We know from Chapter 5 that the cost of inventory can be affected by discounts, returns, transportation costs, and shrinkage. Additionally, the purchase cost of an inventory accounting inventory item can be different from one purchase to the next. For example, the cost of coffee beans could be $5.00 a kilo in October and $7.00 a kilo in November.
Strategic decision for management
The unsold inventory at period end is an asset to the company and is therefore included in the company’s financial statements, on the balance sheet, as shown in Figure 10.2. When making an inventory cost flow assumption, what factors do managers need to consider? Generally, the cost flow assumption should attempt to reflect the actual physical flow of goods as much as possible.
Real-World Applications of Inventory Cost Flow Methods
Assume further that sales each year amounted to $30,000 with cost of goods sold of $20,000 resulting in gross profit of $10,000. Conversely, when prices fall (deflationary times), FIFO ending inventory account balances decrease and the income statement reflects higher cost of goods sold and lower profits than if goods were costed at current inventory prices. The effect of inflationary and deflationary cycles on LIFO inventory valuation are the exact opposite of their effects on FIFO inventory valuation.
Periodic Inventory Method
- Each of these assumptions determines the cost moved from inventory to cost of goods sold to reflect the sale of merchandise in a different manner.
- This method took the most recent purchases and allocated them to the cost of the goods sold first.
- Understanding this relationship is the key to estimating inventory using either the gross profit or retail inventory methods, discussed below.
- In application, Mayberry would need to choose one of the three cost flow assumptions and stick with it year after year so they would be consistent.
Often this is done by using either the periodic inventory method or the perpetual method. The average cost flow assumption assumes that all goods of a certain type are interchangeable and only differ in purchase price. The purchase price differentials are attributed to external factors, including inflation, supply, or demand. Average cost flow assumption is also called “the weighted average cost flow assumption.”
- The last-in, first out method (LIFO) records costs relating to a sale as if the latest purchased item would be sold first.
- The method utilized to assign costs to inventory and COGS can have a big bearing on a company’s key financials, reported profitability, and tax obligations.
- Since FIFO assumes that the first items purchased are sold first, the latest acquisitions would be the items that remain in inventory at the end of the period and would constitute ending inventory.
- Inventory must be evaluated, at minimum, each accounting period to determine whether the net realizable value (NRV) is lower than cost, known as the lower of cost and net realizable value (LCNRV) of inventory.
- Comparing the various costing methods for the sale of one unit in this simple example reveals a significant difference that the choice of cost allocation method can make.
- Therefore, although the identity of the actual item sold is rarely known, the assumption is made in applying FIFO that the first (or oldest) cost is always moved from inventory to cost of goods sold.
- This method would thus achieve the perfect matching of costs to the revenue generated.
Generally accepted accounting principles require that inventory be valued at the lesser amount of its laid-down cost and the amount for which it can likely be sold — its net realizable value (NRV). This concept is known as the lower of cost and net realizable value, or LCNRV. Perpetual inventory incorporates an internal control feature that is lost under the periodic inventory method. Losses resulting from theft and error can easily be determined when the actual quantity of goods on hand is counted and compared with the quantities shown in the inventory records as being on hand.
- Sales still equal $40, so gross profit under FIFO is $30 ($40 – $10).
- When costs are assigned to these items and these individual costs are added, a total inventory amount is calculated.
- “By matching current costs against current sales, LIFO produces a truer picture of income; that is, the quality of income produced by the use of LIFO is higher because it more nearly approximates disposable income” (Rumble, 1983).
- Additionally, there are ways to estimate ending inventory, such as the retail inventory method, and it is possible to assign costs to inventory using the actual cost of each item (specific identification method).
- For large organizations, such transactions can take place thousands of times each day.
- A company may use different cost flow assumptions for different major inventory classes, but these choices should still be applied consistently.
The shoes purchased on March 3 are the oldest and thus we use the cost of the shoes purchased on that day. With that assumption, the remaining inventory would be 19 pairs at $30 and 30 pairs at a cost of $35 each. Let’s assume the Corner Bookstore had one book in inventory at the start of the year 2023 and at different times during 2023 it purchased four additional copies of the same book. During the year 2023, the publisher increased the price of the books due to a paper shortage. The following chart shows Corner Bookstore’s total cost of the five books was $440.
The First In, First Out (FIFO) Accounting Method
Businesses will refer to this as rotating the goods on hand or rotating the stock. Although no shirt did cost $60, this average serves as the basis for both cost of goods sold as well as the cost of the item still on hand. However, for identical items like shirts, cans of tuna fish, bags of coffee beans, hammers, packs of notebook paper and the like, the idea of maintaining such precise records is ludicrous. What informational benefit could be gained by knowing whether the first blue shirt was sold or the second? In most cases, the cost of creating such a meticulous record-keeping system far outweighs any potential advantages.
This information is used to calculate the cost of goods sold amount for each sales transaction at the time of sale. These costs will vary depending on the inventory cost flow assumption used. As we will see in the next sections, the cost of sales may also vary depending on when sales occur. We will use a hypothetical business Corner Bookstore to demonstrate how to flow the costs out of inventory and into the cost of goods sold on the company’s income statement.