Inventory costing for intermediate accounting
Inventory costing
Once companies determine the number of inventory units, they apply unit costs to the quantities to calculate the total cost of inventory and the cost of goods sold. If companies can identify in particular which particular units are sold and which are still in ending inventory, they can use the Specific Identification Method of Inventory Costing. With this method, companies can accurately determine ending inventory and cost of goods sold. It requires companies to keep records of the original cost of each individual inventory item. Traditionally, specific identification was used to keep records of products such as cars, pianos or other expensive items from the time of purchase to the time of sale, much like the barcodes that are used today. This practice is rare today and most companies engage in cost flow assumptions.
Cost flow assumptions differ from specific identification in that they assume cost flows that may not be related to the physical flow of goods. There are three assumed methods including (FIFO), (LIFO), and (Average Cost). Company management generally selects the most appropriate cost flow method.
The first-in, first-out (FIFO) method assumes that the first goods bought are the first to be sold. It is usually parallel to the physical flow of goods. Therefore, the costs of the first goods acquired are the first to be recognized when determining the cost of goods sold. Ending inventory is based on the prices of the most recently purchased units. Businesses obtain the cost of ending inventory by taking the unit cost of the most recent purchase and working backward to all units of the inventory cost. For management, higher net income is an advantage. Makes external users view your business more favorably. Also, management bonuses, if based on net income, will be higher. Therefore, when prices are rising, companies tend to prefer to use FIFO because it generates higher net income. An important advantage of the FIFO method is that, in a period of inflation, the costs assigned to ending inventory will approximate their current cost.
The last in, first out (LIFO) method assumes that the last goods bought are the first to be sold. LIFO never matches the actual physical flow of inventory. The costs of the last goods acquired are the first to be recognized when determining the costs of goods sold. Ending inventory is based on the prices of the oldest units purchased. Businesses obtain the cost of ending inventory by taking the unit cost of the first goods available for sale and working forward until all units of the inventory cost.
The average cost method assigns the cost of goods available for sale based on the weighted average unit cost incurred; it also assumes that the goods are of a similar nature. The company applies the weighted average unit cost to available units to determine the cost of ending inventory. You can check the cost of goods sold with this method by multiplying the units sold by the weighted average unit cost.
Each of the three assumed cost flow methods is acceptable for use. 44% of the main US companies use the FIFO method. They include companies like Reebok International Ltd. and Wendy’s International. 33% use the LIFO method, including companies like Campbell Soup Company, Kroger’s and Walgreen Drugs. 19% use the average cost method, including Starbucks and Motorola. Some companies may use more than one. Black and Decker Manufacturing Company uses LIFO for domestic inventories and FIFO for foreign inventories. The reasons companies adopt different inventory cost flow methods are varied, but generally involve three factors. First, the effects of the income statement, second the effects of the balance sheet and finally the tax effects.
Whichever cost flow method a company chooses to use, it must be used consistently from one accounting principle to another. This approach is often referred to as the consistency principle, which means that a company uses the same accounting principle and methods from year to year. Consistency improves the comparability of financial statements over time periods. Using FIFO one year and LIFO the next would make it difficult to compare net income for the two years.