Inventory Cost Flow Methods: Specific Identification,

School: North Carolina State University - Course: ACC 210 - Subject: Accounting

Inventory Cost Flow Methods Regardless of whether the perpetual or periodic inventory system is used, at some point, a company will have to decide which "cost" to assign to an inventory item it sold. For example, let's assume following detail for a particular inventory item: Aug 1Beg. Inv.2,000 units@$6=$12,000 Aug 8Purchased10,000 units@$7=$70,000 Question: If the company sells 8,000 units on August 14, which "cost" should be assigned those units? Answer:It depends on which inventory cost flow method the company uses. Question:How many units remain in ending inventory? Answer:4,000 units GAAP allows the use of multiple methods: Specific identification:This method uses the actual cost of each item to determine cost of goods sold.For example, maybe 1,000 of the 8,000 units that were sold had a cost of $6.00 and the remaining 7,000 had a cost of $7. This would give a cost of goods sold amount of $55,000. From a practical perspective, this particular method is difficult to apply unless a company sells primarily high dollar, low volume, merchandise in which the tracking of each inventory item is practically feasible and cost-effective.Car dealerships and jewelry stores would be examples of types of companies that may use this method. In recent years, this method has become easier to apply due to more robust inventory tracking systems and the use of RFID or radio frequency identification tags embedded into many items. Weighted-Average cost:This assumption assumes that the ending inventory of a particular item is made up of a representative sample of all such items purchased during the year at different prices. A weighted-average cost per unit is calculated by dividing the cost of goods available for sale by the number of units available for sale. In the above example, the weighted- average cost per unit would be $82,000 ÷ 12,000 = $6.8333 (rounded). Therefore, the cost of the 8,000 units sold is $54,666 and the cost of the 4,000 units which remain in ending inventory is $27,333. FIFO (First-in, First-out): The name of this assumption is describing which items are assumed to be sold first.The first items "in" are assumed to be sold first.Therefore, this assumption assumes the oldest inventory purchases are sold first.Hence, ending inventory will be made up of the newest inventory items.In the above example, the 8,000 units sold are assumed to be the 2,000 units from beginning inventory (at $6 each) plus 6,000 units from the Aug 8 layer (at $7 each). This would give a cost of goods sold amount of $54,000. The 4,000 units which remain in ending inventory are assumed to be the most recent units (at $7 each). If the cost of inventory purchases has risen over time, this method will yield a lower cost of goods sold and a higher cost of ending inventory than the LIFO method. LIFO (Last-in, First-out):The name of this assumption also describes which items are assumed to be sold first.The last items "in" are assumed to be sold first, and the last items "in" would be the most recent purchases.Therefore, this assumption assumes the most recent inventory purchases are sold first.Hence, ending inventory will be made up of the oldest inventory items.