BUS202: Principles of Finance

Inventory costs depends on methods used, which include Specific Identification, Weighted Average Cost, Moving-Average Cost, FIFO, and LIFO.

Key Terms

• $ABC$ analysis: The $ABC$ analysis is a business term used to define an inventory categorization technique often used in materials management. It is also known as Selective Inventory Control. Policies based on $ABC$ analysis: $A$ ITEMS, very tight control and accurate records; $B$ ITEMS, less tightly controlled, and good records; and $C$ ITEMS, simplest controls possible and minimal records.

Inventory management involves a retailer seeking to acquire and maintain a proper merchandise assortment while ordering, shipping, handling, and related costs are kept in check. It also involves systems and processes that identify inventory requirements, set targets, provide replenishment techniques, report actual and projected inventory status, and handle all functions related to the tracking and management of material. This would include the monitoring of material moved into and out of stockroom locations and the reconciling of the inventory balances. It also may include $ABC$ analysis, lot tracking, cycle counting support, etc. Management of the inventories, with the primary objective of determining/controlling stock levels within the physical distribution system, functions to balance the need for product availability against the need for minimizing stock holding and handling costs.

Inventory The inventory costs depend on which method is used.

There are, in fact, so many things that can vary hidden under this appearance of simplicity that a variety of 'adjusting' assumptions may be used. These include:

Specific Identification

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 the yearend 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.

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 number will need to be estimated, therefore reducing the specific identification's benefit of being extremely specific.

Weighted Average Cost

Weighted Average Cost is a method of calculating Ending Inventory cost. It is also known as AVCO. It takes Cost of Goods Available for Sale and divides it by the total amount of goods from Beginning Inventory and Purchases. This gives a Weighted Average Cost per Unit. A physical count is then performed on the ending inventory to determine the amount of goods left. Finally, this amount is multiplied by Weighted Average Cost per Unit to give an estimate of ending inventory cost.

Moving-Average Cost

Moving-Average (Unit) Cost is a method of calculating Ending Inventory cost. Assume that both Beginning Inventory and beginning inventory cost are known. From them the Cost per Unit of Beginning Inventory can be calculated. During the year, multiple purchases are made. Each time, purchase costs are added to beginning inventory cost to get Cost of Current Inventory. Similarly, the number of units bought is added to beginning inventory to get Current Goods Available for Sale. After each purchase, Cost of Current Inventory is divided by Current Goods Available for Sale to get Current Cost per Unit on Goods.

Also during the year, multiple sales happen. The Current Goods Available for Sale is deducted by the amount of goods sold. The Cost of Current Inventory is deducted by the amount of goods sold times the latest (before this sale) Current Cost per Unit on Goods. This deducted amount is added to Cost of Goods Sold.

At the end of the year, the last Cost per Unit on Goods, along with a physical count, is used to determine ending inventory cost.

FIFO and LIFO

FIFO stands for first-in, first-out, meaning that the oldest inventory items are recorded as sold first, but do not necessarily mean that the exact oldest physical object has been tracked and sold.

LIFO stands for last-in, first-out, meaning that the most recently produced items are recorded as sold first. Since the 1970's, some U.S. companies shifted towards the use of LIFO, which reduces their income taxes in times of inflation. However, with International Financial Reporting Standards banning the use of LIFO, more companies have gone back to FIFO. LIFO is only used in Japan and the U.S.

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.