Inventory: Cost flow assumptions

Inventory: Cost flow assumptions

1. If unit costs of inventory items vary over time
--> cost of goods sold and inventory amount will depend on
--> which specific items are sold

2. Example 1
January 1, 2011
--> Entity A had 100 units of merchandise in inventory at $10 per unit cost

January 15, 2011
--> Entity A purchased 300 units of merchandise at $12 per unit cost

January 20, 2011
--> Entity A sold 50 units of merchandise $16 per unit price

Sales revenue = 50 units x $16 = $800
What is the amount of cost of goods sold?

3. Specific identification method
--> if each unit can be identified
--> Entity A can specify which 50 units are sold and
--> decide the cost of each specific unit

4. If inventory items are identical and pooled together
--> Entity A has to decide which 50 units were sold on January 20, 2011

5. If the units in the beginning inventory
--> cost per unit is $10

6. If the units purchased on January 15, 2011
--> cost per unit is $12

7. This is the reason why cost flow assumptions are made
--> when specific identification method is not used

8. Cost flow assumptions
(1) First-in, First-out (FIFO)
--> items purchased first are assumed to be sold first

(2) Last-in, First-out (LIFO)
--> items purchased last are assumed to be sold first

(3) Weighted average
--> weighted average cost of all previous purchases is used
--> to determine the cost of goods sold

9. Example 1, continued
January 1, 2011
--> Entity A had 100 units of merchandise in inventory at $10 per unit cost

January 15, 2011
--> Entity A purchased 300 units of merchandise at $12 per unit cost

January 20, 2011
--> Entity A sold 50 units of merchandise $16 per unit price

Sales revenue = 50 units x $16 = $800
What is the amount of cost of goods sold?

10. First-in, First-out (FIFO)
--> Beginning inventory at January 1, 2011 is assumed to be sold first
--> cost of 50 units sold: $10 per unit
--> 50 units x $10 = $500

11. Last-in, First-out (LIFO)
--> the most recent purchase on January 15, 2011 is assumed to be sold first
--> cost of 50 units sold: $12 per nit
--> 50 units x $12 = $600

12. Weighted average
--> weighted average cost
= (100 x $10 + 300 x $12) / (100 + 300) units
= ($1,000 + $3,600) / 400 units
= $4,600 / 400 = $11.50

Cost of 50 units sold
= 50 units x $11.50 = $575

13. Cost of goods sold summary
(1) FIFO
--> 50 units x $10 = $500

(2) LIFO
--> 50 units x $12 = $600

(3) Weighted average
--> 50 units x $11.50 = $575

13. Inventory
(1) FIFO
--> 50 units x $10 + 300 units x $12
= $500 + $3,600 = $4,100

(2) LIFO
--> 100 units x $10 + 250 units x $12
= $1,000 + $3,000 = $4,000

(3) Weighted average
--> 350 units x $11.50 = $4,025

14. Quick comparison of FIFO and LIFO

--> If the cost of later purchase is higher than those of previous purchases

--> Cost of goods sold
FIFO < Weighted average < LIFO
--> earlier cost (lower cost) is charged for FIFO
--> later cost (higher cost) is charged for LIFO

--> Inventory
LIFO < Weighted average < FIFO
--> later cost (higher cost) stays in inventory for FIFO
--> earlier cost (lower cost) stays in inventory for LIFO