For a firm to calculate the total cost of its ending inventories, it is first necessary to determine the actual quantity of items in the ending inventory and then to attach a price to these items.
This is usually done by taking a physical inventory at least once a year, usually at year-end. A physical inventory is required, regardless of whether a firm uses the perpetual or the periodic inventory method.
After the quantity of items is determined, a particular cost flow pattern is assumed, and prices are attached to each item in the inventory. The total of the prices times the quantity equals the cost of the ending inventory.
Ending Inventory Quantities
Determining the actual quantity of items in the ending inventory usually requires a physical count. This count can take more than a day and often requires the firm to cease operations.
For example, imagine the effort in counting the ending inventory of a large department store. For these reasons, some firms, especially those in the retail sector, use estimation procedures.
When the ending inventory is counted, the firm must ensure that all the items to which it has legal title are part of the count, including goods stored in public warehouses and goods in transit.
Goods in transit include both sales on a FOB destination basis and purchases on a FOB shipping basis. Goods sold but still on hand should not be included.
Costs Included in the Ending Inventory
Under generally accepted accounting principles, the presumption is that inventories should be recorded at cost. The AICPA defines cost as follows:
[Cost is] the price paid or consideration given to acquire an asset. As applied to inventories, cost means in principle the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location.
For retailers, this means that acquisition costs include the purchase price less any sales discounts, plus other freight charges, insurance in transit, and sales taxes that are incurred to have the product ready for sale.
However, costs such as freight charges and insurance are usually small, and the cost of trying to allocate them to individual items outweighs the benefit.
Therefore, most firms simply use the net invoice price when attaching a cost to an individual item in the ending inventory. These other costs then become part of the cost of goods sold.
Indirect costs such as selling and warehouse expenses are not included in the cost of inventory due to the difficulty in reasonably allocating them to particular items. They are, therefore, treated as period expenses and reduce the current period’s income.
However, even after determining the quantity of the ending inventory, figuring out what to include in the acquisition cost is a major accounting problem that has still not been resolved.
The decision must be made as to what price to attach to the particular items in the ending inventory.
In other words, the problem is how an accountant can determine the acquisition cost or price paid for each item in the ending inventory when the items have been purchased at different times for different prices.
Methods of Attaching Prices to the Ending Inventory
At first glance, it seems easy to determine the acquisition cost of each item sold or the acquisition cost of the items in the ending inventory.
However, imagine a firm that sells identical products, such as molded plastic chairs, that have been purchased at different prices. Or imagine a department store that sells a variety of products in different sizes and styles, again purchased at different prices.
Even with a well-developed electronic recordkeeping system, it is difficult—if not impossible—for these types of businesses to determine the price of each item remaining in the ending inventory.
If all items are purchased at the same price, there will be no problem in determining the cost of either the ending inventory or the items sold.
However, prices do not remain stable, and so accountants have developed alternative methods to attach costs to inventory items. These methods use cost flow assumptions, in contrast with physical flow assumptions.
That is to say, an assumption is made that costs flow in any one of four different patterns, regardless of how the goods physically move into and out of the firm. These cost flow assumptions are:
In some limited situations, it is possible to use an actual flow assumption known as specific identification.