Here’s an example of inventory cost accounting using the average cost method. We will do
the inventory accounting for a fictitious company called Toy Giraffe Inc, a company
buying and selling toy giraffes. In the first quarter of the year, Toy Giraffe
Inc is building up its inventory. In January, they buy 100 units (packed in 2 boxes of 50
units each) at $5 per unit. In February, 200 units (4 boxes of 50 units) at $6 per unit.
In March, another 100 units (2 boxes of 50 units) at $7 per unit. The cost per unit for
buying these toy giraffes is going up fast. The Q1 ending inventory is 400 units at a
total purchase price of $2400, so on average $6 per unit. In the warehouse, the company
does not specifically identify the boxes, they just stack them on a big pile. The same
goes for cost accounting and inventory valuation using the average cost method: stack the boxes
on a big pile, and blend the weighted average cost together. $6 average cost per unit is
all we need to remember going into Q2! We can now perform the cost accounting for
the next few months, where we start selling the boxes of toy giraffes. AVCO means average
cost. The ending inventory of Q1 is the beginning inventory of Q2: 400 units at $6 each, $2400
of inventory value in total. The first box of toy giraffes (50 units) is sold in April.
We will do the income statement accounting vertically, in the middle, and the inventory
accounting horizontally. Revenue is 50 times $10 is $500. Cost Of Goods Sold (or COGS)
is 50 units times $6 average cost per unit is $300, and Gross Profit is $200 (50 times
$4 per unit). 350 units (beginning inventory minus units sold) remain in inventory at the
end of April, at the average cost of $6 per unit, so $2100 of inventory value.
The ending inventory of April is the beginning inventory of May. Two boxes of toy giraffes
are sold in May. In the income statement for May, revenue is 100 units times $10 = $1000,
Cost Of Goods Sold (or COGS) is 100 units times $6 = $600, and Gross Profit is $400.
The remaining 250 units (beginning inventory minus units sold) go into the ending inventory,
at the average cost of $6 per unit, so $1500 of inventory value.
The ending inventory of May is the beginning inventory of June. Four boxes of toy giraffes
are sold, sales are really picking up the pace. Revenue for June is 200 units times
$10 = $2000, Cost Of Goods Sold (or COGS) is 200 units times $6 = $1200, and Gross Profit
200 times $4 = $800. The remaining 50 units go to the ending inventory, once again at
the average cost of $6 per unit, so $300 of ending inventory value. It is useful to perform
a physical count at the end of the quarter, to verify that the expected number of inventory
units shown in the accounting system is physically there.
The average cost method for inventory accounting is very simple, especially for companies that
deal with large volumes of very similar items. Average costing requires minimal work to apply
and is, therefore, the least expensive of all the inventory cost accounting methods.
The average cost inventory method blends all purchases together, and comes up with one
number per unit to apply in both Cost Of Good Sold in the income statement and inventory
valuation on the balance sheet. What is the difference between the average
cost method on one side and FIFO/LIFO on the other side? The average cost inventory method
blends all purchases together, and comes up with one number. FIFO and LIFO are cost accounting
fictions that use a concept called inventory layering. For cost accounting and inventory
valuation purposes, when using FIFO or LIFO, the company needs to keep track of the timing
of the buys and the unit cost. Let me show you how that works.
The visual representation of the FIFO inventory flow is at the top, LIFO is at the bottom.
The first box of toy giraffes (50 units) is sold in April. With FIFO, First In First Out,
we assume that the oldest inventory gets sold first: one of the boxes purchased in January.
With LIFO, Last In First Out, we assume that the newest inventory gets sold first: one
of the boxes purchased in March. Two boxes of toy giraffes are sold in May.
With FIFO, First In First Out, we assume that the oldest inventory gets sold first: the
last of the boxes purchased in January, and one of the boxes bought in February. With
LIFO, Last In First Out, we assume that the newest inventory gets sold first: the last
of the boxes purchased in March, and one of the boxes bought in February.
Four boxes of toy giraffes are sold in June. With FIFO, we assume that the oldest inventory
gets sold first: the remaining three boxes bought in February, and one of the boxes purchased
in March. What stays in inventory at quarter end under FIFO, is one box purchased in March.
With LIFO, we assume that the newest inventory gets sold first: the remaining three boxes
bought in February, and one of the boxes purchased in January. What stays in inventory at quarter
end under LIFO, is one box purchased all the way back in January.
Why would we care which month the box comes from? Because it impacts the ending inventory
value on the balance sheet, and profitability in the income statement, that’s why! When
applying FIFO, the ending inventory in June is 50 units valued at $7 per unit: $350. The
ending inventory value under FIFO in this example is $50 higher than that under the
average cost method. And if the inventory value is $50 higher, then the Cost of Goods
Sold (the offset) is $50 lower. When applying LIFO, the ending inventory in
June is 50 units valued at $5 per unit: $250. The ending inventory value under LIFO in this
example is $50 lower than that under the average cost method. And if the inventory value is
lower, then the Cost of Goods Sold (the offset) is $50 higher.