This is principlesofaccounting.com, Chapter 8, on Inventory.
In this particular module, we will look at the basic concepts of inventory costing.
FIFO, LIFO, weighted average methods.
This is a very important module.
Now let's start with the basics however.
The aggregation of the beginning inventory and
purchases gives us the goods available for sale.
Our challenge is then to take that total amount assigned to good available for
sale and decide how much is included in ending inventory for the balance sheet.
And how much should be reported as cost of goods sold on the income statement.
It's really an allocation problem.
The cost of goods available for
sale must be allocated either to cost of goods sold or to ending inventory.
Cost of goods sold appearing on the income statement sales minus cost of goods sold
getting you gross profit or ending inventory appearing on the balance sheet.
Before we look at the specific methods like FIFO and LIFO though, consider this.
If I allocate $1 more to cost of goods sold, through my costing methods, and
one dollar less to ending inventory, that's a necessary thing that occurs.
If what's available to allocate, if I place one dollar more here,
I necessarily place one dollar less there.
And by placing one dollar more in cost of goods sold,
that causes gross profit to be less.
Sales minus an increased cost of goods sold and giving less gross profit and
$1 less than the inventory would give me less on the balance sheet for
the asset inventory.
So, inventory's pushed down, profits are pushed down,
retained earnings is pushed down, balance sheet equality is maintained because.
Inventory's going down as are profits
if I were to shift that $1 from one category to the other.
Now, as we think about what costs to include in ending inventory,
it's important to remember that inventory should include all costs that are ordinary
and necessary to put the goods in place and in condition for resale.
This would include the invoice price, the freight cost.
That is freight in the cost that is necessary to bring it to its intended
condition for resale and similar items.
It does not include however carrying cost of inventory such as interest
that's incurred on financing inventory, storage, or insurance cost.
Those costs are expenses incurred.
They are not inventoriable type costs.
Also excluded are selling costs, freight outcost,
which is deemed to be a selling cost, salesman commissions and so on.
Those costs are also expensed as incurred.
Now, Costing Methods.
Each unit of inventory will not always have the same cost, as we buy or
acquire manufactured goods, there may be a different cost that's incurred per unit.
Therefor a company must adopt an inventory costing method
that is applied consistently from year to year to
allocate the cost of all of the units to the units that are in ending inventory and
the units that are actually sold, or cost of goods sold.
So this gives rise to certain cost flow assumption which are assumptions
of how costs are assigned to inventory.
It bears no relation to physical flow of goods.
If we're talking about milk, for example,
we could cost that milk inventory by FIFO or LIFO or an average cost method.
Even though selling that milk, we would probably try to sell it on a first in,
first out basis to get rid of the older stock and constantly keep the newer stock.
Hold it back until we clear the older stock out of the inventory.
But no matter how our physical flow is occurring such as I described for milk, we
could use any of these methods to assign the cost flow for accounting purposes.
Looking at First-In, First-Out or FIFO, the oldest cost,
the first in are matched against revenue and assigned to cost of goods sold first.
The recent purchases, those that are left over,
the most recent cost, is assigned to ending inventory.
Looking at an example, we had 0 beginning inventory.
These are nails, barrels of nails.
And we had three purchases during the period.
We bought 100 lbs of nails at $1, 100 lbs at $1.10, and 100 lbs at $1.20.
The total cost of all of our purchases was $330.
Our goods available for sale was $330.
When we allocated this on a first in first out basis,
we sold 160 pounds of this particular case.
What sold first was this red barrel at $1.
60 pounds out of the green barrel at $1.10.
That's our 160 lbs that were sold from the first units purchase,
the red and the green.
And we came up with costs of goods sold of 166.
The other amounts, the 40 lbs that remains from the green barrel and
the 100 lbs in the blue barrel even though the units are all commingled,
those amounts were signed in the inventory.
Conversely, Last-In, First-Out is just the opposite.
The recent costs are matched against revenue and
assigned to cost of goods sold, while the oldest purchases remain in inventory.
So here, we have the same purchases of barrels of nails,
three barrels at 100 lbs each at a different cost per lb.
When we assign our $330 of cost of goods available for
sale here we're taking the blue and the green first, that is the last in
is the first out and we're assigning that to cost of goods sold, its $186.
The ending inventory is from the earliest purchases during the period.
Last in, first out.
Last in, first out is uniquely a United States based accounting method.
Many parts of the world will not recognize or allow the LIFO method.
Finally, the weighted-average method is a blending of these two approaches.
An average unit cost is used to calculate the cost of goods sold and
ending inventory.
It's very simply determined by dividing total cost of goods available for
sale by total units.
So on our nail example, $330 was spent on 300 pounds of nails,
giving us an average cost of $1.10 per pound.
And with 176 pounds sold at $1.10, we had $176 in cost of goods sold.
And our ending inventory 140 pounds times the same $1.10 average cost
gave us $154 assigned to ending Inventory.
You might find it helpful, indeed I would encourage you to look at the textbook,
this very illustration is used in the textbook, and explained in there again.
And it probably would be helpful to actually sit down and really think about
the mathematics of what's happening with FIFO, LIFO and weighted average.
To recap, first, remember that beginning inventory and
purchases gives us cost of goods available for sale and that
amount of cost must be allocated either to ending inventory or cost of goods sold.
Second, accountants adopt a cost flow assumption to track those inventory costs
within the accounting system, whether that's FIFO, WIPO or average cost.
Third, the adopted cost flow assumption need not bear
any relation to the actual physical flow of goods.
The costing method is independent of the physical flow of goods.
To recap briefly then, with first in first out,
we have our beginning inventory in gold and our purchases in blue here.
Together that comprises our goods available for sale.
Under first in, first out, our cost of good sold includes those gold
units from beginning inventory, as well as some of the purchases.
What's an ending inventory?
It was from the very last purchases during the period.
LIFO is just the opposite.
Here we have the same beginning inventory and
purchases rolled together to give us goods available for sale.
The ending inventory is all gold.
It came from the beginning inventory in this case and
indeed a little bit of the beginning inventory is deemed to be liquidated along
with all the purchases in the period.
And the weighted average, what I try to show here is all of the cost gets blended
together for an average cost and that cost is then dispersed in both ending inventory
as well as our cost of goods sold.
In the next module, we will look at actual mathematical examples of applying FIFO,
LIFO, and average methods.