Costing Methods OverviewThere are four accepted methods of costing items: specific identification; first-in, first-out; last-in, first-out; and weighted-average. Show
Learning Objectives Review the differences between the four cost accounting methods and demonstrate how to calculate the cost of goods sold Key TakeawaysKey Points
Key Terms
Costing Methods OverviewCost accounting information is designed for managers. Since managers are making decisions only for their own organization, there is no need for the information to be comparable to similar information from other organizations. Instead, the important criterion is that the information must be relevant for decisions that managers, operating in a particular environment of business including strategy, make. Cost accounting information is commonly used in financial accounting information, but first we are concentrating on its use by managers to take decisions. The accountants who handle the cost accounting information add value by providing good information to managers who are making decisions. Among the better decisions, is the better performance of one's organization, regardless if it is a manufacturing company, a bank, a non-profit organization, a government agency, a school club or even a business school. The cost-accounting system is the result of decisions made by managers of an organization and the environment in which they make them. Efficient use of inventory is critical for businesses.: Inventory at a business. Cost accounting is regarded as the process of
collecting, analyzing, summarizing, and evaluating various alternative courses of action involving costs and advising the management on the most appropriate course of action based on the cost efficiency and capability of the management.
Classical cost elements for a manufacturing business are:
Accepted Financial Costing MethodsThere are four accepted methods of costing inventory items:
Each method has advantages and disadvantages. Note that a manufacturing business's inventory will consist of work in process, or unfinished goods, and finished inventory; the costs of unfinished and finished inventory contain a combination of costs related to raw materials, labor, and overhead. On the other hand, a retailer's inventory consists of all finished products purchased from a wholesaler or manufacturer; the costs of their units are based on their acquisition cost rather than the costs associated with manufacturing units. Specific IdentificationThe specific identification method of inventory costing attaches the actual cost to an identifiable unit of product. Firms find this method easy to apply when purchasing and selling large inventory items such as cars. Under the specific identification method, the firm must identify each unit in inventory, unless it is unique, with a serial number or identification tag. FIFO (first-in, first-out)The FIFO (first-in, first-out) method of inventory costing assumes that the costs of the first goods purchased are those charged to cost of goods sold when the company actually sells goods. This method assumes the first goods purchased are the first goods sold. In some companies, the first units in (bought) must be the first units out (sold) to avoid large losses from spoilage. Such items as fresh dairy products, fruits, and vegetables should be sold on a FIFO basis. In these cases, an assumed first-in, first-out flow corresponds with the actual physical flow of goods. LIFO (last-in, first-out)The LIFO (last-in, first-out) method of inventory costing assumes that the costs of the most recent purchases are the first costs charged to cost of goods sold when the company actually sells the goods. Weighted-averageThe weighted-average method of inventory costing is a means of costing ending inventory using a weighted-average unit cost. Companies most often use the weighted-average method to determine a cost for units that are basically the same, such as identical games in a toy store or identical electrical tools in a hardware store. Since the units are alike, firms can assign the same unit cost to them. Calculating Cost of Goods Sold (periodic method) Beginning Inventory + Purchases = Available for Sale Specific Identification MethodSpecific identification is a method of finding out ending inventory cost that requires a detailed physical count. Learning Objectives Describe how a company would use the specific identification method to value inventory Key TakeawaysKey Points
Key Terms
Types of Accounting MethodsThe merchandise inventory figure used by accountants depends on the quantity of inventory items and the cost of the items. There are four accepted methods of costing the items: (1) specific identification; (2) first-in, first-out (FIFO); (3) last-in, first-out (LIFO); and (4) weighted-average. Each method has advantages and disadvantages. General Information Specific identification is a method of finding out ending inventory cost. It
requires a detailed physical count, so that the company knows exactly how many of each goods brought on specific dates remained at year-end inventory. When this information is found, the amount of goods is multiplied by their purchase cost at their purchase date, to get a number for the ending inventory cost. Using Specific Identification The specific identification method of inventory costing attaches the actual cost to an identifiable unit of product. Firms find this method easy to apply when purchasing and selling large inventory items such as cars. Under the specific identification method, the firm must identify each unit in inventory, unless it is unique, with a serial
