inventory costing

Inventory CostingInventory Costing

Average-Cost MethodAverage-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

$275 $1.25 @ units 220

Average-Cost Method IllustratedAverage-Cost Method Illustrated

Salefor Available Units

Salefor Available Goods ofCost Cost Unit Average

Cost of goods available for sale $625 Less June 30 inventory 275 Cost of goods sold $350

Cost Unit Average Inventory Endingin UnitsInventory Ending

$1.25 units 500

$625

Inventory Data – June 30 June 1 Inventory 50 units @ $1.00 $ 50 6 Purchase 50 units @ $1.10 55 13 Purchase 150 units @ $1.20 180 20 Purchase 100 units @ $1.30 130 25 Purchase 150 units @ $1.40 210 Goods available for sale 500 units $625

Sales 280 units On hand, June 30 220 units

First-In, First-Out (FIFO) MethodFirst-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

1

2

3

Ending Inventory“New Items”

Cost sales“Old Items”

First In, First Out (FIFO)The “Pipe Line”First In, First Out (FIFO)The “Pipe Line”

FIFO Method IllustratedFIFO Method Illustrated

Under the FIFO method, the first items purchased are assumed to be the first items sold

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


Effect of FIFO MethodEffect 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) MethodLast-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”Last In, First Out (LIFO)The “Pool”

1

2

3

Cost of sales

“New Items”

Ending Inventory“Old Items”

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




LIFO Method IllustratedLIFO Method Illustrated

Under the LIFO method, the last items purchased are assumed to be the first items sold

This leaves the earliest purchased items in ending inventory

Effect of LIFO MethodEffect 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)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]LIFO vs. FIFO [Rising Prices]Ratio LIFO FIFO

Net Profit MarginNI ÷ Sales

Lower(NI Lower)

Higher(NI Higher)

ROANI ÷ Assets

Lower Higher

ROENI ÷ Equity

Lower Higher

Debt-to-EquityDebt ÷ Equity

Higher(Lower Equity)

Lower(Higher Equity)

ATOSales ÷ Assets

Higher(Lower Assets)

Lower(Higher Assets)

inventory costing

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