6.2 Inventory Methods under Perpetual Inventory Method

Cost of goods sold and Inventory

Remember, cost of goods sold is the cost to the seller of the goods sold to customers. Cost of Goods Sold is an EXPENSE item. Even though we do not see the word Expense this in fact is an expense item found on the Income Statement as a reduction to Revenue.  For a merchandising company, the cost of goods sold can be relatively large. All merchandising companies have a quantity of goods on hand called merchandise inventory to sell to customers. Merchandise inventory (or inventory) is the quantity of goods available for sale at any given time.

You will now learn how to calculate the Cost of Goods Sold using 4 different methods.

The 4 methods of Cost of Goods Sold you will learn are:

  • FIFO (First in, First out) – this means you will use the OLDEST inventory first to fill orders. This also means the oldest costs will appear in Cost of Goods Sold (since this is an Expense account this also means oldest costs will appear in the Income Statement). The most recent costs are shown in the Inventory asset account balances and are provided on the Balance Sheet. This is an advantage because you are now reporting Inventory at the current cost which better reflects what it would cost to replace inventory if that would become necessary due to a disaster. FIFO shows the actual flow of goods…typically you will sell the oldest inventory before the newest inventory.
  • LIFO (Last in, First out) – this means you will use the MOST RECENT inventory first to fill orders. Cost of goods sold will reflect the current or most recent costs and are a better representation of matching since you are matching revenue will current costs of the inventory. The Balance Sheet will show inventory at the oldest inventory costs and may not represent current market value.
  • Weighted Average (also called Average Cost) – this method is best used when the prices change from purchase to purchase and you want consistency. The weighted average method smooths out price changes so you have a steady stream of cost instead of sharp increases and decreases. You will calculate a new Average Cost after each Purchase (Sales will not change the average cost).
  • Specific Identification – clearly, this will be your favorite method…it is the easiest to calculate in our examples because it specifically tells you which purchases inventory comes from. This is most often used for high priced inventory – think car sales for example. When a car dealership purchases a blue BMW convertible for $20,000 and later sells it for $60,000…they will want to show the exact cost of the BMW it sold as opposed to the cost of another car. So, specific identification exactly matches the costs of the inventory with the revenue it creates.

Okay, enough theory – how do these calculations work exactly?  There are a couple of ways you can do them – there is an Inventory Record or a shortcut calculation.  You will see both because they are both beneficial.  Most computer systems will show you the Inventory Record form so you need to understand how to read it.  However, it can be time consuming and not practical for homework and test situations so you learn the alternative method as well.  We will be using the perpetual inventory system in these examples which constantly updates the inventory account balance to reflect inventory on hand.

When calculating the Cost of Goods Sold for a sale, you must IGNORE the selling price.  The selling price has NOTHING to do with the cost.   We are trying to determine how much the items we sold originally COST us – that is the purpose behind cost of goods sold.  Next thing to remember, you can only use items that occurred BEFORE the sale (meaning, you cannot use a purchase from August 28 when calculating cost of goods sold on August 14 – why?  It hasn’t happened yet).  We will pick inventory from the different purchases and use the purchase price to calculate the cost of goods sold.

FIFO (First in, First Out)

Under the FIFO method, we will use the oldest inventory at the time of the sale first.  You must calculate Cost of Goods Sold for each sale individually.  Watch this video on the FIFO Method.

Using the inventory record format, the transactions from the video would look like this under the FIFO method:

 

Date Goods Purchased Cost of Goods Sold

Inventory Balance (or Ending Inventory)

 

Jan 1 Beginning Balance 300 units x $10 = $3,000
Jan 2 200 x $15 = $3,000

300 units x $10 = $3,000 (from Jan 1)

200 units x $15 = $3,000 (from Jan 2)

TOTALS  500 units         $6,000

(sum of purchases to date, $3,000 +$ 3,000)

Jan 8

300 units x $10 = $3,000 (from Jan 1)

Total COGS for 300 units  $ 3,000

200 units x $15 = $3,000

(beg inventory is zero and the Jan 2 purchase remains)

Jan 11 100 x $17 = $1,700

200 units x $15 = $3,000 (from Jan 2)

100 units x $17 = $1,700 (from Jan 11)

TOTALS  300 units          $4,700

Jan 15

 200 units x $15 = $3,000 (from Jan 2)

50 units x $17 = $850 (from Jan 11)

TOTAL COGS  for 250 units  $3,850

50 units x $17 = $850 (from Jan 11)

(Jan 2 purchase has been used and 50 units from the Jan 11 purchase remains)

Jan 18 300 x $20 = $6,000

50 units x $17 = $850 (from Jan 11)

300 units x $20 = $6,000

TOTALS (End. Inventory)  350 Units  $6,850

Total cost of goods sold for January would be $6,850 (3,000 + 3,850).  Sales would be Jan 8 Sales ( 300 units x $30) $9,000 + Jan 11 Sales (250 units x $40) $10,000 or $19,000.  The gross profit (or margin) would be $12,150 ($19,000 Sales – 6,850 cost of goods sold).  The journal entries for these transactions would be (assuming all transactions on credit):

Note:  No journal entry is prepared for beginning inventory since it is a rollover from last period’s ending balance.

