Valuing Inventory

Costing Methods Overview

There are four accepted methods of costing items: specific identification; first-in, first-out; last-in, first-out; and weighted-average.

Learning Objectives

Review the differences between the four cost accounting methods and demonstrate how to calculate the cost of goods sold

Key Takeaways

Key Points

  • Cost accounting is regarded as the process of collecting, analyzing, summarizing, and evaluating various alternative courses of action involving costs and advising the management on the most appropriate course of action based on the cost efficiency and capability of the management.
  • The specific identification method of inventory costing attaches the actual cost to an identifiable unit of product. Firms find this method easy to apply when purchasing and selling large inventory items such as cars.
  • The FIFO (first-in, first-out) method of inventory costing assumes that the costs of the first goods purchased are those charged to cost of goods sold when the company actually sells goods.
  • The LIFO (last-in, first-out) method of inventory costing assumes that the costs of the most recent purchases are the first costs charged to cost of goods sold when the company actually sells the goods.
  • The weighted-average method of inventory costing is a means of costing ending inventory using a weighted-average unit cost. Companies most often use the weighted-average method to determine a cost for units that are basically the same.
  • Beginning Inventory + Purchases = Available for Sale – Ending Inventory = Cost of Good Sold.

Key Terms

  • raw materials: A raw material is the basic material from which a product is manufactured or made.
  • costing: The estimation of the cost of a process or product.
  • inventory: A detailed list of all of the items on hand.

Costing Methods Overview

Cost accounting information is designed for managers. Since managers are making decisions only for their own organization, there is no need for the information to be comparable to similar information from other organizations. Instead, the important criterion is that the information must be relevant for decisions that managers, operating in a particular environment of business including strategy, make. Cost accounting information is commonly used in financial accounting information, but first we are concentrating on its use by managers to take decisions. The accountants who handle the cost accounting information add value by providing good information to managers who are making decisions. Among the better decisions, is the better performance of one’s organization, regardless if it is a manufacturing company, a bank, a non-profit organization, a government agency, a school club or even a business school. The cost-accounting system is the result of decisions made by managers of an organization and the environment in which they make them.

image

Efficient use of inventory is critical for businesses.: Inventory at a business.

Cost accounting is regarded as the process of collecting, analyzing, summarizing, and evaluating various alternative courses of action involving costs and advising the management on the most appropriate course of action based on the cost efficiency and capability of the management.

The following are different cost accounting approaches:

  • standardized or standard cost accounting
  • lean accounting
  • activity-based costing
  • resource consumption accounting
  • throughput accounting
  • marginal costing/cost-volume-profit analysis

Classical cost elements for a manufacturing business are:

  • Raw materials
  • Labor
  • Indirect expenses/ overhead

Accepted Financial Costing Methods

There are four accepted methods of costing inventory items:

  1. specific identification;
  2. first-in, first-out (FIFO);
  3. last-in, first-out (LIFO); and
  4. weighted-average.

Each method has advantages and disadvantages. Note that a manufacturing business’s inventory will consist of work in process, or unfinished goods, and finished inventory; the costs of unfinished and finished inventory contain a combination of costs related to raw materials, labor, and overhead. On the other hand, a retailer’s inventory consists of all finished products purchased from a wholesaler or manufacturer; the costs of their units are based on their acquisition cost rather than the costs associated with manufacturing units.

Specific Identification

The specific identification method of inventory costing attaches the actual cost to an identifiable unit of product. Firms find this method easy to apply when purchasing and selling large inventory items such as cars. Under the specific identification method, the firm must identify each unit in inventory, unless it is unique, with a serial number or identification tag.

FIFO (first-in, first-out)

The FIFO (first-in, first-out) method of inventory costing assumes that the costs of the first goods purchased are those charged to cost of goods sold when the company actually sells goods. This method assumes the first goods purchased are the first goods sold. In some companies, the first units in (bought) must be the first units out (sold) to avoid large losses from spoilage. Such items as fresh dairy products, fruits, and vegetables should be sold on a FIFO basis. In these cases, an assumed first-in, first-out flow corresponds with the actual physical flow of goods.

LIFO (last-in, first-out)

The LIFO (last-in, first-out) method of inventory costing assumes that the costs of the most recent purchases are the first costs charged to cost of goods sold when the company actually sells the goods.

