Inventory Costing
Average-Cost Method
… computes the average cost of all goods
available for sale during the period in order
to determine the value of ending inventory
• Tends to level out the effects of cost increases
and decreases
• Is criticized by some who believe that recent
costs are more relevant for income
measurement and decision making
Average-Cost Method Illustrated
Inventory Data – June 30
June 1
Inventory
50 units
6
Purchase
50 units
13
Purchase
150 units
20
Purchase
100 units
25
Purchase
150 units
Goods available for sale
500 units
Sales
280 units
On hand, June 30
220 units
@
@
@
@
@
$1.00
$1.10
$1.20
$1.30
$1.40
$ 50
55
180
130
210
$625
$625
Cost of Goods Available for Sale

 $1.25
Average Unit Cost 
500 units
Units Available for Sale
Ending Inventory  Units in Ending Inventory  Average Unit Cost
 220 units @ $1.25  $275
Cost of goods available for sale
Less June 30 inventory
Cost of goods sold
$625
275
$350
First-In, First-Out (FIFO)
Method
… is based on the assumption that the costs
of the first items acquired should be
assigned to the first items sold
• The cost of ending inventory reflects the cost of
merchandise from the most recent purchases
• The costs assigned to cost of goods sold are
from the earliest purchases
First In, First Out (FIFO)
The “Pipe Line”
1
2
3
Ending Inventory
“New Items”
Cost sales
“Old Items”
FIFO Method Illustrated
Inventory Data – June 30
June 1
Inventory
50 units
6
Purchase
50 units
13
Purchase
150 units
20
Purchase
100 units
25
Purchase
150 units
Goods available for sale
500 units
Sales
280 units
On hand, June 30
220 units
Under the FIFO method, the first
items purchased are assumed to be
the first items sold
@
@
@
@
@
$1.00
$1.10
$1.20
$1.30
$1.40
$ 50
55
180
130
210
$625
This leaves the most recently
purchased items in ending inventory
Periodic Inventory System – First-In, First-Out Method
150 units @ $1.40 from purchase of June 25
$210
70 units @ $1.30 from purchase of June 20
91
220 units at a cost of
$301
Cost of goods available for sale
Less June 30 inventory
Cost of goods sold
$625
301
$324
Effect of FIFO Method
… is to value the ending inventory at the most
recent costs and include earlier costs in cost of
goods sold
• During periods of consistently rising prices
– FIFO yields the highest possible amount of net income
• Cost of goods sold will show earliest, lower costs incurred
• During periods of consistently falling prices
– FIFO yields the lowest possible amount of net income
A major criticism of FIFO is that it magnifies
the effects of the business cycle on income
Last-In, First-Out (LIFO)
Method
… is based on the assumption that the costs
of the last items acquired should be
assigned to the first items sold
• The cost of ending inventory reflects the cost of
merchandise purchased earliest
• The costs assigned to cost of goods sold are
from the most recent purchases
Last In, First Out (LIFO)
The “Pool”
3
2
1
Ending Inventory
“Old Items”
Cost of
sales
“New Items”
LIFO Method Illustrated
Inventory Data – June 30
June 1
Inventory
50 units
6
Purchase
50 units
13
Purchase
150 units
20
Purchase
100 units
25
Purchase
150 units
Goods available for sale
500 units
Sales
280 units
On hand, June 30
220 units
Under the LIFO method, the last
items purchased are assumed to
be the first items sold
@
@
@
@
@
$1.00
$1.10
$1.20
$1.30
$1.40
$ 50
55
180
130
210
$625
This leaves the earliest purchased
items in ending inventory
Periodic Inventory System – Last-In, First-Out Method
50 units @ $1.00 from June 1 inventory
$ 50
50 units @ $1.10 from purchase of June 6
55
120 units @ $1.20 from purchase of June 13
144
220 units at a cost of
$249
Cost of goods available for sale
Less June 30 inventory
Cost of goods sold
$625
249
$376
Effect of LIFO Method
… is to value the ending inventory at the
earlier costs and include most recent
costs in cost of goods sold
• This assumption does not agree with the
actual physical movement of goods in most
businesses
– Current value of inventory may be unrealistic
– Balance sheet measures (such as working capital
and current ratio) may be distorted and must be
interpreted carefully
• US: LIFO Conformity Rule : Companies that elect to use LIFO for
tax-purposes must also use LIFO for Financial Statements
Effect of LIFO Method (cont’d)
• Strong logical argument for LIFO
– Fairest determination of income occurs if the
current costs of merchandise are matched
against current sales prices
• Smoothes out fluctuations in the business
cycle
– As prices move upward or downward, cost of
goods sold will show costs closer to the price
level at the time the goods were sold
LIFO vs. FIFO [Rising Prices]
Ratio
Net Profit Margin
NI ÷ Sales
ROA
NI ÷ Assets
ROE
NI ÷ Equity
Debt-to-Equity
Debt ÷ Equity
ATO
Sales ÷ Assets
LIFO
FIFO
Lower
(NI Lower)
Lower
Higher
(NI Higher)
Higher
Lower
Higher
Higher
(Lower Equity)
Higher
(Lower Assets)
Lower
(Higher Equity)
Lower
(Higher Assets)