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The Different Inventory Costing Methods

written by: ciel s cantoria•edited by: Michele McDonough•updated: 5/24/2011

Understanding the different inventory costing methods is important in assigning costs to the goods physically counted as ending inventory at the close of the accounting cycle. One should keep in mind that the inventory value at year end is crucial in computing the cost of goods sold and net income.

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    The Significance of Costing Methods in Accounting

    450px-Clerk inventory 

    Businesses engaged in merchandising or manufacturing deal with stock inventories in different forms. There may be merchandise held for resale, raw materials to be used for production, or the finished goods still on hand available for sale while some others include the goods still in the process of production. Emphasis is given on the significance of inventory procedures as well as inventory costing methods as critical in the computation of the business’s Cost of Goods Sold, its related Gross Profit and the final Net Income. The consistency by which the inventory costing methods is applied, is specifically required by GAAP.

    800px-US Navy 081002-N-2074H-072 Information Systems Technician 3rd Class Isabella Concepcion inventories crates of fruit and vegetables 

    There are different inventory costing methods, namely FIFO, LIFO and Average Costs and each method will have different effects. Regardless of the choice of costing method to use, the accounting principles of consistency and accuracy should always prevail. In order to adhere and maintain these two accounting principles, management should establish a clear-cut policy as to which should be applied.

    In as much as the prices of goods bought for resale or raw materials for production may vary within a single accounting cycle, the matter of understanding the basic concepts of each costing method should be one’s first concern.

    Find the explanations of all inventory costing methods below.

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    FIFO or First-in, First-Out Method

    In this type of inventory costing method, the valuation of the ending inventory is based on the prices per unit of the most recent purchases up to the quantity that each price represents in the purchases account. Going back to the Cost of Goods Sold formula, the beginning inventory plus the total purchases is captioned as Total Goods Available for Sale for the Year. After the ending inventory is deducted, the resulting difference is captioned as Cost of Goods Sold. Hence, it is presumed that whatever amount of inventory left unsold or unused, carries the cost of the most recent purchases that were added to the inventory.

    To Illustrate:

    Merchandise Inventory, Beginning = $15,000 (100 boxes of natural bath soap @ $150/box)

    Purchases on March 16, 2009 = $11,100 (75 boxes of natural bath soap @$148/box)

    Merchandise Inventory, End = $7,400 (50 boxes of natural bath soap @$148/box)

    The Greenability All Natural Shop showed an inventory of 100 boxes of all natural soap bought at a unit cost of $150 per box at the beginning of the year. The supplier of the soap offered a discounted price of $148 per box for a minimum purchase of 25 boxes. The owner of the shop decided to take advantage of the mark down in prices and bought 75 boxes as additional stock. Upon physical count at year end cut-off date, only 50 boxes remained as unsold. These 50 boxes therefore were valued at $148/box since it was the most recent unit cost for the year’s purchases.

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    LIFO or Last-in First-out Method

    This inventory costing method is the exact opposite of FIFO, wherein the remaining inventory at year end will be valued at the unit cost based on the earliest purchase prices, which may include the cost of the goods based on previous year’s price records. However, to compute the value of the inventory at year end, there must be a careful monitoring of the prices and quantity of every stock inventory movement from the beginning balance, to the purchases,and up to the ending inventory.

    Inventory, Beg. = 100 boxes @ $150/box

    Total Purchases for the Year = 75 boxes @ $148/ box

    Total Number of Boxes Available for Sale During the Year = 175 boxes

    Inventory, End = 50 boxes

    Total Number of Boxes Sold = 125 boxes (175 boxes – 50 boxes)

    The remaining 50 boxes at year end will be assigned a unit cot of $150/box, since the year’s purchases of 75 boxes bought at $148/box were deemed part of the 125 boxes of soap sold during the year. Thus, the value of the year-end inventory for the all natural soap is $7,500.

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    Average Cost Method

    This method makes use of the mathematical concept of averaging the total value over the total number of units to arrive at the average cost per unit. Using the same figures in our two previous examples, the computation for the average cost per unit is as follows:

    Beginning Inventory: $15,000, 100 boxes

    Purchases for the Year: $11,100, 75 boxes

    Totals: $26,100,175 boxes

    Average Cost per Unit = $26,100 ⁄ 175 boxes

    Average Cost per Unit = $149.14 / box

    Hence, if there are 50 boxes to be recorded as physical inventory at year end, the value of Merchandise Inventory, End will be $7,457.

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    Comparing the Cost of Goods Sold (COGS) for Each Costing Method

    FIFO

    Beginning, Inventory: $15,000

    + Purchases: $11,100

    = Total Goods Available: $26,100

    – Inventory, End: $ 7,400

    = COGS: $18,700

    LIFO

    Beginning, Inventory: $15,000

    + Purchases: $11,100

    = Total Goods Available: $26,100

    – Inventory, End: $7,500

    = COGS: $18,600

    Average Cost

    Beginning, Inventory: $15,000

    + Purchases: $11,100

    = Total Goods Available: $26,100

    – Inventory, End: $7,457

    = COGS: $18, 643

    Based on the above-comparison, it can be noted that the FIFO method results to a higher amount of COGS, if compared to the COGS produced by the two others, LIFO and Average Costs. Higher costs equates to lower income and management will have to decide which of these three different inventory costing method will be applied on a consistent basis for the whole accounting cycle.

    In addition, GAAP rules require that the costing method used should be indicated in the financial reports. To learn more about the significance of inventory costs and further readings about Cost of Goods Sold, kindly refer to a separate article entitled Explaining the Cost of Goods Sold Formula.

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    Reference Materials and Images Credit Section

    Reference Materials:

    • http://cpaclass.com/gaap/sfas/gaap-sfas-151.htm GAAP rules

    Images

    • Wikimedia Commons