Weighted-average

The weighted-average method of inventory costing is a means of costing ending inventory using a weighted-average unit cost. Companies most often use the weighted-average method to determine a cost for units that are basically the same, such as identical games in a toy store or identical electrical tools in a hardware store. Since the units are alike, firms can assign the same unit cost to them.

Calculating Cost of Goods Sold (periodic method)

Beginning Inventory + Purchases = Available for Sale

Available – Ending Inventory = Cost of Good Sold

Specific Identification Method

Specific identification is a method of finding out ending inventory cost that requires a detailed physical count.

Learning Objectives

Describe how a company would use the specific identification method to value inventory

Key Takeaways

Key Points

  • Specific identification is a method of finding out ending inventory cost. It requires a detailed physical count, so that the company knows exactly how many of each goods brought on specific dates remained at year end inventory.
  • In theory, this method is the best method, since it relates the ending inventory goods directly to the specific price they were bought for. However, management can easily manipulate ending inventory cost, since they can choose to report that cheaper goods were sold first, ultimately raising income.
  • Alternatively, management can choose to report lower income, to reduce the taxes they needed to pay.

Key Terms

  • inventory: A detailed list of all of the items on hand.
  • accounting: The development and use of a system for recording and analyzing the financial transactions and financial status of a business or other organization.
  • specific identification method: inventory measurement based on the exact number of goods in inventory and their purchase price
  • serial number: A unique number, assigned to a particular unit of some product, to identify it.

Types of Accounting Methods

The merchandise inventory figure used by accountants depends on the quantity of inventory items and the cost of the items. There are four accepted methods of costing the items: (1) specific identification; (2) first-in, first-out (FIFO); (3) last-in, first-out (LIFO); and (4) weighted-average. Each method has advantages and disadvantages.

General Information

Specific identification is a method of finding out ending inventory cost. It requires a detailed physical count, so that the company knows exactly how many of each goods brought on specific dates remained at year-end inventory. When this information is found, the amount of goods is multiplied by their purchase cost at their purchase date, to get a number for the ending inventory cost.

In theory, this method is the best method because it relates the ending inventory goods directly to the specific price they were bought for. However, this method allows management to easily manipulate ending inventory cost, since they can choose to report that the cheaper goods were sold first, therefore increasing ending inventory cost and lowering cost of goods sold. This will increase the income.

Alternatively, management can choose to report lower income, to reduce the taxes they needed to pay. This method is also a very hard to use on interchangeable goods. For example, it is hard to relate shipping and storage costs to a specific inventory item. These numbers will need to be estimated and reducing the specific identification’s benefit of being extremely specific.

Using Specific Identification

The specific identification method of inventory costing attaches the actual cost to an identifiable unit of product. Firms find this method easy to apply when purchasing and selling large inventory items such as cars. Under the specific identification method, the firm must identify each unit in inventory, unless it is unique, with a serial number or identification tag.

To illustrate, assume that the company in can identify the 20 units on hand at year-end as 10 units from the August 12 purchase and 10 units from the December 21 purchase. The company computes the ending inventory as shown in; it subtracts the USD 181 ending inventory cost from the USD 690 cost of goods available for sale to obtain the USD 509 cost of goods sold. Note that you can also determine the cost of goods sold for the year by recording the cost of each unit sold. The USD 509 cost of goods sold is an expense on the income statement, and the USD 181 ending inventory is a current asset on the balance sheet. The specific identification costing method attaches cost to an identifiable unit of inventory. The method does not involve any assumptions about the flow of the costs as in the other inventory costing methods. Conceptually, the method matches the cost to the physical flow of the inventory and eliminates the emphasis on the timing of the cost determination. Therefore, periodic and perpetual inventory procedures produce the same results for the specific identification method.

image

Specific Identification: Determining ending inventory under specific identification

Cost Flow Assumptions

Inventory cost flow assumptions (e.g., FIFO) are necessary to determine the cost of goods sold and ending inventory.

Learning Objectives

Explain how a company’s inventory cost flow assumptions dictate which method it will use for inventory valuation

Key Takeaways

Key Points

  • Companies make certain assumptions about which goods are sold and which goods remain in inventory (resulting in different accounting methodologies).
  • The only requirement, regardless of method is that: The total cost of goods sold plus the cost of the goods remaining in ending inventory for financial and tax purposes is equal to the actual cost of goods available.
  • Cost flow assumptions are for financial reporting and tax purposes only and do not have to agree with the actual movement of goods.