number or identification tag. Specific Identification: Determining ending inventory under specific identification Cost Flow AssumptionsInventory cost flow assumptions (e.g., FIFO) are necessary to determine the cost of goods sold and ending inventory. Learning Objectives Explain how a company's inventory cost flow assumptions dictate which method it will use for inventory valuation Key TakeawaysKey Points
Key Terms
Cost Flow AssumptionsInventory cost flow assumptions are necessary to determine the cost of goods sold and ending inventory. Companies make certain assumptions about which goods are sold and which goods remain in inventory (resulting in different accounting methodologies). This is for financial reporting and tax purposes only and does not have to agree with the actual movement of goods (companies typically choose a method because of its particular benefits, such as lower taxes). Efficient use of inventory is critical for businesses.: Picture of inventory at a business. The only requirement, regardless of method is that: The total cost of goods sold plus the cost of the goods remaining in the ending inventory for financial and tax purposes is equal to the actual cost of goods available. Specific IdentificationCharacteristics of the specific identification method include:
FIFOCharacteristics of the FIFO method include:
LIFOCharacteristics of the LIFO method include:
Weighted AverageCharacteristics of the weighted average method include:
Additional Notes
LIFO and weighted average cost flow assumptions may yield different end inventories and COGS in a perpetual inventory system than in a periodic inventory system due to the timing of the calculations. In the perpetual system, some of the oldest units calculated in the periodic units-on-hand ending inventory may get expended during a near inventory exhausting individual sale. In the LIFO system, the weighted average system, and the perpetual system, each sale moves the weighted average, so it is a
moving weighted average for each sale. In contrast, in the periodic system, it is only the weighted average of the cost of the beginning inventory, the sum cost of all the purchases, less than the cost of the inventory, divided by the sum of the beginning units and the total units purchased. Average Cost MethodUnder the Average Cost Method, It is assumed that the cost of inventory is based on the average cost of the goods available for sale during the period. Learning Objectives Explain how a company uses the average cost method to value their inventory Key TakeawaysKey Points
Key Terms
Average Cost Method Under the average cost method, it is assumed that the cost of inventory is based on the average cost of the goods available for sale during the period. The average cost is computed by dividing the total cost of goods available for sale by the total units available for sale. This gives a weighted-average unit cost that is applied to the units in the ending inventory. There are two commonly used average cost methods:
Simple Weighted Average Cost method and Moving-Average Cost method.
Moving Average Cost Moving-Average (Unit) Cost is a method of calculating Ending Inventory cost. Assume that both Beginning Inventory and Beginning Inventory Cost are known. From them, the Cost per Unit of Beginning Inventory can be calculated. During the year, multiple purchases are made. Each time, purchase costs are added to Beginning Inventory Cost to get Cost of
Current Inventory. Similarly, the number of units bought is added to Beginning Inventory to get Current Goods Available for Sale. After each purchase, Cost of Current Inventory is divided by Current Goods Available for Sale to get Current Cost per Unit on Goods. $5000200 units=$25\frac{\$5000}{200\text{ units}}=\$25 . $5000+$250200+50=$21\frac{\$5000 + \$250}{200 + 50} = \$21 . 150 units⋅$21=$3150150\text{ units} \cdot \$21 = \$3150 . The cost of goods sold on the income statement is 50 units⋅$21=$105050\text{ units} \cdot \$21 = \$1050 . Weighted-Average under Periodic Inventory ProcedureThe Weighted-Average Method of inventory costing is a means of costing ending inventory using a weighted-average unit cost. Companies most often use the Weighted-Average Method to determine a cost for units that are basically the same, such as identical games in a toy store or identical electrical tools in a hardware store. Since the units are alike, firms can assign the same unit cost to them. Under periodic inventory procedure, a company determines the average cost at the end of the accounting period by dividing the total units purchased plus those in beginning inventory into total cost of goods available for sale. The ending inventory is carried at this per unit cost. Advantages and Disadvantages of Weighted-Average MethodWhen a company uses the Weighted-Average Method and prices are rising, its cost of goods sold is less than that obtained under LIFO, but more than that obtained under FIFO. Inventory is also not as badly understated as under LIFO, but it is not as up-to-date as under FIFO. Weighted-average costing takes a middle-of-the-road approach. A company can manipulate income under the weighted-average costing method by buying or failing to buy goods near year-end. However, the averaging process reduces the effects of buying or not buying. Determining ending inventory: Determining ending inventory under weighted-average method using periodic inventory procedure FIFO MethodFIFO stands for "first-in, first-out," and assumes that the costs of the first goods purchased are charged to cost of goods sold. Learning Objectives Describe how a company would value inventory under the FIFO method Key TakeawaysKey Points
