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.

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.

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

Source: Boundless, https://courses.lumenlearning.com/boundless-accounting/chapter/valuing-inventory/
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Specific Identification Method

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

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.

Cost Flow Assumptions

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

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).

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

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.

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

Gross Profit Method

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

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.

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 $1000⋅.25=$250.

The ending inventory on the balance sheet is $5000−$250=$4750.

Selecting an Inventory Method

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

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