Key Terms

  • assumption: The thing supposed; a postulate, or proposition assumed; a supposition.
  • COGS: COGS (cost of goods sold) is the inventory costs of those goods a business has sold during a particular period.
  • inventory: A detailed list of all of the items on hand.

Cost Flow Assumptions

Inventory cost flow assumptions are necessary to determine the cost of goods sold and ending inventory. Companies make certain assumptions about which goods are sold and which goods remain in inventory (resulting in different accounting methodologies). This is for financial reporting and tax purposes only and does not have to agree with the actual movement of goods (companies typically choose a method because of its particular benefits, such as lower taxes).

Efficient use of inventory is critical for businesses.: Picture of inventory at a business.

The only requirement, regardless of method is that: The total cost of goods sold plus the cost of the goods remaining in the ending inventory for financial and tax purposes is equal to the actual cost of goods available.

Specific Identification

Characteristics of the specific identification method include:

  • Keeps track of the cost of each, specific good sold
  • Perfect matching of costs of goods to goods sold
  • Often impossible or too costly and allows manipulation by management

FIFO

Characteristics of the FIFO method include:

  • Assigns first costs incurred to COGS (cost of goods sold) on the income statement
  • Disallows manipulation by management and cost flow agrees with ideal, physical flow of goods, though the agreement of cost flow and ideal, physical flow of goods is arguably not important
  • Uses the least relevant cost for the income statement and underestimates or overestimates the cost of goods sold if prices are rising or falling, respectively

LIFO

Characteristics of the LIFO method include:

  • Assigns last costs incurred to COGS on the income statement
  • Disallows manipulation by management and uses the most relevant cost for the income statement
  • Underestimates or overestimates cost of goods sold if prices are falling or rising, respectively and cost flow disagrees with ideal, physical flow of goods, though the agreement of cost flow and ideal, physical flow of goods is arguably not important

Weighted Average

Characteristics of the weighted average method include:

  • Assigns average cost incurred to COGS on the income statement
  • Disallows manipulation by management and better estimation of the cost of goods sold than FIFO or LIFO if prices are rising or falling
  • Tends to ignore extreme costs of inventory and there is no theoretical reasoning for using this method

Additional Notes

LIFO and weighted average cost flow assumptions may yield different end inventories and COGS in a perpetual inventory system than in a periodic inventory system due to the timing of the calculations. In the perpetual system, some of the oldest units calculated in the periodic units-on-hand ending inventory may get expended during a near inventory exhausting individual sale. In the LIFO system, the weighted average system, and the perpetual system, each sale moves the weighted average, so it is a moving weighted average for each sale. In contrast, in the periodic system, it is only the weighted average of the cost of the beginning inventory, the sum cost of all the purchases, less than the cost of the inventory, divided by the sum of the beginning units and the total units purchased.

Average Cost Method

Under the Average Cost Method, It is assumed that the cost of inventory is based on the average cost of the goods available for sale during the period.

Learning Objectives

Explain how a company uses the average cost method to value their inventory

Key Takeaways

Key Points

  • Under the average cost method, it is assumed that the cost of inventory is based on the average cost of the goods available for sale during the period.The average cost is computed by dividing the total cost of goods available for sale by the total units available for sale.
  • The weighted-average method of inventory costing is a means of costing ending inventory using a weighted-average unit cost. Companies most often use the weighted-average method to determine a cost for units that are basically the same, such as identical games in a toy store.
  • Moving-Average (Unit) Cost is a method of calculating Ending Inventory cost. Assume that both Beginning Inventory and beginning inventory cost are known. From them the Cost per Unit of Beginning Inventory can be calculated.

Key Terms

  • weighted average: An arithmetic mean of values biased according to agreed weightings.
  • COGS: COGS (cost of goods sold) is the inventory costs of those goods a business has sold during a particular period.
  • depreciable cost: original cost minus salvage value
  • inventory: A detailed list of all of the items on hand.
  • average collection period: 365 divided by the receivables turnover ratio

Average Cost Method

Under the average cost method, it is assumed that the cost of inventory is based on the average cost of the goods available for sale during the period. The average cost is computed by dividing the total cost of goods available for sale by the total units available for sale. This gives a weighted-average unit cost that is applied to the units in the ending inventory. There are two commonly used average cost methods: Simple Weighted Average Cost method and Moving-Average Cost method.

