenses as salaries, advertising, rent, interest, and so on, the cost of goods sold is also an expense. The cost of goods that were sold needs to be matched with the pertinent sales on the income statement, just as commission expense must be matched with sales or other revenues.
The FASB’s Statement of Financial Accounting Concepts No. 6, Elements of Financial Statements, paragraph 81, states that “…expenses themselves are in many forms and are called by various names.
Question 29. What Are Manufacturing Costs?
Manufacturing costs are the costs necessary to convert raw materials into products. All manufacturing costs must be attached to the units produced for external financial reporting under US GAAP. The resulting unit costs are used for inventory valuation on the balance sheet and for the calculation of the cost of goods sold on the income statement.
Manufacturing costs are typically divided into three categories…
- Direct materials. This is the cost of the materials which become part of the finished product. For example, the cost of wood is a direct material in the manufacture of wooden furniture.
- Direct labor. This is the cost of the wages of the individuals who are physically involved in converting raw materials into a finished product. For example, the wages of the person cutting wood into the specified lengths and the wages of the assemblers are direct labor costs in a furniture factory.
- Factory overhead or manufacturing overhead. Factory overhead refers to all other costs incurred in the manufacturing activity which cannot be directly traced to physical units in an economically feasible way. The wages of the person who inspects the completed furniture and the depreciation on the factory equipment are part of the factory overhead costs. Factory overhead is also described as indirect manufacturing costs.
Question 30. What Should Be The Entry When Goods Are Purchased At A Discount?
If you purchase $1000 of goods having a trade discount of 20%, you can debit Purchases (periodic system) or Inventory (perpetual system) for $800 and Accounts Payable for $800. This is consistent with the cost principle which means the cash or cash equivalent amount.
If the invoice allows a 1% discount for paying within 10 days, you can record the 1% discount when you make payment within the allotted time. The entry for paying within 10 days would be: debit Accounts Payable $800, credit Cash for $792, and credit Purchase Discounts $8 (or Inventory $8 if perpetual).
If you are certain to always pay vendor invoices within their discount periods, you could initially record the above invoice at $792 (instead of $800). Debit Purchases or Inventory for $792 and credit Accounts Payable $792. When paying the invoice within the discount period, the entry would be a debit to Accounts Payable for $792 and a credit to Cash for $792. If you fail to pay the invoice within the discount period, the payment will have to be $800 and will be recorded with a debit to Accounts Payable $792, a debit to Purchase Discounts Lost $8, and a credit to Cash for $800.
Question 31. What Are Goods In Transit?
Goods in transit refers to merchandise and other inventory items that have been shipped by the seller, but have not yet been received by the purchaser.
To illustrate goods in transit, let’s use the following example. Company J ships a truckload of merchandise on December 30 to Customer K, which is located 2,000 miles away. The truckload of merchandise arrives at Customer K on January 2. Between December 30 and January 2, the truckload of merchandise is goods in transit. The goods in transit requires special attention if the companies issue financial statements as of December 31. The reason is that the merchandise is the inventory of one of the two companies, but the merchandise is not physically present at either company. One of the two companies must add the cost of the goods in transit to the cost of the inventory that it has in its possession.
The terms of the sale will indicate which company should report the goods in transit as its inventory as of December 31. If the terms are FOB shipping point, the seller (Company J) will record a December sale and receivable, and will not include the goods in transit as its inventory. On December 31, Customer K is the owner of the goods in transit and will need to report a purchase, a payable, and must add the cost of the goods in transit to the cost of the inventory which is in its possession.
If the terms of the sale are FOB destination, Company J will not have a sale and receivable until January 2. This means Company J must report the cost of the goods in transit in its inventory on December 31. (Customer K will not have a purchase, payable, or inventory of these goods until January 2.)
Question 32. What Is Net Realizable Value?
Net realizable value is used in connection with accounts receivable and inventory.
In the case of accounts receivable, net realizable value (NRV) is the amount that is expected to turn to cash. (Some authors refer to it as the cash realizable value.) Net realizable value can also be expressed as the debit balance in the asset account Accounts Receivable minus the credit balance in the contra asset account Allowance for Uncollectible Accounts. For example, if Accounts Receivable has a debit balance of $100,000 and the Allowance for Doubtful Accounts has a proper credit balance of $8,000, the resulting net realizable value of the accounts receivable is $92,000.
