Inventory Costing
For A Periodic Inventory System
• a physical count of inventory is taken at the
end of the fiscal year to determine how many
units you have left in-stock. Throughout the
year, the amount in the inventory account
remains the same. It is expensive and difficult
to do a physical count, so this is normally only
done at year end, when it is required.
• The CICA Handbook says inventory should have a
cost that represents the "fairest matching of costs
against revenue.”
• At the end of each fiscal period, prior to the
preparation of financial statements, a business
must assign a value to the inventory it has on
hand.
• There are a few options available for inventory
valuation.
• If a business only sold one thing and it always
cost the same, it would be easy. The problem is,
most businesses sell a variety of items and the
cost of those items often changes throughout the
year. That makes inventory valuation a real
challenge.
SPECIFIC IDENTIFICATION
• Each item is matched with its actual cost.
• usually used with expensive or unique items
• Method used when sales of item are fairly low in
variety of items and can identify each one easily, either
because it is unique, or it may have a serial number.
• Some examples might be cars, art, electronics, etc.
• If a business can use this method, it is easy to record
the cost of it, while the item is in inventory and when it
is sold.
• When inventory costs are rising, a company can take
advantage of this method by selling off the cheapest
inventory to show a high net income—low cost of
goods sold.
FLOW OF GOODS
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FIFO (First in First Out)
LIFO (Last in First Out)
Average Cost
These methods are far more common
The theory behind these methods of valuation
is that inventory is valued based on the
sequence in which goods are sold.
FIFO
• assumes that goods that are purchased first
are sold first. This method looks like a
conveyor belt. Foods, and other perishable
products, are good examples of this type of
merchandise.
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To calculate the cost of goods sold using FIFO, you need to assign a cost to the 80
units that were sold in the period. The other number to calculate is the ending
inventory. If 80 units are sold, there are 15 units left as ending inventory. In this
case, all 15 units would be valued at the November purchase cost.
Ending Inventory = 15 units x $10 unit cost = $150.
LIFO
• assumes that goods that are purchased last
are sold first
• A pile of logs is a good example of this type of
merchandise. The last logs purchased will be
on top and will be sold first.
• To calculate the cost of goods sold using LIFO, you need to assign a cost to the 80 units
that were sold in the period. The cost of the last 80 units available for sale will be the cost
assigned to the units sold.
• the total cost of the 80 units that were sold was valued at $725. The ending inventory of
15 units is assigned a value equal to the beginning inventory unit cost.
Ending Inventory = 15 units x $8 unit cost = $120.
Average Cost Method
• When inventory is mixed together as it comes
in, an average of the costs over the period can
be used to value inventory. It may be very
hard to tell which piece of inventory is which
and which will be sold first.
• Example: Hardware stores that sell items like
nuts and bolts in bulk
The first step is to calculate an average cost per
unit of our inventory:
Average Cost per Unit = Total Cost of Inventory /
Number of Units in Inventory
= $845 / 95 = $8.89 per unit
Cost of Goods Sold = Number of Units Sold x
Average Cost per Unit
= 80 X 8.89 = $711.20
Ending Inventory = Number of Units in
Inventory x Average Cost per Unit
= 15 x 8.89 = $133.35
• In Canada, FIFO is the most popular method of
inventory valuation. LIFO is not allowed
because of income tax regulations, but is
occasionally used for business analysis.
Journal Entries
• Regardless of which inventory valuation
method you choose, the journal entries used
to record purchases and sales in the periodic
inventory system will remain constant.
• The cost of goods sold calculation and the
adjustment of the inventory account occur at
end of the accounting period when financial
statements are prepared.
Comparing Methods
The following table summarizes the effects of each inventory valuation method
on the income statement, in a period of rising prices:
FIFO
LIFO
AVERAGE
Cost of Goods Sold Lowest
Highest
In Between
Gross Profit/Net
Income
Highest
Lowest
In Between
Ending Inventory
Highest
Lowest
In Between
Balance Sheet Implications
• The balance in the merchandise inventory account on
the balance sheet depends on the valuation method
used.
• This account will have the same value as the ending
inventory used in the cost of goods sold calculation on
the income statement.
• In a period of rising prices, total assets, which include
merchandise inventory, will be highest under FIFO and
lowest under LIFO. This could have implications for
investors in a company.
• Using LIFO or Average Cost may result in an inaccurate
representation of the current replacement costs of the
goods in inventory.
Perpetual System
• The advantage of this system:
– shows a continuous balance of inventory on hand
– The cost of goods sold is recorded with every sales
transaction, not only at the end of the accounting
period
Perpetual Inventory System
• The Appliance Superstore sells a camera called
Supershot. The company uses a perpetual
inventory system. The following is a record of
purchases and sales for Supershot for the
month of April.
FIFO
• To keep track of perpetual inventory using a
FIFO valuation, it's much easier to use an
inventory record card.
FIFO-Perpetual
• To calculate it manually, we record each transaction in order and
recalculate the ending balance each time.
• The unit cost on the sale is always recorded at the cost of purchasing the
item, not the sale price. The point of this section is to figure out your cost
of goods sold.
• When cost of inventory changes, must keep each inventory grouping
separate. See the April 10 ending balance. The first goods in, the seven
units at $150, are listed first, and then the items that were purchased for
$160 are listed second. This makes it easier to use the FIFO method for the
sale on April 12.
LIFO
Average Cost
Effect on Financial Statements
• the impact of the Inventory Valuation decision
on the financial statements under the
perpetual system is the same as the periodic
system.
RECAP-Effects on Income Statement
Period of rising prices:
• FIFO produces a higher income.
• FIFO reports the highest income and LIFO the lowest.
Average cost falls somewhere in the middle.
• To management, higher net income is an advantage.
It causes external users to view the company more
favourably.
• Also, if management bonuses are based on net
income, FIFO will provide the higher income for
higher bonuses.
Effects on Income Statement
Period of falling prices:
• the results from the use of FIFO and LIFO are
reversed. FIFO will report the lowest income
and LIFO the highest.
• If prices are stable, all three cost flow
assumptions will report the same results.
Analysis of Inventory
• Inventory is usually the largest current asset
on the balance sheet and the largest expense
(COGS) on the income statement
• Therefore these numbers are critical for
analyzing how well a company manages its
inventory
Analysis of Inventory
• value of inventory items sometimes fall below
cost due to changes in technology or style
• When the value of inventory is lower than its
cost, the inventory is written down to its
market value.
• done by valuing the inventory at the lower of
cost and market (LCM) in the period in which
the decline occurs
Inventory Turnover Ratio
Cost of goods sold ÷ average inventory
• The number of times inventory “turns over”
during a given period
• Average inventory is usually average of
beginning and ending inventories
Days Sales in Inventory
• Days in year ÷ inventory turnover ratio
• The number of days on average that the
inventory is on hand before being sold
RECAP Inventory Measurables
• Days of sales in inventory focuses on ending
inventory
• Merchandise Turnover focuses on average
inventory
GAAP
Materiality Principle
• May not ignore an amount if its effect on the
financial statement is important to their users
Full Disclosure Principle
• Financial statements must report all relevant
information about the operations and financial
position of the entry
Consistency Principle
• Requires a company to use same accounting
methods period after period so that financial
statement are comparable exclusively