I'm Larry Walter.
This is principlesofaccounting.com, Chapter 8.
And we're going to continue,
in this module, looking at inventory costing methods.
We'll look at an actual example now of calculations related to FIFO,
LIFO and weighted average.
In this example, Gonzales Chemical Company had a beginning inventory balance that
consisted of 4,000 units, with a unit cost of $12 each.
During the period, we had a number of purchases and sales.
A physical count of inventory confirmed that 5,000
units were actually on hand at the end of the period.
And let's look at our schedule of purchases here.
So on January 1, we started with the 4,000 units.
We bought 6,000 units at $16 each on March 5th.
We sold 7,000 units with a selling price, not the cost, but
the selling price, of $22 per unit.
September 7th we bought 8,000 units at $17.
And November 11th, we sold 6,000 units at a selling price of $25 each.
So we started with 4,000 units, then we increased to 10,000.
Then we dropped down to 3,000.
And then we had a purchase that brought us back to 11,000, and
a sale that took us down, finally, to 5,000.
Now, no matter what costing method we use, FIFO, LIFO or weighted average,
we're gonna find that our sales, our total sales, are $304,000.
That is, we sold 7,000 units at $22 and
6,000 units at $25 each, giving us total sales of $304,000.
Sales are reported in the income statement.
Cost of goods sold and gross profit amounts are going to depend on the cost
flow assumption used by the company.
Looking first at FIFO, here we have calculations.
And what we see is we have beginning inventory, $48,000.
That's 4,000 units at $12 each.
We have purchases that total 232,000.
That is, 6,000 times 16 plus 8,000 times 17.
Cumulatively, that's 280,000 of costed goods available for
sale, consisting of these layers.
Our ending inventory, when we make our allocation of the $280,000,
when we allocate that between ending inventory and cost of goods sold,
we find 85,000 in ending inventory and 195,000 in cost of goods sold.
First in, first out.
The first layer, 4,000 at 12, is assumed to be sold.
Of the next layer, 6,000,
that 6,000 is all assumed to be sold, having a unit cost of $16.
And of our last layer of purchases, 8,000, 5,000 of that is our ending inventory.
Remember, by physical count, we determined we had 5,000 units.
The other 3,000 at $17 a unit is assigned a cost to goods sold.
So we sold 4, 6, and 3 at 12, 16, and 17, respectively.
We're left with 5,000 and
had a unit cost of $17 to come up with our ending inventory values.
And on the financial statements, then,
our ending inventory, 85,000 appears on the balance sheet.
Our cost of goods sold of 195,000 appears on the income statement.
Here, I've gone to the extra trouble of showing beginning inventory, 48,000,
plus purchases, 232, to give us our cost of goods available for sale,
280, minus our ending inventory that we determined with our calculations under
FIFO at $85,000, to gives us the $195,000 cost of goods sold.
The sales, 304, minus the 195 gives me the $195,000 gross profit under FIFO.
But let's see what happens under LIFO.
We've got the same beginning inventory, the same purchases,
the same goods available for sale.
The difference here is that we're going to assign $64,000 ending inventory and
$216,000 to cost of goods sold.
The ending inventory, last in, first out.
The last 8,000 purchases assigned to cost of goods sold,
the 5,000 before that is assigned to cost of goods sold.
Of the 5,000 that are in ending inventory is the 1,000 at 16 and the 4,000 at 12.
So it totals to a much lower ending inventory number.
Its the older, cheaper cost.
Here we had increasing cost.
The old, cheap cost stayed in ending inventory.
On the balance sheet, we'll have 64,000 in inventory.
On the income statement, we'll have 216,000 in cost of goods sold.
Again, I know we're going fairly quickly on this video.
These examples, these same examples, are in the textbook for
you to look at in more detail.
The weighted average method takes a little bit different tack.
We'll look at our $280,000 of cost of goods available for sale,
divided by a total of 18,000 units.
That's 4,000 from the beginning inventory plus purchase of 6 and
8, respectively, 18,000 units.
We get an average cost of 15.5555 cents per unit.
I asked you here not to round your calculations because oftentimes
you're multiplying pennies times millions of units.
It adds up to real money, so it's best to carry your decimal out
quite a ways when you're doing your weighted average calculations.
Our 5,000 units in ending inventory, at that per unit price of 15.5555,
gives us ending inventory of $77,778.
And our cost of goods sold, 13,000 times that same per unit price.
Again, the sum total of these two amounts would equal our 280,000 goods available
for sale.
And that appears on the balance sheet as our inventory, and
the 202,222 on the income statement as costs of goods sold.
In comparison here, notice what we have.
Sales are the same under each of the three methods,
cost of goods sold is different and gross profit is different.
There's a generalization here.
During a period of rising prices, LIFO gives us lower inventories and
lower profits.
FIFO gives us higher inventories and higher profits.
That's logical because the higher,
cheaper, more recent costs remain in inventory under FIFO.
Weighted average typically falls in between those two, as you might expect.
Why would anybody consider LIFO?
Well, that's probably driven by a tax consideration in the United States.
Lower profits means a lower tax bill.
Be aware that LIFO conformity rules generally say that if you're going to use
LIFO for tax, you're also required to use it for accounting.
That's a little bit unusual that the tax law is concerned about what you do for
financial accounting.
Oftentimes, they're seen as two different topics entirely.
And in many countries, LIFO is not permitted at all.
There are some conceptual arguments.
LIFO matches recent revenues with the recent costs, maybe producing a better
matching of revenues and expenses and a better determination of income.
However, FIFO places those more recent, relevant cost on the balance sheet.
The old, cheap costs that you might see on a balance sheet using LIFO, may or
may not signal very much about what the worth could be of the inventory held by
the company.
Whatever inventory is used,
it must be clearly communicated in the financial statements.
LIFO companies may detail what inventory cost would be if FIFO was used.
And whatever method is used, it should be used consistently.
Finally, there's a a fourth method.
Specific identification may be used for automobiles or furs or jewelry or
something like that, where every unit is unique, and each unit has a separate cost.
And it's worth the trouble to keep up with the cost by serial number, for
example, on a particularly expensive item of inventory.
So when that unit is sold, you would find the cost for
the specific unit that was sold, and make the matching accordingly.
It requires tedious record keeping.
Maybe not such a big deal in this day and time with good computer systems.
Probably well worth the trouble if you have high dollar inventory.
It's typically only used for
inventories of uniquely identifiable goods that have a fairly high per-unit cost,
as I've indicated already, such as automobiles and jewelry.
So this concludes our look at the calculations under FIFO and LIFO using
a periodic system, where we waited till the end of the period, and then calculated
our ending inventory, and calculated our cost of goods sold and gross profit.
In the next module, we will look at these same methods, but considering them under
a perpetual and alternative process for managing this data flow.