Key Terms
What Is FIFO FIFO stands for "first-in,
first-out", and is a method of inventory costing which assumes that the costs of the first goods purchased are those charged to cost of goods sold when the company actually sells goods. Inventory: Inventory in a warehouse Assumptions of FIFO This method assumes the first goods purchased are the first
goods sold. In some companies, the first units in (bought) must be the first units out (sold) to avoid large losses from spoilage. Such items as fresh dairy products, fruits, and vegetables should be sold on a FIFO basis. In these cases, an assumed first-in, first-out flow corresponds with the actual physical flow of goods. How is it different? Different accounting methods produce different results, because their flow of costs are based upon different assumptions. The FIFO method bases its cost flow on the chronological order purchases are made, while the LIFO method bases it cost flow in a reverse chronological order. The average cost method produces a cost flow based on a weighted average of unit costs. How to Calculate Ending Inventory Using FIFO Ending inventory = beginning inventory + net purchases - cost of goods sold When Using FIFO
LIFO MethodLIFO stands for last-in, first-out, meaning that the most recently produced items are recorded as sold first. Learning Objectives Summarize how using the LIFO method affects a company's financial statements Key TakeawaysKey Points
Key Terms
Accounting Methods A merchandising company can prepare an accurate income statement, statements of retained earnings, and balance sheets only if its inventory is correctly valued. On the income statement, a company using periodic inventory procedure takes a physical inventory to determine the cost of goods sold. Since the cost of goods sold figure
affects the company's net income, it also affects the balance of retained earnings on the statement of retained earnings. On the balance sheet, incorrect inventory amounts affect both the reported ending inventory and retained earnings. Inventories appear on the balance sheet under the heading " Current Assets," which reports current assets in a descending order of liquidity. Because inventories are consumed or converted into cash within a year or one operating cycle, whichever is longer,
inventories usually follow cash and receivables on the balance sheet. LIFOLIFO stands for last-in, first-out, meaning that the most recently produced items are recorded as sold first. Since the 1970s, some U.S. companies shifted towards the use of LIFO, which reduces their income taxes in times of inflation, but with International Financial Reporting Standards banning the use of LIFO, more companies have gone back to FIFO. LIFO is only used in Japan and the United States. The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the "LIFO reserve. " This reserve is essentially the amount by which an entity's taxable income has been deferred by using the LIFO method. LIFO inventory method: Determining LIFO cost of ending inventory under periodic inventory procedure. LIFO Flowchart: LIFO flow of costs under periodic inventory procedure The following is an example of the LIFO inventory costing method (assume the following inventory of Product XX is on hand and purchased on the following dates).
The ending inventory balance on 12/31/12 balance sheet is 4 units⋅$5=$20 4\text{ units} \cdot \$5 = \$20 , and the cost of goods sold on the income statement is 5 units⋅$6+6 units⋅$5=$ 605\text{ units} \cdot \$6 + 6\text{ units} \cdot \$5=\$60 . LIFO Under Perpetual Inventory Procedure Under this procedure, the inventory composition and balance are updated with each purchase and sale. Each time a sale occurs, the items sold are assumed to be the most recent ones acquired. Despite numerous purchases and sales during the year, the ending inventory still
includes the units from beginning inventory. Gross Profit MethodThe gross profit method uses the previous year's average gross profit margin to calculate the value of the inventory. Learning Objectives Explain how a company would use the Gross Profit Method to value inventory Key TakeawaysKey Points
Key Terms
Valuing Inventory An inventory valuation allows a company to provide a monetary value for items
that make up their inventory. Inventories are usually the largest current asset of a business, and proper measurement of them is necessary to assure accurate financial statements. If inventory is not properly measured, expenses and revenues cannot be properly matched and a company could make poor business decisions. Methods Used to Estimate Inventory Cost While the best way to value inventory is to perform a physical inventory, in certain business operations, taking a physical inventory is impossible or impractical. In such a situation, it is necessary to estimate the inventory cost. There are two methods to estimate inventory cost, the retail inventory method and the gross profit method. Gross Profit MethodThe gross profit (or gross margin) method uses the previous year's average gross profit margin (i.e. sales minus cost of goods sold divided by sales) to calculate the value of the inventory. Keep in mind the gross profit method assumes that gross profit ratio remains stable during the period. Inventory.: The gross profit (or gross margin) method uses the previous year's average gross profit margin (i.e. sales minus cost of goods sold divided by sales) to calculate the value of the inventory. To prepare the inventory value via the gross profit method:
