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Cost Inventory Methods

This appendix contains the following topics:

Introduction to Costing Inventory Methods

Average Cost Method

Standard Cost Method

Comparison of Methods

Value Method Considerations

Introduction to Costing Inventory Methods

The cost of purchased goods for inventory varies during the year. When identical items are bought and sold, it is difficult to determine which items have been sold and which are still in inventory. Therefore, to cost inventory, it is necessary to make assumptions about the order in which items were sold.

Because the assumed order of sale may not be the actual order of sale, it is really an assumption about the flow of costs rather than the flow of goods.

Several assumed cost flows are acceptable in accounting practice. Inventory Control allows you to choose from four generally accepted methods:

If desired, the serial (real) cost method can be used for serialized items in conjunction with the average cost method.

To illustrate these four methods, the following data for the month of July will be used:

Inventory Data, July 31

The important data for the four examples which follow is the sale of 280 units. The inventory is relieved of (reduced by) these 280 units. The examples show how inventory is relieved of these 280 units and a chart compares these four methods in terms of the value of closing inventory and the amount of profit.

Average Cost Method

Under the Average Cost method, the cost of inventory is the total cost of inventory on-hand at the beginning of the period, plus the cost of all goods purchased during the period, valued at the average cost of these goods.

Average Cost

Total cost of goods on-hand divided by total quantity of goods expressed as some unit.

Inventory Control also allows the actual costs of individual serialized items to be tracked when the average cost method is used.

Serial Cost

The real cost of an individual serialized item.

Average Cost is updated each time items are received into inventory. If serial costs are being used, the average cost is also recalculated when a serialized item is sole, when a Move In or Move Out serial transaction is posted, and when an inventory adjustment is made (adjustment transaction), using the serial number’s serial cost.

Inventory, July 31

If you are using Serialized Unit Costing, the true unit cost is used for accounting purposes instead of the Average Cost. Refer to the Serial Inventory chapter.

Standard Cost Method

Standard Cost is an inventory valuation system which highlights price variance at the time of purchase. It is designed to assist wholesalers and distributors in assigning profit responsibility between the Purchasing and the sales departments.

In the Standard Cost method, the cost of each item is set and is not changed by the sale or receipt of items. It is only changed by a definite decision and action by you to change it. The actual cost (purchase price) of inventory is automatically at Average Cost.

Standard Cost

Cost is set by you and only changed by reentering a new Standard Cost.

The easiest way to think of Standard Costing is that you set the cost of an item in Items. This becomes the target you set for the purchasing department. You also set the target (with mark up) for the sales department (to determine their portion of the responsibility for profit on an item). Variances (±) from that cost are thereafter tracked, and these variances may be printed on reports.

Inventory, July 31 - Standard Cost Method

Standard cost is set by management at $1.218

500 units x 1.218$609 (standard cost) + $2 (variance) + $2 (purchase variance)

Average unit cost: $611 ÷ 500 = 1.22

Cost of goods sold (280 units x $1.218) = $341

This shows that the Purchasing department bought the goods at $2.00 above the set Standard Cost.

LIFO Method

LIFO

The LIFO (Last in, First out) method is based on the assumption that the most recently purchased units are sold first.

LIFO assumes that the cost of the last items purchased should be assigned to the first items sold, and that the cost of the ending inventory consists of the cost of the merchandise purchased earlier.

FIFO Method

FIFO

The FIFO (First in, First out) method is based on the assumption that the oldest (first into inventory) items in stock are sold first.

FIFO assumes that the cost of the first items acquired should be assigned to the first items sold. The cost of goods on hand at the end of a period are assumed to be from the most recent purchases.

To understand the LIFO and FIFO methods, assume that you have a computer file on all items received. For each shipment received, the quantity and the unit cost of that item is input into the computer. The computer would contain a cost history of all items in inventory. LIFO/FIFO cost histories develop in what are called layers.

LIFO assumes that the last (most recent) item put into inventory is the first to be sold, or relieved from the computer’s Layers.

It is as if all receipts are dumped into a barrel, and the top ones are sold first. Each new shipment is dumped on top and then sold off before the older items, which are at the bottom of the barrel.

The FIFO method assumes that the earliest items (oldest items in stock) are sold first. You are receiving items into the bottom of the barrel, then selling the items from the top of the barrel. The computer’s Cost History data is relieved of the earliest (first) items, rather than the latest as in the LIFO method.

LIFO Layers

Inventory, July 31 - LIFO Method

For LIFO the last layer to be received (July 26) is referred to as the top layer, and the total cost history consists of five layers. (To simplify, we are assuming that the July 1 Inventory is a single purchase).

When sales occur, the layers are relieved from the top down (LIFO), and the cost of the sale is determined from the layers relieved, as follows.

For example, if 280 units are sold:

After the sale, the remaining LIFO layers would look like this:

The remaining layers represent the ending inventory for July 31. Another method of calculating is:

For FIFO, the layers develop in the reverse order of LIFO.

Inventory, July 31 - FIFO Method

The earliest purchases make up the top layers. When sales occur, the layers are relieved from the top down (FIFO). The cost of the sale is determined from the layers relieved, as follows:

The resulting FIFO layers would look like this:

The remaining layers represents the closing inventory for July 31.

Another method of calculation is shown below:

Comparison of Methods

The following four methods of pricing inventory have now been illustrated: Average, Standard, LIFO, and FIFO. All four methods are based on assumptions regarding the flow of costs.

The following is a comparison that shows the effects of the four methods on net income, using the same data as before and assuming sales during July of $500.

Assuming that costs are inflating, LIFO (which charges the most recent and therefore highest cost of goods sold) results in the lowest net income (and the lowest ending inventory value).

For this example, FIFO (which charges the earliest and therefore lowest cost of goods sold) produces the highest net income (and the highest ending inventory value).

Under average cost, the net income and value of ending inventory are between those computed under LIFO and FIFO, reflecting the leveling effect of Average Costing.

During a period of deflation, the reverse effect would occur under LIFO and FIFO (with LIFO showing a higher net income than FIFO).

The outline in the next section is also presented as an opinion on average, standard, LIFO, and FIFO.

Value Method Considerations

You need to consider various options when selecting a valuation method for Average, Standard, LIFO, or FIFO methods.

Average Cost

What is it

Perpetual average cost flow assumption.

Benefits

Comments

Standard Cost

What is it

Modified standard cost system that highlights purchase price variance at time of purchase. This method automatically uses the perpetual average cost flow assumption described above.

Benefits

Comments

LIFO

What is it

Perpetual, specific goods, LIFO cost flow assumption.

Benefits

Comments

FIFO

What is it

Perpetual, specific goods, FIFO cost flow assumption.

Benefits

Comments