The following is an example of the weighted average cost method:

  • On 12/31/12, Furniture Palace has cost of goods available for sale (beginning inventory and purchases) of USD 5,000; 200 units available for sale; sales of 50 units; and an ending inventory of 150 units.
  • The per unit cost of inventory is USD 25 (5,000 / 200 units). The value of the ending inventory on the balance sheet is USD 3,750 (150 units * USD 25). The cost of goods sold on the income statement is USD 1,250 (50 units * USD 25).

Moving Average Cost

Moving-Average (Unit) Cost is a method of calculating Ending Inventory cost. Assume that both Beginning Inventory and Beginning Inventory Cost are known. From them, the Cost per Unit of Beginning Inventory can be calculated. During the year, multiple purchases are made. Each time, purchase costs are added to Beginning Inventory Cost to get Cost of Current Inventory. Similarly, the number of units bought is added to Beginning Inventory to get Current Goods Available for Sale. After each purchase, Cost of Current Inventory is divided by Current Goods Available for Sale to get Current Cost per Unit on Goods.

Also during the year, multiple sales happen. The Current Goods Available for Sale is deducted by the amount of goods sold (COGS), and the Cost of Current Inventory is deducted by the amount of goods sold times the latest (before this sale) Current Cost per Unit on Goods. This deducted amount is added to Cost of Goods Sold. At the end of the year, the last Cost per Unit on Goods, along with a physical count, is used to determine ending inventory cost.

The following is an example of the moving-average cost method:

On 12/29/12, Furniture Palace has beginning inventory of $5,000 and 200 units available for sale. The current cost per unit is [latex]\frac{$5000}{200\text{ units}}=$25[/latex].

On 12/30/12, a purchase of 50 units is made for $250. The new cost per unit after the purchase is [latex]\frac{$5000 + $250}{200 + 50} = $21[/latex].

On 12/31/12, sales for the period were 50 units and ending inventory is 150 units. The value of the ending inventory on the balance sheet is [latex]150\text{ units} \cdot $21 = $3150[/latex]. The cost of goods sold on the income statement is [latex]50\text{ units} \cdot $21 = $1050[/latex].

Weighted-Average under Periodic Inventory Procedure

The Weighted-Average Method of inventory costing is a means of costing ending inventory using a weighted-average unit cost. Companies most often use the Weighted-Average Method to determine a cost for units that are basically the same, such as identical games in a toy store or identical electrical tools in a hardware store. Since the units are alike, firms can assign the same unit cost to them. Under periodic inventory procedure, a company determines the average cost at the end of the accounting period by dividing the total units purchased plus those in beginning inventory into total cost of goods available for sale. The ending inventory is carried at this per unit cost.

Advantages and Disadvantages of Weighted-Average Method

When a company uses the Weighted-Average Method and prices are rising, its cost of goods sold is less than that obtained under LIFO, but more than that obtained under FIFO. Inventory is also not as badly understated as under LIFO, but it is not as up-to-date as under FIFO. Weighted-average costing takes a middle-of-the-road approach. A company can manipulate income under the weighted-average costing method by buying or failing to buy goods near year-end. However, the averaging process reduces the effects of buying or not buying.

image

Determining ending inventory: Determining ending inventory under weighted-average method using periodic inventory procedure

FIFO Method

FIFO stands for “first-in, first-out,” and assumes that the costs of the first goods purchased are charged to cost of goods sold.

Learning Objectives

Describe how a company would value inventory under the FIFO method

Key Takeaways

Key Points

  • This method assumes the first goods purchased are the first goods sold. In some companies, the first units in (bought) must be the first units out (sold) to avoid large losses from spoilage.
  • In periods of rising prices (Inflation) FIFO has higher value of inventory and lower cost of goods sold; in periods of falling prices (deflation) it has lower value of inventory and higher cost of goods sold.
  • Because a company using FIFO assumes the older units are sold first and the newer units are still on hand, the ending inventory consists of the most recent purchases.

Key Terms

  • accounting: The development and use of a system for recording and analyzing the financial transactions and financial status of a business or other organization.
  • FIFO: First in, first out (accounting).
  • inflation: An increase in the quantity of money, leading to a devaluation of existing money.