In the context of inventory, net realizable value is the expected selling price in the ordinary course of business minus any costs of completion, disposal, and transportation. To illustrate, let’s assume that a company’s cost of its inventory is $15,000. However, at the end of the accounting year the inventory can be sold for only $14,000 provided that the company spends an additional $2,000 in packaging, sales commissions, and shipping expense. Hence, the inventory’s net realizable value is $12,000 ($14,000 minus $2,000).
When the net realizable value of a company’s inventory is less than its cost, the company’s balance sheet should report the net realizable value. In our example, the inventory will be reported at $12,000 and the income statement will report a $3,000 loss on the write down of inventory. (The inventory cost of $15,000 is being written down to the NRV of $12,000.)
Question 33. Why Does Inventory Get Reported On Some Income Statements?
Inventory is an asset and its ending balance should be reported as a current asset on a company’s balance sheet. Inventory is not an income statement account. However, the change in Inventory is a component in the calculation of the Cost of Goods Sold. (Cost of Goods Sold is considered to be an expense and is subtracted from Sales on a merchandising company’s income statement.) Some income statements will show the calculation of Cost of Goods Sold as Beginning Inventory + Net Purchases = Goods Available – Ending Inventory. In that situation the beginning and ending inventory does appear on the income statement.
The introductory course in accounting will often use the formula mentioned in calculating the Cost of Goods Sold: Beginning inventory + Net Purchases = Cost of Goods Available – Ending Inventory = Cost of Goods Sold. However, it is my experience that financial statements prepared with accounting software often find that calculation to be awkward, and instead show the following: Net Purchases + or – the change in Inventory = Cost of Goods Sold. The concept is that if ending inventory has increased, some of the cost of the Net Purchases should be added to Inventory and should not be charged against the current period Sales. The result is that the Net Purchases amount on the income statement is reduced and the amount of the reduction is added to the Inventory cost reported on the balance sheet. If the ending Inventory is smaller than the beginning Inventory amount, then the cost in Inventory should be reduced and added to the cost of the Net Purchases to report the correct amount as Cost of Goods Sold on the income statement.
I suspect that the authors of beginning accounting texts believe it is instructional to list the beginning inventory and ending inventory amounts in the Cost of Goods Sold section of the income statement. Perhaps they believe that the Cost of Goods Available is an important concept. As a result, they show the beginning amount of Inventory and the ending amount of Inventory on the Income Statement. I believe that this is awkward for accounting software. (Here are some reasons: The ending balance of last year’s Inventory will have to appear in the year-to-date column of the income statement, while the Inventory’s ending balance from the previous month must be reported in the current month column. The current month’s ending balance in Inventory must appear in both columns.)
To recap, Inventory is a current asset and should be reported on the balance sheet. The change in Inventory has an effect on the Cost of Goods Sold appearing on the income statement. It’s probably easiest to report only the change in Inventory in the Cost of Goods Sold section of the income statement.
Material cost Interview Questions
Question 34. What Is A Trade Discount?
A trade discount is a reduction to the published price of a product. For example, a high-volume wholesaler might be entitled to a 40% trade discount, while a medium-volume wholesaler is given a 30% trade discount. A retail customer will receive no trade discount and will have to pay the published or list price. The use of trade discounts allows for having just one published price for each product.
The sale and purchase will be recorded at the amount after the trade discount is subtracted. For example, when goods with list prices totaling $1,000 are sold to a wholesale customer entitled to a 30% trade discount, both the seller and the buyer will record the transaction at the net amount of $700.
Trade discounts are different from early-payment discounts. (Early-payment discounts of 1% or 2% are likely to be recorded by the seller as a sales discount and by the buyer using the periodic inventory method as a purchase discount.)
Question 35. Is There A Difference Between Work-in-process And Work-in-progress?
It depends on the user of the terms. I use the term “work-in-process” to mean a manufacturer’s inventory that is not yet completed. I think of work-in-process as the goods that are on the factory floor of a manufacturer. The amount of Work-in-Process Inventory would be reported along with Raw Materials Inventory and Finished Goods Inventory on the manufacturer’s balance sheet as a current asset.
