## Inventory Cost Methods

### Learning Outcomes

• Illustrate the use of specific identification cost flow assumption
• Illustrate the use of weighted average cost flow assumption
• Illustrate the use of First-in, First-out (FIFO) cost flow assumption
• Illustrate the use of Last-in, First-out (LIFO) cost flow assumption

Here is an overview of the cost flow assumptions:

In order to put this principle in context, let’s take a simple example and apply each of the four examples in turn. We’ll assume that NewCo Sporting Goods has decided to start selling baseball bats in October, starting with a model called the Slugger, and that the company made three purchases, listed in the table below. Notice that the cost of each bat is different for each purchase.

Product ID Description Cost Quantity Purchases NewCo Sporting Goods 12/31/20XX Slugger purchased 10/15/20XX 10.00 10 100.00 Slugger purchased 11/15/20XX 12.00 25 300.00 Slugger purchased 12/15/20XX 15.00 8 120.00 $520.00 Say at the end of the year you have 12 bats left in stock, according to your physical count, and that for simplicity’s sake, you have decided to use the periodic method of accounting for inventory, where you wait until the end of the year to compute COGS. You have the following information: • Beginning inventory was zero because this is your first year in business. • You purchased three different “lots” of baseball bats, 43 in total, with a total cost of$520.
• There are 12 bats in ending inventory.

What cost do you assign to those 12 bats? The answer is, it depends on the cost flow assumption used.

Let’s take a quick look at each cost flow assumption using the periodic method, and then we’ll apply what we have learned to the perpetual method.

## 1. Specific Identification

Technically, the specific identification method of assigning costs to items in inventory isn’t an assumption because it is a direct assignment of the cost of the item purchased to the item. Assume that when each bat came in, we put a sticker on it. Green for the $10 bats, red for the$12 bats, and blue for the $15 bats. We look at the 12 bats in ending inventory and specifically identify which ones are left. We find two green bats, six red bats, and four blue bats. Product ID Description Cost Quantity Total Purchases Ending Inventory Total Inventory Value NewCo Sporting Goods 12/31/20XX Slugger purchased 10/15/20XX 10.00 10 100.00 2 20.00 Slugger purchased 11/15/20XX 12.00 25 300.00 6 72.00 Slugger purchased 12/15/20XX 15.00 8 120.00 4 60.00$ 520.00 $152.00 Because we identified the exact cost of each bat, we can calculate the cost of ending inventory precisely. Two green bats at$10 each, plus six red bats at $12 each, and four blue bats at$15 each makes the total cost of ending inventory equal $152 using the historical cost principle and the specific identification cost-flow method. Assume each bat sold for$20. We had 43 bats. There are 12 left, so we sold 31 bats at $20 each for total sales of$620. We’ll assume no discounts, no returns or allowances, and no freight in. Here is our calculation of gross profit on bats:

NewCo Sporting Goods
Gross Profit Calculation
Specific Identification method
Description Amount Total
Gross sales $620.00 Beginning inventory$-
Purchases $520.00 Less ending inventory 152.00 Costs of goods sold$368.00
Gross profit Single Line$252.00Double Line Gross profit % 40.64% Another way to look at this is we sold 8 of the$10 bats, 19 of the $12 bats, and 4 of the$15 bats. What is the total cost of bats sold? $80 +$228 + $60 =$368.

Product ID Description Cost Quantity Total Purchases Cost of Goods Sold Total Inventory Value NewCo Sporting Goods 12/31/20XX Slugger purchased 10/15/20XX 10.00 10 100.00 8 80.00 Slugger purchased 11/15/20XX 12.00 25 300.00 19 228.00 Slugger purchased 12/15/20XX 15.00 8 120.00 4 60.00 $520.00$ 368.00

## 2. Weighted Average

A “straight” or unweighted average would be ($10 +$12 + $15) / 3 =$12.33, which actually gives each price equal weight. However, we bought a lot more bats at $12 than at the other price points, so we should give those bats more weight. We do that by multiplying the price (our cost) by the units, which we have already done in the table above to get Total Purchases. Divide that number by total units, and we get the weighted average cost:$520.00 / 43 units = $12.09. Not a radical difference in this case, but for a bigger business, the effect of using the wrong calculation would be magnified. There are 12 units in ending inventory at an average cost of$12.09 for a total ending inventory cost of $145.12. NewCo Sporting Goods Gross Profit Calculation Weighted Average Method Description Amount Total Gross sales$ 620.00
Beginning inventory $- Purchases$520.00
Less ending inventory $145.12 Costs of goods sold$374.88
Gross profit Single Line$245.12Double Line Gross profit % 39.54% ## 3. First-in, First-out (FIFO) First-in, First-out (FIFO) could also be called “last in still here.” The first purchases we made are assumed to be the first items sold, so the most recent purchases are the ones left in ending inventory. In this case, we would assume that the 12 bats left in our store at the end of the year were the eight we bought on the 15th of December and four of the bats we bought on the 15th of November. Product ID Description Cost Quantity Purchases Ending Inventory Total Inventory Value NewCo Sporting Goods 12/31/20XX Slugger purchased 10/15/20XX 10.00 10 100.00 – – Slugger purchased 11/15/20XX 12.00 25 300.00 4 48.00 Slugger purchased 12/15/20XX 15.00 8 120.00 8 120.00$ 520.00 $168.00 NewCo Sporting Goods Gross Profit Calculation FIFO Description Amount Total Gross sales$ 620.00
Beginning inventory $- Purchases$520.00
Less ending inventory $168.00 Costs of goods sold$352.00
Gross profit Single Line$268.00Double Line Gross profit % 43.23% ## 4. Last-in, First-out (LIFO) Last-in, First-out (LIFO) is the exact opposite of FIFO. We assume that the first items we sell come from the most recent purchases. Another way to think of this, in terms of the costs assigned to ending inventory, is “first in still here” This system creates an interesting and sometimes perplexing problem called “LIFO layers” that we will discuss later. For now, here is the same information we’ve been examining, this time using the LIFO cost flow assumption: Product ID Description Cost Quantity Purchases Ending Inventory Total Inventory Value NewCo Sporting Goods 12/31/20XX Slugger purchased 10/15/20XX 10.00 10 100.00 10 100.00 Slugger purchased 11/15/20XX 12.00 25 300.00 2 24.00 Slugger purchased 12/15/20XX 15.00 8 120.00 – –$ 520.00 $124.00 NewCo Sporting Goods Gross Profit Calculation LIFO Description Amount Total Gross sales$ 620.00
Beginning inventory $- Purchases$520.00
Less ending inventory $124.00 Costs of goods sold$396.00
Gross profit Single Line$224.00Double Line Gross profit % 36.13% Let’s look at all four methods, side by side:  SpecID WAVE FIFO LIFO Gross sales$ 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%

Which method would make investors and lenders happiest? Which method would result in the lowest taxes? Which method makes the most sense for this business, and why?

How would you apply any of these methods to a perpetual inventory system?

Let’s find out.