Inventory Cost Flow Assumptions

This chapter introduces the idea that inventory costs change over time--most often increasing in cost. If you purchase inventory and the cost of the inventory changes, what are the implications? One implication is that, at the time of sale, you need to know the original purchase price, so that you can determine the cost of merchandise sold. The original cost can be determined based on the specific identity of the unit sold, or can be assigned, based on an assumed cost flow.

Specific Identification Method

Some kinds of businesses sell expensive and one-of-a-kind types of inventory, such that each unit must be cataloged as it comes in, identified by a product number, and then recorded as sold when the sale occurs. A piano, a BMW automobile, or a computer system might fall into this category. There may be variation in the cost of such assets--for example, a merchandiser might sell a certain grand piano for $10,000 and a smaller spinet piano for $3,000. The variation in the product line and the relatively high cost of the inventory might suggest that the merchandiser keep track of every single unit. This would be the ideal method for determining an exact figure for cost of goods sold, as the units are managed one by one. This inventory method is called the Specific Identification Method.

Example: Diane sells pianos. A customer purchases a piano for $15,000. At the time of sale, Diane looks up the price she paid for the piano ($12,000). She records the sale at $15,000 and records cost of merchandise sold for $12,000.

The specific identification method is useful for items that are unique from one another and have a high cost. If you sell pianos, you have some that are inexpensive, and some that are more ornate, with higher quality materials and performance. You keep track of each unit's cost as it comes in and goes out.

However, what if the goods are of low value, and in many cases, are identical in cost, function and appearance? Products such as cans of soup, candy bars, and flashlights are bought and sold in large quantities, and unlike a piano, if one or two get lost, there is little harm done. Such inventory items can be kept track of in an expedient manner. We can keep track of the batches of such items coming in, and going out. If we always pay $3.00 per flashlight and sell them for $6.00, the sale of 10 flashlights means that we had sales of $60 and cost of goods sold of $30.

Now, here's the problem: If there are variations in the cost of the inventory purchased, how should we know which goods are the ones that got sold?

Example: you own 50 flashlights that cost us $3. You purchase is 50 more flashlights at a new cost of $3.50. Total inventory cost is $325. Assuming that the flashlights are identical in every detail, when we sell the next 10 flashlights, should we use the $3 figure or the $3.50 figure in determining the cost of goods sold?

The answer to this dilemma is to adopt an inventory cost flow assumption for the computation of cost of goods sold.

Inventory Cost Flow Assumptions

A company will repeatedly make purchases of merchandise for resale, and the prices paid for the merchandise will fluctuate. The costs of the units purchased can be recorded, but it may not be practical to attach a specific cost figure to an individual unit of product -- especially if the product is acquired in large volumes, has a low unit value, and if the units are indistinguishable from one another. On the other hand, the high unit value of each product in a new car dealership makes it worthwhile to keep track of each unit as it comes in, and later goes out.

A classic inventory example is that of the landscaper who sells soil to the public. The landscaper makes the following purchases of soil: 5 yards at $6.00 per yard; 5 yards at $8.00 per yard; and 5 yards at $9.00 per yard. These shipments are all dumped in one big pile, making the $6.00 soil, the $8.00 soil and the $9.00 soil indistinguishable from one another. Now a customer comes in and purchases 8 yards of soil for $10.00 per yard. What gross profit was earned on this transaction? It all depends on how we determine the cost of merchandise sold. Here is a case in which the inventory cost flow must be assumed.

The inventory cost flow assumptions are:

  1. First In First Out (FIFO): we assume that the first units in are the first units sold

  2. Last In First Out (LIFO): we assume that the last units in are the first units sold

  3. Average Cost: we use the average cost per unit to value the cost of merchandise sold

Each of the three methods is illustrated using the example above. Let's summarize the data:

Date Units Cost/Unit Total Cost
1/8 5 $6.00 $30.00
1/10 5 $8.00 $40.00
1/12 5 $9.00 $45.00
  15 yards   $115.00
  Yards sold 8 yards Price = $10.00

Note that the earliest units purchased were for $6.00/unit; but the price went up to $8.00 for the second purchase, and finally increased to $9.00 per unit for the purchase on 1/12. This represents a period of inflation, as the prices kept increasing. To calculate the gross profit, we must subtract cost of merchandise sold from the revenue. As indicated in the table above, the revenue was 8 yards * $10 = $80. What was the cost of merchandise sold? The cost of merchandise sold depends on which inventory assumption you choose.

