Financial Accounting:
Overview of Inventory Valuation
In order to determine the value of inventory,
the quantity of goods is only half the calculation.
The other half is cost.
So quantity times cost equals total value of inventory.
So what is the cost of inventory items?
You will soon discover that is not an easy question to answer.
There are four methods to cost inventory:
specific-unit-cost
First-In, First-Out
Last-In, First-Out, and
average-cost.
A company can use any of these methods
to account for its inventory.
The specific-unit-cost method
is also known as the specific-identification method.
With this method,
a company knows exactly which items were sold
and exactly the cost of the item.
This costing method is best for businesses
that sell unique, easily identified inventory items,
such as real estate, cars, and jewels.
But any business that has low sales volume
and a wide range of prices and costs
could use this method.
This method uses the specific cost of each unit of inventory
to determine Cost of goods sold
and the value of the remaining items in inventory.
One of the things we will see over and over
with the topic of inventory valuation
is that we need to know the cost of inventory
so we can record the sale of goods journal entries as shown here.
So which method is best for businesses
that have high volume sales
and a very small range of prices and costs?
Well any of these three cost flow assumptions are fine.
These methods are cost flow assumptions
because we don't know, and are not tracking,
the exact items sold or the exact cost of the items sold.
Let me be clear by what I mean.
We know which items sold, let's say a gallon of milk.
But the exact gallon of milk,
and the exact cost of the one specific gallon of milk,
isn't something most businesses are going to track.
So they assume that the gallon sold was the first one purchased.
Or they assume the gallon sold was the last one purchased.
Or they assume the gallon sold
was some average of all of the gallons they had on hand.
That's how these cost-flow assumption methods are used.
Under FIFO, which stands for first-in, first-out,
With this inventory costing method,
the cost of goods sold is based on the oldest purchases:
so the First In is the First Out of the warehouse.
Under the FIFO method,
companies are assumed to sell their oldest inventory first,
therefore their ending inventory comes from their most recent purchases.
Most physical goods flow this way.
Almost every perishable item in a grocery store
physically moves like FIFO.
The oldest milk is in the front of the dairy case.
But that doesn't mean that all grocery stores
use FIFO to value their inventory.
They can use any method they want.
When a company makes a sale using FIFO,
the Cost of Goods Sold (COGS)
is assumed to be the oldest item purchased.
LIFO is the opposite of FIFO.
Under LIFO, which stands for Last-In, First-Out,
(this costing method)
ending inventory comes from the oldest costs,
meaning the first purchased in the period.
The cost of goods sold is based
on the most recent purchases (the newest costs).
And that is, the Last one In
is the First one Out of the warehouse (sold).
When a company makes a sale using LIFO,
the COGS is assumed to be the newest item purchased.
Under the Average-Cost inventory,
businesses compute an average cost per unit.
Ending inventory and cost of goods sold
are then based on the same average cost per unit.
Under the average-cost method,
an average price is calculated and applied to all goods.
Before we learn about why companies
choose one method over another,
let's recall that there are two methods to track inventory:
Perpetual and Periodic.
Since the perpetual method of tracking inventory
keeps a running total of inventory units and values,
the perpetual inventory record is often used to do this,
albeit automated nowadays.
The perpetual inventory record
tracks the purchases and sales of units at cost
and revalues ending inventory after each transaction.
We'll see this in detail when we look at the examples
of the different valuation methods.
So which method should we use to value inventory?
Well it depends.
FIFO is the most popular inventory costing method;
LIFO is the next most popular;
and, Average cost ranks third.
Here are the benefits of each.
During a period of rising prices,
and if we think of the history of prices,
they're always rising, if the range of time is big enough,.
So, during a period of rising prices,
FIFO results in the lowest COGS, the highest gross profit,
the highest net income and the highest ending inventory.
This is why it is the most popular method.
LIFO results in the highest COGS,
therefore the lowest gross profit,
lowest net income,
the lowest taxable income,
and the lowest ending inventory.
The tax benefit is why this the second-most popular method.
Average costs fall somewhere in between these two.
So if maximizing net income is most important, choose FIFO.
If minimizing taxable income is most important, choose LIFO.
And you choose Average if you want some benefits of both.
And that concludes this video
but I encourage you to watch the example videos
on calculating COGS and ending inventory
with FIFO, LIFO and Average Cost.
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