Application of Different Cost Flow Assumptions
The data for the Cerf Company shown below will be used to demonstrate the computations required to apply three cost flow assumptions and the specific Identification method. Three points should be made about this example. First, It is simplistic in that only six purchases are made during the year. However, the procedures In this example hold for more complex, real purchasing patterns. Second, we are using the periodic inventory system, which for cost flow purposes does not require that we keep track of the particular dates upon which actual sales are made. In a perpetual inventory system, the dates of the particular sales are Important. Third, each of these methods is an alternative under accepted accounting principles (GAAP).
First In, First Out (FIFO)
Under the FIFO method, the costs attached to the first goods purchased are assumed to be the costs of the first goods sold; the cost of the ending Inventories consists of the costs of the latest goods purchased. FIFO refers to a means of determining the cost of goods sold during the period, We will see, however, that when applying the FIFO method the cost of the ending inventory is determined first, after which the cost of the goods sold is easily derived.
Using the data just presented, the cost of the ending inventory under FIFO is $2,785, and the cost of goods sold is $7,655. These figures are determined as follows:
As the preceding figures indicate, the 600 units in the ending inventory consist of (1) the 250 units purchased on November 29 and (2) 350 of the 400 units purchased on September 27. The 50 items remaining from the September 27 purchase, as well as the units from prior purchases and the beginning inventory, are assumed to have been sold. However, we could directly calculate the cost of goods sold as follows:
This approach is rarely used because firms sell many more goods than they have on hand at the end of the year, and so it is easier to count the smallest number, what is left.
In 2019, 2018 ending inventory of $2,785 becomes the beginning inventory. Although this inventory consists of 2 distinct layers of 250 and 350 units, respectively, each purchased at different prices, it is usually not necessary to maintain these layers. The inventory can be brought forward as 600 units at a cost of $2,785. The reason that we can merge these two layers is that under the FIFO method, these goods will be the first ones sold in the next year. When they become part of the goods sold, the cost becomes part of a large pool in which the identity of the layers is not important.
Although a number of goods physically move on a FIFO basis, this is not a necessary criterion for its use. For example, think of a large barrel of nails in a hardware store. As additional nails are added to the barrel, they are placed on top of the older nails, and when the nails are sold, the top nails are sold first. In this situation, the nails move in a last-in, first-out pattern. Nonetheless, the management of the hardware store is free to choose the FIFO method of pricing its inventories.
Last In, First Out (LIFO)
Under the LIFO method of pricing inventories, the cost attached to the last goods purchased is assumed to be the cost of the first goods sold. Therefore, the cost of the ending inventory consists of the cost of the items of the earliest purchases.
Using the previous data, the cost of the ending inventory under LIFO is $2,410, and the cost of goods sold is $8,030. These figures are determined as follows:
As the above illustration indicates, the 600 units in the ending inventory are assumed to consist of (1) 500 units from the beginning inventory and (2) 100 units from the January 24 purchases. As we did in the previous example, we could directly calculate the cost of the goods sold of $8,030 instead of deriving it by subtracting the ending inventory of $2,410 from the goods available for sale of $10,440.
When the LIFO method is used, it is important to maintain separate layers of costs of ending inventory. Therefore, in our illustration, the beginning inventory for the following period is carried forward in two layers comprising 500 units at $4.00 and 100 units at $4.10. If next year’s ending inventory falls below 600 units, the 100 units represented by the January 24 purchase would be included in the cost of goods sold before the 500 units represented by the beginning inventory. That is, inventory is decreased in the order that it was originally added, and because the January 24 layer was added last, under the LIFO method it is considered to be sold first.
Under the average cost method, a weighted average cost per unit is calculated by dividing the total cost of the goods available for sale by the number of units available for sale, For the Cerf Company this calculation is:
This $4.35 cost per unit is applied to both the ending inventory and the goods available for sale and is as follows:
In 2020 the beginning inventory, consisting of 600 units at a total cost of $2,610, is included in the computation of the weighted average unit cost of goods available for sale.
In some situations, it is practical to determine the specific acquisition cost of the items remaining in the ending inventory. For example, an automobile dealer has records of the exact cost of every car sold and every car remaining in inventory at the end of the year. Other examples of such firms are furniture companies, antique stores, and coin and stamp dealers. Depending on the costs and benefits, other firms might want to maintain such records.
To illustrate this method, assume that the Cerf’ Company is able to determine that the 600 items in the ending inventory are from the specific purchases listed below and thus computed the cost of the ending inventory to be $2,640 and the cost of goods sold to be $7,800.
In addition to the practical problems of keeping track of the costs of the specific items in the inventory, there are theoretical problems with the specific identification method. For example, assume that a firm produces only one type of item and that all items are identical (fungible). Wheat and other commodities are examples of fungible goods. Buyers of such products are indifferent as to which specific item or lot they buy, and so the firm’s management is free to specific lot(s) it desires. That is, the buyer of 10 ounces of gold does not care which lot the gold comes from, as long as all the gold is of the same quality. Thus the firm’s management can sell the gold from any lot it chooses.
Management is able to manipulate income by selling lots with certain acquisition costs. To demonstrate this point, assume that the management of the Cerf Company wants to maximize its income for the current year. In this situation, the firm sells those goods with the lowest acquisition costs (that is, the items purchased at $4.00 and $4.10). Next year, if management decides to minimize its income, it will sell those products with the highest acquisition prices. Each year management could make such decisions without having to maintain a consistent pattern from year to year. Therefore, it has some ability to manipulate the firm’s income.
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About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.