Inventory Costing

For A Periodic Inventory System

• a physical count of inventory is taken at the end of the fiscal year to determine how many units you have left in-stock. Throughout the year, the amount in the inventory account remains the same. It is expensive and difficult to do a physical count, so this is normally only done at year end, when it is required.

• The CICA Handbook says inventory should have a cost that represents the "fairest matching of costs against revenue.”

• At the end of each fiscal period, prior to the preparation of financial statements, a business must assign a value to the inventory it has on hand.

• There are a few options available for inventory valuation.

• If a business only sold one thing and it always cost the same, it would be easy. The problem is, most businesses sell a variety of items and the cost of those items often changes throughout the year. That makes inventory valuation a real challenge.

SPECIFIC IDENTIFICATION • Each item is matched with its actual cost. • usually used with expensive or unique items• Method used when sales of item are fairly low in

variety of items and can identify each one easily, either because it is unique, or it may have a serial number.

• Some examples might be cars, art, electronics, etc. • If a business can use this method, it is easy to record

the cost of it, while the item is in inventory and when it is sold.

• When inventory costs are rising, a company can take advantage of this method by selling off the cheapest inventory to show a high net income—low cost of goods sold.

FLOW OF GOODS

• FIFO (First in First Out)• LIFO (Last in First Out)• Average Cost• These methods are far more common• The theory behind these methods of valuation

is that inventory is valued based on the sequence in which goods are sold.

FIFO

• assumes that goods that are purchased first are sold first. This method looks like a conveyor belt. Foods, and other perishable products, are good examples of this type of merchandise.

• To calculate the cost of goods sold using FIFO, you need to assign a cost to the 80 units that were sold in the period. The other number to calculate is the ending inventory. If 80 units are sold, there are 15 units left as ending inventory. In this case, all 15 units would be valued at the November purchase cost.

• Ending Inventory = 15 units x $10 unit cost = $150.

LIFO

• assumes that goods that are purchased last are sold first

• A pile of logs is a good example of this type of merchandise. The last logs purchased will be on top and will be sold first.

• To calculate the cost of goods sold using LIFO, you need to assign a cost to the 80 units that were sold in the period. The cost of the last 80 units available for sale will be the cost assigned to the units sold.

• the total cost of the 80 units that were sold was valued at $725. The ending inventory of 15 units is assigned a value equal to the beginning inventory unit cost.

Ending Inventory = 15 units x $8 unit cost = $120.

Average Cost Method

• When inventory is mixed together as it comes in, an average of the costs over the period can be used to value inventory. It may be very hard to tell which piece of inventory is which and which will be sold first.

• Example: Hardware stores that sell items like nuts and bolts in bulk

The first step is to calculate an average cost per unit of our inventory:Average Cost per Unit = Total Cost of Inventory / Number of Units in Inventory

= $845 / 95 = $8.89 per unit Cost of Goods Sold = Number of Units Sold x Average Cost per Unit

= 80 X 8.89 = $711.20 Ending Inventory = Number of Units in Inventory x Average Cost per Unit

= 15 x 8.89 = $133.35

• In Canada, FIFO is the most popular method of inventory valuation. LIFO is not allowed because of income tax regulations, but is occasionally used for business analysis.

Journal Entries

• Regardless of which inventory valuation method you choose, the journal entries used to record purchases and sales in the periodic inventory system will remain constant.

• The cost of goods sold calculation and the adjustment of the inventory account occur at end of the accounting period when financial statements are prepared.

Comparing Methods

FIFO LIFO AVERAGE

Cost of Goods Sold Lowest Highest In Between Gross Profit/Net Income

Highest Lowest In Between

Ending Inventory Highest Lowest In Between

The following table summarizes the effects of each inventory valuation method on the income statement, in a period of rising prices:

Balance Sheet Implications

• The balance in the merchandise inventory account on the balance sheet depends on the valuation method used.

• This account will have the same value as the ending inventory used in the cost of goods sold calculation on the income statement.

• In a period of rising prices, total assets, which include merchandise inventory, will be highest under FIFO and lowest under LIFO. This could have implications for investors in a company.

• Using LIFO or Average Cost may result in an inaccurate representation of the current replacement costs of the goods in inventory.

Perpetual System

• The advantage of this system:– shows a continuous balance of inventory on hand– The cost of goods sold is recorded with every sales

transaction, not only at the end of the accounting period

Perpetual Inventory System

• The Appliance Superstore sells a camera called Supershot. The company uses a perpetual inventory system. The following is a record of purchases and sales for Supershot for the month of April.

FIFO• To keep track of perpetual inventory using a

FIFO valuation, it's much easier to use an inventory record card.

FIFO-Perpetual• To calculate it manually, we record each transaction in order and recalculate the

ending balance each time. • The unit cost on the sale is always recorded at the cost of purchasing the item, not

the sale price. The point of this section is to figure out your cost of goods sold.

• When cost of inventory changes, must keep each inventory grouping separate. See the April 10 ending balance. The first goods in, the seven units at $150, are listed first, and then the items that were purchased for $160 are listed second. This makes it easier to use the FIFO method for the sale on April 12.

LIFO

Average Cost

Effect on Financial Statements

• the impact of the Inventory Valuation decision on the financial statements under the perpetual system is the same as the periodic system.

RECAP-Effects on Income Statement

Period of rising prices:• FIFO produces a higher income. • FIFO reports the highest income and LIFO the lowest.

Average cost falls somewhere in the middle. • To management, higher net income is an advantage.

It causes external users to view the company more favourably.

• Also, if management bonuses are based on net income, FIFO will provide the higher income for higher bonuses.

Effects on Income Statement

Period of falling prices:• the results from the use of FIFO and LIFO are

reversed. FIFO will report the lowest income and LIFO the highest.

• If prices are stable, all three cost flow assumptions will report the same results.

Analysis of Inventory

• Inventory is usually the largest current asset on the balance sheet and the largest expense (COGS) on the income statement

• Therefore these numbers are critical for analyzing how well a company manages its inventory

Analysis of Inventory

• value of inventory items sometimes fall below cost due to changes in technology or style

• When the value of inventory is lower than its cost, the inventory is written down to its market value.

• done by valuing the inventory at the lower of cost and market (LCM) in the period in which the decline occurs

Inventory Turnover Ratio

Cost of goods sold ÷ average inventory• The number of times inventory “turns over”

during a given period• Average inventory is usually average of

beginning and ending inventories

Days Sales in Inventory

• Days in year ÷ inventory turnover ratio• The number of days on average that the

inventory is on hand before being sold

RECAP Inventory Measurables

• Days of sales in inventory focuses on ending inventory

• Merchandise Turnover focuses on average inventory

GAAPMateriality Principle• May not ignore an amount if its effect on the

financial statement is important to their usersFull Disclosure Principle• Financial statements must report all relevant

information about the operations and financial position of the entry

Consistency Principle• Requires a company to use same accounting

methods period after period so that financial statement are comparable exclusively