I use the term “work-in-progress” to mean construction of long term assets (that will be used in the company’s business) that are not yet completed. For example, if a company is constructing an addition to its building and the work is only partially completed, the amount spent so far would be recorded as Work-in-Progress, Construction in Progress, or Construction Work-in-Progress (CWIP) and the account would be on the balance sheet as a long-term asset in the section entitled Property, Plant and Equipment. When the project is completed and put into service, the amount would be transferred out of CWIP and would be reported in the account Buildings within Property, Plant and Equipment. At that point, the depreciation of the addition will begin. (If a company is constructing an assembly line or a huge machine that will take time to build, the amounts would also be accumulated in CWIP. When the project is completed and is placed into service, the amount will be transferred from CWIP to Equipment and depreciation will begin.)
To make matters even more complicated, companies producing items under a long-term contract would use an account entitled Construction-in-Process.
Question 36. What Is A Lifo Reserve?
Let’s assume that a company’s accounting system uses FIFO (first-in, first-out), but the company wants its financial and income tax reporting to use a LIFO (last-in, first-out) cost flow assumption due to persistent inflation of its costs. The LIFO reserve is a contra inventory account that will reflect the difference between the FIFO cost and LIFO cost of its inventory.
With consistently increasing costs, the balance in the LIFO reserve account will have a credit balance—resulting in less costs reported in inventory. Recall that under LIFO the latest (higher) costs are expensed to the cost of goods sold, while the older (lower) costs remain in inventory.
The credit balance in the LIFO reserve reports the difference in the inventory costs under LIFO versus FIFO since the time that LIFO was adopted. The change in the balance during the current year represents the current year’s inflation in costs.
The change in the balance in the LIFO reserve will also increase the current year’s cost of goods sold. That in turn reduces the company’s profits and taxable income. The change in the balance of the LIFO reserve during the current year multiplied by the income tax rate reveals the difference in the income tax for the year. (The balance in the LIFO reserve times the income tax rate reveals the difference in income tax since LIFO was adopted.)
The disclosure of the LIFO reserve allows you to better compare the profits and ratios of a company using LIFO with the profits and ratios of a company using FIFO.
Since the accounting profession has discouraged the use of the word “reserve” in financial reporting, the inventory notes in annual reports have descriptions such as Revaluation to LIFO, Excess of FIFO over LIFO cost, and LIFO allowance instead of LIFO reserve.
Standard Costing Interview Questions
Question 37. What Is Inventory Change And How Is It Measured?
Inventory change is the difference between last period’s ending inventory and the current period’s ending inventory. If last period’s ending inventory was $100,000 and the current period’s ending inventory is $115,000, the inventory change is an increase of $15,000.
The inventory change is often presented as an adjustment to purchases in the calculation of the cost of goods sold. If purchases were $300,000 during the current period and the inventory amounts are
those listed above, the cost of goods sold is $285,000. (Purchases of $300,000 minus the $15,000 increase in inventory. The logic is that not all $300,000 of purchases should be matched against sales, because $15,000 of the purchases went into inventory.) This is an alternative to the method used in introductory accounting: beginning inventory of $100,000 + purchases of $300,000 = $400,000 of cost of goods available – ending inventory of $115,000 = cost of goods sold of $285,000.
If last period’s ending inventory was $100,000 and the current period’s ending inventory is $93,000, the inventory change is a decrease of $7,000. Assuming purchases of $300,000 in the current period, the cost of goods sold is $307,000 ($300,000 of purchases plus the $7,000 decrease in inventory).
Question 38. What Are Inventoriable Costs?
Inventoriable costs are 1) the costs to purchase or manufacture products which will be resold, plus 2) the costs to get those products in place and ready for sale. Inventoriable costs are also known as product costs.
To illustrate, let’s assume that a retailer purchases an item for resale by paying $20 to the supplier. The item is purchased FOB shipping point, which means that the retailer must pay the freight from the supplier to its location. If that freight cost is $1, then the retailer’s inventoriable cost is $21. Assuming this is the only item in the retailer’s inventory, the retailer’s balance sheet will report inventory at a cost of $21. When the item is sold, the retailer’s inventory will decrease by $21 and the $21 will be reported on the income statement as the cost of goods sold.
In the case of a manufacturer, a product’s inventoriable costs are the costs of the direct materials, direct labor and manufacturing overhead incurred in manufacturing the product.
Question 39. What Is The Difference Between Cost And Expense?
A cost might be an expense or it might be an asset. An expense is a cost that has expired or was necessary in order to earn revenues. We hope the following three examples will illustrate the difference between a cost and an expense.
