In a perpetual inventory system, the cost of merchandise sold and the ending inventory are determined on an ongoing basis as sales and purchases occur. This is in contrast to a periodic inventory system, which determines these costs at the end of a specific period of time. There are four common methods used to assign costs to inventory and the cost of merchandise sold under a perpetual inventory system:
- Specific identification: When each item in inventory can be directly traced to a specific purchase and its invoice, we can use specific identification (also known as specific invoice pricing) to assign costs. This method is appropriate for small inventory sizes and low volume of sales.
- First-in, first-out (FIFO): This method assumes that inventory items are sold in the order in which they were acquired. Therefore, the cost flow follows the order of expenditures. To determine the cost of ending inventory, we start with the most recent purchases and work backwards.
- Last-in, first-out (LIFO): This method assumes that the most recent purchases are sold first, with their costs being charged to the cost of goods sold. The costs of the earliest purchases are assigned to inventory. The cost flow is in the reverse order of expenditures.
- Weighted average: This method requires calculating the average cost per unit of merchandise available for sale. The cost flow is an average of the expenditures. To determine the cost of ending inventory, we first calculate the average cost per unit, then multiply this by the units on hand at the end of the period.
Each of these methods has its own advantages and disadvantages, and the appropriate method will depend on the specific circumstances of the business. It is important to choose the method that most accurately reflects the true cost of the inventory and cost of goods sold.