What Is FIFO

FIFO stands for “first-in, first-out”, and is a method of inventory costing which assumes that the costs of the first goods purchased are those charged to cost of goods sold when the company actually sells goods.

FIFO and LIFO methods are accounting techniques used in managing inventory and financial matters involving the amount of money a company has tied up within inventory of produced goods, raw materials, parts, components, or feed stocks. These methods are used to manage assumptions of cost flows related to inventory, stock repurchases (if purchased at different prices), and various other accounting purposes.

Inventory: Inventory in a warehouse

Assumptions of FIFO

This method assumes the first goods purchased are the first goods sold. In some companies, the first units in (bought) must be the first units out (sold) to avoid large losses from spoilage. Such items as fresh dairy products, fruits, and vegetables should be sold on a FIFO basis. In these cases, an assumed first-in, first-out flow corresponds with the actual physical flow of goods.

Because a company using FIFO assumes the older units are sold first and the newer units are still on hand, the ending inventory consists of the most recent purchases. When using periodic inventory procedure to determine the cost of the ending inventory at the end of the period under FIFO, you would begin by listing the cost of the most recent purchase. If the ending inventory contains more units than acquired in the most recent purchase, it also includes units from the next-to-the-latest purchase at the unit cost incurred, and so on. You would list these units from the latest purchases until that number agrees with the units in the ending inventory.

How is it different?

Different accounting methods produce different results, because their flow of costs are based upon different assumptions. The FIFO method bases its cost flow on the chronological order purchases are made, while the LIFO method bases it cost flow in a reverse chronological order. The average cost method produces a cost flow based on a weighted average of unit costs.

The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the “LIFO reserve. ” This reserve is essentially the amount by which an entity’s taxable income has been deferred by using the LIFO method.

How to Calculate Ending Inventory Using FIFO

Ending inventory = beginning inventory + net purchases – cost of goods sold

Keep in mind the FIFO assumption: Costs of the first goods purchased are those charged to cost of goods sold when the company actually sells goods.

When Using FIFO

  • Periods of Rising Prices (Inflation)FIFO (+) Higher value of inventory (-) Lower cost of goods sold
  • Periods of Falling Prices (Deflation)FIFO (-) Lower value of inventory (+) Higher cost of goods sold

LIFO Method

LIFO stands for last-in, first-out, meaning that the most recently produced items are recorded as sold first.

Learning Objectives

Summarize how using the LIFO method affects a company’s financial statements

Key Takeaways

Key Points

  • FIFO and LIFO Methods are accounting techniques used in managing inventory and financial matters involving the amount of money a company has tied up within inventory of produced goods, raw materials, parts, components, or feed stocks.
  • LIFO stands for last-in, first-out, meaning that the most recently produced items are recorded as sold first.
  • The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the “LIFO reserve. ” This reserve is essentially the amount by which an entity’s taxable income has been deferred by using the LIFO method.

Key Terms

  • LIFO: Last-in, first-out (accounting).
  • income statement: A calculation which shows the profit or loss of an accounting unit (company, municipality, foundation, etc.) during a specific period of time, providing a summary of how the profit or loss is calculated from gross revenue and expenses.
  • inventory: A detailed list of all of the items on hand.

Accounting Methods

A merchandising company can prepare an accurate income statement, statements of retained earnings, and balance sheets only if its inventory is correctly valued. On the income statement, a company using periodic inventory procedure takes a physical inventory to determine the cost of goods sold. Since the cost of goods sold figure affects the company’s net income, it also affects the balance of retained earnings on the statement of retained earnings. On the balance sheet, incorrect inventory amounts affect both the reported ending inventory and retained earnings. Inventories appear on the balance sheet under the heading ” Current Assets,” which reports current assets in a descending order of liquidity. Because inventories are consumed or converted into cash within a year or one operating cycle, whichever is longer, inventories usually follow cash and receivables on the balance sheet.

FIFO and LIFO methods are accounting techniques used in managing inventory and financial matters involving the amount of money a company has tied up within inventory of produced goods, raw materials, parts, components, or feed stocks. These methods are used to manage assumptions of cost flows related to inventory, stock repurchases (if purchased at different prices), and various other accounting purposes.