A company has a cost of $6,000 for property insurance covering the next six months. Initially the cost of $6,000 is reported as the current asset Prepaid Insurance. However, in each of the following six months, the company will report Insurance Expense of $1,000—the amount that is expiring each month. The unexpired portion of the cost will continue to be reported as the asset Prepaid Insurance.
The cost of equipment used in manufacturing is initially reported as the long lived asset Equipment. However, in each accounting period the company will report part of the asset’s cost as Depreciation Expense.
A retailer’s purchase of merchandise is initially reported as the current asset Inventory. When the merchandise is sold, the cost of the merchandise sold is removed from Inventory and is reported on the income statement as the expense entitled Cost of Goods Sold.
The matching principle guides accountants as to when a cost will be reported as an expense.
Question 40. What Is The Difference Between Normal Costing And Standard Costing?
Normal costing is used to value manufactured products with the actual materials costs, the actual direct labor costs, and manufacturing overhead based on a predetermined manufacturing overhead rate. These three costs are referred to as product costs and are used for the cost of goods sold and for inventory valuation. If there is a difference between 1) the overhead costs assigned or applied to products, and 2) the overhead costs actually incurred, the difference is referred to as a variance. If the amount of the variance is not significant, it will usually be assigned to the cost of goods sold. If the variance is significant, it should be prorated to the cost of goods sold and to the work in process and finished goods inventories.
Standard costing values its manufactured products with a predetermined materials cost, a predetermined direct labor cost, and a predetermined manufacturing overhead cost. These standard costs will be used for valuing the manufacturer’s cost of goods sold and inventories. If the actual costs vary only slightly from the standard costs, the resulting variances will be assigned to the cost of goods sold. If the variances are significant, they should be prorated to the cost of goods sold and to the inventories.
Sales Promoter Interview Questions
Question 41. Are Utility Bills An Expense Or A Liability?
Because of double-entry accounting and the accrual-basis of accounting, the cost of utilities (electricity, natural gas, sewer, water, etc.) will involve both an expense and a liability. For example, a retailer who is responsible for her store’s heat and light will incur an expense for the amount of utilities used during the accounting period. The retailer will also have a liability for
the utilities that were used but have not yet been paid. Since the utility company provides the electric and gas service before it bills the user, the retailer will be incurring an expense every day and will be incurring a liability every day. The amount of the liability increases each day and is reduced by the amount paid by the retailer. (When the retailer pays the amount billed by the utility for the previous month’s usage, the retailer will still have a liability for the utilities used since last month.)
For a manufacturer, the cost of the utilities used in the factory will be assigned or allocated to the products as manufacturing overhead. If all of the products manufactured remain in inventory, the cost of the utilities used in the factory are embedded in the inventory’s cost. When products are sold, the cost of utilities allocated to those products will automatically be expensed as part of the cost of goods sold. Under accrual accounting, the cost of the utilities that were used are included in the products’ cost—whether or not the utilities have been paid. Because of double-entry accounting, the amount owed for the utilities that were used is also reported on the balance sheet as a liability.
Since natural gas, electricity, and other utilities are used before the meters are read and billed by the utility company, the company using the utilities will have to estimate (1) the amounts used during an accounting period, and (2) the amounts owed at the end of each accounting period. The amounts are entered into the accounting records through an accrual-type adjusting entry.
Question 42. Where Is A Contingent Liability Recorded?
A contingent liability that is both probable and the amount can be estimated is recorded as 1) an expense or loss on the income statement, and 2) a liability on the balance sheet. As a result, a contingent liability is also referred to as a loss contingency. Warranties are cited as a contingent liability that meets both of the required conditions (probable and the amount can be estimated). Warranties will be recorded at the time of a product’s sale with a debit to Warranty Expense and a credit to Warranty Liability.
A loss contingency which is possible but not probable, or the amount cannot be estimated, will not be recorded in the accounts. Rather, it will be disclosed in the notes to the financial statements.
A loss contingency that is remote will not be recorded and will not have to be disclosed in the notes to the financial statements.
Marketing Interview Questions
Question 43. What Is The Days’ Sales In Inventory Ratio?
The days’ sales in inventory tells you the average number of days that it took to sell the average inventory held during the specified one-year period. You can also think of it as the number of days of sales that was held in inventory during the specified year. The calculation of the days’ sales in inventory is: the number of days in a year (365 or 360 days) divided by the inventory turnover ratio.