Under FIFO, the first units in are assumed to be sold first. We sold 8 units. The cost of merchandise sold would be 5 units at $6.00 (the first ones we purchased, on 1/8) plus 3 of the $8.00 units we purchased on 1/10. So, cost of merchandise sold = $30.00+$24.00=$54.00. The units left would be 2 units at $8.00 from the 1/10 purchase + 5 units at $9.00 for a total of $16+$45 = $61.00--which would appear as Inventory on the balance sheet. The income statement under FIFO would appear as follows:

Sales (8 yards @$10)   $80.00
Cost of Merchandise Sold--FIFO    
5 units @ $6.00 $30.00  
3 units @ $8.00 $24.00 $54.00
Gross Profit   $26.00

Under LIFO, we assume that the last units we purchased (on 1/12) were the first ones sold, and we work in reverse order of the purchases.

Sales (8 yards @$10)   $80.00
Cost of Merchandise Sold--LIFO    
5 units @ $9.00 $45.00  
3 units @ $8.00 $24.00 $69.00
Gross Profit   $11.00

The cost of merchandise sold would consist of 8 units--which ones? Under LIFO, we start with the 5 units at $9.00 and add in 3 units at $8.00, for a total of $69.00. The units left on the balance sheet would be 2 units at $8.00 plus 5 units at $6.00, a total of $46.00.

Comparing FIFO and LIFO, note that the gross profit under FIFO is larger than the gross profit under LIFO. This is because the FIFO cost of merchandise sold consists of the earlier, cheaper units.

What about the average cost method? If we calculate cost of merchandise sold under the average cost method, the following results occur.

Sales (8 yards @$10)   $80.00
Cost of Merchandise Sold--Average Cost Method    
8 units at $7.67*   $61.33
Gross Profit   $18.67
*Average Cost Per Unit = $115/15 units $7.67  

We can derive the average cost per unit from the original data table, which shows that we purchased a total of 15 units for a total cost of $115. The average cost per unit = $115/15=$7.67 per unit. This average is used for both income statement and balance sheet calculations. Cost of merchandise sold is 8 units * $7.67=$61.33 and the ending inventory on the balance sheet would be 7 units * $7.67 = $53.66.

Financial Statement Effects of Cost Flow Assumptions

In a period of inflation (prices rising) , FIFO will produce a higher net income than LIFO or Average Cost. This is because the earliest costs will go to Cost of Goods Sold (lower costs) to be matched with revenues for the period. The latest costs (higher costs) will end up in ending inventory. For this reason, a company wishing to enhance its earnings might choose FIFO during an inflationary period. Another company, with a goal of minimizing its tax burden might choose LIFO during an inflationary period, to reduce its net income.

Note that a company must choose one cost flow assumption for a particular class of inventory -- they cannot simply switch back and forth among the three inventory methods; such a practice would make financial statements difficult to fairly compare with one another.

FIFO is by far the most often used inventory flow assumption. Perhaps it just seems more logical to view the cost of inventory as flowing in a similar way to the physical movement of the inventory. And although the average cost method sounds appealing at first, the averaging process leads to an average cost that doesn't come out evenly, which is an inconvenience.

One other note to this chapter is that inventory philosophies have changed over the past twenty years. In the United States, the philosophy of years past was to manufacture or purchase as many units as possible, to always be able to satisfy customer needs. However, having the maximum number of units available means that resources (particularly cash) are being sunk in inventory units that have not sold yet--incurring other costs as well, such as interest, the cost of damaged or stolen goods prior to sale, inventory taxes, and freight charges.

The more modern view is that a company should strive to minimize the amount of inventory on hand--by reducing the size of product lines carried, arrangements with suppliers to deliver goods in a more timely manner (ideally after the sale to our customer has occurred!), and internet retailing strategies.

Some companies have even strived to reduce their inventory to near zero. If you were running a merchandising business and had no inventory, but you knew a willing supplier who had the inventory, theoretically you could sell the inventory to a third party prior to purchasing it, leaving you with no unsold inventory. In such a case, there would be no reason to make a choice among FIFO, LIFO and Average Cost--because all units would get sold every period.

Inventory Valuation -- Lower of Cost or Market

The cost principle is a pervasive one in accounting. However, there are occasions in which some departure from the cost principle is warranted. One such situation is when the replacement cost of inventory is lower than actual cost. Inventory is often such a large proportion of current assets and total assets, that it would be deceptive to continue to carry such inventory at cost, in the event that it is becoming obsolete or unsalable. Lower of cost or market valuation is used in these situations.

Lower of Cost or Market (LCM) valuation is discussed briefly in your text. The term "market" refers to current replacement cost of the inventory. In high-technology industries, it is common for the latest "generation" of a product (such as a personal computer) to reduce the market value of earlier generation products. If you have 100 cameras for sale, and the latest camera comes out, you will experience a loss, because the ones you already purchased will decline in value. The LCM rule requires you to reduce the cost of your original 100 cameras to the cost at which they can be replaced--which will almost always be less than you paid for them. An entry will be made to cost of merchandise sold, and a credit to the inventory account.

