In a merchandising business, inventory is merchandise that is held for resale. As such, it will ordinarily be converted into cash in less than a year and is thus a current asset.
In manufacturing business, there will usually be inventories of raw materials and goods in process in addition to an inventory of finished goods.
Determining Inventory:Physical Count
Under the periodic method, inventory is physically counted at regular intervals (annually, quarterly, or monthly). When this system is used, credits are made to the Inventory account or to Purchases, not as each sale is made, but rather in total at the end of the inventory period.
To approach the problem of inventory measurement, in order to assign the business cost to each item, three methods of valuation
- First-In, First-Out (FIFO)
- Last-In, First-Out (LIFO)
- Weighted Average
Chart 1
Date Type Units Unit Cost Totals
Jan. 1 Inventory 100 $8 $ 800.00
Feb. 2 Purchase 175 $10 1,750.00
June 2 Purchase 250 $11 2,750.00
Nov. 5 Purchase 275 $12 3,300.00
Available for sale 800 $8,600.00
It will be assumed that a physical count of inventory on the last day of the accounting period December 31 showed 375 units on hand. Therefore, 425 units (800-375) were sold during the year.
Costing Inventory: First-In, First-Out (FIFO)
The first-in, first-out (FIFO) method of costing inventory assumes that goods are sold in the order in which they were purchased.Therefore, the goods that were bought first (first-in) are the first goods to be sold (first-out), and the goods that remain on hand (ending inventory) are assumed to be made up of the latest costs. Therefore, for income determination, earlier costs are matched with revenue and the most recent costs are used for balance sheet valuation.
This method is consistent with the actual flow of costs, since merchandisers attempt to sell their old stock first. (Perishable items and high-fashion items are examples.) FIFO is the mos widely used inventory method of those that will be discussed.
Example 1
Under FIFO, those goods left at the end of the period are considered to be those received last. Therefore, the 350 units on hand on December 31 would be costed as follows:
Most recent purchase (Oct. 4) 290 units @ $15 = $4,350
Next most recent purchase (June 5) 60 units @ $12 = 720
Ending inventory 350 units $5,070
The latest cost of the inventory consists of 290 units at $15. However, since the ending inventory consists of 350 units, we must refer to the next most recent purchase of 60 units at $12. Therefore, you could say that the process for determining the cost of the units n hand involves working backward through the purchases until there is a sufficient quantity to cover the ending inventory count. Thus the ending inventory under the FIFO method would be valued and recorded at $5,070
Example 2
The cost of goods sold can be determined by subtracting the value of the ending inventory from the total value of the inventory available for sale ($5,900 - $2,715 = $3,185). Since 350 units remain as ending inventory, the number of units sold is 385 (750 - 365).
This can also be computed as
115 units if inventory (Jan. 1) @ $8 = $ 920
145 units purchased (Mar. 10) @ $7 = 1,015
125 units purchased (June 6) @ $10 = 1,250
385 Total cost of goods sold $3,185
It should be noted that as a method of assigning costs, FIFO may be used regardless of the actual physical flow of merchandise. Indeed, we might say that FIFO really stands for first-price-in, first-price-out. In a period of rising prices--inflation--the FIFO method will yield the largest inventory value, thus resulting in a larger net income. This situation occurs because this method assigns an inventory cost based on the most recent, higher costs. Conversely, the FIFO method would produce a smaller cost of goods sold, because the earlier, lower costs are assigned to the cost of goods sold. Because FIFO results in the most recent charges to inventory, the value of the ending inventory is closer to its replacement cost than under any other method.
Example 3
Two years of determining the value of the same number of units in the inventory are shown below.
a) First year, 2007 (rising costs):
Inventory 15 units @ $5 = $ 75
First purchase 15 units @ 7 = 105
Second purchase 15 units @ 8 = 120
Third purchase 15 units @ 9 = 135
60 units $435
If 15 units are on hand, the value under FIFO would be computed as
Third purchase 15 units @ $9 = $135
Thus, the ending inventory of 15 units is $135.
The cost of goods sold would be calculated as $435 - $135 = $300.
b) Second year, 2007 (falling cost):
Inventory 15 units @ $9 = $135
First purchase 15 units @ 8 = 120
Second purchase 15 units @ 7 = 105
Third purchase 15 units @ 5 = 75
60 units $435
If 15 units are on hand, the value under FIFO would be computed as
Third purchase 15 units @ $5 = $75
Thus the ending inventory of 15 units is $75.
The cost of goods sold would be calculated as $435 - $75 = $360
Note that even though there are 15 units left in both years, under FIFO, the year 2006 produces a higher ending inventory in a rising market, thus producing a higher net income. This is because the cost of goods sold is lower in a rising market ($435 - $135 = $300) than in declining market ($435 - $75 = $360). Thus the lower the cost, the higher the profit.
Go to Costing Inventory: Last-In, First-Out (LIFO)
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