For example, if a company had an inventory turnover ratio of 9, the company’s inventory turned over 9 times during the year. If we use 360 as the number of days in the year, the company had (on average) 40 days of inventory on hand during the year (360 days divided by the inventory turnover ratio of 9).
Since the inventory turnover ratio reflects the average amount of inventory during the year, and since sales usually fluctuate during the year, the days’ sales in inventory is an approximation.
Question 44. What Are The Effects Of Overstating Inventory?
If a corporation overstates its inventory, it will also be overstating its gross profit and net income as well as its current assets, total assets, retained earnings, stockholders’ equity, and all of the related financial ratios.
The gross profit and net income are overstated as a result of overstating inventory because not enough of the cost of goods available is being charged to the cost of goods sold. The higher amount of net income means that the reported amount of retained earnings and stockholders’ equity is also too high.
Since the overstated amount of inventory at the end of one accounting period becomes the beginning inventory of the following period, the following period’s cost of goods sold will be too high and will result in the period’s gross profit and net income being too low. (The retained earnings and other balance sheet amounts will be correct at the end of the second period.)
Question 45. What Is Inventory Valuation?
In the U.S. inventory valuation is the dollar amount associated with the items contained in a company’s inventory. Initially the amount is the cost of the items defined as all of the costs necessary to get the inventory items in place and ready for sale. (The costs of selling and administration are not included in the cost of inventory.)
Since the inventory items are c
onstantly being sold and restocked and since the costs of the items are constantly changing, a company must select a cost flow assumption. Cost flow assumptions include first-in, first-out; weighted average; and last-in, first out. The company is expected to be consistent in its application of the selected cost flow assumption.
A manufacturer’s inventory valuation will include the costs of production, namely direct materials, direct labor, and manufacturing overhead. Manufacturers are also required to consistently follow their cost flow assumptions.
Inventory valuation is important in that it affects the cost of goods sold, a significant amount reported on the company’s income statement. Inventory is also an important component of a company’s current assets, working capital, and current ratio.
If the net realizable value of a company’s inventory declines to a value which is less than its cost, the company is usually required to report the inventory at its net realizable value. (Net realizable value is the expected selling price minus the the costs of completion, disposal, and transportation.)
Question 46. Why Would A Company Use Lifo Instead Of Fifo?
If a company that sells products (retailer, manufacturer, etc.) finds the cost of its items increasing, the use of LIFO will result in less taxable income and less income tax payments than FIFO. Over a long period of time, or when costs increase dramatically, the lower income tax payments will be significant.
Another reason for a company to use the LIFO cost flow assumption is to improve the matching of costs with sales. Under LIFO, the recent costs will be matched on the income statement with the recent sales revenues. (Recall that LIFO means the “last costs in” will be the “first costs out” of inventory and onto the income statement as the cost of goods sold.)
Let’s illustrate this with an example. A new company purchases aluminum for $1.00 per pound and sells it for $1.20 per pound. After several months, the company has 10,000 pounds of aluminum in inventory at a cost of $10,000. Its next purchase of 20,000 pounds came with a cost increase: the cost of aluminum increased to $1.10 per pound. The company immediately increased its selling price by ten cents per pound and sold 10,000 pounds of aluminum for $1.30 per pound. The company’s income statement will report sales of $13,000. The company must now match the cost of the 10,000 pounds of aluminum with the $13,000 of sales.
Under LIFO, the cost of goods sold will be $11,000 (10,000 lbs. sold X the recent cost of $1.10 per lb.). Using FIFO, the cost of goods sold will be $10,000 (10,000 lbs. sold X the first or older cost of $1.00 per lb.). How much gross profit did the company actually earn? Did it earn $2,000 ($13,000 – $11,000) as LIFO indicated? Or, did the company earn $3,000 ($13,000 – $10,000) as indicated by FIFO?
Business-savvy people will say the company earned only $2,000 from its main operating activity of buying and selling aluminum. They argue that the true profit is the amount remaining after you replace the 10,000 pounds of aluminum that was sold. If it will cost $1.10 per pound to replace the aluminum that was sold, the true profit is $2,000. The $3,000 computed under FIFO includes $1,000 of phantom or illusory profits. (In other words, the company was lucky to be holding 10,000 pounds of aluminum when the aluminum market increased by ten cents per pound.)
