Effects of Inventory Cost Methods

Learning Outcomes

  • Compare and contrast the effect of different cost flow assumptions on gross profit and net income

Here is the recap of the four cost assumptions using the periodic method of accounting for ending inventory and COGS using the numbers from the introduction to this section:

NewCo Sporting Goods
Gross Profit Calculation –
periodic method
SpecID WAVE FIFO LIFO
Gross sales $ 620.00 $ 620.00 $ 620.00 $ 620.00
Cost of Goods Sold 368.00 374.88 352.00 396.00
Gross profit Single Line$252.00Double Line Single Line$245.12Double Line Single Line$268.00Double Line Single Line$224.00Double Line
Gross profit % 40.65% 39.54% 43.23% 36.13%

And here is that same data presented using the perpetual method:

NewCo Sporting Goods
Gross Profit Calculation –
perpetual method
SpecID WAVE FIFO LIFO
Gross sales $ 620.00 $ 620.00 $ 620.00 $ 620.00
Cost of Goods Sold 368.00 369.15 352.00 384.00
Gross profit Single Line$252.00Double Line Single Line$250.85Double Line Single Line$268.00Double Line Single Line$236.00Double Line
Gross profit % 40.65% 40.46% 43.23% 38.06%

Notice that specific identification is the same under both the periodic and perpetual method since we were using the actual cost of the item matched against the revenue it produced. Also, FIFO is the same under both systems since the oldest layers of inventory are cleared out first, leaving current costs in ending inventory. LIFO and moving weighted average are different, though, because of the constant updating of the accounting records.

In addition, what differences do you see between the assumptions?

LIFO gives the lowest gross profit, but only because the prices of our inventory purchases were rising. If our costs were falling, LIFO would give the highest gross profit. FIFO then, in periods of rising prices, will give us a higher gross profit than LIFO because we would be using the oldest (lower) costs for COGS.

Weighted average (or moving weighted average if you are using a perpetual inventory accounting system) will always fall between FIFO and LIFO. Specific identification will usually be somewhere between the two, but depending on the actual physical flow of goods, it could also be very close to one or the other.

Practice Question

Summary

In summary, here are your choices:

You can use FIFO, LIFO, weighted average, or specific identification cost flow assumptions, and either a perpetual accounting or periodic accounting to move those costs from inventory to COGS.