Inventory Cost Accounting: Methods & Examples

The value of a company’s shares of stock often moves significantly with information about earnings. The reason is that inventory measurement bears directly on the determination of income! The slightest adjustment to inventory will cause a corresponding change in an entity’s reported income. The outcomes for gross margin, under each of these different
cost assumptions, is summarized in
Figure 10.21. The outcomes for gross margin, under each of these different cost assumptions, is summarized in Figure 10.21.

The First-In, First-Out (FIFO) method assumes that the oldest unit of inventory is the sold first.
As you’ve learned, the perpetual inventory system is updated
continuously to reflect the current status of inventory on an
ongoing basis.
Specific identification requires tedious record keeping and is typically only used for inventories of uniquely identifiable goods that have a fairly high per-unit cost (e.g., automobiles, fine jewelry, and so forth).
LIFO is opposite of FIFO and reports the most current prices as being cost of goods sold.

ABC company had 200 items on 7/31, which is the ending inventory count for July as well as the beginning inventory count for August. As of 8/31, ABC Company completed another count and determined they now have 300 items in ending inventory. This means that 700 items were sold in the month of August (200 beginning inventory + 800 new purchases ending inventory). Alternatively, ABC Company could have backed into the ending inventory figure rather than completing a count if they had known that 700 items were sold in the month of August. So, when inventory is sold, the newest cost of an item in inventory will be recovered and reported on the income statement as part of the cost of goods sold.

Examples of Calculating Ending Inventory

Likewise, freight-out and sales commissions would be expensed as a selling cost rather than being included with inventory. The gross margin, resulting from the specific identification periodic cost allocations of $7,260, is shown in Figure 10.6. Ending inventory was made up of 10 units at $21 each, 65 units at $27 each, and 210 units at $33 each, for a total specific identification ending inventory value of $8,895. Subtracting this ending inventory from the $16,155 total of goods available for sale leaves $7,260 in cost of goods sold this period. Figure 10.14 shows the gross margin, resulting from the
specific identification perpetual cost allocations of $7,260.

Usually, financial accounting methods do not have to conform to methods chosen for tax purposes. However, in the U.S., LIFO “conformity rules” generally require that LIFO be used for financial reporting if it is used for tax purposes. In many countries LIFO is not permitted for tax or accounting purposes, and there is discussion about the U.S. perhaps adopting this global approach. Once the unit cost of inventory https://accounting-services.net/first-in-first-out-method/ is determined via the preceding logic, specific costing methods must be adopted. In other words, each unit of inventory will not have the exact same cost, and an assumption must be implemented to maintain a systematic approach to assigning costs to units on hand (and to units sold). Ending inventory is the value of goods still available for sale and held by a company at the end of an accounting period.

Ending Inventory, COGS, and Gross Profit for Specific Identification

As you can see the value of a company’s inventory does directly impact their reported income and general financial health. LIFO is opposite of FIFO and reports the most current prices as being cost of goods sold. However, it does create the lowest COGS numbers when prices are rising, which can result in the highest taxable income. We place products in pricing tiers when they are bought and then make a general assumption on the order that those pricing tiers will pulled off the shelf and sold. In the process of choosing an inventory system (or tool), you must also consider the costing method you will want to use.

Which Is Better, LIFO or FIFO?

The last transaction was an additional purchase of 210 units for $33 per unit. Ending inventory was made up of 30 units at $21 each, 45 units at $27 each, and 210 units at $33 each, for a total LIFO perpetual ending inventory value of $8,775. The specific identification method of cost allocation directly tracks each of the units purchased and costs them out as they are sold. In this demonstration, assume that some sales were made by specifically tracked goods that are part of a lot, as previously stated for this method. For The Spy Who Loves You, the first sale of 120 units is assumed to be the units from the beginning inventory, which had cost $21 per unit, bringing the total cost of these units to $2,520. Once those units were sold, there remained 30 more units of the beginning inventory.

What if I want to change my inventory method? Can I do that?

This and other unethical
short-term accounting decisions made by Petersen and Knapp led to
the bankruptcy of the company they were supposed to oversee and
resulted in fraud charges from the SEC. Practicing ethical
short-term decision making may have prevented both scenarios. Petersen and Knapp allegedly participated in channel stuffing, which is the process of recognizing and recording revenue in a current period that actually will be legally earned in one or more future fiscal periods. This and other unethical short-term accounting decisions made by Petersen and Knapp led to the bankruptcy of the company they were supposed to oversee and resulted in fraud charges from the SEC. Practicing ethical short-term decision making may have prevented both scenarios.

Calculations of Costs of Goods Sold, Ending Inventory, and

This does not mean that changes cannot occur; however, changes should only be made if financial reporting is deemed to be improved. The preceding results are consistent with a general rule that LIFO produces the lowest income (assuming rising prices, as was evident in the Gonzales example), FIFO the highest, and weighted average an amount in between. Because LIFO tends to depress profits, one may wonder why a company would select this option; the answer is sometimes driven by income tax considerations. Lower income produces a lower tax bill, thus companies will tend to prefer the LIFO choice.

Advancements in inventory management software, RFID systems, and other technologies leveraging connected devices and platforms can ease the inventory count challenge. Figure 10.12 shows the gross margin resulting from the weighted-average periodic cost allocations of $8283. Figure 10.20 shows the gross margin, resulting from the
weighted-average perpetual cost allocations of $7,253.

One may further assume that the cost of the units sold is $2,900,000, which can be calculated as cost of goods available for sale minus ending inventory. The cost of goods sold could be verified by summing up the individual cost for each unit sold. The inventory valuation method chosen by management impacts many popular financial statement metrics. Inventory-related income statement items include the cost of goods sold, gross profit, and net income.

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