Determining the Cost of Inventory

2.1 Introduction

This chapter is the continuation of the previous chapter, in which we have discussed the meaning and concepts of inventory. In this chapter, we will discuss the determination of the cost of inventory.

Costs included in merchandise inventory are those expenditures necessary, directly or indirectly, to bring an item to a salable condition and location. In other words, cost of an inventory item includes its invoice price minus any discount, plus any added or incidental costs necessary to put it in a place and condition for sale. Added or incidental costs can include import duties, transportation-in, storage, insurance against losses while the goods are in transit, and costs incurred in an aging process(for example, aging of wine and cheese).

Minor costs that are difficult to allocate to specific inventory items may be excluded from inventory cost and treated as operating expenses of the period. This is based on materiality principle or the cost-to –benefit constraint.

 

One of the most important decisions in accounting for inventory is determining the per unit costs assigned to inventory items. When all units are purchased at the same unit cost, this process is simple since the same unit cost is applied to determine the cost of goods sold and ending inventory. But when identical items are purchased at different costs, a question arises as to what amounts are included in the cost of merchandise sold and what amounts remain in inventory. A periodic inventory system determines cost of merchandise sold and inventory at the end of the period. We must record cost of merchandise sold and reductions in inventory as sales occur using a perpetual inventory system. How we assign these costs to inventory and cost of merchandise sold affects the reported amounts for both systems.

There are four methods commonly used in assigning costs to inventory and cost of merchandise sold. These are:

                        * Specific identification

                        * First-in first-out(FIFO)

                        * Last-in first-out (LIFO)

                        * Weighted average  

Let us see these costing methods under periodic inventory system based on the following illustration

Illustration:

Beza Company began the year and purchased merchandise as follows:

            Jan-1        Beginning inventory                       80 units@ Br. 60 = Br. 4,800

            Feb. 16    Purchase                            400 units@       56 =     22,400

            Sep.2       Purchase                            160 units @      50 =       8,000

            Nov. 26   Purchase                            320 units@       46 =     14,720

            Dec. 4     Purchase                            240 units@       40 =       9,600

                               Total                             1200 units                  Br.59, 520

The ending inventory consists of 300 units, 100 from each of the last three purchases.

   2.2.1 Specific Identification Method

When each item in inventory can be directly identified with a specific purchase and its invoice, we can use specific identification (also called specific invoice pricing) to assign costs. This method is appropriate when the variety of merchandise carried in stock is small and the volume of sales is relatively small. We can specifically identify the items sold and the items on hand.

Example

From the above illustration, the ending inventory consists of 300 units, 100 from each of the last purchases. So, the items on hand are specifically known from which purchases they are:

Cost of ending inventories under specific identification method

              Br. 40 x 100                =            Br. 4,000

              Br. 46 x 100                =                  4,600

              Br. 50 x 100                =                  5,000

                          300units                    Br. 13,600

 

* Cost of Ending inventory cost   =  Br. 13,600

* The cost of merchandise sold    =   Cost of goods available for sale - Ending inventory

                                    = Br. 59,520 – Br. 13,600

                                    = Br. 45,920

 

   2.2.2 First-in, First-out (FIFO)

This method of assigning cost to inventory and the goods sold assumes inventory items are sold in the order acquired. This means the cost flow is in the order in which the expenditures were made. So, to determine the cost of ending inventory, we have to start from the most recent purchase and continue to the next recent. Because the first purchased items (old purchases) are the first to be sold they are used (included) in the computation of cost of goods sold.

For example, easily spoiled goods such as fruits, vegetables etc., must be sold near the time of their acquisition. So, the inventory on hand will be from the recent purchases. As an example, consider the previous illustration on page 21.

The cost of ending inventory under FIFO method

               = Br. 40 x 240             Br.     9,600

               = Br. 46 x   60                       2,760

                            300 units       Br. 12,360

 

* Cost of Ending inventory                         Br. 12,360

* Cost of merchandise sold = Br. 59,520  –  Br. 12,360

                                                               Br. 47,160

 

   2.2.3 Last-in first-out (LIFO)

This method of assigning cost assumes that the most recent purchases are sold first. Their costs are charged to cost of goods sold, and the costs of the earliest purchases are assigned to inventory. The cost flow is in the reverse order in which expenditures were made.