Date Account Debit Credit
Jan 2 Merchandise Inventory 3,000
   Accounts Payable 3,000
Jan 8 Accounts Receivable 9,000
     Sales 9,000
Cost of goods sold 3,000
     Merchandise Inventory 3,000
Jan 11 Merchandise Inventory 1,700
   Accounts Payable 1,700
Jan 15 Accounts Receivable 10,000
   Sales 10,000
Cost of goods sold 3,850
     Merchandise Inventory 3,850
Jan 18 Merchandise Inventory 6,000
   Accounts Payable 6,000

 

LIFO (Last in, First out)

Under the LIFO method, we will use most recent purchases at the time of the sale first.  You must calculate Cost of Goods Sold for each sale individually.  Let’s look at the this video:

Using the inventory record format, the transactions from the video would look like this under the LIFO method:

Date Goods Purchased Cost of Goods Sold

Inventory Balance (or Ending Inventory)

 

Mar 1
200 x $10 = $2,000 200 units x $10 = $2,000 (from Mar 2)
Mar 16
 150 x $12 = $1,800

200 units x $10 = $2,000 (from Mar 2)

150 units x $12 = $1,800 (from Mar 16)

TOTALS  350 units          $3,800

Apr 13
225 x $16 = $3,600

200 units x $10 = $2,000 (from Mar 2)

150 units x $12 = $1,800 (from Mar 16)

225 units x $16 = $3,600 (from Apr 13)

TOTALS  350 units          $3,800

May 1

225 units x $16 = $3,600 (from Apr 13)

25 units x $12 = $300 (from Mar 16)

TOTAL COGS  for 250 units  $3,900

200 units x $10 = $2,000 (from Mar 2)

125 units remaining x $12 = $1,800 (from Mar 16)

TOTALS  325 units          $3,500

 Total cost of goods sold for the month would be $3,900.

Weighted Average (or Average Cost)

The Weighted Average method strives to smooth out price changes during the period.  To do this, we will calculate an average cost of inventory at the end of the month under the periodic method (perpetual method calculates average cost of inventory after each purchase).  Sales of inventory will not affect the average cost of inventory.  It does NOT matter which purchase the inventory comes from when using the average cost method.  Instead, we will use the average cost calculated  to determine cost of goods sold for any sales transactions.  Average Cost is calculated by taking the TOTAL COST of INVENTORY / TOTAL INVENTORY QUANTITY.  Let’s look at a video:

The Inventory Record for this information in the video would be:

Purchases Cost of goods sold Inventory Balance Avg Cost
Jan 1 300 units $3,000 $10.00 ($3,000 / 300 units)
Jan 2 200 units x $15 = $3,000

500 units $6,000

(add Jan 1 and Jan 2 together)

$12.00 ($6,000 / 500 units)
Jan 8 300 units x $12 avg cost = $3,600

200 units $2,400

(take Jan 2 balance – Jan 8 cogs)

Jan 11 100 units x $17 = $1,700

300 units $4,100

(add Jan 8 balance and Jan 11 purchase)

13.67

(rounded)

($4,100 / 300 units)
Jan 15 250 units x $13.67 avg cost = $3,417.50

50 units $682.50**

(take Jan 11 balance – Jan 15 cogs)

Jan 16 300 units x $20 = $6,000

350 units $6,682.50

(add Jan 15 balance and Jan 16 purchase)

19.09 (rounded) ($6,682.50 / 350 units)

**Jan 15 and 16 off a little from the information in the video due to rounding of the average cost.

Total cost of goods sold for January would be $7,017.50 ($3600 + 3,417.50).  Since total Sales would the same as we calculated before $19,000.  The gross profit (or margin) would be $11,982.50 ($19,000 Sales – 7017.50 cost of goods sold).  The journal entries for these transactions would be would be the same as show above the only thing changing would be the AMOUNT of cost of goods sold used in the Jan 8 and Jan 15 entries.

Specific Identification

Finally, the last method – we are saving the easiest one for last.  Specific identification will tell you exactly which purchase to use when determining cost.

Easy, huh?  No guess work, no hard thinking – just take the information given and calculate based on the purchase prices given.  Let’s look at another example:

Date Description Qty Price per Unit Total Amount
May 1 Beginning Inventory 150 $ 300 $ 45,000
May 6 Purchase 350 350   122,500
May 17 Purchase 80 450   36,000
May 25 Purchase 100 458   45,800
May 30 Sold 300 1,400  420,000
  • On May 9, you sold 180 units consisting of 80 units from beginning inventory and 100 units from the May 6 purchase.
  • May 30 sold 300 units consisting of 200 units from the May 6 purchase and 100 units from the May 25 purchase

Using an Inventory Record, cost of goods sold would look like this:

Date Goods Purchased Cost of Goods Sold

Inventory Balance

 

May 1 Beginning Balance 150 x $300 = $ 45,000
May 6 350  x $350 = $122,500

150 x $300 = $45,000

350 x $350 = 122,500

TOTALS 500 units      $167,500

May 9

  80 x $300 =  24,000

100 x $350 =  35,000

COGS 180 units    $ 59,000

70 x $300 = $21,000

250 x $350 = 87,500

TOTALS 320 units      $108,500

May 17 80 x $450 = $36,000

70 x $300 = $21,000

250 x $350 = 87,500

80 x $450 = 36,000

TOTALS  400 units      $144,500

May 25 100 x $458 = $45,800

70 x $300 = $21,000

250 x $350 =   87,500

80 x $450 =     36,000

100 x $458 =   45,800

TOTALS  500 units        $190,300

May 30

200 x $350 =  70,000

100 x $458 =  45,700

COGS  300 units   $ 174,800

70 x $300 = $21,000

50 x $350 =   17,500

80 x $450 =   36,000

End. Inventory  200 units        $74,500

The total cost of goods sold for May would be $233,800 (59,000 + 174,800).