In our example, LIFO will mean $1,000 less of taxable income and $400 less in tax payments for a corporation with a combined federal and state income tax rate of 40%. That’s good for the company’s cash flow. It will help the company meet its payments to its suppliers for the higher costing aluminum.
Question 47. What Is A Purchase Discount?
A purchase discount is a deduction that may be available to a buyer if the buyer pays an invoice within a prescribed time. For example, a supplier’s invoice for $10,000 with the credit terms 2/10 net 30 indicates that the buyer will be allowed a purchase discount of $200 (2% of $10,000) if the buyer pays within 10 days. If the buyer pays in 30 days, there is no purchase discount.
Under a periodic inventory system, the purchase discount on merchandise purchased is credited to the general ledger account Purchase Discounts. The credit balance in this account (along with the credit balance in the Purchase Returns and Allowances account) will be deducted from the debit balance in the Purchases account in calculating the amount of net purchases.
A purchase discount of 2% for paying 20 days early (paying in 10 days instead of 30 days) equates to an annual rate of 36%. A purchase discount of 1% for paying 20 days early means an annual rate of 18%.
Question 48. What Is A Purchase Return?
A purchase return occurs when a buyer returns merchandise that it has purchased from a supplier.
Under the periodic inventory system, the cost of the merchandise that was returned is recorded as 1) a credit to the general ledger account Purchase Returns or the account Purchase Returns and Allowances, and 2) a debit to Accounts Payable. (The supplier/seller will record the return with a debit to Sales Returns and a credit to Accounts Receivable.)
The credit balance in the Purchase Returns account will partially offset the debit balance in the account Purchases.
Since the return of purchased merchandise is time consuming (and therefore costly), having the separate general ledger account Purchase Returns allows managers to quickly see the magnitude of the returns.
Question 49. What Is The Gross Profit Method Of Inventory?
The gross profit method is a technique for estimating the amount of ending inventory. The gross profit method might be used to estimate each month’s ending inventory or it might be used as part of a calculation to determine the approximate amount of inventory that has been lost due to theft, fire, or other causes.
The gross profit method of estimating ending inventory assumes that we know the gross profit percentage or gross margin ratio. For example, if a company purchases goods for $80 and sells them for $100, its gross profit is $20 and it has a gross profit percentage or ratio of 20% of the selling price. When this company has sales of $50,000 it is assumed that its cost of those goods will be $40,000 ($50,000 minus 20% of $50,000; or 80% of $50,000).
Let’s assume we need to estimate the cost of the July 31 inventory. The last time the merchandise inventory was counted was seven months earlier on December 31 and it had a cost of $15,000. Since December 31, the company purchased merchandise with a cost of $42,000; its sales were $50,000; and the gross profit percentage has remained at 20%. We can estimate the July 31 inventory as follows:
Inventory cost at December 31: $15,000
Purchases between December 31 and July 31 at cost: $42,000
Expected cost of goods available: $57,000 ($15,000 + $42,000)
Cost of goods sold: $50,000 of sales x 80% = $40,000
Estimated Inventory at July 31 at cost: $17,000 ($57,000 – $40,000)
Question 50. What Is A Customer Deposit?
A customer deposit could be an amount paid by a customer to a company prior to the company providing it with goods or services. In other words, the company receives the money prior to earning it. The company receiving the money has an obligation to provide the goods or services to the customer or to return the money.
For example, Ace Manufacturing Co. might agree to produce an expensive, custom-made machine for one of its customers. Ace requires that the customer pay $50,000 before Ace begins to design and construct the machine. The $50,000 payment is made in December 2012 and the machine must be finished by June 30, 2013. The $50,000 is a down payment toward the machine’s price of $400,000.
In December 2012, Ace will debit Cash for $50,000 and will credit Customer Deposits, a current liability account. (The customer will record the $50,000 payment with a debit to a long-term asset account such as Construction Work in Progress or Downpayment on New Equipment, and will credit Cash.)
Question 51. What Is The Inventory Turnover Ratio?
The calculation for the inventory turnover ratio is: Cost of Goods Sold for a Year divided by Average Inventory during the same 12 months.
To illustrate the inventory turnover ratio, let’s assume 1) that during the most recent year a company’s Cost of Goods Sold was $3,600,000, and 2) the company’s average cost in its Inventory account during the same 12 months was calculated to be $400,000. The company’s inventory turnover ratio is 9 ($3,600,000 divided by $400,000) or 9 times.