LIFO

LIFO stands for last-in, first-out, meaning that the most recently produced items are recorded as sold first. Since the 1970s, some U.S. companies shifted towards the use of LIFO, which reduces their income taxes in times of inflation, but with International Financial Reporting Standards banning the use of LIFO, more companies have gone back to FIFO. LIFO is only used in Japan and the United States. The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the “LIFO reserve. ” This reserve is essentially the amount by which an entity’s taxable income has been deferred by using the LIFO method.

image

LIFO inventory method: Determining LIFO cost of ending inventory under periodic inventory procedure.

image

LIFO Flowchart: LIFO flow of costs under periodic inventory procedure

The following is an example of the LIFO inventory costing method (assume the following inventory of Product [latex]X[/latex] is on hand and purchased on the following dates).

  • Purchase date 10/1/12: 10 units at a cost of USD 5
  • Purchase date 10/5/12: 5 units at a cost of USD 6
  • On 12/30/12, 11 units of Product [latex]X[/latex] are sold. When the sale is made, it is assumed that the 5 units purchased on 10/5/12 (the sale eliminates this inventory layer) and 6 units purchased on 10/1/12 were sold.

The ending inventory balance on 12/31/12 balance sheet is [latex]4\text{ units} \cdot $5 = $20[/latex], and the cost of goods sold on the income statement is [latex]5\text{ units} \cdot $6 + 6\text{ units} \cdot $5=$60[/latex].

LIFO Under Perpetual Inventory Procedure

Under this procedure, the inventory composition and balance are updated with each purchase and sale. Each time a sale occurs, the items sold are assumed to be the most recent ones acquired. Despite numerous purchases and sales during the year, the ending inventory still includes the units from beginning inventory.

Applying LIFO on a perpetual basis during the accounting period, results in different ending inventory and cost of goods sold figures than applying LIFO only at year-end using periodic inventory procedure. For this reason, if LIFO is applied on a perpetual basis during the period, special inventory adjustments are sometimes necessary at year-end to take full advantage of using LIFO for tax purposes.

Gross Profit Method

The gross profit method uses the previous year’s average gross profit margin to calculate the value of the inventory.

Learning Objectives

Explain how a company would use the Gross Profit Method to value inventory

Key Takeaways

Key Points

  • There a two methods to estimate inventory cost the retail inventory method and the gross profit method.
  • If taking a physical inventory is impossible or impractical, it is necessary to estimate the inventory cost.
  • Keep in mind the gross profit method assumes that gross profit ratio remains stable during the period.

Key Terms

  • gross profit: The difference between net sales and the cost of goods sold.
  • monetary: Of, pertaining to, or consisting of money.

Valuing Inventory

An inventory valuation allows a company to provide a monetary value for items that make up their inventory. Inventories are usually the largest current asset of a business, and proper measurement of them is necessary to assure accurate financial statements. If inventory is not properly measured, expenses and revenues cannot be properly matched and a company could make poor business decisions.

A company will chose an inventory accounting system, either perpetual or periodic. In perpetual inventory the accounting records must show the amount of inventory on hand at all times. Periodic inventory is not updated on a regular basis.

Methods Used to Estimate Inventory Cost

While the best way to value inventory is to perform a physical inventory, in certain business operations, taking a physical inventory is impossible or impractical. In such a situation, it is necessary to estimate the inventory cost. There are two methods to estimate inventory cost, the retail inventory method and the gross profit method.

Both methods can be used to calculate the inventory amount for the monthly financial statements, or estimate the amount of missing inventory due to theft, fire or other disaster. Either of these methods should never be used as a substitute for performing an annual physical inventory.

Gross Profit Method

The gross profit (or gross margin) method uses the previous year’s average gross profit margin (i.e. sales minus cost of goods sold divided by sales) to calculate the value of the inventory. Keep in mind the gross profit method assumes that gross profit ratio remains stable during the period.

image

Inventory.: The gross profit (or gross margin) method uses the previous year’s average gross profit margin (i.e. sales minus cost of goods sold divided by sales) to calculate the value of the inventory.

To prepare the inventory value via the gross profit method:

  • Calculate the cost of goods available for sale as the sum of the cost of beginning inventory and cost of net purchases.
  • Determine the gross profit ratio. Gross profit ratio equals gross profit divided by sales. Use projected gross profit ratio or historical gross profit ratio whichever is more accurate and reliable.
  • Multiply sales made during the period by gross profit ratio to obtain estimated cost of goods sold.
  • Calculate the cost of ending inventory as the difference of cost of goods available for sale and estimated cost of goods sold.

