Valuing Inventory: Cost Flow Assumptions Saylor Academy

It’s often used in businesses with easy-to-track inventories, such as antique shops. The cost of goods available for sale equals the beginning value of inventory plus the cost of goods purchased. Two purchases occurred during the year, so the cost of goods available for sale is $ 7,200. The low gross margin results when the latest and highest costs are allocated to cost of goods sold.

• Recall that under the perpetual inventory system, cost of goods sold is calculated and recorded in the accounting system at the time when sales are recorded.
• This is because the acquisition price of the inventory consistently rises during the year, from $4.10 to $4.70.
• Also called the average cost method, it creates an average unit cost that results in a per-unit cost that remains consistent throughout the accounting period.
• Given that the cost of inventory is premised on the most recent purchases, these costs are highly likely to reflect the higher inflationary prices.

As discussed in the appendix to Chapter 5, the ending inventory amount will be recorded in the accounting records when the income statement accounts are closed to the Income Summary at the end of the year. The amount of the closing entry for ending inventory is obtained from the income statement. Using the example above and assuming no other revenue or expense items, the closing entry to adjust ending inventory to actual under each inventory cost flow assumption would be as follows. Generally accepted accounting principles require that inventory be valued at the lesser amount of its laid-down cost and the amount for which it can likely be sold — its net realizable value (NRV). This concept is known as the lower of cost and net realizable value, or LCNRV. A further consideration would be the effects on the income statement and balance sheet.

What is the Weighted-Average Cost Flow Assumption?

It takes less time and labor to implement an average cost method, thereby reducing company costs. The method works best for companies that sell large numbers of relatively similar products. Whatever method is chosen, it should be applied on a consistent basis. It would be inappropriate for a company to change cost flow assumptions year to year, simply to achieve a certain result in net income.

Cost of goods sold can then be valued at retail, meaning that it will equal sales for the period. From this, ending inventory at retail can be determined and then converted back to cost using the mark-up. Let’s apply the weighted-average cost flow assumption to our baseball bat example, using a periodic inventory system. With FIFO, it is assumed that the $5 per unit hats remaining were sold first, followed by the $6 per unit hats. The specific identification method isn’t a cost flow assumption because you’re perfectly matching your inventory costs with your inventory sales.

Consequently, LIFO is criticized because the inventory cost on the balance sheet is often unrealistically low. In terms of its effects on the balance sheet and income statement, LIFO has the opposite effect of FIFO. In an economy where prices are rising, LIFO results in the lowest gross margin and the lowest ending inventory. The inventory profit is considered a holding gain caused by the increase in the acquisition price of the inventory between the time that the firm purchased and then sold the item. On the one hand, many accountants approve of using FIFO because ending inventories are recorded at costs that approximate their current acquisition or replacement cost.

This method is only used when the periodic inventory system is in place. With this method, companies add up the total cost of goods purchased or produced during a specified time. This amount is then divided by the number of items the company purchased or produced during that same period. To determine the cost of goods sold, the company then multiplies the number of items sold during the period by the average cost per item. Choosing among weighted average cost, FIFO, or LIFO can have a significant impact on a business’ balance sheet and income statement. Businesses would select any method based on the nature of the business, the industry in which the business is operating, and market conditions.

Companies that use the periodic system and want to apply the same cost to all units in an inventory account use the weighted average cost method. The weighted average cost per unit equals the cost of goods available for sale divided by the number of units available for sale. The average cost method calculates the total cogs for a certain period and then divides it by the number of units sold to provide an average unit cost. This provides figures between those of fifo and lifo, which may be viewed as less conservative than lifo but more conservative than fifo. The last in, first out (LIFO) accounting method assumes that the latest items bought are the first items to be sold. With this accounting technique, the costs of the oldest products will be reported as inventory.

3.2: Cost Flow Assumptions

Therefore, Company A’s merchandise turnover is more favourable than Company B’s. Using the information above to apply specific identification, the resulting inventory record card appears in Figure 6.6. Assume a company sells only one product and uses the perpetual inventory system.

Cost Flow Methods

Estimating ending inventory requires an understanding of the relationship of ending inventory with cost of goods sold. LO3 – Explain and calculate lower of cost and net realizable value inventory adjustments. The information in Figure 6.9 is repeated in Figure 6.10 to reinforce that goods available for sale equals the sum of goods sold and ending inventory. While the LIFO inventory valuation method is accepted in the United States, it is considered controversial and prohibited by the International Financial Reporting Standards (IFRS). If you’re using the wrong credit or debit card, it could be costing you serious money.

That is, LIFO would produce the highest gross margin and the highest ending inventory cost. Another reason why businesses would use LIFO is that during periods of inflation, the LIFO method matches higher cost inventory with revenue. Also, through matching lower cost inventory with revenue, what is a credit card cash advance and the associated fees the FIFO method can minimize a business’ tax liability when prices are declining. Since January 13 is our last transaction, let’s assume that no other transactions occurred during the month. Let’s foot the columns by adding the total costs under the Purchases and Cost of Goods Sold columns.

Example of the Inventory Cost Flow Assumption

Average cost method assigns a cost to inventory items based on the total cost of goods purchased or produced in a period divided by the total number of items purchased or produced. It’s possible to change cost flow assumptions, but it requires the help of a CPA and a tax attorney to revalue your inventory and quantify the impact on your financial statements. The last‐in, first‐out (LIFO) method assumes the last units purchased are the first to be sold. This method usually produces different results depending on whether the company uses a periodic or perpetual system. The weighted average cost per unit multiplied by the number of units remaining in inventory determines the ending value of inventory.

The average of the two prices is $11 (10 + 12 divided by 2) but the weighted moving average is $340 divided by 29 (total cost of inventory on hand divided by units) which is, in this case, $11.72. The average is much closer to $12 than to $10 because there are so many more of the $12 units. This means the average cost at the time of the sale was $87.50 ([$85 + $87 + $89 + $89] ÷ 4). Because this is a perpetual average, a journal entry must be made at the time of the sale for $87.50. The $87.50 (the average cost at the time of the sale) is credited to Inventory and is debited to Cost of Goods Sold.

Why should I use average cost method?

Under the periodic inventory system, cost of goods sold and ending inventory values are determined as if the sales for the period all take place at the end of the period. These calculations were demonstrated in our earliest example in this chapter. Companies that use the perpetual system and want to apply the average cost to all units in an inventory account use the moving average method.

First, unless items are easy to physically segregate, it may difficult to identify which items were actually sold. As well, although physical segregation may be possible, this method could be expensive to implement, as a great deal of record keeping is required. The second disadvantage of this method is its susceptibility to earnings-management techniques.