In this video we're going to cover an Inventory Cost Flow Assumption
FIFO which means First In First Out.
[Music]
Hey there my name is James
you're watching Accounting Stuff and today we're continuing our
how to account for inventory mini-series.
There’s got to be a better name for it than that.
So far we've covered cost of goods sold and the
perpetual and periodic inventory systems.
If you missed either of those you can find them linked up here
and down there in the description.
Today we're moving onto another hotly requested topic
Inventory Cost Flow Assumptions.
By the way if you hear any squawking there's a really noisy crow there.
I've tried telling it to be quiet but it won't listen to me.
Anyway there are three Inventory Cost Flow Assumptions
that you should be aware of FIFO, LIFO and AVCO.
In this video we'll be doing FIFO.
I'm going to show you a 4 step process to calculate
cost of goods sold and closing inventory using this method.
So let's get into it.
When do we need Inventory Cost Flow Assumptions?
Let's think back to our inventory calculation from
the previous video.
Opening inventory plus additions gives us cost of goods available for sale
and when we subtract our cost of goods sold from this we get our closing inventory.
Now here's the thing up until now we've assumed
one constant cost price across all of your inventory.
But in reality this isn't always the case.
Your opening inventory might have cost you $2 per unit but your
additions might have cost you $3 per unit.
So your inventory on hand or your cost of goods available for sale
could be made up of a whole mix of $2 and $3 units
and when you get around to making a sale you need to work out how much this cost
needs to flow out of the inventory account in your balance sheet
into your cost of goods sold account.
An expense account kept in your income statement
and also how much of this cost should remain where it is
in your closing inventory.
To work this out you can use Cost Flow Assumptions.
Cost Flow Assumptions are rules that help us estimate what
these cost flows are.
These are assumptions so they don't necessarily reflect
the reality of underlying transactions.
There are three main types of Cost Flow Assumption
FIFO LIFO and AVCO First In First Out
Last In First Out and the Average Cost method.
In this video we're going to concentrate on FIFO
but I'll be covering LIFO and AVCO in the near future as well
so if you'd like to see that remember to subscribe.
Okay so FIFO…
First In First Out what's this all about?
When you make a sale using the FIFO method
you make the assumption that your oldest inventory
is going to be sold first.
Your oldest inventory is what you bought first
so you're going to imagine that you sell it first every time.
First In First Out.
But how do you account for this?
I think it's time for an example.
Business is booming in the window cleaning industry.
Word of this catches your ears and you decide to get into wholesale
buying and selling and squeegees in bulk.
Yeah that's what these are called.
Squeegees!
It's the beginning of November and you have 220 Squeegees
in your inventory you bought these for $2 each.
On November 5th you buy another 400 squeegees for $1,200
and on November 12th you sell 500 squeegees for $2,750.
Question what is your cost of goods sold
and closing inventory for November assuming that no other
transactions have taken place
and that you're using the FIFO Cost Flow Assumption?
First In First Out.
To help you get to the bottom of this I've put together four steps
which we're going to run through now but you can also find them
on my cheat sheet.
You can help support this channel by buying it on my website
I'll link to it down below.
Step 1 Draw an inventory cost flow table.
What on earth is that?
It's a table made up of five columns
date
description quantity
cost per unit and total cost.
Okay Step 2 Enter what you know.
Here's where we use the information given to us to fill out
as much of this table as possible.
So let's do that.
You began November with 220 squeegees which cost you $2 per unit.
So on November 1st you had an opening inventory made up of
220 units which cost you $2 per unit.
A few days later you bought another 400 squeegees which
cost you $1,200 in total.
We'll add that to the table as well.
On November 5th you made additions of 400 units which
cost you $1,200 in total.
In an inventory cost flow table you want to leave an empty row beneath
every addition or sale.
This is where your subtotals are going to go.
Your goods available for sale or your closing inventory
after the final transaction.
It'll become clear why in a moment.
Okay finally on November 12th you sold 500 squeegees for $2,750.
So on November 12th you sold 500 units which needs
to be negative because you no longer own these squeegees.
The sale reduced your inventory on hand and
you sold these for $2,750 so we'll deduct that here…
Hold up, wait… we can't do that.
You sold 500 squeegees for $2,750.
This is the revenue that you made not what these squeegees
actually cost you.
So we can't enter the $2,750 into your total cost of goods sold
we'll have to work this one out.
We're also going to need to work out your closing inventory
at the end of the month on November 30th.
Which brings us on to Step 3 It's time to fill in the blanks.
There are a couple of things to be aware of when filling out
a cost flow table under FIFO.
We'll need to calculate the cost per unit of your
opening inventory and additions but you can ignore the cost per unit
of your goods available for sale goods sold and closing inventory.
We'll start off by calculating the total cost of your opening inventory.
You began the month holding 220 units which cost you $2 per unit
220 multiplied by $2 is $440 Next up we have to work out
the cost per unit of your additions.
You bought 400 units costing you a total of $1,200.
$1,200 divided by 400 units is $3 per unit.
That's quite an increase from the cost per unit of your opening inventory.
Something to bear in mind when picking Inventory Cost Flow Assumptions.
But more on that soon.
Now we'll take some subtotals to work out your goods available for sale.
220 units plus 400 units is 620 units available for sale
and $440 plus $1,200 is $1,640 your total cost of goods available for sale.
Remember I said that under FIFO we can keep the cost per unit
of your goods available for sale and goods sold blank.
That means we can move on to working out your total cost of goods sold.
Here's where FIFO comes in.
First In First Out.
You sold 500 units but what did it cost you?
Well under FIFO the first units you bought in are the first to be sold.
You had an opening inventory of 220 units which cost you $2 per unit
but you still need to sell another 280 units to reach 500.
The next 280 units come from your additions which cost you $3 per unit.
So here's our workings 220 units multiplied by $2 is $440
and 280 units multiplied by $3 is $840 440 plus 840 is $1,280
this is your total cost of goods sold.
Nice work!
That was the hard part now let's take some totals to find out
your closing inventory on November 30th.
620 minus 500 gives you 120 units and 1,640 minus 1,280 gives you $360
your total cost of closing inventory.
Step 4 Calculate your total cost of goods sold
and your closing inventory.
Well like I said the hard part is over.
Your total cost of goods sold for the month can be calculated
by adding up your cost of goods sold for each sale.
Here you've only made one sale so your total cost of goods sold
for November is $1,280 and the total cost of your
closing inventory is $360.
The inventory cost flow table makes it easy for us to work these out
and if any of this looks familiar to you it's because
it mirrors the inventory calculation that we had up earlier.
So why would you choose the FIFO method?
Well it's one of the easiest Cost Flow Assumptions to use in practice
and in an inflationary economy where prices are rising
the cost of your inventory might be going up like it did in this example.
So choosing FIFO can make your profits look bigger because
you're matching your current revenues against your older
cheaper cost of goods.
Revenue less cost of goods sold is gross profit and as you can see
in this example your gross profit calculated under FIFO
is larger than your gross profit calculated using
the LIFO or AVCO methods.
But as a business owner this isn't necessarily a good thing.
High profits can mean high taxes which can negatively impact
your cash flow.
So if possible is worth considering the Last In First Out
or Average Cost methods.
In my next two videos we'll explore these.
You can subscribe to Accounting Stuff so you
don't miss out on those videos.
I'll drop both of them in the playlist over here as soon as they're done.
Like I said I've created a Cost Flow Assumptions Cheat Sheet
which you can find here as well.
See you soon.