In calculating the cost of goods sold, we will start from the earliest purchases.

As an example, take the previous illustration

The cost-ending inventory under FIFO method

                        =Br.60  x   80 = Br. 4,800

                        =Br. 56 x 220 =     12,320

                                        300 units

Ending inventory cost =          Br. 17,120

Cost of merchandise sold = Br. 59,520 – Br. 17,120

                                         = Br. 42,400

 

   2.2.4 Weighted Average Method

This method of assigning cost requires computing the average cost per unit of merchandise available for sale. That means the cost flow is an average of the expenditures.

To calculate the cost of ending inventory, we will calculate first the cost per unit of goods available for sale

Average cost per unit = Cost of goods available for sale

                                        Total units available for sale

Then the weighted average unit cost is multiplied by units on hand at the end of the period to calculate the cost of ending inventory. Also, the same average unit cost is applied in the computation of cost of goods sold.

As an example, take the previous illustration

Weighted average unit cost = Br. 59,520 = Br. 49.60

                                                        1,200

*  Ending inventory cost = Br. 49.60x 300

                                   =  Br. 14,880

* Cost of merchandise sold = Br. 59,520-Br. 14,880

                                                =  Br. 44,640

 

If the cost of units and prices at which they are sold remains stable, all the four methods yield the same results. But if prices change, the three methods usually yield different amounts for:

• Ending inventory
• Cost of merchandise sold
• Gross profit or net income

In periods of rising (increasing) prices: (or if there is inflationary trend):

FIFO yields – higher ending inventory

                  _  Lower cost of merchandise sold

                  _  Higher gross profit (net income)

LIFO yields _  Lower ending inventory

                   _  Higher cost of merchandise sold

                    _  Lower gross profit (net income)

‰  Weighted average yields the results between the two.

 

In periods of declining (decreasing) prices:

FIFO yields _ Lower ending inventory

  _ Higher cost of merchandise sold

  _ Lower gross profit or net income

LIFO yields_ higher ending inventory

 _ Lower cost of merchandise sold

 _ Higher gross profit or net income

‰  Weighted average- between the two

 

2.4 Inventory costing methods under perpetual inventory system

Under perpetual inventory systems we will apply the inventory costing methods each time sale of merchandise is made. We calculate the cost of goods (merchandise) sold and inventory on hand at the time of each sale. This means the merchandise inventory account is continually updated to reflect purchase and sales.

Illustration:

The beginning inventory, purchases and sales of Nesru Company for the month of January fare as follows:

                                                        Units                    Cost

Jan. 1     Inventory                                  12                  Br. 10.00

       6     Sale                                        5     

     10     purchase                                 10                 Br. 12.00

     20     Sale                                        8     

     25     purchase                                 8                  Br. 12.50

     27     Sale                                       10     

     30     purchase                                 15                  Br. 14.00

 

   2.4.1 First-in first-out Method

The assignment of costs to goods sold and inventory using FIFO is the same for both the perpetual and periodic inventory systems. Because each withdrawal of goods is from the oldest stock on hand. The oldest is the same whether we use periodic inventory system or perpetual inventory system.

Let us calculate the cost of goods sold and ending inventory under perpetual inventory system from the above illustration.     

Perpetual - FIFO

Date	Purchase			Cost of merchandise sold			Inventory
	Qty.	Unit cost	Total cost	Qty	Unit cost	Total cost	Qty	Unit cost	Total cost
Jan. 1							15	Br. 10.00	Br. 150.00
6				5	Br. 10.00	Br. 50.00	10	10.00	100.00
10	10	Br. 12.00	Br.120.00				10 10	10.00       12.00	100.00       120.00
20				8	10.00	80.00	2 10	10.00       12.00	20.00       120.00
25	8	12.50	100.00				2 10 8	10.00       12.00       12.50	20.00       120.00       100.00
27				2 8	10.00 12.00	20.00 96.00	2 8	12.00       12.50	24.00       100.00
30	15	14.00	210.00				2 8 5	12.00       12.50       14.00	24.00       100.00       210.00
				23		Br. 246.00	25		Br. 334.00

So, the cost of merchandise sold and ending inventory under perpetual- FIFO method are Br. 246 and Br. 334 respectively.

