Ch6. Inventory and Cost Accounting — CVP Analysis and the Fundamentals of Cost Calculation

What Is Inventory?

Inventory: Assets held for sale in the ordinary course of business, or in the process of being produced for such sale.

Types of Inventory:
- Merchandise: Finished goods purchased for resale (retail/wholesale)
- Finished Goods: Products manufactured by the company (manufacturing)
- Work-in-Progress (WIP): Goods partially through the production process
- Raw Materials: Materials to be used in production

Inventory Valuation Methods

The method used to allocate inventory costs affects both cost of goods sold (COGS) and ending inventory balances.

First-In, First-Out (FIFO)

Assumes the oldest inventory is sold first.

Example: Purchased 100 units at $10 each in January, 100 units at $12 each in February.
         Sold 150 units in March.

COGS = 100 units × $10 + 50 units × $12 = $1,600
Ending Inventory = 50 units × $12 = $600

During periods of rising prices: Ending inventory value ↑, COGS ↓, Net Income ↑

Weighted Average Cost

Allocates costs based on an average unit cost calculated across all purchases.

Average Unit Cost = Total Cost of Purchases / Total Units Purchased

Method Not Permitted Under IFRS

Last-In, First-Out (LIFO): Assumes the most recently purchased goods are sold first. Prohibited under IFRS (though still permitted under US GAAP).

Components of Manufacturing Cost

Manufacturing Cost:

Direct Materials   → Raw materials directly incorporated into the product
+ Direct Labor     → Wages of production workers
+ Manufacturing Overhead → Factory rent, depreciation, indirect materials
────────────────────────────────────────────────
= Total Manufacturing Cost

Period Costs: Selling and administrative expenses not directly tied to production (expensed in the current period)

CVP Analysis (Cost-Volume-Profit Analysis)

Analysis of how changes in costs and volume (output) affect profit.

Core concepts:

Contribution Margin = Revenue − Variable Costs
Contribution Margin Ratio = Contribution Margin / Revenue

Operating Income = Contribution Margin − Fixed Costs

Break-Even Point (BEP)

The level of sales at which operating income equals zero.

BEP in Units   = Fixed Costs / Contribution Margin Per Unit
BEP in Revenue = Fixed Costs / Contribution Margin Ratio

Example: Fixed costs $100,000, Selling price $10/unit, Variable cost $6/unit
Contribution margin per unit = 10 − 6 = $4
BEP in units = 100,000 / 4 = 25,000 units
BEP in revenue = 25,000 × $10 = $250,000

Target Profit Sales Volume

Target Sales Volume = (Fixed Costs + Target Profit) / Contribution Margin Per Unit

Margin of Safety

Margin of Safety = Actual Revenue − BEP Revenue
Margin of Safety Ratio = Margin of Safety / Actual Revenue × 100%

The higher the margin of safety ratio, the more comfortable the buffer above the break-even point.

FIFO ★★★★★ : Assumes the oldest inventory is sold first. During periods of rising prices, ending inventory carries higher value and net income is reported higher. Memory tip: FIFO = oldest goods sold first

Contribution Margin ★★★★★ : Revenue minus variable costs. The amount that contributes to covering fixed costs and generating profit. Memory tip: Contribution margin = the portion that “contributes” to covering fixed costs

Break-Even Point (BEP) ★★★★★ : The sales volume or revenue level at which profit is zero. BEP = Fixed Costs ÷ Contribution Margin Ratio. Any sales above this level generate profit. Memory tip: BEP = Fixed Costs ÷ (Selling Price − Variable Cost per unit)

Practice Quiz

Q. Between FIFO and weighted average, which method reports higher profit during a period of rising prices?

FIFO. The older (cheaper) inventory is recognized as COGS first, resulting in lower COGS and higher reported profit.

Q. Fixed costs are $20,000; selling price is$ 5/unit; variable cost is $3/unit. What is the break-even point in units?

Contribution margin per unit = $5 −$ 3 = $2. BEP =$ 20,000 ÷ $2 = 10,000 units.