Inventory Estimation

Why would a company ever need to estimate its inventory? First, it is very costly to go around and count the inventory, particularly if the purpose of the count is to generate a monthly or quarterly income statement. Thus, if a company wishes to issue quarterly financial statements, an estimate of the inventory is usually sufficient in lieu of a detailed physical inventory. Also, in the event of a disaster, such as a fire or flood, it may be impossible to perform a count because the inventory has been destroyed. In order to estimate the amount of the loss, an estimate becomes necessary.

The Gross Profit Method can be used to estimate the cost of your ending inventory. This method is based on the following inventory formula:

Beginning Inventory + Purchases of Inventory minus Ending Inventory = Cost of Goods Sold.

With a little mathematical manipulation, it would be also true that:

Beginning Inventory + Purchases of Inventory minus Cost of Goods Sold = Ending Inventory.

The gross profit is calculated as: Sales minus Cost of Goods Sold = Gross Profit. It may not seem likely, but for a particular company, the gross profit percentage remains reasonably constant from year to year, in the absence of technological or market changes. So, if you know the gross profit percentage, you can calculate the approximate gross profit for a period of time, and work back to the approximate cost of merchandise sold, and ultimately, the ending inventory figure.

Inventory Errors

Sometimes an error is made in the calculation of a company's inventory. This might be a result of over- or under-counting of units in the inventory, or misallocation of prices to inventory layers. What is the effect of over- or understatement of inventory on net income?

If Ending Inventory is overstated, Net Income will be overstated as well. Here's the analysis:

Beginning Inventory + Purchases = Cost of Goods Available for Sale;

Cost of Goods Available for Sale - Ending Inventory = Cost of Goods Sold;

If Ending Inventory is overstated, Cost of Goods Sold will be understated;

If Cost of Goods Sold is understated, Gross Profit and Net Income will be Overstated.

If Beginning Inventory is overstated, Net Income will be understated. Can you reason it out?

Also note that an error in ending inventory one period will have a reverse effect in the subsequent period. This is because 1) the ending inventory of one period becomes the beginning inventory for the next period and 2) errors in beginning and ending inventory affect net income in opposite ways. This also means that an error in the inventory count in one period will likely be "washed out" in the following period, because the ending inventory in one period will become the beginning inventory in the subsequent period.

Perpetual vs. Periodic Inventory System

There are two inventory methods in general use: the perpetual inventory system (covered earlier in Chapter 6) and the periodic inventory system. Although you are not required to prepare journal entries or financial statements for the periodic method, you should have a general idea of how the system works. The method you learned in Chapter 6 is called the perpetual inventory system, because the Inventory account is perpetually updated. The following types of events described in Chapter 6 all affect the inventory account.

1. Purchase of inventory;

2. Sale of inventory;

3. Return of goods to our supplier;

4. Return of goods from our customer (if the goods can be sold to someone else);

5. Freight charges on incoming merchandise;

6. Discovery of damaged inventory or loss of inventory from theft.

The precision with which we can track each unit of inventory is highly dependent on efficient processing of business documents, as well as the use of a computerized inventory system.

In "the old days", when computers were not so prevalent, a less sophisticated system (the periodic inventory system) was used.

The Periodic Inventory System in a Nutshell

Under the periodic inventory system, we start the year (January 1 for example) with a balance in the Inventory account. We keep track of purchases we make throughout the year. Then, at the end of the year, we make a physical count to verify the amount of inventory remaining. From the balance of the Purchases account, as well as knowledge of the beginning and ending inventory amounts, the cost of goods sold can be determined using the following formula. The formula goes like this:

Beginning Inventory + Cost of Goods Purchased - Ending Inventory = Cost of Goods Sold

Imagine a business operating in 1970, a time when computer systems were not affordable by most small businesses. A merchandiser such as a small grocery store would keep track of purchases of inventory as they were made, as well as daily sales. Without the help of a computer, the cost of goods sold would be difficult to compute at the moment of sale, making the perpetual system of accounting impossible. Under the periodic system, the cost of goods sold would be computed once per year, immediately after taking a physical inventory. If you know the amount of inventory you started with on January 1 (from last year's physical inventory), and knew the amount purchased during the year, the cost of goods sold could be calculated (using the formula above) as soon as you calculated the amount of inventory still left at the end of this year.

Note that the Ending Inventory of one year is the Beginning Inventory of the next.

There is no question that the perpetual inventory system is superior to the periodic inventory system. Why do you need to know about the periodic inventory system? There are occasions in which the inventory you are dealing with is inexpensive, and may also be inconvenient to measure, implying that a computerized system is not warranted. For example, a hardware store that sells nails by the pound might use the periodic system, because the individual units are inexpensive and difficult to count. A good approximation of cost of goods sold (by the pound, for example) might be advantageous, rather than labeling each unit and scanning it at the check register. Additionally, the materiality (significance) of an error in measurement is low.