Example

The following is an example on how to calculate ending inventory using the gross profit method.

Furniture Palace has cost of goods available for sale of $5000. Sales were $1000.

The company has projected a gross profit ratio of 25%.

The estimated cost of goods sold on the income statement for the period is [latex]$1000\cdot.25 = $250[/latex].

The ending inventory on the balance sheet is [latex]$5000 - $250=$4750[/latex].

Selecting an Inventory Method

When selecting an inventory method, managers should look at the advantages and disadvantages of each.

Learning Objectives

Summarize the differences between LIFO, FIFO and Specific Identification and explain how a company would use that information to select an inventory method

Key Takeaways

Key Points

  • Specific identification provides the most precise matching of costs and revenues and is, therefore, the most theoretically sound method.
  • The FIFO method has four major advantages: (1) it is easy to apply, (2) the assumed flow of costs corresponds with the normal physical flow of goods, (3) no manipulation of income is possible, and (4) the balance sheet amount for inventory is likely to approximate the current market value.
  • During periods of inflation, LIFO shows the largest cost of goods sold (COGS) of any of the costing methods because the newest costs charged to cost of goods sold are also the highest costs.
  • When a company uses the weighted-average method and prices are rising, its cost of goods sold is less than that obtained under LIFO, but more than that obtained under FIFO.

Key Terms

  • inventory: A detailed list of all of the items on hand.
  • balance sheet: A summary of a person’s or organization’s assets, liabilities. and equity as of a specific date.

Advantages and Disadvantages of Specific Identification

Companies that use the specific identification method of ‘inventory costing’ state their cost of goods sold and ending inventory as the actual cost of specific units sold and on hand. Some accountants argue that this method provides the most precise matching of costs and revenues and is therefore the most theoretically sound method. This statement is true for some one-of-a-kind items, such as autos or real estate. For these items, use of any other method would seem illogical. However, one disadvantage of the specific identification method is that it permits the manipulation of income.

Advantages and Disadvantages of FIFO

The FIFO method has four major advantages:

  1. It is easy to apply.
  2. The assumed flow of costs corresponds with the normal physical flow of goods.
  3. No manipulation of income is possible.
  4. The balance sheet amount for inventory is likely to approximate the current market value.

All the advantages of FIFO occur because when a company sells goods, the first cost it removes from inventory are the oldest unit costs. The cost attached to the unit sold is always the oldest cost. Under FIFO, purchases at the end of the period have no effect on cost of goods sold or net income ([fig:11053]]). The disadvantages of FIFO include the recognition of paper profits and a heavier tax burden if used for tax purposes in periods of inflation.

An example of how to calculate the ending inventory balance of the period using FIFO — assume the following inventory is on hand and purchased on the following dates:

  • Inventory of Product X –
  • Purchase date: 10/1/12 — 10 units at a cost of USD 5
  • Purchase date: 10/5/12 — 5 units at a cost of USD 6
  • On 12/30/12, a sale of Product X is made for 11 units
  • When the sale is made, it is assumed that the 10 units purchased on 10/1/12 and 1 unit purchased on 10/5/12 were sold
  • The ending inventory balance on 12/31/12 balance sheet is 4 units at a cost of USD 6, or USD 24. The cost of goods sold on the income statement is USD 56 (10 units * USD 5 + 1 unit * USD 6).

Advantages and disadvantages of LIFO

During periods of inflation, LIFO shows the largest cost of goods sold of any of the costing methods because the newest costs charged to cost of goods sold are also the highest costs. The larger the cost of goods sold, the smaller the net income. Those who favor LIFO argue that its use leads to a better matching of costs and revenues than the other methods. When a company uses LIFO, the income statement reports both sales revenue and cost of goods sold in current dollars. The resulting gross margin is a better indicator of management ‘s ability to generate income than gross margin computed using FIFO, which may include substantial inventory (paper) profits.