Let us see them under periodic - FIFO method:

Units on hand  =  units available for sale – units sold

                        =  (15 + 10 + 8 + 15 ) – ( 5+ 8 + 10 )

                        =  48 - 23 = 25

Cost of ending inventory = Br. 14 x 15      =  Br. 210

                                            Br. 12.50 x 8   =        100

                                            Br. 12 x 2        =          24           

                                                                       Br.   334

Cost of goods available for sale = Br. 120 + Br. 100 + Br. 210 = Br. 580

Cost of goods sold = Br. 580 – Br. 334

                                    Br 246

So, the same results of cost of gods sold and ending inventory under both periodic inventory systems.

 

   2.4.2 Lasting, First-Out method

Unlike FIFO method, different results may occur under periodic and perpetual inventory system. The most recent purchases change when new purchase occurs.

Let us calculate first the cost of goods sold and ending inventory for the above illustration under perpetual inventory system. Then, we will see the results under periodic inventory system.

Perpetual - LIFO

Date	Purchase			Cost of merch. Sold			Inventory
	Qty	Unit cost	Total cost	Qty	Unit cost	Total cost	Qty	Unit cost	Total cost
Jan. 1							15	Br. 10.00	Br. 150.00
6				5	Br. 10.00	Br. 50.00	10	10.00	100.00
10	10	Br. 12.00	Br. 120.00				10 10	10.00 12.00	100.00 120.00
20				8	Br. 12.00	Br. 96.00	10 2	10.00 12.00	100.00 24.00
25	8	12.50	100.00				10 2 8	10.00 12.00 12.50	100.00 24.00 100.00
27				8 2	12.50 12.00	100.00 24.00	10	10.00	100.00
30	15	14.00	210.00				10 15	10.00 24.00	100.00 210.00
				23		Br. 270.00	25		Br. 310.00

 

So, the cost of merchandise sold and ending inventory under perpetual inventory system are Br. 270 and Br. 310 respectively.

The results under periodic inventory system are:

Cost of ending inventory = Br. 10 x 15 =   Br. 150

                                            Br. 12 x 10 =  120 

                                                                 25 

                                                              Br. 270          

Cost of merchandise sold = Br. 580 - 270

                                           = Br. 310

As you see, the results are different under periodic & perpetual inventory systems.

 

   2.4.3 Weighted average cost method.

Under this method, the average unit cost is calculated each time purchased is made to be applied on the sales made after the purchases. The results may be different under periodic and perpetual inventory system.

Let us calculate the cost of merchandise sold and ending inventory comes out from the previous illustration under perpetual inventory system.

Average Cost Method (Moving Average)

Date	Purchase			Cost of merchandise sold			Inventory
	Qty	Unit cost	Total cost	Qty	Unit cost	Total cost	Qty	Unit cost	Total cost
Jan. 1							15	Br. 10.00	Br. 150.00
6				5	Br. 10.00	Br. 50.00	10	10.00	100.00
10	10	12.00	Br. 120.00				20	11.00 = 100+120     10+10	220.00
20				8	11.00	88.00	12	11.00	132.00
25	8	12.00	100.00				20	11.60 + 132+100 12+8	232.00
27				10	11.60	116.00	10	11.60	116.00
30	15	14.00	210.00				15	13.04 116+210 10+15	326.00
				23		Br. 254.00	25	Br. 13.04	Br 326.00

   So, the cost of goods sold and ending inventory under perpetual inventory system are Br. 254.00 and Br. 326.00, respectively.

The results under periodic inventory system are:

Weighted average unit cost = Br. 580 = Br. 12.08

                                                       48

Ending inventory cost = Br. 12.08 x 25

                                    = Br. 302        

Cost of merchandise sold = Br. 580 – Br. 302

                                          = Br. 278  

So, the result is different under periodic and perpetual inventory systems.