The higher the inventory turnover ratio, the better, provided you are able to fill customers’ orders on time. It would be foolish to lose customers because you didn’t carry sufficient inventory quantities.
A company’s inventory turnover ratio should be compared to 1) its previous ratios, 2) its planned ratio, and 3) the industry average.
Even with a favorable inventory turnover ratio, a company may have some excess and obsolete inventory items. Therefore, it is wise to compare the quantity of each item in inventory with the recent sales of each item.
Question 52. If Inventory Is Understated At The End Of The Year, What Is The Effect On Net Income?
If inventory is understated at the end of the year, the net income for the year is also understated.
Here’s a brief explanation. If a company has a cost of goods available of $100,000 and it assigns too little of that cost to inventory, then too much of that cost will appear on the income statement as the cost of goods sold. Too much cost on the income statement will mean too little net income.
Another way to view this is through the accounting equation, Assets = Liabilities + Owner’s Equity. If you assign too little of the cost of goods available to Assets, then the amount of Owner’s Equity will be too little—caused by net income being too little.
Question 53. What Is The Difference Between Fifo And Lifo?
The difference between FIFO and LIFO results from the order in which changing unit costs are removed from inventory and become the cost of goods sold. When the unit costs have increased, LIFO will result in a larger cost of goods sold and a smaller ending inventory compared with FIFO. If the unit costs are stable, there will be little or no difference between FIFO and LIFO. Also note that the order in which the costs are removed from inventory is independent of the order in which the physical units are removed from inventory.
To illustrate the difference between FIFO and LIFO, let’s assume that a retail store carried only one product during its first year of business. It purchased 30 units in January at a cost of $40 each, 30 units in June at $43 each, and 30 units in November at $46 each. Thus, for the year the retailer purchased 90 units with a total actual cost of $3,870 [30X$40 + 30X$43 + 30X$46]. Let’s also assume that 70 units were sold and that 20 units remain in inventory at the end of the year.
FIFO assumes that the first costs (the oldest costs) for 70 of the units will be removed from inventory and will be expensed on the income statement as the cost of goods sold. Hence, the FIFO cost flow assumption is that the 70 units sold had a cost of $2,950 [30X$40 + 30X$43 + 10X$46]. FIFO also assumes that the 20 units remaining in inventory had the most recent cost of $46 each for a total of $920.
LIFO assumes that the last costs (the most recent actual costs) for 70 units will be removed from inventory and will be expensed on the income statement as the cost of goods sold regardless of which units were actually shipped to customers. Therefore, the LIFO cost flow assumption is that the 70 units sold had a cost of $3,070 [30X$46 + 30X$43 + 10X$40]. LIFO also assumes that the 20 units remaining in inventory had the oldest cost of $40 each for a total of $800.
In our example, LIFO results in $120 less of ending inventory and $120 less of gross profit (because the cost of goods sold was larger). The lower gross profit and the associated lower taxable income for a U.S. company can mean less income tax payments if the company is profitable and has significant and increasing levels of inventory.
Question 54. What Is Carriage Inwards?
Carriage inwards refers to the transportation costs associated with the purchase of merchandise or other assets. The buyer is responsible for the cost of carriage inwards when it buys items and the prices are stated as being FOB shipping point. Carriage inwards is also known as freight-in or transportation-in.
When goods or merchandise are purchased FOB shipping point and the periodic inventory method is used, the buyer will likely record the cost of the carriage inwards in the general ledger account Carriage Inwards (or Freight-in or Transportation-in). The carriage inwards costs are considered to be part of the cost of items purchased. In other words, part of the costs of carriage inwards should be assigned to the units in inventory and some should be assigned to the units that have been sold.
In the case of assets other than inventory items that are purchased FOB shipping point, the buyer should add the carriage inwards cost to the asset’s cost. This is necessary because accountants define an asset’s cost as all of the costs that are necessary to get an asset in place and ready for use.
Question 55. Are Commissions A Cost Of Goods Sold Account Or An Expense?
Sales commissions are a selling expense. Selling expenses are reported on the income statement as part of the operating expenses. Often the operating expenses will appear as selling, general and administrative expenses or SG&A.
Sales commissions are not part of the cost of a product and therefore are not assigned to the cost of goods held in inventory or to the cost of goods sold.
Question 56. What Is The Difference Between Inventory And The Cost Of Goods Sold?