An example of how to calculate the ending inventory balance of the period using LIFO — assume the following inventory is on hand and purchases are made on the following dates:

  • Inventory of Product X –
  • Purchase date: 10/1/12 — 10 units at a cost of USD 5
  • Purchase date: 10/5/12 — 5 units at a cost of USD 6
  • On 12/30/12, a sale of Product X is made for 11 units. When the sale is made, it is assumed that the 5 units purchased on 10/5/12 and 6 units purchased on 10/1/12 were sold.
  • The ending inventory balance on 12/31/12, is 4 units at a cost of USD 5, or USD 20. The cost of good sold on the income statement is USD 60 (5 units * USD 6 + 6 units * USD 5).

Advantages and Disadvantages of Weighted-Average

When a company uses the weighted-average method and prices are rising, its cost of goods sold is less than that obtained under LIFO, but more than that obtained under FIFO. Inventory is not as understated as under LIFO, but it is not as up-to-date as under FIFO. A company can manipulate income under the weighted-average costing method by buying or failing to buy goods near year-end. However, the averaging process reduces the effects of buying or not buying.

The following is an example of the weighted average cost method:

  • On 12/31/12, Furniture Palace has cost of goods available for sale of USD 5,000; 200 units available for sale; sales of 50 units; and an ending inventory of 150 units.
  • The per unit cost of inventory is USD 25 (5,000 / 200 units). The value of the ending inventory on the balance sheet is USD 3,750 (150 units * USD 25). The cost of goods sold on the income statement is USD 1,250 (50 units * USD 25).

Impacts of Costing Methods on Financial Statements

The method a company uses to determine it cost of inventory (inventory valuation) directly impacts the financial statements.

Learning Objectives

Differentiate between the FIFO, LIFO and Average Cost inventory valuation methods

Key Takeaways

Key Points

  • Without inflation all three inventory valuation methods would produce the same results. However, prices do tend to rise over the years, and the company’s method costing method affects the valuation ratios.
  • The FIFO method assumes that the first unit in inventory is the first until sold. FIFO gives a more accurate value for ending inventory on the balance sheet. On the other hand, FIFO increases net income and increased net income can increase taxes owed.
  • The LIFO method assumes the last item entering inventory is the first sold. During periods of inflation LIFO shows ending inventory on the balance sheet much lower than what the inventory is truly worth at current prices, this means lower net income due to a higher cost of goods sold.
  • The average cost method takes a weighted average of all units available for sale during the accounting period and then uses that average cost to determine the value of COGS and ending inventory.

Key Terms

  • ending inventory: Ending inventory is the amount of inventory a company have in stock at the end of this fiscal year.
  • net income: Gross profit minus operating expenses and taxes.

Inventory Valuation

The method a company uses to determine it cost of inventory (inventory valuation) directly impacts the financial statements. The three main methods for inventory costing are First-in, First-Out (FIFO), Last-in, Last-Out (LIFO) and Average cost.

image

Inventory valuation method.: The inventory valuation method a company chooses directly effects its financial statements.

First-in, First-Out

The FIFO method assumes that the first unit in inventory is the first until sold. For example, during the week a factory produces items. On Monday the items cost is $5 per unit to make, on Tuesday it is a $5.50 per unit. When the item is sold on Wednesday FIFO records the cost of goods sold for those items as $5. So, the balance sheet has the cost of goods sold at $1 and the balance sheet retains the remaining inventory at $5.50.

Last-in, First-out

The LIFO method assumes the opposite, that the last item entering inventory is the first sold. That means the factory would record the Wednesday cost of goods sold as $5.50 and the remaining inventory at $5.

Average Cost

This method is the most easy to calculate; it takes a weighted average of all units available for sale during the accounting period and then uses that average cost to determine the value of COGS and ending inventory. Assuming the factory made a total of 100 units the price per unit would be [latex]\frac{$5.00 \cdot 50 + $5.50 \cdot 50}{100}=$5.25[/latex].

Impact on the Financial Statements

Without inflation, all three inventory valuation methods would produce the same results. Unfortunately, prices do tend to rise over the years, and the company’s method costing method affects the valuation ratios.

During periods of inflation, the FIFO gives a more accurate value for ending inventory on the balance sheet. On the other hand, FIFO increases net income (due to the age of the inventory being used in cost of goods sold) and Increased net income can increase taxes owed.

Using LIFO during periods of inflation tend to show and ending inventory amount on the balance sheet that is much lower than what the inventory is truly worth at current prices, this means lower net income due to a higher cost of goods sold.

With average cost, the results fall in between FIFO and LIFO. Keep in mind deflation (falling prices) have an opposite effect on each method.