Example The following is an example on how to calculate ending inventory using the gross profit method. $1000⋅.25=$250\$1000\cdot.25 = \$250 . $5000−$250=$4750\$5000 - \$250=\$4750 . Selecting an Inventory MethodWhen selecting an inventory method, managers should look at the advantages and disadvantages of each. Learning Objectives Summarize the differences between LIFO, FIFO and Specific Identification and explain how a company would use that information to select an inventory method Key TakeawaysKey Points
Key Terms
Advantages and Disadvantages of Specific IdentificationCompanies that use the specific identification method of 'inventory costing' state their cost of goods sold and ending inventory as the actual cost of specific units sold and on hand. Some accountants argue that this method provides the most precise matching of costs and revenues and is therefore the most theoretically sound method. This statement is true for some one-of-a-kind items, such as autos or real estate. For these items, use of any other method would seem illogical. However, one disadvantage of the specific identification method is that it permits the manipulation of income. Advantages and Disadvantages of FIFOThe FIFO method has four major advantages:
All the advantages of FIFO occur because when a company sells goods, the first cost it
removes from inventory are the oldest unit costs. The cost attached to the unit sold is always the oldest cost. Under FIFO, purchases at the end of the period have no effect on cost of goods sold or net income ([fig:11053]]). The disadvantages of FIFO include the recognition of paper profits and a heavier tax burden if used for tax purposes in periods of inflation.
Advantages and disadvantages of LIFO During periods of inflation, LIFO shows the largest cost of goods sold of any of the costing methods because the newest costs charged to cost of goods sold are also the highest costs. The larger the cost of goods sold, the smaller the net income. Those who favor LIFO argue that its use leads to a better matching of costs and revenues than the
other methods. When a company uses LIFO, the income statement reports both sales revenue and cost of goods sold in current dollars. The resulting gross margin is a better indicator of management 's ability to generate income than gross margin computed using FIFO, which may include substantial inventory (paper) profits.
Advantages and Disadvantages of Weighted-Average When a company uses the weighted-average method and prices are rising, its cost of goods sold is less than that obtained under LIFO, but more than that obtained under FIFO. Inventory is not as understated as under LIFO, but it is not as up-to-date as under FIFO. A company can manipulate income under the weighted-average costing method by buying or failing to buy goods near year-end.
However, the averaging process reduces the effects of buying or not buying.
Impacts of Costing Methods on Financial StatementsThe method a company uses to determine it cost of inventory (inventory valuation) directly impacts the financial statements. Learning Objectives Differentiate between the FIFO, LIFO and Average Cost inventory valuation methods Key TakeawaysKey Points
Key Terms
Inventory ValuationThe method a company uses to determine it cost of inventory (inventory valuation) directly impacts the financial statements. The three main methods for inventory costing are First-in, First-Out (FIFO), Last-in, Last-Out (LIFO) and Average cost. Inventory valuation method.: The inventory valuation method a company chooses directly effects its financial statements. First-in, First-Out $5.00⋅50+$5.50⋅50100=$5.25\frac{\$5.00 \cdot 50 + \$5.50 \cdot 50}{100}=\$5.25 . Impact on the Financial Statements Without inflation, all three inventory valuation
methods would produce the same results. Unfortunately, prices do tend to rise over the years, and the company's method costing method affects the valuation ratios. Licenses and AttributionsCC licensed content, Shared previously
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What types of products would work well using the specific identification method?Specific identification inventory valuation is often used for more expensive items such as furniture or vehicles. It also is used when the products stored have widely different features and costs.
Which method is the most logical for inventory valuation?For most companies, FIFO is the most logical choice since they typically use their oldest inventory first in the production of their goods, which means the valuation of COGS reflects their production schedule.
Which inventory identification method should I use?Specific identification is the most accurate inventory accounting method. It tracks the cost of each item in your inventory and the actual price of each item that sold.
Is FIFO method logical?The FIFO method follows the logic that to avoid obsolescence, a company would sell the oldest inventory items first and maintain the newest items in inventory.
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