Inventory for a retailer or distributor is the merchandise that was purchased and has not yet been sold to customers. For a manufacturer, inventory consists of raw materials, packaging materials, work-in-process, and the finished goods that are owned and on hand. Inventory is generally valued at its cost. If a business has inventory it is often a major component of its current assets.
The cost of goods sold is the cost of the merchandise or products that have been sold to customers during the period of the income statement. For a company that sells goods, the cost of goods sold is usually the largest expense on its income statement. As a result, care must be taken when computing and matching the cost of goods sold with the sales revenues.
To illustrate how inventory and the cost of goods sold are connected, let’s assume that a retailer carries only one product. It has 100 units of the product in inventory at the beginning of the year and purchases an additional 1,500 units during the year. Accountants refer to the combination of the beginning inventory plus the purchases for the period as the goods available for sale, which in this example is 1,600 units. If there are 125 units on hand at the end of the year, the ending inventory will report the cost of 125 units. The cost of goods sold for the year will be the cost of the 1,475 units that are no longer available.
If the per unit costs of the products (or inputs) change during the year, the company must
follow a cost flow assumption [FIFO, LIFO, or average] in order to divide the cost of goods available for sale between the ending inventory and the cost of goods sold.
Question 57. What Is Work-in-process Inventory?
You can think of work-in-process (WIP) inventory as the goods that are on the factory floor. The manufacturing of these goods has begun but has not yet been completed.
You can also think of work-in-process inventory as the general ledger current asset account that reports the cost of the goods that are on the factory floor. In the U.S. the cost reported as WIP should be the cost of the direct materials, direct labor and the allocation of manufacturing overhead for the goods on the factory floor.
As the WIP goods become completely manufactured, their cost will be credited to the WIP account and will be debited to the Finished Goods Inventory account.
Question 58. How Do You Calculate The Cost Of Goods Sold For A Retailer?
A retailer’s cost of goods sold is equal to the cost of its beginning inventory plus the cost of its net purchases (the combination of these is the cost of goods available) minus the cost of its ending inventory.
The cost of goods sold is also the cost of the net purchases plus or minus the change in the inventory during the accounting period. For example, if the inventory increased, the cost of goods sold is the cost of the net purchases minus the increase in the inventory. If the inventory decreased, the cost of goods sold is the cost of the net purchases plus the decrease in inventory.
When there is inflation, the retailer must also choose a cost flow assumption, such as FIFO, LIFO, or average. The cost flow assumption will make a difference in the amounts reported as the cost of goods sold and the costs reported as inventory. (The cost flow assumption can be different from the way inventory items are rotated or sold.)
Question 59. What Are Cost Flow Assumptions?
The phrase cost flow assumptions often refers to the methods available for moving the costs of a company’s products from its inventory to its cost of goods sold. In the U.S. the cost flow assumptions include FIFO, LIFO, and average. (If specific identification is used, there is no need to make an assumption.)
FIFO, LIFO, and average are cost flow assumptions because the costs flowing out of inventory do not have to match the specific physical units being shipped. Let’s illustrate this important point with a company that has four units of the same product in its inventory. The units were purchased at increasing costs and in the following sequence: $40, $41, $43, and $44. If the company ships the oldest unit (the unit with a cost of $40), it will expense via the cost of goods sold: $40 under FIFO, $44 under LIFO, or $42 under the average method. If the company ships the most recently purchased unit (the physical unit having a cost of $44), the inventory will be reduced and the cost of goods sold will be increased by: $40 under FIFO, $44 under LIFO, or the average of $42. In other words, the cost used to reduce the inventory and to increase the cost of goods sold was based on an assumed cost flow without regard to which physical unit was actually shipped.
Other than a one-time change to a better cost flow assumption, the company must consistently use the same cost flow assumption.
Question 60. What Is Inventory Shrinkage?
Inventory shrinkage is the term used to describe the loss of inventory. For example, if the inventory records of a retailer report that 3,261 units of Product X are on hand, but a physical count indicates that there are only 3,248 units on hand, there is an inventory shrinkage of 13 units. The retailer’s inventory shrinkage might be due to shoplifting, employee theft, damage, obsolescence, etc.
The term shrinkage is also used by manufacturers when referring to the loss of raw materials during a production process. For example, a manufacturer of baked food items will experience shrinkage throughout its processes due to ingredients adhering to the beaters and bowls, and also due to evaporation. This shrinkage is also known as spoilage or waste and it can be either normal or abnormal.